Open Economy Macroeconomics

The Balance Of Payments

An open economy is one that interacts with other countries through various channels, primarily through trade in goods and services and through financial markets. To systematically record all economic transactions between the residents of a country and the rest of the world during a given period (typically a year), a country prepares a statement known as the Balance of Payments (BoP).

The BoP account is prepared using the principles of double-entry bookkeeping. Every transaction has two aspects, a credit entry and a debit entry. By convention, any transaction that results in a flow of foreign currency into the country is recorded as a credit (+) item. Any transaction that results in a flow of foreign currency out of the country is recorded as a debit (-) item.

The BoP account is broadly divided into two main accounts: the Current Account and the Capital Account.

Current Account

The Current Account records all transactions relating to the trade of goods and services, income receipts and payments, and unilateral transfers. These transactions do not affect the assets or liabilities status of a country. The components are:

Trade in Goods (Visible Trade): This includes the export and import of physical, tangible goods.
- Exports of Goods: Recorded as a credit item as it leads to an inflow of foreign exchange.
- Imports of Goods: Recorded as a debit item as it leads to an outflow of foreign exchange.
The balance of exports and imports of goods is known as the Balance of Trade (BoT) or Trade Balance.

$$ \text{Balance of Trade (BoT)} = \text{Value of Exports of Goods} - \text{Value of Imports of Goods} $$

A positive BoT is a trade surplus, while a negative BoT is a trade deficit.
Trade in Services (Invisible Trade): This includes the export and import of non-tangible services.
- Net Factor Income: This includes income from work (compensation of employees) and investment (profit, interest, dividend) flowing in and out of the country.
- Net Non-Factor Income: This includes payments for services like shipping, banking, insurance, tourism, and software services.
The net value of services trade is the Balance of Invisible Trade.
Transfers to and from abroad (Unilateral Transfers): These are receipts and payments that are made without any corresponding good or service in return. They are one-way payments. Examples include gifts, donations, and personal remittances sent by non-residents (e.g., Indians working abroad) to their families in India.

The sum of the Balance of Trade and the Balance of Invisibles gives the Current Account Balance (CAB).

$$ \text{Current Account Balance} = \text{BoT} + \text{Balance of Services} + \text{Net Unilateral Transfers} $$

Capital Account

The Capital Account records all international transactions that involve a change in the assets or liabilities of the residents of a country or its government. The components are:

Investments: This refers to the movement of capital for investment purposes.
- Foreign Direct Investment (FDI): Investment made to acquire a long-term interest and significant influence in the management of an enterprise in another country (e.g., buying a factory). Inflows are credit, outflows are debit.
- Foreign Portfolio Investment (FPI): Investment in financial assets like shares and bonds of a foreign country, without any controlling interest. FPI is generally more volatile than FDI. Inflows are credit, outflows are debit.
Loans / External Borrowings:
- External Commercial Borrowings (ECBs): Borrowing by Indian companies from foreign sources at market rates.
Borrowing from abroad is a credit item (inflow), while lending to foreigners or repayment of loans is a debit item (outflow).
Changes in Foreign Exchange Reserves: The foreign exchange reserves are the financial assets held by the central bank (RBI). Any withdrawal from these reserves is a credit item, and any addition to these reserves is a debit item. These are typically part of accommodating transactions.

Balance Of Payments Surplus And Deficit

In accounting terms, the BoP always balances (Total Credits = Total Debits). However, for economic analysis, we distinguish between autonomous transactions and accommodating transactions.

Autonomous Transactions: These are international economic transactions that take place for their own sake, such as for profit motives (e.g., exports, imports, FDI). They are independent of the state of the BoP. They are also known as 'above the line' items.
Accommodating Transactions: These are transactions that are undertaken to cover the deficit or surplus arising from autonomous transactions. The primary accommodating item is the movement of official foreign exchange reserves. They are also known as 'below the line' items.

The overall balance of payments is the sum of the current account balance and the capital account balance (excluding the official reserve account).

$$ \text{Overall BoP Balance} = \text{Current Account Balance} + \text{Capital Account Balance} + \text{Errors & Omissions} $$

A BoP Deficit occurs when the total inflows from autonomous transactions are less than the total outflows. This deficit must be financed by the central bank by selling foreign currency from its official reserves. This results in a decrease in foreign exchange reserves.

