Open Economy Overview

• An open economy interacts with other countries through output, financial, and labor markets.
• This contrasts with a closed economy, which has no linkages with the rest of the world.

Output Market

• An economy can trade in goods and services with other countries.
• This trading widens choice for consumers and producers to select between domestic and foreign goods.

Financial Market

• An economy can buy financial assets from other countries.
• It gives investors the choice between domestic and foreign assets.

Labor Market

• Firms can choose where to locate production, and workers can choose where to work.
• Immigration laws can restrict the movement of labor between countries.
• The movement of goods has served as a substitute for the movement of labor, traditionally.
• An open economy trades with other nations in goods, services, and financial assets.
• Foreign trade influences aggregate demand through leakage and injection.
• Buying foreign goods results in spending escaping the circular flow of income, decreasing aggregate demand,.
• Exports to foreigners inject money into the circular flow, increasing aggregate demand.
• When goods move across national borders, currency is required.
• There is no single currency issued by a single bank at the international level.
• Economic agents accept a national currency if they are convinced that the amount of goods they can buy with it will not change frequently, which maintains a stable purchasing power.
• Without this stability, a currency will not be used as an international medium of exchange.
• Governments have tried to gain the confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset.
• The issuing authority would have no control over the value of that asset into which the currency can be converted, typically gold or other national currencies.
• Aspects affecting credibility are the ability to convert freely in unlimited amounts and the price at which this conversion takes place.
• The international monetary system handles these issues and ensures stability in international transactions.
• With increased transaction volumes, gold ceased to be the asset into which national currencies could be converted.
• Of importnace in transactions between two countries the currency in which the trade occurs.
• The foreign exchange rate, or simply the exchange rate, is the price of one currency in terms of another currency.

Balance of Payments (BoP)

• This records transactions in goods, services, and assets between residents of a country and the rest of the world over a specified time period, typically a year.
• There are two main accounts in the BoP: the current account and the capital account.

Current Account

• This account records trade in goods and services, and transfer payments.
• Trade in goods includes exports and imports of goods.
• Trade in services includes factor income and non-factor income transactions.
• Transfer payments are receipts from a country for 'free', without providing any goods or services in return, consisting of gifts, remittances, and grants from governments or private citizens living abroad.
• Buying foreign goods results in expenditure from a country becoming the income of that foreign country.
• Buying foreign goods/imports decreases domestic demand of goods and services.
• Selling foreign goods/exports brings income to the country and increases the aggregate domestic demand for goods and services

Balance on Current Account.

• Occurs when receipts on current account are equal to the payments on the current account.
• A surplus means the nation is a lender to other countries.
• A deficit current account means the nation is a borrower from other countries.
• The components include: Balance of Trade or Trade Balance and Balance on Invisibles.

Balance of Trade (BOT)

• The difference between the value of exports and value of imports of goods of a country in a given period of time.
• Exports of goods are a credit item, while imports of goods are a debit item.
• Also called Trade Balance.
• Is in balance when exports of goods are equal to the imports of goods.
• Surplus arises if a country exports more goods than it imports.
• Deficit arises if a country imports more goods than it exports.

Net Invisibles

• The difference between the value of exports and value of imports of invisibles.
• These include services, transfers, and flows of income between different countries.
• Service trade includes both factor and non-factor income.
• Factor income includes net international earnings on factors of production.
• Non-factor income is net sale of service products like shipping, banking, tourism, and software services.

Capital Account

• This records all international transactions of assets like money, stocks, bonds, and Government debt.
• Purchase of assets is a debit item
• An Indian buying a UK Car Company enters capital account transactions as a debit item, because the foreign exchange is flowing out of India.
• The sale of assets, such as a sale of shares of an Indian company to a Chinese customer, is a credit item.
• Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), external borrowings, and assistance are part of capital account transactions.
• Capital account balance occurs when capital inflows equal to capital outflows.
• A surplus happens when capital inflows are greater than capital outflows.
• A deficit occurs when capital inflows are lesser than capital outflows.

