Chapter Notes

Open Economy Macroeconomics

An open economy is one that interacts with other countries. Unlike a closed economy, which has no links to the rest of the world, most modern economies trade goods, services, and financial assets internationally.

These global linkages happen in three main ways:

• Output Market: Countries can trade goods and services with each other. This gives consumers and producers a wider choice between domestic and foreign products.
• Financial Market: People and institutions can buy financial assets (like stocks and bonds) from other countries, allowing investors to diversify their portfolios.
• Labour Market: Companies can choose where to set up production, and workers can choose where to work, although this is often restricted by immigration laws.

This chapter will focus on the first two linkages: the output and financial markets.

Foreign trade affects a country's aggregate demand in two important ways:

1. Imports as a Leakage: When residents buy foreign goods, that money leaves the country's circular flow of income. This is considered a leakage and decreases aggregate demand for domestic goods.
2. Exports as an Injection: When foreigners buy a country's goods, money flows into the country. This is an injection into the circular flow and increases aggregate demand for domestically produced goods.

International transactions require a system for exchanging currencies. The price of one currency in terms of another is called the foreign exchange rate, or exchange rate.

The Balance of Payments

The balance of payments (BoP) is a systematic record of all economic transactions between the residents of a country and the rest of the world over a specific period, usually a year. The BoP has two main accounts: the current account and the capital account.

Current Account

The Current Account records transactions related to the trade of goods and services, as well as transfer payments. Its main components are:

• Trade in Goods: This includes the export and import of physical goods (like cars, machinery, and clothes).
• Trade in Services: This includes payments for services. It is further divided into:
  • Factor Income: Earnings from factors of production, such as rent, interest, profit, and wages earned from abroad.
  • Non-factor Income: Payments for services like shipping, banking, tourism, and software services.
• Transfer Payments: These are "free" receipts or payments where no goods or services are exchanged. They include gifts, grants, and remittances sent by citizens living abroad.

Balance on Current Account

The current account is in balance when its receipts equal its payments.

• A Current Account Surplus (Receipts > Payments) means the nation is a net lender to the rest of the world.
• A Current Account Deficit (Receipts < Payments) means the nation is a net borrower from the rest of the world.

The Balance on Current Account has two key parts:

• Balance of Trade (BOT): This is the difference between the value of a country's exports of goods and its imports of goods. It is also called the Trade Balance. A trade surplus occurs when exports are greater than imports, while a trade deficit occurs when imports are greater than exports.
• Balance on Invisibles: This is the difference between the value of exports and imports of services, transfers, and income flows.

Capital Account

The Capital Account records all international transactions of assets. An asset is any form in which wealth can be held, such as money, stocks, bonds, or government debt.

• Debit Item (Outflow): A purchase of a foreign asset is a debit on the capital account because it causes foreign currency to flow out of the country.
• Credit Item (Inflow): A sale of a domestic asset to a foreigner is a credit on the capital account because it brings foreign currency into the country.

Key components of the capital account include Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), and external borrowings.

Balance on Capital Account

The capital account is in balance when capital inflows equal capital outflows.

• A surplus in the capital account occurs when inflows are greater than outflows.
• A deficit in the capital account occurs when inflows are less than outflows.

Balance of Payments Surplus and Deficit

In principle, a country must finance any deficit. If a country has a current account deficit (it spends more abroad than it earns), it must finance this by having a capital account surplus (by selling assets or borrowing from abroad).

Therefore, the sum of the current and capital accounts should be zero: Current account + Capital account ≡ 0

When a current account deficit is perfectly matched by a net capital inflow (international lending), the country is in balance of payments equilibrium.

However, sometimes there is an overall deficit or surplus. In this case, the country's central bank intervenes by using its foreign exchange reserves.

• Overall BoP Deficit: If there is a deficit, the central bank sells foreign exchange from its reserves. This is called an official reserve sale.
• Overall BoP Surplus: If there is a surplus, the central bank buys foreign exchange, adding to its reserves.

Autonomous and Accommodating Transactions

Economic transactions can be classified as either autonomous or accommodating.

• Autonomous Transactions: These are international economic transactions made for reasons independent of the BoP, such as to earn a profit. For example, a company exporting goods to make money. These are called 'above the line' items. The balance of these transactions determines if the BoP is in surplus or deficit.
• Accommodating Transactions: These transactions are determined by the state of the BoP. They are meant to cover the deficit or surplus arising from autonomous transactions. Official reserve transactions are the primary example of accommodating items, as they "accommodate" the gap. These are called 'below the line' items.

Errors and Omissions

Since it is very difficult to record every single international transaction accurately, a third component called errors and omissions is included in the BoP to ensure the accounts balance.

The Foreign Exchange Market

The foreign exchange market is the market where national currencies are traded for one another. Major participants include commercial banks, foreign exchange brokers, and monetary authorities like the central bank.

