Open Economy Macroeconomics

2.1 Core concepts

• An open economy interacts with other countries through three channels — output market (trade in goods and services), financial market (trade in financial assets) and labour market (movement of workers, restricted by immigration laws). (NCERT §intro, p. 85)
• Foreign trade influences Indian aggregate demand in two ways: imports are a leakage from the circular flow (decreasing aggregate demand) and exports are an injection (increasing aggregate demand for domestically produced goods). (NCERT §intro, p. 86)
• Because there is no single international currency issued by a single bank, foreign agents accept a national currency only if its purchasing power is stable; the international monetary system was set up to ensure this stability. (NCERT §intro, p. 86)
• The price of one currency in terms of another is the foreign exchange rate (or exchange rate). (NCERT §intro, p. 86)
• Balance of Payments (BoP) records the transactions in goods, services and assets between residents of a country and the rest of the world for a specified time period, typically a year; it has two main accounts — the current account and the capital account. (NCERT §6.1, p. 86)
• Current Account is the record of trade in goods and services and transfer payments; trade in services covers factor income (labour, land, capital) and non-factor income (shipping, banking, tourism, software etc.); transfers are receipts got 'free' such as gifts, remittances and grants. (NCERT §6.1.1, p. 87)
• Current account is in balance when receipts equal payments; a surplus means the nation is a lender to other countries and a deficit means it is a borrower. (NCERT §6.1.1, p. 87)
• Balance of Current Account has two components — Balance of Trade (BoT) and Balance on Invisibles. BoT is the difference between value of exports and value of imports of goods; export of goods is a credit item and import of goods is a debit item. (NCERT §6.1.1, p. 87)
• Net Invisibles is the difference between value of exports and value of imports of invisibles — services (factor + non-factor income) and transfers and flows of income. (NCERT §6.1.1, p. 88)
• Capital Account records all international transactions of assets (money, stocks, bonds, government debt). Purchase of assets abroad is a debit item; sale of domestic assets to foreigners is a credit item. Items include FDIs, FIIs, external borrowings and external assistance. (NCERT §6.1.2, p. 88)
• BoP equilibrium: Current account + Capital account ≡ 0; a current account deficit must be financed by a capital account surplus, i.e. a net capital inflow. (NCERT §6.1.3, p. 89)
• Alternatively, the central bank uses its foreign exchange reserves to balance any deficit — selling foreign exchange when there is a deficit (official reserve sale). A decrease in official reserves is an overall BoP deficit; an increase is an overall BoP surplus. (NCERT §6.1.3, p. 89)
• Autonomous transactions are made for reasons other than to bridge the BoP gap (e.g. to earn profit) — these are 'above the line' items. BoP is in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments. (NCERT §6.1.3, p. 89)
• Accommodating transactions ('below the line') are determined by the gap in the BoP; official reserve transactions are the accommodating item. (NCERT §6.1.3, p. 89)
• Errors and omissions form a third element of BoP, reflecting the difficulty of recording every international transaction accurately. (NCERT §6.1.3, p. 89)
• Foreign exchange market is the market in which national currencies are traded for one another; major participants are commercial banks, foreign exchange brokers, other authorised dealers and monetary authorities — the market is world-wide. (NCERT §6.2, p. 91)
• Demand for foreign exchange arises to purchase foreign goods and services, to send gifts abroad, and to purchase foreign financial assets; a rise in the price of foreign exchange reduces demand for imports, hence demand for foreign exchange falls. (NCERT §6.2.1, p. 91)
• Supply of foreign exchange arises from exports (foreigners buying domestic goods/services), foreign transfers/gifts received, and foreigners buying home-country assets; a rise in price of foreign exchange tends to increase exports and hence supply (subject to elasticities). (NCERT §6.2.1, pp. 91–92)
• Flexible (floating) exchange rate is determined by market forces of demand and supply; in a completely flexible system, central banks do not intervene. A rise in exchange rate means rupee depreciation; a fall means rupee appreciation. (NCERT §6.2.2, p. 92)
• Speculation, interest rate differentials and income changes are short-run determinants — higher home interest rates appreciate the domestic currency; faster growth in domestic aggregate demand than the world's tends to depreciate the domestic currency. (NCERT §6.2.2, p. 93)
• In the long run, the Purchasing Power Parity (PPP) theory predicts that exchange rates adjust so the same product costs the same across countries, reflecting differences in price levels. (NCERT §6.2.2, p. 93)
• Fixed exchange rate is set by the government. If the fixed rate is above the market rate, supply of dollars exceeds demand and RBI absorbs the excess by buying dollars (accumulating reserves); if it is below, the government withdraws from past dollar holdings to meet excess demand. (NCERT §6.2.2, p. 94)
• Devaluation: in a fixed exchange rate system, a government action that increases the exchange rate (makes domestic currency cheaper). Revaluation: a government action that decreases the exchange rate (makes domestic currency costlier). (NCERT §6.2.2, p. 94)
• Fixed exchange rate systems require credibility and large reserves and are prone to speculative attacks; flexible systems automatically take care of BoP surpluses/deficits and give countries independence in monetary policy. (NCERT §6.2.3, p. 95)
• Managed floating ("dirty floating") is a mixture of flexible and fixed systems — central banks intervene to moderate exchange rate movements when appropriate; official reserve transactions are therefore not equal to zero. (NCERT §6.2.4, p. 95)

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

• Fig. 6.1, p. 87 — Components of Current Account: trade in goods (exports/imports) + trade in services (factor income, non-factor income) + transfers (gifts, remittances, grants).
• Fig. 6.2, p. 88 — Components of Capital Account: FDIs, FIIs, external borrowings, external assistance.
• Table 6.1, p. 90 — Sample BoP for India in million USD; shows trade deficit (–90), invisibles (+52), current account deficit (–38), capital account surplus (+41.15), errors and omissions (+3.15), overall balance = 0, reserves change = 0.
• Equilibrium under Flexible Exchange Rates, p. 92 — D and S curves intersect at exchange rate e and quantity q of dollars.
• Fig. 6.2, p. 92 — Effect of an increase in demand for imports: demand curve shifts right; equilibrium exchange rate rises from e0 = 50 to e1 = 70 (rupee depreciates).
• Fig. 6.3, p. 94 — Foreign exchange market with fixed exchange rates; at e1 > e there is excess supply of dollars (AB) absorbed by RBI.

2.5 Key formulas

2.4 Common confusions / NTA trap points

• Balance of Trade vs Balance on Current Account: BoT is only goods; current account = BoT + Net Invisibles (services, transfers, income). (p. 87)
• Depreciation/Appreciation (flexible system, market-driven) vs Devaluation/Revaluation (fixed system, government-driven). (pp. 92, 94)
• Autonomous (above-the-line, independent of BoP) vs Accommodating (below-the-line, official reserve transactions to bridge the gap). (p. 89)
• Sign convention in BoP: imports of goods, purchase of foreign assets and decrease in receipts are debit items; exports, sale of domestic assets to foreigners are credit items. (pp. 87–88)
• Official reserves and BoP: decrease in official reserves indicates overall BoP deficit; increase indicates surplus — the sign reverses from intuition. (p. 89)