BoP Surplus

The Foreign Exchange Market

The foreign exchange market is the market where national currencies are traded for one another. It is not a physical place but a global network of banks, brokers, and financial institutions. The major participants include commercial banks, multinational corporations, foreign exchange brokers, and central banks.

Foreign Exchange Rate

The foreign exchange rate (or simply exchange rate) is the price of one currency in terms of another. For example, if we need to pay ₹83 to buy one US dollar, the exchange rate is ₹83/$.

Nominal vs. Real Exchange Rate

Nominal Exchange Rate (e): This is the rate at which one currency can be exchanged for another, as quoted in the market. It does not account for differences in price levels between countries. For example, $e = 83$ ₹/$.
Real Exchange Rate (RER): This is a more comprehensive measure that compares the relative prices of goods and services in two countries. It adjusts the nominal exchange rate for the price levels in both countries. The RER is a measure of a country's international competitiveness.
The formula is:

$$ \text{Real Exchange Rate (RER)} = \frac{e \times P_f}{P_d} $$

Where:
- $e$ = Nominal Exchange Rate (in units of domestic currency per unit of foreign currency)
- $P_f$ = Price level in the foreign country
- $P_d$ = Price level in the domestic country
If RER > 1, foreign goods are more expensive than domestic goods, making domestic goods more competitive. If RER < 1, domestic goods are more expensive.

Appreciation and Depreciation

Depreciation: An increase in the exchange rate (e.g., from ₹80/$ to ₹83/$). This means the domestic currency (Rupee) has become less valuable, and you need more rupees to buy one dollar. Depreciation makes imports more expensive and exports cheaper, which can improve the trade balance.
Appreciation: A decrease in the exchange rate (e.g., from ₹83/$ to ₹80/$). This means the domestic currency has become more valuable. Appreciation makes imports cheaper and exports more expensive.

Note: The terms devaluation and revaluation are used in a fixed exchange rate system, where the government officially sets a lower or higher exchange rate, respectively. Depreciation and appreciation occur in a flexible system due to market forces.

Determination Of The Exchange Rate

In a flexible (or floating) exchange rate system, the exchange rate is determined by the market forces of demand for and supply of foreign exchange.

Demand for Foreign Exchange

The demand for foreign currency arises from the need to make payments to foreigners. The main sources of demand are:

To purchase goods and services from other countries (imports).
To invest in foreign countries (FDI and FPI outflows).
To send gifts and remittances abroad.
For speculation (buying foreign currency in the hope that its value will rise).

There is an inverse relationship between the exchange rate and the quantity demanded of foreign exchange. When the exchange rate rises (depreciation), foreign goods become more expensive, so the demand for imports and thus for foreign currency falls. This results in a downward-sloping demand curve.

Supply of Foreign Exchange

The supply of foreign currency comes from the receipts of foreign currency from abroad. The main sources of supply are:

Receipts from the sale of goods and services to other countries (exports).
Foreign investment into the domestic country (FDI and FPI inflows).
Gifts and remittances received from abroad.

There is a direct relationship between the exchange rate and the quantity supplied of foreign exchange. When the exchange rate rises (depreciation), domestic goods become cheaper for foreigners, so they buy more. This increases exports and thus the supply of foreign currency. This results in an upward-sloping supply curve.

Equilibrium Exchange Rate

The equilibrium exchange rate is determined at the point where the demand for foreign exchange equals its supply. In the graph, this occurs at point E, with the equilibrium exchange rate being e*.

A graph showing the determination of the exchange rate. The Y-axis is the Exchange Rate (e.g., ₹/$) and the X-axis is the Quantity of Foreign Exchange (e.g., $). The downward-sloping demand curve and the upward-sloping supply curve intersect at point E, determining the equilibrium exchange rate e*.

If the exchange rate is above e*, supply exceeds demand, leading to pressure for the rate to fall (appreciate). If the rate is below e*, demand exceeds supply, leading to pressure for the rate to rise (depreciate).

