Chapter 6 Open Economy Macroeconomics

Introduction

Unlike a closed economy which has no interaction with the rest of the world, an open economy engages in economic transactions with other countries. These interactions occur through various channels, linking domestic and international markets.

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Linkages With Other Countries

An open economy establishes connections with other nations through three primary avenues:

• Output Market: Countries trade goods and services. Consumers and producers can choose between domestically produced and foreign goods (imports and exports).
• Financial Market: Economies can buy and sell financial assets (like stocks, bonds, government debt) from other countries. This allows investors to diversify their portfolios internationally.
• Labour Market: Though often restricted by immigration laws, labour can move between countries, allowing firms to locate production internationally and workers to seek employment abroad.

This chapter primarily focuses on the first two linkages: trade in goods and services, and transactions in financial assets.

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Influence Of Foreign Trade

International trade significantly impacts the aggregate demand within an economy:

• Imports: When domestic residents purchase foreign goods and services, this spending constitutes a leakage from the domestic circular flow of income, reducing aggregate demand for domestically produced goods.
• Exports: When foreigners purchase domestically produced goods and services, this spending constitutes an injection into the domestic circular flow, increasing aggregate demand for goods produced within the country.

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Foreign Exchange And International Monetary System

International transactions involving trade or financial assets require the exchange of national currencies. Since there is no single global currency, countries need to exchange their currency for the currency of the country they are transacting with. The price of one currency in terms of another is called the foreign exchange rate or exchange rate.

For a currency to be widely accepted in international transactions, it needs to maintain a relatively stable purchasing power. Historically, attempts were made to ensure currency stability by pegging them to assets like gold or other major currencies. The international monetary system provides the framework and mechanisms to facilitate and stabilize international transactions.

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 during a specific period (usually a year). It is structured into two main accounts (under the traditional classification): the Current Account and the Capital Account.

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Current Account

The Current Account records transactions related to the trade of currently produced goods and services, as well as unilateral transfers.

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Trade In Goods And Services And Transfer Payments

The components of the Current Account are:

• Trade in Goods (Visible Trade): Records exports and imports of physical goods. Exports are recorded as credits (foreign currency inflow), and imports are recorded as debits (foreign currency outflow).
• Trade in Services (Invisible Trade): Records exports and imports of services. This includes:
  • Factor Income: Earnings from the international use of factors of production, such as wages/salaries received by residents working abroad or paid to non-residents working domestically (labour income), and interest, rent, and profits received from investments abroad or paid to foreigners for their investments domestically (investment income).
  • Non-factor Services: Earnings from services like shipping, banking, tourism, software services, etc.
• Transfer Payments: Unrequited receipts or payments, where there is no corresponding flow of goods or services. This includes gifts, remittances (money sent by residents working abroad to their families at home), and grants from governments or private sources. Receipts are credits, and payments are debits.

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Balance On Current Account

The balance on Current Account is the difference between total receipts and total payments on the current account.

$ \text{Current Account Balance} = \text{Total Current Account Receipts} - \text{Total Current Account Payments} $

• A Current Account Surplus occurs when receipts exceed payments, meaning the country is a net lender to the rest of the world on current transactions.
• A Current Account Deficit occurs when payments exceed receipts, meaning the country is a net borrower from the rest of the world on current transactions.
• A Balanced Current Account occurs when receipts equal payments.

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Balance Of Trade (Bot)

The Balance of Trade (BOT) or Trade Balance specifically refers to the difference between the value of exports and imports of goods only.

$ \text{BOT} = \text{Value of Exports of Goods} - \text{Value of Imports of Goods} $

• A Trade Surplus means exports of goods are greater than imports of goods.
• A Trade Deficit means imports of goods are greater than exports of goods.

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Net Invisibles

Net Invisibles is the balance on the services, income, and transfers components of the current account. It is the difference between the value of exports and imports of these invisible items.

$ \text{Net Invisibles} = (\text{Exports of Services} + \text{Income Receipts} + \text{Transfer Receipts}) - (\text{Imports of Services} + \text{Income Payments} + \text{Transfer Payments}) $

The Current Account Balance is the sum of the Balance of Trade and Net Invisibles.

