The key difference between the balance of trade and the current account balance lies in their scope. The balance of trade is a narrower concept and is one component of the current account balance.

Balance of Trade (BoT):

The Balance of Trade records the difference between a country's total value of exports of goods and its total value of imports of goods only. It deals exclusively with tangible or 'visible' items.

BoT = Value of Exports of Goods - Value of Imports of Goods.

Current Account Balance:

The Current Account Balance is a much broader measure. It includes the balance of trade and also records the trade in 'invisibles'. It is the sum of:

• Balance of Trade (trade in goods).
• Balance on Invisibles, which includes:
  • Trade in Services (e.g., shipping, software, tourism).
  • Factor Income (e.g., profits, interest, dividends).
  • Transfer Payments (e.g., remittances, grants).

Current Account Balance = Balance of Trade + Balance on Invisibles.

Official reserve transactions refer to the buying and selling of foreign currencies and other reserve assets (like gold) by the central bank of a country. These transactions are carried out to settle the overall balance of payments.

Importance in the Balance of Payments:

Official reserve transactions are the ultimate financing or accommodating items in the BoP. Their importance is to bridge the gap between a country's total autonomous receipts and its total autonomous payments.

• If a country has a BoP deficit (autonomous payments > autonomous receipts), the central bank will sell foreign exchange from its official reserves to meet the net demand for foreign currency. This leads to a decrease in official reserves.
• If a country has a BoP surplus (autonomous receipts > autonomous payments), the central bank will buy the excess foreign exchange, leading to an increase in its official reserves.

Therefore, these transactions are crucial for maintaining stability in the foreign exchange market, especially under a fixed or managed exchange rate system, and they reflect the overall deficit or surplus in a country's balance of payments.

Nominal Exchange Rate:

The nominal exchange rate is the price of one currency in terms of another, without any adjustment for the price levels in the two countries. It is the rate at which one can exchange the currency of one country for the currency of another. For example, ₹80 = $1.

Real Exchange Rate:

The real exchange rate is the relative price of goods between two countries. It adjusts the nominal exchange rate for differences in the price levels of the two countries. It measures the rate at which one can exchange the goods and services of one country for the goods and services of another.

Which rate is more relevant?

The real exchange rate would be more relevant for deciding whether to buy domestic or foreign goods.

Explanation: The nominal exchange rate only tells you the price of currencies, but the real exchange rate tells you about purchasing power. It determines the competitiveness of a country's goods. If the real exchange rate is high, it means foreign goods are relatively more expensive than domestic goods, so one would prefer to buy domestic goods. Conversely, if the real exchange rate is low, foreign goods are relatively cheaper, making them more attractive to purchase.

Step 1: Find the nominal exchange rate (e).

The hint asks for the price of the foreign currency (Yen) in terms of the domestic currency (Rupees).

We are given: 1.25 Yen = 1 Rupee

Therefore, 1 Yen = $\frac{1}{1.25}$ Rupees

So, the nominal exchange rate (e) = 0.8 Rupees per Yen.

Step 2: Calculate the real exchange rate (R).

The formula for the real exchange rate is:

$R = e \times \frac{P_f}{P}$

Where:

• e = Nominal exchange rate = 0.8
• $P_f$ = Price level in the foreign country (Japan) = 3
• P = Price level in the domestic country (India) = 1.2

Substituting the values:

$R = 0.8 \times \frac{3}{1.2}$

$R = \frac{2.4}{1.2} = 2$

The real exchange rate is 2. This means that the price of Japanese goods is twice the price of Indian goods, or one unit of a Japanese good can be exchanged for two units of an Indian good.

Under the gold standard, currencies were pegged to a fixed amount of gold, which kept exchange rates between countries stable. This system had a self-correcting or automatic mechanism, known as the "price-specie-flow mechanism," to restore BoP equilibrium.

The mechanism worked as follows:

1. BoP Deficit Situation: Suppose Country A has a BoP deficit with Country B. This means its payments to B exceed its receipts from B. To settle this deficit, Country A would have to ship gold to Country B.

2. Effect on Money Supply: The outflow of gold would reduce the money supply in Country A, as the money supply was tied to its gold reserves. Conversely, the inflow of gold would increase the money supply in Country B.

3. Effect on Price Levels: The reduced money supply in Country A would lead to a fall in its general price level (deflation). The increased money supply in Country B would lead to a rise in its general price level (inflation).

