Open Economy Macroeconomics

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Economics Class XII (Introductory Macroeconomics), Chapter 6.

Why does the price of a dollar matter to you?

A phone made in China, a software contract signed in Bengaluru for a client in the US, a cousin's tuition fee in London, a remittance from Dubai: every one of these crosses a border and needs a currency swap. Add up all such transactions for a year and you get the balance of payments. The price at which the swap happens is the exchange rate. This chapter answers two questions that CUET asks again and again. How do we record a country's dealings with the world? And what decides the price of foreign money?

What makes an economy open

A closed economy has no links with the rest of the world. Real economies are open, and they connect through three channels.

This chapter works with the first two. Trade in goods has traditionally been seen as a substitute for the movement of labour. Foreign trade also changes aggregate demand in two ways. When Indians buy foreign goods, the spending leaks out of the circular flow and reduces demand for domestic output. When foreigners buy Indian exports, it is an injection that raises demand for domestic output.

Money is a problem across borders because no single bank issues an international currency. Foreigners accept a national currency only if its purchasing power stays stable. Governments once earned that trust by promising to convert their currency at a fixed price into gold or another currency. As trade grew, gold stopped being the asset into which currencies were converted. What matters in a transaction today is the currency in which the trade is settled. An Indian buying a good priced at 10 dollars needs to know the price of a dollar in rupees, which is the foreign exchange rate.

The balance of payments: a country's bank statement

The balance of payments (BoP) records transactions in goods, services and assets between residents of a country and the rest of the world over a period, typically a year. It has two main accounts, the current account and the capital account, plus a small item for errors and omissions.

Credit and debit. A credit entry brings foreign exchange into the country. A debit entry sends it out.

Inside the current account. The current account has two components. Balance of trade (BoT), also called the trade balance, is exports of goods minus imports of goods. It is in surplus if the country exports more goods than it imports and in deficit otherwise. Net invisibles are the difference between exports and imports of invisibles: services, transfers and income flows. Services include factor income (net earnings on labour, land and capital abroad) and non-factor income (shipping, banking, tourism, software). Transfers are receipts that residents get for free without giving any goods or services, such as gifts, remittances and grants, whether from governments or private citizens abroad.

$$\text{BoT} = \text{Exports of goods} - \text{Imports of goods}$$

$$\text{Current account balance} = \text{BoT} + \text{Net invisibles}$$

The capital account. An asset is any form in which wealth can be held. Buying an asset abroad is a debit; selling one to foreigners is a credit. The capital account is in balance when inflows (loans received from abroad, sale of assets or shares) equal outflows (repayment of loans, purchase of assets or shares abroad).

Beyond the textbook. For the exam: the BoP has a current account and a capital account. In reality: following the International Monetary Fund's newer accounting standard, the Reserve Bank of India also splits the BoP into three accounts: current, financial and capital. Trade in financial assets such as bonds and shares moves to the financial account. The RBI still publishes the older two-account version as well. Why it matters: if a question is based on the two-account structure, answer from it. The three-account version is the same information filed differently.

How BoP balances: financing a deficit

A country with a current account deficit spends more abroad than it earns, like a person who spends more than her income. It must pay the difference by selling assets or borrowing abroad. A current account deficit is therefore financed by a net capital inflow, a capital account surplus.

$$\text{Current account} + \text{Capital account} \equiv 0$$

When the two offset exactly, the BoP is in equilibrium and no reserves move. The alternative is for the central bank to use its official reserves of foreign exchange to bridge the gap. The RBI sells foreign exchange when there is a deficit. This is an official reserve sale. A fall in official reserves is the overall BoP deficit, and a rise is the overall BoP surplus. The monetary authorities are the ultimate financier of a deficit, or the recipient of a surplus.

Autonomous and accommodating transactions. Why does reserve change decide the overall balance? Because of how transactions are classified.

Official reserve transactions are the accommodating item. Everything else is autonomous. They matter more under fixed exchange rates than under floating rates.

Finally, errors and omissions is a balancing item that reflects the difficulty of recording every international transaction accurately.

Worked example: reading a BoP statement. Here is a sample BoP in USD million. Find the trade balance, current account balance, capital account balance and the value of errors and omissions needed for the overall balance to be zero.