Foreign Exchange Rate

The Foreign Exchange Rate (or Forex Rate) is the price of one currency in terms of another. It connects the currencies of different countries, allowing for the comparison of international costs and prices.

Demand for Foreign Exchange

People demand foreign currency for several reasons:

• To buy goods and services from other countries (imports).
• To send gifts or make transfers abroad.
• To purchase financial assets in another country.

There is an inverse relationship between the price of foreign exchange and the quantity demanded. If the price of a foreign currency rises, foreign goods become more expensive, leading to lower demand for imports and thus a lower demand for foreign currency.

Supply of Foreign Exchange

Foreign currency flows into a country for the following reasons:

• When foreigners purchase the country's goods and services (exports).
• When foreigners send gifts or make transfers to the country.
• When foreigners buy domestic assets.

Generally, a rise in the price of foreign exchange makes domestic goods cheaper for foreigners. This can increase exports, leading to a greater supply of foreign exchange.

Determination of the Exchange Rate

Countries use different systems to determine their exchange rates. The main types are flexible, fixed, and managed floating.

Flexible Exchange Rate

A Flexible Exchange Rate, also known as a Floating Exchange Rate, is determined by the market forces of demand and supply. The exchange rate settles at the equilibrium point where the demand for a currency equals its supply. In a completely flexible system, central banks do not intervene in the market.

• Depreciation: If the demand for foreign currency increases (e.g., more people want to travel abroad), its price will rise. For instance, the exchange rate might move from ₹50 per dollar to ₹70 per dollar. This means the domestic currency (rupee) has lost value. An increase in the exchange rate is called a depreciation of the domestic currency.
• Appreciation: If the price of the domestic currency in terms of foreign currency increases (e.g., the rate falls from ₹70 to ₹50 per dollar), it is called an appreciation of the domestic currency. This means you need fewer rupees to buy one dollar.

Speculation

Exchange rates are also affected by speculation. If investors believe a currency, like the British pound, is going to appreciate against the rupee, they will buy pounds now to sell them later for a profit. This increased demand for pounds can cause the exchange rate to rise immediately, making the belief a self-fulfilling prophecy.

Interest Rates and the Exchange Rate

The interest rate differential (the difference in interest rates between countries) is a key short-run factor. If interest rates are higher in country B than in country A, investors from country A will buy country B's currency to invest in its high-yield bonds. This increases the demand for country B's currency, causing it to appreciate, while country A's currency depreciates.

Income and the Exchange Rate

When a country's income increases, its citizens tend to spend more, including on imported goods. This increases the demand for foreign currency, causing the domestic currency to depreciate. If incomes abroad also rise, demand for the country's exports will increase. The net effect on the exchange rate depends on whether imports or exports grow faster.

Exchange Rates in the Long Run

The Purchasing Power Parity (PPP) theory helps predict long-run exchange rates. It suggests that, without trade barriers, an exchange rate should adjust so that the same product costs the same amount in different countries. Over the long run, exchange rates tend to reflect differences in price levels between countries.

Fixed Exchange Rates

In a Fixed Exchange Rate system, the government fixes the exchange rate at a specific level. The central bank must then intervene in the foreign exchange market to maintain this rate.

• If the fixed rate is above equilibrium: There will be an excess supply of foreign currency. The central bank must buy this excess supply to prevent the rate from falling.
• If the fixed rate is below equilibrium: There will be an excess demand for foreign currency. The central bank must sell foreign currency from its reserves to meet this demand.

In this system:

• Devaluation occurs when the government officially increases the exchange rate, making the domestic currency cheaper. This is often done to boost exports.
• Revaluation occurs when the government decreases the exchange rate, making the domestic currency more expensive.

Merits and Demerits of Flexible and Fixed Exchange Rate Systems

• Fixed Exchange Rate System:
  • Merit: Provides stability and predictability in international trade.
  • Demerit: Prone to speculative attacks. If people believe the government cannot maintain the fixed rate due to low reserves, they may sell the currency aggressively, forcing a devaluation. It also requires the central bank to hold large foreign exchange reserves.
• Flexible Exchange Rate System:
  • Merit: The exchange rate automatically adjusts to correct surpluses or deficits in the BoP. It also gives the government more flexibility in its monetary policy.
  • Demerit: Can be volatile, creating uncertainty for businesses involved in international trade.

Managed Floating

Most countries today use a system of Managed Floating, also known as dirty floating. This is a hybrid system that combines elements of both fixed and flexible rates.

• The exchange rate is largely determined by market forces (the "float" part).
• However, the central bank intervenes to buy or sell foreign currencies whenever it feels necessary to moderate sharp fluctuations (the "managed" part). In this system, official reserve transactions are not zero.