Merits And Demerits Of Flexible And Fixed Exchange Rate Systems

Feature	Flexible Exchange Rate System	Fixed Exchange Rate System
Definition	Exchange rate is determined by market forces of demand and supply.	Exchange rate is officially fixed by the government or central bank.
Merits	Automatic Adjustment: BoP deficits/surpluses are automatically corrected through currency depreciation/appreciation. Frees Monetary Policy: The central bank is free to use monetary policy for domestic goals (like inflation control) rather than for maintaining the exchange rate. No Need for Large Reserves: The central bank does not need to hold large foreign exchange reserves to defend the currency.	Stability: Provides stability and certainty in exchange rates, which promotes international trade and investment. Disciplines Monetary Policy: Prevents the government from pursuing excessively inflationary policies. Checks Speculation: Discourages destabilizing speculation.
Demerits	Volatility and Uncertainty: Fluctuations in the exchange rate can create uncertainty and discourage trade. Speculation: Can encourage destabilizing speculation. Inflationary Potential: Continuous depreciation can lead to imported inflation.	Requires Large Reserves: The central bank must hold large reserves to defend the fixed rate against market pressures. Loss of Monetary Autonomy: Monetary policy must be dedicated to maintaining the peg, not domestic goals. Risk of Speculative Attacks: If the market believes the fixed rate is unsustainable, it can lead to massive speculative attacks and a currency crisis.

Managed Floating

A managed floating exchange rate system, also known as a 'dirty float', is a hybrid of the fixed and flexible systems. In this system, the exchange rate is primarily determined by market forces, but the central bank intervenes in the foreign exchange market to influence the rate.

The central bank does not try to maintain a specific fixed rate but intervenes to prevent excessive volatility or to guide the currency towards a certain direction. For example, if the domestic currency is depreciating too rapidly, the central bank (like the RBI) will sell foreign currency (e.g., US dollars) from its reserves to increase its supply and slow down the depreciation. Conversely, if the currency is appreciating too much, it will buy foreign currency to curb the appreciation.

This is the system that most countries, including India, follow today. It aims to combine the benefits of flexibility (automatic adjustment) with the benefit of stability (reduced volatility).

Exchange Rate Management: The International Experience

The international monetary system has evolved significantly over the past 150 years, moving between different exchange rate regimes.

The Gold Standard

The classical Gold Standard prevailed from around 1870 until the outbreak of World War I in 1914. Under this system:

Each country defined the value of its currency in terms of a certain amount of gold. For example, 1 US Dollar might be defined as 20 grains of gold, and 1 British Pound as 100 grains of gold.
This established a fixed exchange rate between currencies, known as the mint parity. In our example, the exchange rate would be £1 = $5.
Countries guaranteed the free convertibility of their domestic currency into gold at the fixed rate.
The system had a self-correcting mechanism for BoP imbalances. A deficit country would experience an outflow of gold, which would reduce its money supply, lower prices, and make its exports more competitive, thus correcting the deficit. The reverse would happen in a surplus country.

The Gold Standard collapsed during World War I as countries suspended gold convertibility to finance the war.

The Bretton Woods System

After the chaos of the inter-war years, representatives from 44 nations met at Bretton Woods, USA, in 1944 to design a new international monetary system. This system, which lasted until 1971, was an adjustable peg system.

The US dollar was the anchor of the system. It was pegged to gold at a fixed rate of $35 per ounce, and the US guaranteed the convertibility of dollars into gold at this price.
All other member countries pegged their currencies to the US dollar at a fixed rate. They could adjust this peg, but only in cases of a 'fundamental disequilibrium' and with the agreement of the International Monetary Fund (IMF), which was created to oversee the system.
This created a system of fixed exchange rates, intended to provide stability for world trade to recover after the war. The World Bank was also created to provide long-term loans for reconstruction and development.

The Bretton Woods system collapsed in 1971 when the US, facing large BoP deficits and a drain on its gold reserves, unilaterally suspended the convertibility of the dollar into gold.

The Current Scenario

Since the collapse of the Bretton Woods system, the world has operated on a non-system, a mixture of different exchange rate regimes.

