An open economy interacts with other countries through various channels, unlike a closed economy which has no linkages with the rest of the world.
Foreign trade influences aggregate demand in two ways:
Balance of Payments (BoP): Records transactions in goods, services, and assets between residents of a country and the rest of the world for a specified period (typically a year).
Records trade in goods and services and transfer payments. Components include:
| Component | Description |
|---|---|
| Trade in Goods | Exports and imports of goods |
| Trade in Services | Factor income (earnings on factors of production) and non-factor income (services like shipping, banking, tourism) |
| Transfer Payments | Receipts received 'for free' (gifts, remittances, grants) |
Balance on Current Account:
Records all international transactions of assets (money, stocks, bonds, government debt).
| Component | Description |
|---|---|
| Investments | Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs) |
| External Borrowings | Commercial borrowings, short-term debt |
| External Assistance | Government aid, inter-governmental loans |
Balance on Capital Account:
Key relationship: Current account + Capital account = 0
A current account deficit must be financed by a capital account surplus (net capital inflow).
Official Reserve Sale: When central bank sells foreign exchange to balance BoP deficit.
Overall Balance: Decrease/increase in official reserves is called overall BoP deficit/surplus.
| Autonomous Transactions | Accommodating Transactions |
|---|---|
| Made for reasons other than bridging BoP gap | Determined by BoP gap (deficit/surplus) |
| 'Above the line' items | 'Below the line' items (mainly official reserve transactions) |
| Independent of BoP state | Dependent on autonomous transactions' net consequences |
Third element of BoP accounting for inaccuracies in recording international transactions.
Example from India's BoP (Table 6.1):
Foreign Exchange Market: Market where national currencies are traded for one another.
Exchange Rate: Price of one currency in terms of another (e.g., Rs 50 per dollar).
Reasons for demand:
Law of Demand: As exchange rate rises (domestic currency depreciates), demand for foreign exchange decreases (imports become more expensive).
Sources of supply:
As exchange rate rises, supply may increase (exports become cheaper for foreigners).
Three exchange rate systems:
Determined by market forces of demand and supply without central bank intervention.
Fig. 6.1: Equilibrium under Flexible Exchange Rates
[Diagram showing demand and supply curves intersecting to determine exchange rate]
Depreciation: Increase in price of foreign currency in terms of domestic currency (domestic currency loses value).
Appreciation: Decrease in price of foreign currency in terms of domestic currency (domestic currency gains value).
In the long run, exchange rates adjust so that the same product costs the same in different countries when measured in a common currency.
Example 6.1:
If a shirt costs $8 in US and Rs 400 in India, PPP exchange rate = 400/8 = Rs 50/$.
If prices rise 20% in India (Rs 480) and 50% in US ($12), new PPP rate = 480/12 = Rs 40/$ (dollar depreciated).
Government fixes the exchange rate at a particular level.
Fig. 6.3: Foreign Exchange Market with Fixed Exchange Rates
[Diagram showing government intervention at fixed exchange rates]
Devaluation: Official increase in fixed exchange rate (making domestic currency cheaper).
Revaluation: Official decrease in fixed exchange rate (making domestic currency costlier).
Combination of flexible and fixed systems where central banks intervene occasionally to moderate exchange rate movements.
| System | Advantages | Disadvantages |
|---|---|---|
| Fixed Exchange Rate | Stability in international transactions | Prone to speculative attacks; requires large reserves |
| Flexible Exchange Rate | Automatic BoP adjustment; monetary policy independence | Exchange rate volatility |
Closed economy: Y = C + I + G
Open economy: Y = C + I + G + X - M or Y = C + I + G + NX
Where NX = X - M (Net Exports)
Imports function: M = M̅ + mY
Where:
Exports (X) are considered exogenous (X = X̅).
Y = A̅ + cY - mY
Solution: Y* = (1/(1 - c + m)) × A̅
Open Economy Multiplier: ΔY/ΔA = 1/(1 - c + m)
Smaller than closed economy multiplier (1/(1 - c)) because imports create additional leakage.
Example 6.2:
If c = 0.8 and m = 0.3:
Closed economy multiplier = 1/(1-0.8) = 5
Open economy multiplier = 1/(1-0.8+0.3) = 2
Thus, same increase in autonomous spending has smaller effect in open economy.
Export multiplier: ΔY*/ΔX̅ = 1/(1 - c + m)
Import multiplier: ΔY*/ΔM̅ = -1/(1 - c + m)