$ \text{Current Account Balance} = \text{Balance of Trade} + \text{Net Invisibles} $

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Capital Account

The Capital Account records all international transactions involving assets. An asset is anything that holds wealth (money, stocks, bonds, real estate, etc.).

• Credit items on the Capital Account represent capital inflows, where foreigners are buying domestic assets or domestic residents are borrowing from abroad (foreign currency inflow). Examples: Foreign Direct Investment (FDI) into the country, Foreign Institutional Investment (FII) into the country, external commercial borrowings received, sale of domestic securities to foreigners, decrease in foreign assets held by residents.
• Debit items on the Capital Account represent capital outflows, where domestic residents are buying foreign assets or repaying foreign loans (foreign currency outflow). Examples: FDI by domestic residents abroad, FII by residents abroad, repayment of external borrowings, purchase of foreign securities by residents, increase in foreign assets held by residents.

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Balance On Capital Account

The balance on Capital Account is the difference between total capital inflows (receipts) and total capital outflows (payments).

$ \text{Capital Account Balance} = \text{Total Capital Inflows} - \text{Total Capital Outflows} $

• A Capital Account Surplus occurs when inflows are greater than outflows.
• A Capital Account Deficit occurs when outflows are greater than inflows.

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Balance Of Payments Surplus And Deficit

The fundamental identity of Balance of Payments accounting states that the sum of the Current Account balance and the Capital Account balance must ideally be zero (in a system without official reserve transactions initially):

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

This means that a current account deficit must be financed by a capital account surplus (borrowing from abroad or selling assets), and a current account surplus leads to a capital account deficit (lending abroad or acquiring foreign assets).

In practice, the BoP may not always balance exactly due to errors and omissions. Any remaining overall deficit or surplus is balanced by transactions involving the country's official foreign exchange reserves, managed by the Central Bank.

Overall Balance of Payments is the sum of the Current Account balance, Capital Account balance, and Errors & Omissions.

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

If the Overall Balance is non-zero, the Central Bank intervenes using Official Reserve Transactions:

• An Overall BoP Deficit ($\text{Overall Balance} < 0$) is financed by the Central Bank selling foreign currency from its reserves ($\text{Reserve Change} > 0$, i.e., decrease in reserves shown as a credit).
• An Overall BoP Surplus ($\text{Overall Balance} > 0$) leads to the Central Bank buying foreign currency and adding to its reserves ($\text{Reserve Change} < 0$, i.e., increase in reserves shown as a debit).

Thus, the final BoP identity including official reserves is:

$ \text{Current Account} + \text{Capital Account} + \text{Errors & Omissions} + \text{Change in Official Reserves} = 0 $

Official Reserve Transactions are particularly relevant in a fixed exchange rate system where the central bank actively manages reserves to maintain the peg.

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Autonomous And Accommodating Transactions

BoP transactions can be classified based on their motivation:

• Autonomous Transactions ('Above the Line'): These transactions are undertaken for reasons independent of the state of the BoP, such as to earn profit (e.g., trade in goods/services, long-term capital flows like FDI). The BoP surplus or deficit is determined by the net balance of these autonomous transactions.
• Accommodating Transactions ('Below the Line'): These transactions are carried out specifically to cover the deficit or surplus in the autonomous transactions, i.e., to balance the BoP. Official Reserve Transactions are the prime example of accommodating transactions. They are determined by the overall balance of autonomous transactions.

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Errors And Omissions

Due to the vast number and complexity of international transactions, precisely recording every single one is challenging. The Errors and Omissions item in the BoP accounts is included to statistically balance the accounts, reflecting the net effect of unrecorded or misrecorded transactions.