Major global currencies like the US dollar, the Euro, the Japanese Yen, and the British Pound float freely against one another, with their values determined by market forces.
Many developing countries, including India, China, and Brazil, follow a managed floating system.
Some countries choose to peg their currency to a major currency, often the US dollar or the Euro, to import stability.

This mixed system provides flexibility but has also been characterized by significant exchange rate volatility and periodic currency crises.

Exchange Rate Management: The Indian Experience

India's exchange rate policy has undergone a radical transformation since its independence, moving from a rigid, controlled regime to a flexible, market-oriented one.

Phase 1: The Fixed Regime (1947-1991)

From independence until the early 1990s, India followed a fixed exchange rate system.

Initially, the Indian Rupee (INR) was pegged to the British Pound.
After the breakdown of Bretton Woods, the rupee was pegged to the US dollar and later, from 1975 onwards, to a basket of currencies of India's major trading partners.
The exchange rate was officially determined by the RBI and was not reflective of market demand and supply. The government frequently resorted to devaluation of the rupee to deal with BoP crises, notably in 1966.

This system was supported by strict foreign exchange controls and a highly protectionist trade policy.

Phase 2: The Transition and Liberalisation (1991-Present)

The severe BoP crisis of 1991 forced India to undertake major economic reforms, including a shift in its exchange rate policy.

1991 Devaluation: As an immediate measure, the rupee was devalued by about 18-19% in July 1991 to make exports more competitive.
LERMS (1992-93): India moved to a transitional dual exchange rate system called the Liberalised Exchange Rate Management System (LERMS). Under this system, there was a market-determined rate and an official rate. Exporters were required to surrender 40% of their earnings at the lower official rate, while the remaining 60% could be converted at the higher market rate.
Unified Market Rate (1993): The dual system was replaced by a single, unified, market-determined exchange rate system in March 1993.

Since 1993, India has followed a managed floating exchange rate system. The RBI does not target a specific level for the rupee. Instead, it closely monitors the foreign exchange market and intervenes by buying or selling US dollars only to curb excessive volatility and prevent disruptive movements in the exchange rate. The objective is to maintain orderly conditions in the market, not to peg the currency at any particular level. This approach has allowed India to absorb external shocks while building up substantial foreign exchange reserves.

Determination Of Equilibrium Income In Open Economy

The inclusion of the foreign sector (exports and imports) modifies the simple Keynesian model of income determination. In an open economy, aggregate demand is not just from domestic sources (C, I, G) but also from the rest of the world (exports), while a part of domestic demand 'leaks' out to pay for imports.

National Income Identity For An Open Economy

Aggregate Demand (AD) in a four-sector open economy is the sum of consumption (C), investment (I), government expenditure (G), and net exports (X-M).

$$ AD = C + I + G + (X - M) $$

The equilibrium condition is where total output (Y) equals planned aggregate demand (AD).

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

Components in an Open Economy

Consumption (C), Investment (I), Government Spending (G): These are determined as in a closed economy. However, it's understood that some of this spending is on imported goods.
Exports (X): Exports depend on the income of foreign countries, their tastes, and the real exchange rate. From the perspective of the domestic economy's income, exports are considered autonomous. So, $X = \bar{X}$.
Imports (M): Imports depend on the domestic level of income (Y) and the real exchange rate. As domestic income rises, people and firms spend more, including on imported goods. This relationship is captured by the import function:
$$ M = \bar{M} + mY $$

Where $\bar{M}$ is autonomous imports (imports that don't depend on income) and $m$ is the Marginal Propensity to Import (MPM). MPM is the fraction of an additional unit of income that is spent on imports ($m = \Delta M / \Delta Y$).

Derivation of Equilibrium Income

We start with the equilibrium condition and substitute the behavioural functions:

$ Y = AD $

$ Y = (\bar{C} + cY) + \bar{I} + \bar{G} + \bar{X} - (\bar{M} + mY) $

(For simplicity, we assume no taxes, so disposable income is Y).

