UPSC Economics Planning and Economic Development NCERT Extracts - Open Economy : Macroeconomics

NCERT Extracts - Open Economy : Macroeconomics

Category : UPSC




  • An open economy is one that trades with other nations in goods and services and, most often, also in financial assets.
  • Indians, for instance, enjoy using products produced around the world and some of our production is exported to foreign 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 domestically produced goods.
  • Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. In 2013-14, this was 44.1 per cent for the Indian Economy. There are several countries whose foreign trade proportions are above 50 per cent of GDP.
  • Now, when goods move across national borders, money must move in the opposite direction. At the international level, there is no single currency that is issued by a central authority.
  • Foreign economic agents will accept a national currency only if they are convinced that 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.
  • Governments have tried to gain confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing authority has no control. This other asset most often has been gold, or other national currencies.
  • There are two aspects of this commitment that has affected its credibility - the ability to convert freely in unlimited amounts and the price at which conversion takes place.
  • The international monetary system has been set up to handle these issues and ensure stability in international transactions. A nation's commitment regarding the above two issues will affect its trade and financial interactions with the rest of the world.


The Balance of Payments


  • The balance of payments (BoP) record the transactions in goods, services and assets , between residents of a country with the rest of the world for a specified time period typically a year. There are two main accounts in the BoP - the current account and the capital account.
  • The current account records exports and imports in goods and services and transfer payments. The trade balance which is obtained by subtracting imports of goods from the exports of goods.
  • When exports exceed imports, there is a trade surplus and when imports exceed exports there is a trade deficit. In 2012-13, imports exceeded exports leading to a huge trade deficit in India ofUS$ 195.6 billion.
  • Trade in services denoted as invisible trade (because they are not seen to cross national borders) includes both factor income (net income from compensation of employees and net investment income, the latter equals, the interest, profits and dividends on our assets abroad minus the income foreigners earn on assets they own in India) and net non-factor income (shipping, banking, insurance, tourism, software services, etc.).
  • Transfer payments are receipts which the residents of a country receive 'for free', without having to make any present or future payments in return. They consist of remittances, gifts and grants. They could be official or private.
  • The balance of exports and imports of goods is referred to as the trade balance. Adding trade in services and net transfers to the trade balance, we get the current accomit balance. The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc.
  • We note that any transaction resulting in a payment to foreigners is entered as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive sign.
  • BoP surplus and deficit
  • The essence of international payments is that just like an individual who spends more than his income must finance the difference by selling assets or by borrowing, a country that has a deficit in its current account (spending more abroad 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 is of necessity financed by a net capital inflow.
  • Alternatively, the country could engage in official reserve transactions, running down its reserves of foreign exchange, in the case of a deficit by selling foreign currency in the foreign exchange market. 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).
  • The balance of payments deficit or surplus is obtained after adding the current and capital account balances.
  • A country is said to be in balance of payments equilibrium when the sum of its current account and its non-reserve capital account equals zero, so that the current account balance is financed entirely by international lending without reserve movements.
  • Autonomous and accommodating transactions
  • International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance due to profit motive).
  • These items are called 'above the line5 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 net consequences of the autonomous items, that is, whether the BoP is in surplus or deficit.
  • The official reserve transactions are seen as the accommodating item in the BoP (all others being autonomous).
  • Errors and omissions constitute the third element in the BoP (apart from the current and capital accounts) which is the 'balancing item' reflecting our inability to record all international transactions accurately.


The Foreign Exchange Market


  • The foreign exchange market - the market in which national currencies are traded for one another. The major participants in this market are commercial banks, foreign exchange brokers and other authorised dealers and the monetary authorities.
  • It is important to note that, although the participants themselves may have their own trading centres, the market itself is world-wide.
  • There is close and continuous contact between the trading centres and the participants deal in more than one market.
  • The price of one currency in terms of the other is known as the exchange rate. Since there is a symmetry between the two currencies, the exchange rate may be defined in one of the two ways.
  • First, as the amount of domestic currency required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of Rs. 50 means that it costs Rs. 50 to buy one dollar, and second, as the cost in foreign currency of purchasing one unit of domestic currency.
  • In the above case, we would say that it costs 2 cents to buy a rupee. The practice in economic literature, however, is to use the former definition - as the price of foreign currency in terms of domestic currency.
  • This is the bilateral nominal exchange rate - bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound.
  • However, returning to our example, if one wants to plan a trip to London, he needs to know how expensive British goods are relative to goods at home.
  • The measure that captures this is the real exchange rate - the ratio of foreign to domestic prices, measured in the same currency.