4. Adjustment in Trade: The goods of Country A would now be cheaper for residents of Country B, leading to an increase in Country A's exports. At the same time, the goods of Country B would be more expensive for residents of Country A, leading to a decrease in Country A's imports.

5. Restoration of Equilibrium: The rise in exports and fall in imports would automatically correct Country A's BoP deficit, bringing the balance of payments back into equilibrium without any government intervention.

Under a flexible (or floating) exchange rate regime, the exchange rate is determined freely by the market forces of demand for and supply of foreign exchange, with no intervention from the central bank.

• The demand for foreign exchange is downward sloping. It arises from the need to make payments to other countries, such as for imports or purchasing foreign assets. A higher exchange rate makes foreign goods more expensive, reducing the quantity of foreign currency demanded.
• The supply of foreign exchange is generally upward sloping. It arises from receipts from other countries, such as from exports. A higher exchange rate makes domestic goods cheaper for foreigners, increasing exports and thus the quantity of foreign currency supplied.

The equilibrium exchange rate is established at the point where the demand curve for foreign exchange intersects the supply curve. At this rate, the quantity of foreign exchange demanded is exactly equal to the quantity supplied.

Both devaluation and depreciation refer to a fall in the value of a country's currency in terms of foreign currencies. However, they differ in the mechanism through which this fall occurs.

Yes, the central bank would need to intervene in a managed floating system. In fact, this intervention is the defining feature of the system.

Explanation:

A managed floating exchange rate system (also called a "dirty float") is a hybrid of the fixed and flexible systems. While the exchange rate is largely determined by market forces of demand and supply (the 'float' part), the central bank periodically intervenes by buying or selling foreign currencies (the 'managed' part).

The central bank intervenes not to maintain a specific fixed rate, but to influence the movement of the exchange rate. The primary reasons for intervention are:

• To prevent excessive volatility and smooth out short-term fluctuations.
• To guide the currency towards a level that is considered more desirable for the economy's macroeconomic goals, such as boosting exports or controlling inflation.

No, the concepts of 'demand for domestic goods' and 'domestic demand for goods' are not the same in an open economy.

Domestic Demand for Goods:

This refers to the total demand for all goods (both domestically produced and imported) by the residents of a country. It is the sum of private consumption (C), investment (I), and government spending (G).

Domestic Demand for Goods = C + I + G

Demand for Domestic Goods:

This refers to the total demand for goods that are produced within the country. It includes the domestic demand for goods, but we must subtract the spending on imports (M) and add the demand from foreigners, which is exports (X).

Demand for Domestic Goods = C + I + G + (X - M)

This is the aggregate demand for an open economy.

The marginal propensity to import (m) is the fraction of an additional unit of income that is spent on imports. It is the slope of the import function.

For the given import function, $M = 60 + 0.06Y$, the marginal propensity to import (m) is the coefficient of Y, which is 0.06.

Relationship with the Aggregate Demand Function:

The aggregate demand (AD) function for an open economy is $AD = C + I + G + X - M$.

Substituting the import function into the AD equation, we get:

$AD = (C + I + G + X - 60) - 0.06Y$

The marginal propensity to import enters the aggregate demand function with a negative sign. It acts as a leakage from the circular flow of income. This has two main effects:

1. It makes the aggregate demand curve flatter, as a portion of any increase in income is now spent on imports rather than on domestic goods.

2. It reduces the size of the autonomous expenditure multiplier, as the leakage from each round of spending is larger.

The open economy autonomous expenditure multiplier is smaller than the closed economy multiplier because an open economy has an additional leakage from the circular flow of income: imports.

The formulas for the multipliers are:

• Closed Economy Multiplier = $\frac{1}{1 - c}$ or $\frac{1}{MPS}$
• Open Economy Multiplier = $\frac{1}{1 - c + m}$ or $\frac{1}{MPS + MPM}$

where 'c' is the marginal propensity to consume (MPC), and 'm' is the marginal propensity to import (MPM).

Explanation:

In the multiplier process, an initial injection of spending creates income, which in turn induces further consumption spending. In a closed economy, all of this induced spending is on domestically produced goods, becoming income for domestic producers in the next round.

However, in an open economy, a portion of the induced consumption spending is on imported goods. This portion, determined by the marginal propensity to import (m), "leaks out" of the domestic circular flow and becomes income for foreign producers. Because this leakage is larger in each round, the subsequent increases in domestic income are smaller. This weakens the overall chain reaction, resulting in a smaller final impact on national income and thus a smaller multiplier.