Now, we solve for the equilibrium income, Y, by gathering all terms containing Y on the left-hand side:

$ Y - cY + mY = \bar{C} + \bar{I} + \bar{G} + \bar{X} - \bar{M} $

$ Y(1 - c + m) = \bar{C} + \bar{I} + \bar{G} + \bar{X} - \bar{M} $

The equilibrium level of income in an open economy is:

$$ Y^* = \frac{\bar{C} + \bar{I} + \bar{G} + \bar{X} - \bar{M}}{1 - c + m} $$

The Open Economy Multiplier

From the equilibrium income equation, we can derive the open economy multiplier. The multiplier shows the change in income resulting from a change in any autonomous component of aggregate demand.

$$ \text{Open Economy Multiplier} = \frac{1}{1 - c + m} = \frac{1}{(1-c) + m} = \frac{1}{s + m} $$

Where $s$ is the marginal propensity to save (1-c) and $m$ is the marginal propensity to import.

The open economy multiplier is smaller than the closed economy multiplier ($k_{closed} = 1/(1-c)$). This is because in an open economy, there is an additional leakage from the circular flow of income: imports. For every additional rupee of income, a part is saved (leakage) and another part is spent on imports (leakage). Since the total leakage (s+m) is larger, the multiplier effect is smaller. An increase in autonomous spending will have a less powerful impact on domestic income in an open economy compared to a closed one.

Key Concepts

Open Economy: An economy that engages in economic transactions with other countries.
Balance of Payments (BoP): A systematic record of all economic transactions between the residents of a country and the rest of the world.
Current Account: Part of the BoP that records trade in goods, services, and unilateral transfers.
Capital Account: Part of the BoP that records transactions of financial assets and liabilities.
Balance of Trade (BoT): The difference between the value of a country's exports and imports of goods.
Autonomous Transactions: International transactions undertaken for reasons like profit, independent of the BoP state.
Accommodating Transactions: Transactions undertaken to cover the deficit or surplus in the BoP, such as changes in official reserves.
Foreign Exchange Rate: The price of one currency in terms of another.
Nominal Exchange Rate: The market-quoted rate of exchange between two currencies.
Real Exchange Rate: The nominal exchange rate adjusted for price differences between countries, reflecting a country's competitiveness.
Flexible Exchange Rate: A system where the exchange rate is determined by market forces of demand and supply.
Fixed Exchange Rate: A system where the government or central bank officially fixes the exchange rate.
Managed Floating: A hybrid system where the exchange rate is market-determined, but the central bank intervenes to manage volatility.
Depreciation: A decrease in the value of a currency under a flexible exchange rate system.
Appreciation: An increase in the value of a currency under a flexible exchange rate system.
Devaluation: An official reduction in the value of a currency by the government under a fixed exchange rate system.
Revaluation: An official increase in the value of a currency by the government under a fixed exchange rate system.
Marginal Propensity to Import (MPM): The fraction of additional income that is spent on imports.
Open Economy Multiplier: The ratio of change in income to a change in autonomous spending in an open economy. It is equal to $1/(1-c+m)$.

Summary

Open Economy Macroeconomics studies how economies that trade with the rest of the world work. The interaction with other countries is systematically recorded in the Balance of Payments (BoP) account, which is divided into the Current Account (for trade in goods, services, and transfers) and the Capital Account (for transactions in assets and liabilities). A deficit or surplus in the BoP is settled through accommodating transactions, primarily by changes in the official foreign exchange reserves held by the central bank.

Transactions between countries require the exchange of national currencies, which takes place in the foreign exchange market. The price at which currencies are traded is the exchange rate. This rate can be determined in different ways. Under a flexible exchange rate system, it is determined by market forces of demand and supply. Under a fixed exchange rate system, it is set by the government. Most countries today, including India, use a hybrid system called managed floating, where the central bank intervenes to prevent excessive volatility.

The international monetary system has evolved from the Gold Standard to the Bretton Woods system of adjustable pegs, and finally to the current mixed system. India has also transitioned from a fixed exchange rate regime to a market-based managed float since the economic reforms of 1991.

The openness of an economy also affects the determination of its national income. Aggregate demand now includes net exports (exports minus imports). Because a portion of any increase in income 'leaks' out of the country to pay for imports (measured by the marginal propensity to import), the open economy multiplier is smaller than the multiplier in a closed economy. This means that changes in autonomous spending have a more muted effect on domestic income in a country that is open to international trade.