Red exchange rate = epf/p

Where P and Pf are the price levels here and abroad, respectively, and e is the rupee price 'of foreign exchange (the nominal exchange rate).

  • The numerator expresses prices abroad measured in rupees, the denominator gives the domestic price level measured in rupees, so the real exchange rate measures prices abroad relative to those at home.
  • If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency.
  • For instance, if a pen costs $ 4 in the US and the nominal exchange rate is Rs. 50 per US$, then with a real exchange rate of 1, it should cost Rs. 200 (ePf = 50 x 4) in India.
  • If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home. The real exchange rate is often taken as a measure of a country's international competitiveness.
  • Since a country interacts with many countries, we may want to see the movement of the domestic currency relative to all other currencies in a single number rather than by looking at bilateral rates.
  • That is, we would want an index for the exchange rate against other currencies, just as we use a price index to show how the prices of goods in general have changed.
  • This is calculated as the Nominal Effective Exchange Rate (NEER) which is a multilateral rate representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade (the average of export and import shares is taken as an indicator of this).
  • The Real Effective Exchange Rate (REER) is calculated as the weighted average of the real exchange rates of all its trade partners, the weights being the shares of the respective countries in its foreign trade.
  • It is interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.


Determination of the exchange rate

  • The question arises as to why the foreign exchange rate is at this level and what causes its movements? To understand the economic principles that lie behind exchange rate determination, we study the major exchange rate regimes that have characterised the international monetary system.
  • There has been a move from a regime of commitment of fixed-price convertibility to one without commitments where residents enjoy greater freedom to convert domestic currency into foreign currencies but do not enjoy a price guarantee.


Flexible exchange rates

  • In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply.
  • In a completely flexible system, the central banks follow a simple set of rules - they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market (and therefore, there are no official reserve transactions).
  • The link between the balance of payments accounts and the transactions in the foreign exchange market is evident when we recognise that all expenditures by domestic residents on foreign goods, services and assets and all foreign transfer payments (debits in the BoP accounts) also represent demand for foreign exchange.
  • The Indian resident buying a Japanese car pays for it in rupees but the Japanese exporter will expect to be paid in yen. So rupees must be exchanged for yen in the foreign exchange market.
  • Conversely, all exports by domestic residents reflect equal earnings of foreign exchange.
  • For instance, Indian exporters will expect to be paid in rupees and, to buy our goods, foreigners must sell their currency and buy rupees.
  • Total credits in the BoP accounts are then equal to the supply of foreign exchange.
    • Another reason for the demand for foreign exchange is for speculative purposes.
  • Speculation
  • Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency.
  • 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.
  • 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 which move around the world in search of the highest interest rates.
  • If we assume that government bonds in country A pay 8 per cent rate of interest where a is equally safe bonds in country B yield 10 per cent, the interest rate diferential 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 as currency.
  • This means that the demand curve for country As 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's 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 Parity (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.
  • According to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates.
  • If one country has higher inflation than another, its exchange rate should be depreciating. However, we note that if American prices rise faster than Indian prices and, at the same time, countries erect tariff barriers to keep Indian shirts out (but not American ones), the dollar may not depreciate.
  • Also, there are many goods that are not tradeable and inflation rates for them will not matter. Further, few goods that different countries produce and trade are uniform or identical.
  • Most economists contend that other factors are more important than relative prices for exchange rate determination in the short run. However, in the long run, purchasing power parity plays an important role.