The country has a trade deficit and a current account deficit, matched by a capital account surplus, so the BoP is in balance and reserves do not change.

Common wrong step. Reading a trade deficit of −90 as the BoP deficit. The trade balance covers goods only. The BoP balance includes invisibles, the capital account and errors and omissions.

Worked example: a BoP deficit and the reserves. Exports of goods are USD 200 million, imports of goods USD 260 million and net invisibles are +USD 30 million. The capital account shows a net inflow of USD 20 million, and errors and omissions are zero. What is the overall balance and what happens to reserves?

Common wrong step. Saying the BoP is in surplus because the capital account is positive. Only the overall balance counts. The capital inflow covered two thirds of the current account deficit, and the rest had to come out of reserves.

Pause and predict: an Indian software firm earns USD 5 million from a client in the United States. Which account records it, as credit or debit, and does it enter the balance of trade?

Check your answer: it is a credit in the current account, under non-factor services (an invisible). It does not enter the balance of trade, which counts only goods.

Beyond the textbook. For the exam: a current account deficit is financed by a capital account surplus, or by running down reserves. In reality: whether a deficit is worrying depends on its size and on what finances it. Long-term investment such as FDI is a more stable source than short-term borrowing or portfolio flows, which can reverse quickly. Why it matters: the same deficit figure can be comfortable or risky depending on how it is financed, so never answer a "should a deficit alarm us" question with a flat yes or no.

The foreign exchange market and the exchange rate

The market in which national currencies are traded for one another is the foreign exchange market. Its main participants are commercial banks, foreign exchange brokers, other authorised dealers and monetary authorities, and it is worldwide. The exchange rate (forex rate) is the price of one currency in terms of another. If you pay ₹50 for 1 dollar, the exchange rate is ₹50 per dollar. To keep things simple, assume the world has only India and the US, so there is one exchange rate.

Demand for foreign exchange comes from three needs: buying goods and services from abroad, sending gifts abroad, and buying foreign financial assets. When the price of foreign exchange rises, foreign goods cost more in rupees, so imports and hence the demand for foreign exchange fall. The demand curve slopes downward.

Supply of foreign exchange comes from exports (foreigners buying our goods), gifts and transfers received, and foreigners buying our assets. When the price of foreign exchange rises, Indian goods become cheaper for foreigners, so exports tend to rise and supply increases. The supply curve slopes upward, although whether supply actually rises depends on the elasticity of demand for exports and imports.

Three exchange rate systems

Flexible exchange rate. The rate settles where the demand curve cuts the supply curve. In the schedule below, the exchange rate is in ₹ per dollar and quantities are in USD million.

Initially demand equals supply at ₹50 (USD 100 million). Suppose Indians travel abroad more, so demand for dollars shifts to the right at every rate. At ₹50 there is now excess demand (150 against 100), so the price of the dollar is bid up. The new equilibrium is at ₹60, where demand and supply are both USD 130 million.

Worked example: depreciation or appreciation? Using the schedule, the rate moves from ₹50 to ₹60 per dollar. Describe what happens to each currency and by how much.

Common wrong step. Saying the rupee strengthened because the number went up from 50 to 60. The number is the rupee price of a dollar. A higher number means the rupee buys less foreign exchange. Also note the two percentages differ: the dollar rises 20% while the rupee falls only about 16.7%.

Short-run factors that move the rate.

If bonds in country A pay 8% and equally safe bonds in country B pay 10%, the interest differential is 2 percentage points. Investors move funds to B, so A's currency depreciates and B's appreciates.

Pause and predict: interest rates in India rise while those in the US stay the same. With no restrictions on buying bonds, what happens to the rupee in the short run?

Check your answer: it tends to appreciate. Foreign investors want rupee bonds, so demand for rupees rises, and Indian investors buy fewer dollar bonds, so the supply of rupees offered falls.

Purchasing power parity. In the long run, the purchasing power parity (PPP) theory says that without barriers to trade (tariffs, quotas) and apart from transport costs, a product should cost the same in every country when measured in a common currency. Exchange rates adjust to reflect differences in price levels.

Worked example: PPP and the real exchange rate. A phone costs ₹30,000 in India and 400 dollars in the US. Find the PPP rate. Then prices rise 10% in India and 20% in the US. Find the new PPP rate. Finally, if the actual rate is ₹80 per dollar, find the real exchange rate for a basket that costs ₹2,000 in India and 50 dollars in the US.

