Economics Chapter 1.6 – Open Economy Macroeconomics

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Chapter 1.6 – Open Economy Macroeconomics

Economics Chapter 1.6 – Open Economy Macroeconomics

1. Open Economy: Overview

An open economy is an economy that engages in international trade and financial transactions with other countries, unlike a closed economy that is isolated from foreign influences. In the modern world, most economies are open, with multiple points of interaction:

  1. Output Market:
    • Trade in goods and services occurs between countries, giving consumers a wider variety of products to choose from (both domestic and foreign goods).
    • Producers also benefit from access to foreign markets for their goods.
    • Example: Indian consumers can purchase smartphones made in China, and Indian producers can export software services to the U.S.
  2. Financial Market:
    • Countries interact by buying and selling financial assets such as bonds, stocks, and loans. This allows investors to diversify their portfolios by holding foreign assets.
    • Example: An Indian company might invest in the U.S. stock market, or a foreign investor might buy shares in an Indian company.
  3. Labour Market:
    • Workers may move between countries, and companies can choose to locate production in different countries.
    • Immigration laws and policies influence this movement. Often, trade in goods is seen as a substitute for labor mobility.
    • Example: A U.S. company might open a factory in India due to lower labor costs.
  4. Trade’s Impact on Aggregate Demand:
    • Imports represent a leakage from the domestic economy as spending flows out to foreign producers.
    • Exports act as an injection, adding demand for domestically produced goods from foreign buyers.
    • Example: When an Indian buys a foreign car, it decreases India’s aggregate demand. Conversely, when software is exported to the U.S., it increases India’s demand for goods and services.

2. Currency and Foreign Exchange

International Currency Confidence

  • For any currency to be accepted globally, it must maintain stable purchasing power.
  • If the value of the currency fluctuates often, foreign agents may not accept it for international transactions.

Historical Context

  • In the past, governments promised that their currency could be converted into another asset (usually gold) at a fixed price.
  • This practice was aimed at building trust in the currency’s value.

3. Balance of Payments (BoP)

Overview:

  • The Balance of Payments (BoP) is a comprehensive record of a country’s economic transactions with the rest of the world over a specific period, typically a year. It covers all cross-border activities in goods, services, and financial assets.

Main Accounts:

  • Current Account:
    • Records transactions in goods, services, and unilateral transfers (like gifts and remittances).
    • Subdivisions:
      1. Trade in Goods (exports and imports).
      2. Trade in Services (factor income like wages and interest, non-factor income like tourism and banking).
      3. Transfer Payments: Payments like remittances and grants that do not involve an exchange of goods or services.
  • Capital Account:
    • Tracks international transactions involving assets like stocks, bonds, and loans.
    • Subdivisions:
      1. Foreign Direct Investment (FDI): Investments where a foreign entity takes a controlling interest in an asset or business.
      2. Foreign Institutional Investment (FII): Investments in stocks and bonds by foreign investors.
      3. External Borrowings: Loans taken from foreign lenders.
      4. External Assistance: Financial aid from foreign countries or institutions.

4. Balance on Current and Capital Accounts

Current Account Balance

  • Surplus: When the country earns more from exports and transfers than it spends on imports.
  • Deficit: When the country spends more on imports and transfers than it earns from exports.

Trade Balance (Balance of Trade, BoT):

  • The difference between exports and imports of goods.
    • If exports exceed imports, there’s a trade surplus.
    • If imports exceed exports, there’s a trade deficit.

Balance on Invisibles:

  • This includes trade in services, factor income (wages, dividends, interest), and transfers.
  • Net Invisibles are the difference between the export and import of services.

Capital Account Balance:

  • Capital Inflows (like FDI and FIIs) add foreign exchange to the economy.
  • Capital Outflows (like the purchase of foreign assets or repayment of foreign loans) remove foreign exchange.
  • A surplus in the capital account occurs when inflows exceed outflows, and a deficit occurs when outflows exceed inflows.

BoP Equilibrium

  • BoP is balanced when the Current Account and Capital Account balance out.
  • A current account deficit must be financed by a capital account surplus (foreign borrowing or selling assets).

5. Foreign Exchange Market

Foreign Exchange Rate:

  • The price of one currency in terms of another.
  • Example: If 1 USD = 75 INR, the exchange rate is 75 rupees per dollar.

Demand and Supply of Foreign Exchange:

  • Demand for Foreign Exchange:
    • People demand foreign currency to:
      1. Import goods and services.
      2. Send gifts abroad.
      3. Purchase foreign financial assets.
  • Supply of Foreign Exchange:
    • Foreign currency comes into the country through:
      1. Exports of goods and services.
      2. Foreign transfers like remittances.
      3. Sale of domestic assets to foreign investors.

6. Determination of Exchange Rates

Flexible Exchange Rate (also called Floating Exchange Rate):

  • Determined by market forces (supply and demand).
  • Depreciation and appreciation occur based on changes in demand and supply of currencies.

Fixed Exchange Rate:

  • The government intervenes to maintain the exchange rate at a fixed level.
  • Devaluation: A deliberate reduction in the value of the domestic currency to boost exports.
  • Revaluation: An increase in the value of the domestic currency.

Managed Floating:

  • A hybrid system where the exchange rate is largely determined by market forces but the central bank intervenes to stabilize excessive fluctuations.

7. Speculation and Exchange Rates

  • Speculation in foreign exchange markets occurs when traders buy or sell currencies based on expected future movements in exchange rates.
  • If people expect a currency to appreciate, demand for it rises, which can lead to self-fulfilling prophecies in the market.

8. BoP Surplus and Deficit

  • A BoP deficit occurs when a country’s outflows exceed inflows, requiring the country to finance the gap either by borrowing from abroad or selling reserves.
  • A BoP surplus occurs when inflows exceed outflows, increasing the country’s foreign exchange reserves.

9. Autonomous vs Accommodating Transactions

  • Autonomous transactions: Occur for reasons unrelated to BoP, such as profit motives.
  • Accommodating transactions: Designed specifically to correct imbalances in the BoP.

10. Equilibrium Income in an Open Economy

National Income Identity:

  • In a closed economy: Y=C+I+G Where Y is income, C is consumption, I is investment, and G is government spending.
  • In an open economy: Y=C+I+G+(X−M)

Where XXX represents exports and MMM represents imports.

  • Net Exports (NX) is the difference between exports and imports:
    • NX = X – M.
    • A positive NX indicates a trade surplus, while a negative NX indicates a trade deficit.

Multiplier in an Open Economy:

  • The open economy multiplier is smaller than that in a closed economy due to leakages (imports):

Multiplier=1/1−(c−m) Where ccc is the marginal propensity to consume and mmm is the marginal propensity to import.

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