Fixed exchange rates

  • Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s. Prior to that, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level.
  • Sometimes, a distinction is made between the fixed and pegged exchange rates. It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable - it may be changed.
  • There is a common element between the two systems. Under a fixed exchange rate system, such as the gold standard, adjustment to BoP surpluses or deficits cannot be ran brought about through changes in the exchange rate.
  • Adjustment must either come about 'automatically' through the workings of the economic system (through the mechanism explained by Hume), or be brought about by the government.
  • A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics.
  • However, there is another option open to the government - it may change the exchange rate. A devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system.
  • The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy.
  • Most governments change the exchange rate very infrequently. In our analysis, we use the terms fixed and pegged exchange rates interchangeably to denote an exchange rate regime where the exchange rate is set by government decisions and maintained by government actions.
  • We examine the way in which a country can 'peg' or fix the level of its exchange rate. We assume that Reserve bank of India (RBI) wishes to fix an exact par value for the rupee at Rs. 45 per dollar.
  • Assuming that this official exchange rate is below the equilibrium exchange rate (here e* = Rs. 50) of the flexible exchange rate system, the rupee will be overvalued and the dollar undervalued.
  • This means that if the exchange rate were market determined, the price of dollars in terms of rupees would have to rise to clear the market.
  • At Rs. 45 to a dollar, the rupee is more expensive than it would be at Rs. 50 to a dollar (thinking of the rate in dollar-rupee terms, now each rupee costs 2.22 cents instead of 2 cents).
  • At this rate, the demand for dollars is higher than the supply of dollars. Since the demand and supply schedules were constructed from the BoP accounts (measuring only autonomous transactions), this excess demand implies a deficit in the BoP.
  • The deficit is bridged by central bank intervention. In this case, the RBI would sell dollars for rupees in the foreign exchange market to meet this excess demand, thus neutralising the upward pressure on the exchange rate.
  • The RBI stands ready to buy and sell dollars at that rate to prevent the exchange rate from rising (since no one would buy at more) or falling (since no one would sell for less).
  • Now the RBI might decide to fix the exchange rate at a higher level - Rs. 47 per dollar - to bridge part of the deficit in BoP. This devaluation of the domestic currency would make imports expensive and our exports cheaper, leading to a narrowing of the trade deficit.
  • It is important to note that repeated central bank intervention to finance deficits and keep the exchange rate fixed will eventually exhaust the official reserves.
  • This is the main flaw in the system of fixed exchange rates. Once speculators believe that the exchange rate cannot be held for long they would buy foreign exchange (say, dollars) in massive amounts.
  • The demand for dollars will rise sharply causing a BoP deficit. Without sufficient reserves, the central bank will have to allow the exchange rate to reach its equilibrium level.
  • This might amount to an even larger devaluation than would have been required before the speculative 'attack' on the domestic currency began.
  • International experience shows that it is precisely this that has led many countries to abandon the system of fixed exchange rates. Fear of such an attack induced the US to let its currency float in 1971, one of the major events which precipitated the breakdown of the Bretton Woods system.


Managed Heating

  • 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 float 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.