No.	Item	Million USD
1.	Exports (of goods only)	150
2.	Imports (of goods only)	240
3.	Trade Balance [2 – 1]	–90
4.	(Net) Invisibles [4a + 4b + 4c]	52
	a. Non-factor Services	30
	b. Income	–10
	c. Transfers	32
5.	Current Account Balance [ 3+ 4]	–38
6.	Capital Account Balance [6a + 6b + 6c + 6d + 6e + 6f]	41.15
	a. External Assistance (net)	0.15
	b. External Commercial Borrowings (net)	2
	c. Short-term Debt	10
	d. Banking Capital (net) of which	15
	Non-resident Deposits (net)	9
	e. Foreign Investments (net) of which [6eA + 6eB]	19
	A. FDI (net)	13
	B. Portfolio (net)	6
	f. Other Flows (net)	–5
7.	Errors and Omissions	3.15
8.	Overall Balance [5 + 6 + 7]	0
9.	Reserves Change	0

The Foreign Exchange Market

The Foreign Exchange Market (Forex Market) is where different national currencies are bought and sold. This market facilitates international trade and financial transactions by determining the exchange rate between currencies. Key participants include commercial banks, foreign exchange brokers, authorised dealers, and central banks.

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Foreign Exchange Rate

The Foreign Exchange Rate is the price of one currency expressed in terms of another currency (e.g., $\textsf{₹}80$ per US Dollar). It is the link that allows for the comparison of prices of goods, services, and assets across different countries.

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Demand For Foreign Exchange

Demand for a foreign currency (say, US Dollars by Indian residents) arises from the desire to make payments to other countries. Reasons include:

• Purchasing goods and services from abroad (Imports).
• Sending gifts and transfers abroad.
• Buying financial or physical assets in foreign countries.
• Tourism abroad.

The demand for foreign exchange is generally inversely related to the exchange rate (price of foreign currency). If the price of US Dollars increases (e.g., from $\textsf{₹}70$ to $\textsf{₹}80$ per dollar), US goods become more expensive for Indians, leading to fewer imports from the US, and thus a lower quantity of US Dollars demanded by Indians, ceteris paribus.

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Supply Of Foreign Exchange

Supply of a foreign currency (say, US Dollars in India) arises from the receipts from other countries. Reasons include:

• Selling goods and services to foreigners (Exports).
• Receiving gifts and transfers from abroad.
• Selling domestic financial or physical assets to foreigners (Capital Inflows).
• Foreigners visiting the domestic country (Tourism).

The supply of foreign exchange is generally positively related to the exchange rate (price of foreign currency). If the price of US Dollars increases, Indian goods become cheaper for Americans (as they get more rupees per dollar). This tends to increase India's exports to the US, leading to a higher quantity of US Dollars supplied in the Indian foreign exchange market, ceteris paribus (though the actual impact depends on the price elasticity of demand for exports).

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Determination Of The Exchange Rate

The method by which the exchange rate of a currency is determined varies across countries and over time. The main systems are Flexible, Fixed, and Managed Floating exchange rates.

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Flexible Exchange Rate

Under a Flexible Exchange Rate System (also called Floating Exchange Rate System), the exchange rate is determined purely by the forces of demand and supply in the foreign exchange market, without central bank intervention.

In the graph, the equilibrium exchange rate ($e^*$) and the quantity of foreign currency traded ($q^*$) are determined at the intersection of the demand (D) and supply (S) curves.

If demand for foreign currency increases (e.g., due to higher imports), the demand curve shifts rightward (from D to D'). At the original exchange rate, there is excess demand. This puts upward pressure on the price of foreign currency, leading to a higher exchange rate ($e_1$).

An increase in the exchange rate (the price of foreign currency in terms of domestic currency) is called Depreciation of the domestic currency. For example, if the exchange rate changes from $\textsf{₹}70/$ to $\textsf{₹}80/$, the Rupee has depreciated against the Dollar, as you now need more Rupees to buy one Dollar. The Dollar has appreciated against the Rupee.

A decrease in the exchange rate (the price of foreign currency in terms of domestic currency) is called Appreciation of the domestic currency. If the rate changes from $\textsf{₹}80/$ to $\textsf{₹}70/$, the Rupee has appreciated against the Dollar, as you need fewer Rupees to buy one Dollar. The Dollar has depreciated against the Rupee.

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Speculation

Expectations about future exchange rate movements can influence current demand and supply for foreign currency. If investors expect a foreign currency (say, the Pound) to appreciate against the domestic currency (Rupee), they will increase their current demand for the Pound to profit from the expected rise in value. This increased demand can actually cause the Pound to appreciate in the present, making the initial expectation self-fulfilling. This behavior is known as speculation.

