[Introductory Macroeconomics] Chapter 6: Open Economy Macroeconomics

Open Economy Macroeconomics

When an economy trades with the rest of the world — exporting goods, importing commodities, borrowing and lending abroad — it is called an open economy. Macroeconomic analysis must then account for international trade and financial flows.

Balance of Payments (BoP)

The Balance of Payments is a systematic record of all economic transactions between residents of a country and the rest of the world during a given period. It has two main accounts:

1. Current Account
Records transactions in goods and services, income, and current transfers.
Trade Balance (Merchandise Balance): Exports of goods - Imports of goods.
Balance on Invisibles: Services (software, tourism), Investment income (interest, dividends), and Unilateral transfers (remittances, foreign aid).
Current Account Balance = Trade Balance + Balance on Invisibles

2. Capital Account
Records transactions involving financial assets and liabilities.
Foreign Direct Investment (FDI)
Portfolio Investment (FPI — stocks, bonds)
External commercial borrowings
NRI deposits
Official reserve transactions

The BoP Identity: Current Account + Capital Account + Errors & Omissions = 0 (By double-entry accounting principle)
OR: Current Account Deficit = Capital Account Surplus (approximately)

Foreign Exchange Market

The exchange rate is the price of one currency in terms of another.
Demand for foreign exchange (forex): Arises from imports, travel abroad, remittances out, capital outflows.
Supply of forex: Arises from exports, foreign tourists in India, remittances in, FDI, FPI inflows.

Exchange Rate Systems:

Flexible (Floating) Exchange Rate: Determined by demand and supply in the forex market. No government intervention.
Depreciation: Home currency falls in value (market-driven).
Appreciation: Home currency rises in value (market-driven).

Fixed Exchange Rate: Government/central bank fixes the rate. Must intervene by buying/selling foreign currency.
Devaluation: Government deliberately reduces the fixed value of its currency.
Revaluation: Government deliberately raises the fixed value.

Managed Float: RBI intervenes occasionally to prevent excess volatility, but does not fix the rate. India follows this system.

Purchasing Power Parity (PPP)

PPP theory states that exchange rates tend to adjust so that a basket of goods costs the same in all countries when measured in a common currency.
If a burger costs $5 in the USA and Rs. 250 in India, PPP exchange rate = 250/5 = Rs. 50 per dollar.

Effects of Depreciation

When the rupee depreciates (more rupees per dollar):
Exports become cheaper for foreigners → export quantity rises (positive for trade balance)
Imports become costlier for Indians → import quantity falls (positive for trade balance)
But in the short run, if demand is inelastic, trade balance may worsen first (J-curve effect)

Example 1

Current account calculation
Exports of goods = Rs. 50,000 crore. Imports of goods = Rs. 70,000 crore. Trade deficit = -20,000 crore. Export of services = Rs. 15,000 crore. Import of services = Rs. 8,000 crore. Remittances received = Rs. 5,000 crore. Balance on invisibles = 15,000 - 8,000 + 5,000 = 12,000 crore. Current Account Balance = -20,000 + 12,000 = -Rs. 8,000 crore (deficit).

Example 2

Exchange rate and imports
1 USD = Rs. 80. India imports oil worth $100. Cost in rupees = 100 x 80 = Rs. 8,000. If rupee depreciates to Rs. 90 per dollar: cost = 100 x 90 = Rs. 9,000. Imports become 12.5% more expensive, encouraging a switch to domestic alternatives.

Example 3

Exchange rate and exports
Indian software firm exports services worth Rs. 1,00,000 crore. At Rs. 80/dollar, this = $1,250 crore. For a US buyer, if the rupee depreciates to Rs. 100/dollar, the same Rs. 1,00,000 crore now costs only $1,000 crore — Indian services become cheaper for foreign buyers, boosting export demand.

Example 4

BoP identity
If Current Account Deficit = Rs. 2,00,000 crore and Capital Account Surplus = Rs. 1,80,000 crore, then the BoP deficit = Rs. 20,000 crore. This is financed by running down official foreign exchange reserves. Total BoP still balances when reserve changes are included.

Example 5

Fixed vs flexible exchange rate
Under a fixed rate of Rs. 75/dollar, if market pressure pushes demand for dollars up (rupee should weaken to Rs. 80), RBI sells dollars from its reserves to supply dollars and maintain Rs. 75. Under a flexible rate, the rate simply moves to Rs. 80 without RBI intervention.

Example 6

Devaluation vs depreciation
India in 1966 devalued the rupee from Rs. 4.76 to Rs. 7.50 per dollar — a deliberate government decision under the fixed rate system. In contrast, today the rupee moving from Rs. 82 to Rs. 84 per dollar is depreciation — a market-determined movement.

Example 7

PPP in practice
If a Big Mac costs $5 in the USA and Rs. 250 in India, the implied PPP exchange rate is Rs. 50 per dollar. But the market rate may be Rs. 83 per dollar — this suggests the rupee is "undervalued" in PPP terms. PPP is used to compare living standards across countries.

Common mistakes

Depreciation (market-driven) is NOT the same as devaluation (government decision under fixed exchange rate).
A current account deficit is NOT always harmful — it may reflect high growth and productive capital inflows.
The BoP as a whole ALWAYS balances (by accounting identity) — a deficit refers specifically to the current account or non-reserve capital account.
Exports are a SUPPLY of foreign exchange (Indian exporters receive dollars), not demand.

Summary

Open economy macroeconomics adds exports, imports, and international capital flows to the analysis. The Balance of Payments records all international transactions. The exchange rate, determined by forex demand and supply (under floating rates), affects trade competitiveness. Depreciation makes exports cheaper and imports dearer. India uses a managed float. The BoP must always balance by accounting identity.