Exchange Rate Management: The International Experience


The gold standard

  • From around 1870 to the outbreak of the First World War in 1914, the prevailing system was the gold standard which was the epitome of the fixed exchange rate system.
  • All currencies were defined in terms of gold; indeed some were actually made of gold. Each participant country committed to guarantee the free convertibility of its currency into gold at a fixed price.
  • This meant that residents had, at their disposal, a domestic currency which was freely convertible at a fixed price into another asset (gold) acceptable in international payments. This also made it possible for each currency to be convertible into all others at a fixed price. Exchange rates were determined by its worth in terms of gold (where the currency was made of gold, its actual gold content).
  • For example, if one unit of say currency A was worth one gram of gold, one unit of currency B was worth two grams of gold, currency B would be worth twice as much as currency A.
  • Economic agents could directly convert one unit of currency B into two units of currency A, without having to first buy gold and then sell it.
  • The rates would fluctuate between an upper and a lower limit, these limits being set by the costs of melting, shipping and recoining between the two currencies.
  • To maintain the official parity each country needed an adequate stock of gold reserves. All countries on the gold standard had stable exchange rates.
  • The question arose - would not a country lose all its stock of gold if it imported too much (and had a BoP deficit)? The mercantilist explanation was that unless the state intervened, through tariffs or quotas or subsidies, on exports, a country would lose its gold and that was considered one of the worst tragedies.
  • David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if the stock of gold went down, all prices and costs would fall commensurately and no one in the country would be worse off.
  • Also, with cheaper goods at home, imports would fall and exports rise (it is the real exchange rate which will determine competitiveness).
  • The country from which we were importing and making payments in gold would face an increase in prices and costs, so their now expensive exports would fall and their imports of the first country's now cheap goods would go up.
  • The result of this price-specie-flow (precious metals were referred to as 'specie' in the eighteenth century) mechanism is normally to improve the BoP of the country losing gold, and worsen that of the country with the favourable trade balance, until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow.
  • The equilibrium is stable and self-correcting, requiring no tariffs and state action. Thus, fixed exchange rates were maintained by an automatic equilibrating mechanism.
  • Several crises caused the gold standard to break down periodically. Moreover, world price levels were at the mercy of gold discoveries.
  • This can be explained by looking at the crude Quantity Theory of Money, M = kPY, according to which, if output (GNP) increased at the rate of 4 per cent per year, the gold supply would have to increase by 4 per cent per year to keep prices stable.
  • With mines not producing this much gold, price levels were falling all over the world in the late nineteenth century, giving rise to social unrest.
  • For a period, silver supplemented gold introducing 'bimetallism9. Also, fractional reserve banking helped to economise on gold.
  • Paper currency was not entirely backed by gold; typically countries held one-fourth gold against its paper currency.
  • Another way of economising on gold was the gold exchange standard which was adopted by many countries which kept their money exchangeable at fixed prices with respect to gold but held little or no gold.
  • Instead of gold, they held the currency of some large country (the United States or the United Kingdom) which was on the gold standard.
  • All these and the discovery of gold in Klondike and South Africa helped keep deflation at bay till 1929.
  • Some economic historians attribute the Great Depression to this shortage of liquidity. During 1914-45, there was no maintained universal system but this period saw both a brief return to the gold standard and a period of flexible exchange rates.


The Bretton Woods System

  • The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and reestablished a system of fixed exchange rates.
  • This was different from the international gold standard in the choice of the asset in which national currencies would be convertible.
  • A two-tier system of convertibility was established at the centre of which was the dollar. The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $ 35 per ounce of gold.
  • The second-tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price.
  • The latter was called the official exchange rate. For instance, if French francs could be exchanged for dollars at roughly 5 francs per dollar, the dollars could then be exchanged for gold at $ 35 per ounce, which fixed the value of the franc at 175 francs per ounce of gold (5 francs per dollar times $ 35 per ounce).
  • A change in exchange rates was to be permitted only in case of a 'fundamental disequilibrium' in a nation's BoP which came to mean a chronic deficit in the BoP of sizeable proportions.
  • Such an elaborate system of convertibility was necessary because the distribution of gold reserves across countries was uneven with the US having almost 70 per cent of the official world gold reserves.
  • Thus, a credible gold convertibility of the other currencies would have required a massive redistribution of the gold stock. Further, it was believed that the existing gold stock would be insufficient to sustain the growing demand for international liquidity.
  • One way to save on gold, then, was a two-tier convertible system, where the key currency would be convertible into gold and the other currencies into the key currency.
  • In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves.
  • At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit (other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar).
  • The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded.
  • The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment.
  • This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system.
  • Triffin suggested that the IMF should be turned into a "deposit bank' for central banks and a new 'reserve asset' be created under the control of the IMF.
  • In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as 'paper gold', in the IMF with the intention of increasing the stock of international reserves.
  • Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974.
  • At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, and pound sterling) of the five countries (France, Germany, Japan, the UK and the US).
  • It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies.
  • The original installments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country's economic importance as indicated by the value of its international trade).
  • The breakdown of the Bretton Woods system was preceded by many events, such as the devaluation of the pound in 1967, flight from dollars to gold in 1968 leading to the creation of a two-tiered gold market (with the official rate at $ 35 per ounce and the private rate market determined), and finally in August, 1971, the British demand that US guarantee the gold value of its dollar holdings.
  • This led to the US decision to give up the link between the dollar and gold.
  • The 'Smithsonian Agreement' in 1971, which widened the permissible band of movements of the exchange rates to 2.5 per cent above or below the new 'central rates' with the hope of reducing pressure on deficit countries, lasted only 14 months.
  • The developed market economies, led by the United Kingdom and soon followed by Switzerland and then Japan, began to adopt floating exchange rates in the early 1970s.
  • In 1976, revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them (to a single currency, a basket of currencies, or to the SDR). There are no rules governing pegged rates and no de facto supervision of floating exchange rates.