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Interest Rates And The Exchange Rate

In the short run, differences in interest rates between countries (interest rate differentials) can significantly affect exchange rates by driving international capital flows. If a country increases its interest rates relative to other countries, it attracts foreign investors seeking higher returns on financial assets. This increases the demand for the domestic currency and its supply in the foreign exchange market decreases (as domestic investors find domestic assets more attractive than foreign ones). This increased demand and decreased supply lead to an appreciation of the domestic currency.

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Income And The Exchange Rate

Changes in national income also affect exchange rates. An increase in domestic income typically leads to increased spending, including spending on imported goods. Higher imports increase the demand for foreign currency, leading to a depreciation of the domestic currency, ceteris paribus. Conversely, an increase in foreign income can boost demand for a country's exports, increasing the supply of foreign currency and leading to an appreciation of the domestic currency. The net effect on the exchange rate depends on the relative growth rates of domestic and foreign incomes and the sensitivity of imports and exports to income changes.

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Exchange Rates In The Long Run

The Purchasing Power Parity (PPP) Theory suggests that in the long run, under conditions of free trade, exchange rates between two currencies should adjust so that an identical basket of goods costs the same in both countries when measured in the same currency. Effectively, the exchange rate reflects the ratio of the price levels in the two countries.

$ \text{Exchange Rate (Domestic/Foreign)} = \frac{\text{Price Level in Domestic Country}}{\text{Price Level in Foreign Country}} $

If inflation is higher in one country than another, the currency of the high-inflation country is expected to depreciate in the long run according to PPP, to maintain the relative price of goods.

Answer:

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Fixed Exchange Rates

In a Fixed Exchange Rate System, the government or the Central Bank officially sets and maintains the exchange rate at a predetermined level, regardless of market demand and supply forces.

To maintain the fixed rate, the Central Bank must intervene in the foreign exchange market. If the market demand for foreign currency exceeds the supply at the fixed rate (excess demand), the Central Bank must sell foreign currency from its reserves. If the market supply exceeds demand (excess supply), the Central Bank must buy the excess foreign currency, accumulating reserves.

In the graph, the market equilibrium rate is 'e'. If the government fixes the rate at $e_1$ (higher than market equilibrium), there is excess supply of foreign currency (AB). The Central Bank must buy this excess supply to prevent the foreign currency from depreciating (domestic currency appreciating). If the fixed rate is $e_2$ (lower than market equilibrium), there is excess demand for foreign currency. The Central Bank must sell foreign currency from its reserves to prevent it from appreciating (domestic currency depreciating).

Maintaining a fixed rate requires sufficient foreign exchange reserves to manage imbalances. If a country runs persistent deficits in its autonomous transactions, it will continuously lose reserves. If reserves become low, the fixed rate may become unsustainable.

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Devaluation And Revaluation

In a fixed exchange rate system:

• Devaluation occurs when the government officially raises the fixed exchange rate (making the domestic currency cheaper relative to foreign currencies).
• Revaluation occurs when the government officially lowers the fixed exchange rate (making the domestic currency more expensive relative to foreign currencies).

These are deliberate policy actions by the government, distinct from depreciation and appreciation which occur due to market forces in a flexible system.

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Merits And Demerits Of Flexible And Fixed Exchange Rate Systems

Each system has advantages and disadvantages:

• Fixed Exchange Rates:
  • Merit: Provides certainty and stability for international trade and investment, reducing exchange rate risk. Can impose fiscal discipline if the government is unwilling to print money or borrow heavily.
  • Demerit: Requires the Central Bank to hold large foreign exchange reserves. Limits the government's ability to use independent monetary policy (monetary policy might be used to defend the peg). Vulnerable to speculative attacks, where expectations of devaluation/revaluation can trigger massive capital flows, forcing the government to abandon the fixed rate.
• Flexible Exchange Rates:
  • Merit: Does not require holding large reserves. Allows independent monetary policy focused on domestic goals (inflation, employment). Automatic adjustment of the exchange rate helps correct BoP imbalances in the current account over time.
  • Demerit: Creates exchange rate volatility and uncertainty, which can deter international trade and investment (though this can be mitigated with hedging instruments). Can amplify domestic economic shocks.

