Chapter 6 — Open Economy Macroeconomics

An open economy is one that interacts with other countries through trade in goods and services and in financial assets. Foreign trade influences aggregate demand in two ways: imports are a leakage from the circular flow of income while exports are an injection into it.

The three channels are: (1) Output Market — trade in goods and services with other countries; (2) Financial Market — buying and selling of financial assets across countries; and (3) Labour Market — movement of workers and firms across borders, though immigration laws restrict this.

The BoP records all transactions in goods, services, and assets between residents of a country and the rest of the world for a specified period, typically a year. It has two main accounts — the current account and the capital account — plus an errors and omissions item.

The current account records trade in goods and services and transfer payments. It includes the Balance of Trade (exports minus imports of goods), Net Invisibles (services — both factor and non-factor income — plus income flows), and transfer payments such as gifts, remittances, and grants from governments or private citizens abroad.

The capital account records all international transactions of assets such as money, stocks, bonds, and government debt. It includes Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), external borrowings, and assistance. Purchase of assets is a debit item; sale of assets is a credit item.

Autonomous transactions are made for reasons independent of the BoP position — for example, to earn profit — and are called 'above the line' items. Accommodating transactions are made specifically to bridge the gap in the BoP and are called 'below the line' items; official reserve transactions are the key accommodating item.

Under a flexible (floating) exchange rate system, the rate is determined by market forces of demand and supply. Central banks do not intervene. When demand for foreign exchange rises (e.g., more imports), the domestic currency depreciates; when supply of foreign exchange rises (e.g., more exports), it appreciates.

Depreciation is a market-driven fall in the value of domestic currency in terms of foreign currency under a flexible exchange rate system. Devaluation is a deliberate government action that increases the exchange rate (making domestic currency cheaper) under a fixed exchange rate system.

According to PPP theory, as long as there are no trade barriers, exchange rates in the long run adjust so that the same product costs the same whether measured in rupees in India or dollars in the US (except for transport differences). Over the long run, exchange rates reflect differences in price levels between two countries.

Managed floating — also called dirty floating — is a mixture of flexible and fixed exchange rate systems. Without any formal international agreement, central banks intervene to buy and sell foreign currencies to moderate exchange rate movements whenever they consider it appropriate. Official reserve transactions are therefore not equal to zero.

A higher interest rate in one country attracts foreign investors who buy that country's currency, increasing its demand and causing it to appreciate. A lower interest rate causes investors to move funds abroad, depreciating the domestic currency. The difference in interest rates between countries is called the interest rate differential.

The open economy multiplier is 1/(1−c+m), where c is the marginal propensity to consume and m is the marginal propensity to import. It is smaller than the closed economy multiplier 1/(1−c) because imports are an additional leakage from the circular flow of income — a proportion of each round of induced consumption spending falls on foreign goods, reducing the impact on domestic income.

The marginal propensity to import (m) is the fraction of an extra rupee of income that is spent on imports — analogous to the marginal propensity to consume. In the import function M = M̄ + mY, the term m is the marginal propensity to import, with 0 < m < 1.

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