The current scenario

  • Many countries currently have fixed exchange rates. Some countries peg their currency to the dollar.
  • The creation of the European Monetary Union in January, 1999, involved permanently fixing the exchange rates between the currencies of the members of the Union and the introduction of a new common currency, the Euro, under the management of the European Central Bank.
  • From January, 2002, actual notes and coins were introduced. So far, 12 of the 25 members of the European Union have adopted the euro.
  • Some countries pegged their currency to the French franc; most of these are former French colonies in Africa. Others peg to a basket of currencies, with the weights reflecting the composition of their trade.
  • Often smaller countries also decide to fix their exchange rates relative to an important trading partner. Argentina, for example, adopted the currency board system in 1991.
  • Under this, the exchange rate between the local currency (the peso) and the dollar was fixed by law. The central bank held enough foreign currency to back all the domestic currency and reserves it had issued.
  • In such an arrangement, the country cannot expand the money supply at will. Also, if there is a domestic banking crisis (when banks need to borrow domestic currency) the central bank can no longer act as a lender of last resort.
  • However, following a crisis, Argentina abandoned the currency board and let its currency float in January, 2002.
  • Another arrangement adopted by Equador in 2000 was dollarisation when it abandoned the domestic currency and adopted the US dollar. All prices are quoted in dollar terms and the local currency is no longer used in transactions.
  • Although uncertainty and risk can be avoided, Equador has given the control over its money supply to the Central Bank of the US - the Federal Reserve - which will now be based on economic conditions in the US.
  • On the whole, the international system is now characterised by a multiple of regimes. Most exchange rates change slightly on a day-to-day basis, and market forces generally determine the basic trends.
  • Even those advocating greater fixity in exchange rates generally propose certain ranges within which governments should keep rates, rather than literally fix them.
  • Also, there has been a virtual elimination of the role for gold. Instead, there is a free market in gold in which the price of gold is determined by its demand and supply coming mainly from jewellers, industrial users, dentists, speculators and ordinary citizens who view gold as a good store of value.


The Determination of Income in an Open Economy


  • With consumers and firms having an option to buy goods produced at home and abroad, we now need to distinguish between domestic demand for goods and the demand for domestic goods.
  • National income identity for an open economy
  • In a closed economy, there are three sources of demand for domestic goods - Consumption (C), government spending (G), and domestic investment (I).
  • We can write: Y = C + I + G
  • In an open economy, exports (X) constitute an additional source of demand for domestic goods and services that comes from abroad and therefore must be added to aggregate demand.
  • Imports (M) supplement supplies in domestic markets and constitute that part of domestic demand that falls on foreign goods and services.
  • Therefore, the national income identity for an open economy is: Y+M=C+I+G+X
  • To examine the roles of imports and exports in determining equilibrium income in an open economy, we follow the same procedure as we did for the closed economy case - we take investment and government spending as autonomous.
  • In addition, we need to specify the determinants of imports and exports. The demand for imports depends on domestic income (Y) and the real exchange rate (R).
  • Higher income leads to higher imports. Recall that the real exchange rate is defined as the relative price of foreign goods in terms of domestic goods.
  • A higher R makes foreign goods relatively more expensive, thereby leading to a decrease in the quantity of imports. Thus, imports depend positively on Y and negatively on R.
  • The export of one country is, by definition, the import of another. Thus, our exports would constitute foreign imports. It would depend on foreign income, Yf, and on R.
  • A rise in Yf will increase foreign demand for our goods, thus leading to higher exports. An increase in R, which makes domestic goods cheaper, will increase our exports. Exports depend positively on foreign income and the real exchange rate.
  • Thus, exports and imports depend on domestic income, foreign income and the real exchange rate. We assume price levels and the nominal exchange rate to be constant, hence R will be fixed.
  • From the point of view of our country, foreign income, and therefore exports, are considered exogenous (X == X).
  • The demand for imports is thus assumed to depend on income and have an autonomous component.
  • An increase in demand for our exports is an increase in aggregate demand for domestically produced output and will increase demand just as would an increase in government spending or an autonomous increase in investment.
  • In contrast, an autonomous rise in import demand is seen to cause a fall in demand for domestic output and causes equilibrium income to decline.


