OPEN ECONOMICS- MACROECONOMICS

1. Introduction 

1. Output Market: An economy can trade in goods and services with other countries. This widens choice in the sense that consumers and producers can choose between domestic and foreign goods.
2. Financial Market: Most often an economy can buy financial assets from other countries. This allows investors to choose between domestic and foreign assets.
3. Labour Market: Firms can choose where to locate production and workers to choose where to work. There are various immigration laws which restrict the movement of labour between countries.

 The Elaboration of Open Economics

• An open economy is said to trade with other nations in goods and services and most often, also in financial assets.
• Indians for instance, can consume products which are produced around the world and some of the products from India are exported to other countries.
• Foreign trade, therefore, influences Indian aggregate demand in two ways.
• First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing aggregate demand.
• Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for goods produced within the domestic economy. When goods move across national borders, money must be used for the transactions.
• At the international level there is no single currency that is issued by a single bank.
• Foreign economic agents will accept a national currency only if they are convinced that the amount of goods they can buy with a certain amount of that currency will not change frequently.
• In other words, the currency will maintain a stable purchasing power.
• Without this confidence, a currency will not be used as an international medium of exchange and unit of account since there is no international authority with the power to force the use of a particular currency in international transactions.
• The international monetary system has been set up to handle these issues and ensure stability in international transactions.

2.1 Current Account

• Current Account is the record of trade in goods and services and transfer payments.
• Trade in goods includes exports and imports of goods.
• Trade-in services include factor income and non-factor income transactions. Transfer payments are the receipts which the residents of a country get for ‘free’, without having to provide any goods or services in return.
• They consist of gifts, remittances and grants. They could be given by the government or by private citizens living abroad.

Balance on Current Account Current: The account is in balance when receipts on the current account are equal to the payments on the current account. A surplus current account means that the nation is a lender to other countries and a deficit current account means that the nation is a borrower from other countries.

Balance on the Current Account has two components:  Balance of Trade or Trade Balance and Balance on Invisibles. 

Balance of Trade or Trade Balance

• Balance of Trade (BOT) is the difference between the value of exports and the value of imports of goods of a country in a given period.
• Export of goods is entered as a credit item in BOT, whereas import of goods is entered as a debit item in BOT.
• It is also known as Trade Balance.
• BOT is said to be in balance when exports of goods are equal to the imports of goods.
• Surplus BOT or Trade surplus will arise if a country exports more goods than what it imports.
• Whereas, Deficit BOT or Trade deficit will arise if a country imports more goods than what it exports.
• Net Invisibles is the difference between the value of exports and the value of imports of invisibles of a country in a given period. Invisibles include services, transfers and flows of income that take place between different countries.
• Services trade includes both factor and non-factor income.
• Factor income includes net international earnings on factors of production (like labour, land and capital).
• Non-factor income is the net sale of service products like shipping, banking, tourism, software services, etc.

2.2. Capital Account

• Capital Account Capital Account records all international transactions of assets.
• An asset is any one of the forms in which wealth can be held, for example, money, stocks, bonds, Government debt, etc.
• Purchase of assets is a debit item on the capital account.
• If an Indian buys a UK Car Company, it enters capital account transactions as a debit item (as foreign exchange is flowing out of India).
• On the other hand, the sale of assets like the sale of shares of an Indian company to a Chinese customer is a credit item on the capital account.
• These items are Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), external borrowings and assistance.

Balance on Capital

• Account Capital account is in balance when capital inflows (like receipt of loans from abroad, sale of assets or shares in foreign companies) are equal to capital outflows (like repayment of loans, purchase of assets or shares in foreign countries).
• Surplus in capital accounts arises when capital inflows are greater than capital outflows, whereas deficit in capital account arises when capital inflows are lesser than capital outflows.

 2.3. Balance of Payments Surplus and Deficit

• The essence of international payments is that just like an individual who spends more than her income must finance the difference by selling assets or by borrowing, a country that has a deficit in its current account
• (spending more than it receives from sales to the rest of the world) must finance it by selling assets or by borrowing abroad.
• Thus, any current account deficit must be financed by a capital account surplus, that is, a net capital inflow.
• Current account + Capital account = 0
• In this case, in which a country is said to be in balance of payments equilibrium, the current account deficit is financed entirely by international lending without any reserve movements.
• Alternatively, the country could use its reserves of foreign exchange to balance any deficit in its balance of payments.
• The reserve bank sells foreign exchange when there is a deficit.
• This is called an official reserve sale.
• The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus).
• The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus).
• We note that official reserve transactions are more relevant under a regime of fixed exchange rates than when exchange rates are floating.

Autonomous and Accommodating Transactions

• International economic transactions are called autonomous when transactions are made due to some reason other than to bridge the gap in the balance of payments, that is when they are independent of the state of BoP.
• One reason could be to earn profit.
• These items are called ‘above the line’ items in the BoP.
• The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments.
• Accommodating transactions (termed ‘below the line’ items), on the other hand, are determined by the gap in the balance of payments, that is, whether there is a deficit or surplus in the balance of payments.
• In other words, they are determined by the net consequences of the autonomous transactions.
• Since the official reserve transactions are made to bridge the gap in the BoP, they are seen as the accommodating item in the BoP (all others being autonomous).
• Errors and Omissions It is difficult to record all international transactions accurately.
• Thus, we have a third element of BoP (apart from the current and capital accounts) called errors and omissions which reflects this. Table 6.1 provides a sample of Balance of Payments for India.