To derive the open economy multiplier with proportional taxes, we start with the equilibrium condition: $Y = AD$.

The Aggregate Demand (AD) for an open economy is: $AD = C + I + G + X - M$.

We define the components as follows:

1. Consumption (C) = $\bar{C} + c(Y_D)$, where $Y_D$ is disposable income.

2. Disposable Income ($Y_D$) = $Y - T = Y - tY = Y(1-t)$.

3. Imports (M) = $\bar{M} + mY$.

4. I, G, and X are autonomous: $\bar{I}, \bar{G}, \bar{X}$.

Now, substitute these into the equilibrium equation:

$Y = [\bar{C} + c(1-t)Y] + \bar{I} + \bar{G} + \bar{X} - (\bar{M} + mY)$

Group the autonomous terms and the terms containing Y:

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

Move all terms with Y to the left side:

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

Factor out Y:

$Y[1 - c(1-t) + m] = \text{Autonomous Expenditure}$

The open economy multiplier with proportional taxes is the reciprocal of the term in the brackets. Therefore, the multiplier (k) is:

(a) Find equilibrium income.

First, substitute the tax function into the consumption function to get consumption as a function of total income (Y).

$Y_D = Y - T = Y - 50$

$C = 40 + 0.8(Y - 50) = 40 + 0.8Y - 40 = 0.8Y$

Now use the equilibrium condition: Y = C + I + G + X - M

$Y = (0.8Y) + 60 + 40 + 90 - (50 + 0.05Y)$

$Y = 0.8Y + 190 - 50 - 0.05Y$

$Y = 140 + 0.75Y$

$0.25Y = 140 \implies Y = 140 / 0.25 = 560$

The equilibrium income is 560.

(b) Find the net export balance at equilibrium income.

Net Exports (NX) = X - M = $90 - (50 + 0.05Y)$

Substitute Y = 560:

$NX = 90 - (50 + 0.05 \times 560) = 90 - (50 + 28) = 90 - 78 = 12$

The net export balance is a surplus of 12.

(c) What happens when government purchases increase from 40 to 50?

The change in G is $\Delta G = 50 - 40 = 10$.

First, find the multiplier (k): $k = \frac{1}{1 - c + m} = \frac{1}{1 - 0.8 + 0.05} = \frac{1}{0.25} = 4$.

Change in Income ($\Delta Y$) = $k \times \Delta G = 4 \times 10 = 40$.

New Equilibrium Income = $560 + 40 = 600$.

New Net Export Balance = $90 - (50 + 0.05 \times 600) = 90 - (50 + 30) = 90 - 80 = 10$.

Equilibrium income increases to 600 and the net export balance decreases to a surplus of 10.

We start from the initial equilibrium calculated in Question 13, where Y = 560 and Net Exports = 12.

Given Change:

Exports (X) change from 90 to 100. So, the change in exports ($\Delta X$) = 10.

Change in Equilibrium Income:

The multiplier for exports is the same as the government expenditure multiplier, which we found to be 4.

Change in Income ($\Delta Y$) = Multiplier $\times \Delta X = 4 \times 10 = 40$.

New Equilibrium Income = $560 + 40 = 600$.

New Net Export Balance:

New Net Exports (NX') = New Exports (X') - Imports (M)

$NX' = 100 - (50 + 0.05 \times \text{New Y})$

$NX' = 100 - (50 + 0.05 \times 600) = 100 - (50 + 30) = 100 - 80 = 20$.

The equilibrium income increases to 600 and the net export balance increases to a surplus of 20.

The Purchasing Power Parity (PPP) theory states that the nominal exchange rate will adjust to keep the real exchange rate constant. The real exchange rate (R) is given by:

$R = e \times \frac{P_{USA}}{P_{India}}$

Where e is the nominal exchange rate (Rs per $).

In 2010:

Let's assume initial price levels $P_{India} = P_1$ and $P_{USA} = P_2$. The exchange rate $e_1 = 30$.

In 2030:

Prices in India have doubled, so the new price level $P'_{India} = 2 \times P_1$.

Prices in the USA have remained fixed, so $P'_{USA} = P_2$.

Let the new exchange rate be $e_2$.