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Managed Floating

Most countries today operate under a Managed Floating Exchange Rate System. This is a hybrid system combining features of both flexible and fixed rates. The exchange rate is generally market-determined, but the Central Bank intervenes occasionally by buying or selling foreign currency to smooth out excessive volatility or influence the rate towards a desired level. This is sometimes referred to as 'dirty floating'. Official reserve transactions occur under this system, unlike in a pure flexible system.

Determination Of Equilibrium Income In Open Economy

Introducing international trade (exports and imports) changes the national income identity and affects the determination of equilibrium income compared to a closed economy model.

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National Income Identity For An Open Economy

In a closed economy, aggregate demand ($Y$) is the sum of consumption (C), investment (I), and government spending (G): $Y = C + I + G$.

In an open economy, there are additional components influencing the demand for domestically produced goods:

• Exports (X) represent demand for domestic goods from foreigners.
• Imports (M) represent the portion of domestic spending that falls on foreign goods.

The national income identity in an open economy is:

$ \text{Y} + \text{M} = \text{C} + \text{I} + \text{G} + \text{X} $

This identity states that the total supply of goods available domestically (domestic output Y plus imports M) equals the total demand for goods (consumption C, investment I, government spending G, and exports X).

Rearranging the identity to show total demand for domestic output:

$ \text{Y} = \text{C} + \text{I} + \text{G} + \text{X} - \text{M} $

$ \text{Y} = \text{C} + \text{I} + \text{G} + \text{NX} $

Where $\text{NX} = \text{X} - \text{M}$ is Net Exports. NX is positive for a trade surplus and negative for a trade deficit.

To determine equilibrium income in this open economy model (assuming fixed prices and interest rates), we use planned (ex ante) values for C, I, G, X, and M. We assume the consumption function is $C = \bar{C} + cY$. We assume investment ($\bar{I}$) and government spending ($\bar{G}$) are autonomous. We also assume exports are autonomous ($\bar{X}$). Imports are assumed to depend positively on domestic income (Y) and have an autonomous component ($\bar{M}$):

$ \text{M} = \bar{\text{M}} + m\text{Y} $

Where $m$ is the marginal propensity to import, representing the fraction of an extra rupee of income spent on imports ($0 < m < 1$).

Equilibrium occurs when planned aggregate demand for domestic goods equals planned domestic output (Y):

$ \text{Y} = \text{C} + \text{I} + \text{G} + \text{X} - \text{M} $

Substituting the functions:

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

Group the autonomous expenditure terms: $A = \bar{\text{C}} + \bar{\text{I}} + \bar{\text{G}} + \bar{\text{X}} - \bar{\text{M}}$.

$ \text{Y} = A + c\text{Y} - m\text{Y} $

$ \text{Y} - c\text{Y} + m\text{Y} = A $

$ \text{Y}(1 - c + m) = A $

Equilibrium income ($Y^*$) is:

$ Y^* = \frac{A}{1 - c + m} $

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The Open Economy Multiplier

The Open Economy Autonomous Expenditure Multiplier is the ratio of the change in equilibrium income to a change in autonomous expenditure (A) in an open economy:

$ \text{Open Economy Multiplier} = \frac{\Delta Y}{\Delta A} = \frac{1}{1 - c + m} $

Comparing this to the closed economy multiplier ($ \frac{1}{1-c} $), since the marginal propensity to import ($m$) is greater than zero, the denominator $(1 - c + m)$ is larger than $(1 - c)$. Therefore, the open economy multiplier ($ \frac{1}{1-c+m} $) is smaller than the closed economy multiplier.

This is because imports represent a leakage from the circular flow of income. When income increases, some of the additional spending is on imports, which does not generate income domestically. This weakens the multiplier effect in an open economy compared to a closed one.

Answer:

Changes in the autonomous components of exports ($\bar{X}$) and imports ($\bar{M}$) also affect equilibrium income. An increase in autonomous exports acts like any other increase in autonomous expenditure, increasing equilibrium income. An autonomous increase in imports (a rise in $\bar{M}$), however, shifts the AD curve downwards and decreases equilibrium income.

$ \frac{\Delta Y}{\Delta \bar{X}} = \frac{1}{1 - c + m} $

$ \frac{\Delta Y}{\Delta \bar{M}} = \frac{-1}{1 - c + m} $