Key Points

An open economy is one that interacts with other countries through trade in goods and services (Output Market), financial assets (Financial Market), and to some extent, labor (Labour Market).

The Balance of Payments is a systematic record of all economic transactions between the residents of a country and the rest of the world over a specific time period, typically a year.

The BoP has two main accounts: the Current Account, which records trade in goods, services and transfers, and the Capital Account, which records transactions of assets.

The Current Account records exports and imports of goods and services, as well as transfer payments like gifts and remittances. A surplus means the nation is a lender, while a deficit means it is a borrower.

The Balance of Trade is the difference between the value of a country's exports of goods and its imports of goods. It is a key component of the Current Account.

The Capital Account records all international transactions of assets, such as money, stocks, bonds, and government debt. It includes Foreign Direct Investment (FDI) and external borrowings.

Autonomous transactions are made for reasons like profit, independent of the BoP status. Accommodating transactions, like official reserve sales, are made to cover a deficit or surplus in autonomous transactions.

The foreign exchange rate is the price of one currency in terms of another. It links the currencies of different countries and enables international trade and investment.

People demand foreign exchange to purchase goods and services from other countries, to send gifts abroad, or to purchase financial assets in another country.

Foreign currency flows into a country through exports, when foreigners send gifts or transfers, or when they purchase assets in the home country.

A flexible or floating exchange rate is determined purely by the market forces of demand and supply for a currency, without any intervention from the central bank.

In a fixed exchange rate system, the government or central bank fixes the exchange rate at a particular level and intervenes in the market to maintain that rate.

Also known as dirty floating, this is a hybrid system where the exchange rate is largely market-determined, but the central bank intervenes to moderate excessive fluctuations.

Depreciation is a decrease in the value of a currency under a flexible exchange rate system due to market forces. Devaluation is a deliberate downward adjustment of a currency's value by the government in a fixed exchange rate system.

Appreciation is an increase in the value of a currency under a flexible exchange rate system due to market forces. Revaluation is a deliberate upward adjustment of a currency's value by the government in a fixed exchange rate system.

PPP is a long-run theory suggesting that exchange rates will adjust so that an identical product will cost the same in different countries when expressed in a common currency.

These are transactions carried out by the central bank, involving the sale or purchase of foreign currencies from its reserves, to manage the balance of payments and influence the exchange rate.

The open economy multiplier is smaller than the closed economy multiplier because a portion of any increase in income is spent on imports, which is a leakage from the circular flow of domestic income.