According to PPP, the real exchange rate must remain constant:

$e_1 \times \frac{P_2}{P_1} = e_2 \times \frac{P'_2}{P'_1}$

$30 \times \frac{P_2}{P_1} = e_2 \times \frac{P_2}{2P_1}$

Canceling out the common terms ($P_1$ and $P_2$):

$30 = e_2 \times \frac{1}{2}$

$e_2 = 30 \times 2 = 60$

According to the PPP theory, the exchange rate in the year 2030 will be Rs 60 = 1$.

If inflation is higher in Country A than in Country B while the nominal exchange rate is fixed, the trade balance of Country A is likely to worsen, moving towards a deficit or a larger deficit.

Explanation:

1. Effect on Exports: Higher inflation in Country A means its goods are becoming more expensive. Since the nominal exchange rate is fixed, these higher prices translate directly into higher prices for foreign buyers. This will reduce the competitiveness of Country A's exports, leading to a fall in export volume and revenue.

2. Effect on Imports: At the same time, goods from Country B (where inflation is lower) are becoming relatively cheaper for the residents of Country A. This will lead to an increase in imports into Country A.

The combination of falling exports and rising imports will cause the trade balance (Exports - Imports) of Country A to deteriorate.

A current account deficit (CAD) is not necessarily a cause for alarm. Whether it is a concern depends on the underlying reasons for the deficit and how it is being financed.

When a CAD might NOT be a cause for alarm:

If the deficit is driven by imports of capital goods (machinery, technology) which are used to finance a high level of domestic investment, it can be a sign of a healthy, growing economy. In this case, the country is borrowing from abroad to build up its productive capacity, which will generate future income to repay the foreign debt.

When a CAD IS a cause for alarm:

A CAD becomes a cause for concern if it reflects low national savings and is being used to finance high levels of consumption (both private and government). This means the country is "living beyond its means" by borrowing from abroad to fund current consumption, which is not sustainable in the long run. It is also alarming if the deficit is being financed by volatile, short-term capital inflows ("hot money"), which can be withdrawn quickly and trigger a financial crisis.

Given: C = 100 + 0.75$Y_D$, I = 500, G = 750, T = 0.2Y, X = 150, M = 100 + 0.2Y.

1. Calculate Equilibrium Income (Y):

Disposable Income ($Y_D$) = Y - T = Y - 0.2Y = 0.8Y.

Consumption (C) = 100 + 0.75(0.8Y) = 100 + 0.6Y.

Equilibrium condition: Y = C + I + G + X - M

$Y = (100 + 0.6Y) + 500 + 750 + 150 - (100 + 0.2Y)$

$Y = 100 + 0.6Y + 1400 - 100 - 0.2Y$

$Y = 1400 + 0.4Y$

$0.6Y = 1400 \implies Y = 1400 / 0.6 \approx 2333.33$

Equilibrium income is 2333.33.

2. Calculate Budget Deficit or Surplus:

Budget Balance = Taxes (T) - Government Spending (G)

T = 0.2 $\times$ Y = 0.2 $\times$ 2333.33 = 466.67

Budget Balance = 466.67 - 750 = -283.33

The government has a budget deficit of 283.33.

3. Calculate Trade Deficit or Surplus:

Trade Balance = Exports (X) - Imports (M)

M = 100 + 0.2 $\times$ Y = 100 + 0.2 $\times$ 2333.33 = 100 + 466.67 = 566.67

Trade Balance = 150 - 566.67 = -416.67

The country has a trade deficit of 416.67.

Countries have entered into various exchange rate arrangements to bring stability to their external accounts. These range from rigid pegs to more flexible systems.

1. The Gold Standard: A historical system where countries fixed the value of their currency to a specific amount of gold. This created a system of fixed exchange rates between countries and had an automatic mechanism to correct balance of payments imbalances.

2. Fixed Exchange Rate Systems (Pegs): A country pegs its currency at a fixed rate to another major currency (like the US dollar) or a basket of currencies. The central bank must intervene in the forex market to maintain this rate. The Bretton Woods system was a prime example of a global fixed-rate system.

3. Currency Board: A very strict form of a fixed exchange rate where the domestic currency is fully backed by a foreign reserve currency. The country's ability to issue domestic currency is tied directly to its holdings of the foreign currency, which imposes strong discipline on monetary policy.

4. Managed Floating: This is a hybrid system where the exchange rate is primarily market-determined, but the central bank intervenes to manage volatility or guide the rate towards a desired level. This is the most common arrangement today.

5. Monetary Union: A group of countries adopts a single common currency (e.g., the Eurozone). This completely eliminates exchange rate risk and instability among member countries but requires them to give up their independent monetary policy.