3. The Foreign Exchange Market

• The market in which national currencies are traded for one another is known as the foreign exchange market.
• The major participants in the foreign exchange market are commercial banks, foreign exchange brokers and other authorised dealers and monetary authorities.
• It is important to note that although participants themselves may have their own trading centres , the market itself is worldwide.
• There is a close and continuous contact between the trading centres and the participants deal in more than one market.

3.1. Foreign Exchange Rate Foreign Exchange Rate (also called Forex Rate)

• It is the price of one currency in terms of another.
• It links the currencies of different countries and enables comparison of international costs and prices.
  • For example, if we have to pay Rs 50 for $1 then the exchange rate is Rs 50 per dollar.
• To make it simple, let us consider that India and the USA are the only countries in the world and so there is only one exchange rate that needs to be determined.
• Demand for Foreign Exchange People demand foreign exchange because: they want to purchase goods and services from other countries; they want to send gifts abroad; and, they want to purchase financial assets of a certain country.

• A rise in the price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign good.
• This reduces demand for imports and hence demand for foreign exchange also decreases, other things remaining constant.
• Supply of Foreign Exchange Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners.
• A rise in the price of foreign exchange will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant.
• This increases India’s exports and hence supply for foreign exchange may increase (whether it actually increases depends on several factors, particularly the elasticity of demand for exports and imports.

3.2. Determination of the Exchange Rate

• Different countries have different methods of determining their currency’s exchange rate.
• It can be determined through a Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.
• Flexible Exchange Rate This exchange rate is determined by the market forces of demand and supply. It is also known as the Floating Exchange Rate.

Example: In a completely flexible system, the Central banks do not intervene in the foreign exchange market. Similarly, in a flexible exchange rate regime, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is called Appreciation of the domestic currency (rupees) in terms of foreign currency (dollars). This means that the value of rupees relative to the dollar has risen and we need to pay fewer rupees in exchange for one dollar.

Speculation

• Money in any country is an asset.
• If Indians believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds.
• Thus exchange rates also get affected when people hold foreign exchange on the expectation that they can make gains from the appreciation of the currency.
• This expectation in turn can actually affect the exchange rate in the following way.
• If the current exchange rate is Rs. 80 to a pound and investors believe that the pound is going to appreciate by the end of the month and will be worth Rs.85, investors think if they gave the dealer Rs. 80,000 and bought 1000 pounds, at the end of the month, they would be able to exchange the pounds for Rs. 85,000, thus making a profit of Rs. 5,000.
• This expectation would increase the demand for pounds and cause the rupee-pound exchange rate to increase in the present, making the beliefs self-fulfilling.

Interest Rates and the Exchange Rate

• In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries.
• There are huge funds owned by banks, multinational corporations and wealthy individuals who move around the world in search of the highest interest rates.
• If we assume that government bonds in country A pay an 8 per cent rate of interest whereas equally safe bonds in county B yield 10 per cent, the interest rate differential is 2 per cent.
• Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency.
• At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency.
• This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency.
• Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency.
• Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.

Income and the Exchange Rate

• When income increases, consumer spending increases.
• Spending on imported goods is also likely to increase.
• When imports increase, the demand curve for foreign exchange shifts to the right.
• There is a depreciation of the domestic currency.
• If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward.
• On balance, the domestic currency may or may not depreciate.
• What happens will depend on whether exports are growing faster than imports.
• In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world normally finds its currency depreciating because its imports grow faster than its exports.
• Its demand curve for foreign currency shifts faster than its supply curve

Exchange Rates in the Long Run

• The Purchasing Power (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.
• According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India or dollars in the US, yen in Japan and so on, except for differences in transportation.
• Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.

Fixed Exchange Rates: In this exchange rate system, the Government fixes the exchange rate at a particular level.

3.3. Merits and Demerits of Flexible and Fixed Exchange Rate Systems

• The main feature of the fixed exchange rate system is that there must be credibility that the government will be able to maintain the exchange rate at the level specified.
• Often, if there is a deficit in the BoP, in a fixed exchange rate system, governments will have to intervene to take care of the gap by using its official reserves.
• If people know that the amount of reserves is inadequate, they would begin to doubt the ability of the government to maintain the fixed rate.
• This may give rise to speculation of devaluation. When this belief translates into aggressive buying of one currency thereby forcing the government to devalue, it is said to constitute a speculative attack on a currency.
• Fixed exchange rates are prone to these kinds of attacks, as has been witnessed in the period before the collapse of the Bretton Woods System.
• The flexible exchange rate system gives the government more flexibility and they do not need to maintain large stocks of foreign exchange reserves.
• The major advantage of flexible exchange rates is that movements in the exchange rate automatically take care of the surpluses and deficits in the BoP. Also, countries gain independence in conducting their monetary policies, since they do not have to intervene to maintain exchange rates which are automatically taken care of by the market.

3.4. Managed Floating

• Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system.
• It is a mixture of a flexible exchange rate system (the floating part) and a fixed rate system (the managed part).
• Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate.
• Official reserve transactions are, therefore, not equal to zero.