Change in prices

  • Next we consider the effects of changes in prices, assuming the exchange rate to be fixed. If prices of domestic products fall, while say foreign prices remain constant, domestic exports will rise, adding to aggregate demand, and hence will raise our output and income.
  • Analogously, a rise in prices of a country's exports will decrease that country's net exports and output and income. Similarly, a price increase abroad will make foreign products more expensive and hence again raise net exports and domestic output and income. Price decreases abroad have the opposite effects.


Exchange rate changes

  • Changes in nominal exchange rates would change the real exchange rate and hence international relative prices. A depreciation of the rupee will raise the cost of buying foreign goods and make domestic goods less costly.
  • This will raise net exports and therefore increase aggregate demand. Conversely, a currency appreciation would reduce net exports and, therefore, decrease aggregate demand.
  • However, we must note that international trade patterns take time to respond to changes in exchange rates. A considerable period of time may elapse before any improvement in net exports is apparent.


Trade Deficits, Savings and Investment


  • An essential difference between a closed economy and an open economy is that while in a closed economy saving and investment must always be equal, in an open economy, they can differ.
  • When a country runs a trade deficit, it is important to look at the right side of equation to see whether there has been a decrease in saving, increase in investment, or an increase in the budget deficit.
  • There is reason to worry about a country's long-run prospects if the trade deficit reflects smaller saving or a larger budget deficit (when the economy has both trade deficit and budget deficit, it is said to be facing twin deficits).
  • The deficit could reflect higher private or government consumption. In such cases, the country's capital stock will not rise rapidly enough to yield enough growth (called the 'growth dividend') it needs to repay its debt. There is less cause to worry if the trade deficit reflects a rise in investment, which will build the capital stock more quickly and increase future output.
  • However, we must note that since private saving, investment and the trade deficit are jointly determined, other factors too must be taken into account.


Exchange Rate Management: The Indian Experience


  • India's exchange rate policy has evolved in line with international and domestic developments. Post-independence, in view of the prevailing Bretton Woods system, the Indian rupee was pegged to the pound sterling due to its historic links with Britain.
  • A major development was the devaluation of the rupee by 36.5 per cent in June, 1966. With the breakdown of the Bretton Woods system, and also the declining share of UK in India's trade, the rupee was delinked from the pound sterling in September, 1975.
  • During the period between 1975 to 1992, the exchange rate of the rupee was officially determined by the Reserve Bank within a nominal band of plus or minus 5 per cent of the weighted basket of currencies of India's major trading partners.
  • The Reserve Bank intervened on a day-to-day basis which resulted in wide changes in the size of reserves. The exchange rate regime of this period can be described as an adjustable nominal peg with a band.
  • The beginning of 1990s saw significant rise in oil prices and suspension of remittances from the Gulf region in the wake of the Gulf crisis. This, and other domestic and international developments, led to severe balance of payments problems in India.
  • The drying up of access to commercial banks and short-term credit made financing the current account deficit difficult.
  • India's foreign currency reserves fell rapidly from US$ 3.1 billion in August to US$ 975 million on 12 July, 1991.
  • Apart from measures like sending gold abroad, curtailing non-essential imports, approaching the IMF and multilateral and bilateral sources, introducing stabilisation and structural reforms, there was a two-step devaluation of 18-19 per cent of the rupee on 1 and 3 July, 1991.
  • In March, 1992, the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rates was introduced.
  • Under this system, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank and 60 per cent was to be converted at the market determined rates.
  • The dual rates were converged into one from 1 March, 1993; this was an important step towards current account convertibility, which was finally achieved in August, 1994 by accepting Article-VIII of the Articles of Agreement of the IMF.
  • The exchange rate of the rupee thus became market determined, with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases.

Other Topics

NCERT Extracts - Open Economy : Macroeconomics

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