Common wrong step. Expecting the currency of the country with higher inflation to strengthen because its prices are higher. Higher prices make its goods less competitive, so to keep trade in balance the value of its currency in foreign money must fall. Its currency depreciates.

The nominal exchange rate is the price of one currency in terms of another. The real exchange rate adjusts for price levels and is the relative price of foreign goods in terms of domestic goods. It is the more relevant rate when deciding whether to buy a domestic or a foreign good.

Beyond the textbook. For the exam: in the long run, exchange rates adjust so the same product costs the same everywhere. In reality: PPP is a long-run guide, not a day-to-day predictor. Many goods and services (haircuts, rents) are not traded across borders at all, so their price gaps do not get arbitraged away. Why it matters: use PPP to predict the direction of long-run pressure, and use demand and supply to explain actual daily movements.

Fixed exchange rate and intervention. Here the government fixes the rate at a chosen level. In the schedule above the market rate is ₹50. Suppose the government wants to encourage exports and fixes a higher rate of ₹70 per dollar, making the rupee cheaper for foreigners. At ₹70, demand is USD 60 million and supply USD 160 million, so there is an excess supply of dollars.

Worked example: defending a fixed rate. Use the schedule to find what the RBI must do at ₹70, and what it must do if it fixes the rate at ₹40.

Common wrong step. Believing a government can hold any rate for free. A rate above the market rate piles up reserves, and a rate below the market rate drains them.

In a fixed system, a government action that raises the exchange rate (cheapens the home currency) is devaluation. A government action that lowers the rate (makes the home currency costlier) is revaluation.

Fixed or flexible: which is better?

A speculative attack is aggressive buying of a currency that forces the government to devalue. Such attacks were seen before the collapse of the Bretton Woods system. Without any formal agreement, the world has since moved to managed floating: a mixture of float and fixed in which central banks buy and sell currencies to moderate movements when they think it appropriate.

The open economy multiplier

In a closed economy $Y = C + I + G$. With trade, exports add demand for our goods and imports are the part of demand that falls on foreign goods.

$$Y = C + I + G + X - M$$

Net exports $NX = X - M$. Positive $NX$ is a trade surplus and negative $NX$ is a trade deficit. Imports depend positively on domestic income and negatively on the real exchange rate. Exports depend on foreign income (taken as given for us) and positively on the real exchange rate. With the price levels and nominal exchange rate fixed, imports are

$$M = \overline{M} + mY$$

Here $m$ is the marginal propensity to import, the fraction of an extra rupee of income spent on imports. Substituting and collecting the autonomous items into $\overline{A}$ gives

$$Y^{*} = \dfrac{\overline{A}}{1 - c + m}, \qquad \text{open economy multiplier} = \dfrac{1}{1 - c + m}$$

Because $m > 0$, the multiplier is smaller than the closed economy value $\dfrac{1}{1-c}$. Why: in each round of spending, part of the extra consumption falls on foreign goods. Imports are an additional leakage from the circular flow of domestic income, so less is passed on as demand for domestic output. Exports and the autonomous part of imports are extra autonomous items. A rise in exports adds to income by $\dfrac{1}{1-c+m}$ per rupee, and a rise in autonomous imports reduces income by the same multiple.

Worked example: open versus closed. An economy has $C = 60 + 0.75(Y - T)$, $T = 40$, $I = 80$, $G = 60$, $X = 70$ and imports $M = 30 + 0.15Y$. Find equilibrium income, the trade balance, the multiplier, and the effect of a rise in exports of 20.

Common wrong step. Using the closed economy multiplier of 4. That would give a rise of 80 and ignore the leakage to imports. Notice also that although income rose, net exports improved by only 12.5 (the 20 extra exports minus 7.5 extra imports induced by the higher income).

Exam traps

Formula sheet

60-second revision

Where this chapter connects

• Previous: Government Budget and the Economy covers the budget and deficits that interact with the external account.
• Related: Determination of Income and Employment builds the closed economy multiplier that imports reduce.
• Related: National Income Accounting introduces net exports and factor income from abroad.
• Related: Money and Banking explains the RBI, which holds the official reserves.