Balance of Payments Surplus and Deficit

• A country with a deficit in its current account must finance it by selling assets or by borrowing abroad.
• Any current account deficit must be financed by a capital account surplus.
• Current Account + Capital Account = 0, as a balance of payments equilibrium, in which the current account deficit is financed entirely by international lending without any reserve movements.
• A country could also use its reserves of foreign exchange to balance any deficit in its balance of payments, so the reserve bank sells foreign exchange when there is a deficit.
• Official reserve sale is when the reserve bank sells foreign exchange on a deficit.
• Overall balance of payments deficit (surplus) refers to the decrease (increase) in official reserves.
• Monetary authorities are the ultimate financiers/recipients of any deficit/surplus.
• Official reserve transactions are more relevant under a regime of fixed exchange rates than when exchange rates are floating.

Autonomous and Accommodating Transactions

• Autonomous transactions are independent of the state of BoP, but made due to reasons other than to bridge the gap in the payments balance.
• These, called "above the line" items in the BoP, earn profit.
• The balance of payments is in surplus or deficit if autonomous receipts are greater or less than autonomous payments.
• Accommodating transactions, or “below the line" items, are determined by the gap in the balance of payments, based on whether there is a deficit or surplus.
• Official reserve transactions accommodate the gap in the BoP, and are the accommodating item in the BoP.

Errors and Omissions

• Reflects difficulties in accurately recording all international transactions.

Foreign Exchange Market

• Currencies are traded for one another in this market, this is known as the exchange rate.
• The major participants include commercial banks, foreign exchange brokers, authorized dealers, and monetary authorities.
• The market is world-wide, with close and continuous contact between trading centers and participants.

Foreign Exchange Rate

• Also called Forex Rate.
• It is the price of one currency in terms of another.
• It links the currencies of different countries, and enables comparison of international costs and prices.

Demand for Foreign Exchange

• Want to purchase goods and services from other countries.
• Sending gifts abroad.
• Purchasing financial assets of a certain country.
• A rise in price of foreign exchange leads to a rise purchasing a foreign good.
• This reduces demand for imports, hence demand for foreign exchange also decreases.

Supply of Foreign Exchange

• Exports lead to purchases of domestic goods and services by foreigners.
• Foreigners send gifts or make transfers.
• Assets of a home country are bought by foreigners.
• A rise in price of foreign exchange will reduce the foreigner's cost while purchasing products from India.
• Exports increase, hence supply for foreign exchange may increase.

Determination of the Exchange Rate

• Is determined through Flexible, Fixed, or Managed Floating Exchange Rates

Flexible Exchange Rate

• This rate is determined by the market forces of supply and demand. Also called Floating Exchange Rate.
• The exchange rate is determined where demand intersects with supply.
• Central banks do not intervene in the foreign exchange market with it.
• An increase in demand for foreign goods and services changes the exchange rate.
• Depreciation of domestic currency (rupees) in terms of foreign currency (dollars) is where the price of foreign currency (dollar) has increased in terms of domestic currency (rupees).
• Appreciation of the domestic currency (rupees) is where the price of domestic currency has incresed in terms of foreign currency.

Speculation

• If people in a country believe the currency in another country is going to rise, they will want to hold those currencies.
• This exchange rates are impacted when people use foreign exchange to make change from the appreciation of the currency.

Interest Rates and the Exchange Rate

• Short run factor that influences movements.
• Interest rate differential is the difference between interest rates between countries.
• When interest rates in a country pay more, investors in other countries will by currency and earn interest.
• Demand curve shifts to the left and the supply curve to the right, causing depreciation of the country A's currency and appreciation country B's currency.

Income and the Exchange Rate

• an increase in consumer spending happens when income increases.
• When imports increase, the demand curve for foreign exchange shifts to the right: Depreciation of the domestic currency.
• Currency may or may not depreciate depending on whether exports are growing faster than imports.
• a country whose aggregate demand grows faster than the rest of the world normally finds its currency depreciating because its imports grow faster than its exports.

Exchange Rates in the Long Run

• Purchasing Power (PPP) theory is used to make long-run predictions regarding exchange rates in a flexible system.
• Exchange rates should eventually adjust so that the same product costs the same everywhere is purchased.

Fixed Exchange Rates

• Government fixes the exchange rate at a particular level.
• The higher exchange rate is set by government if it wants to encourage exports and for exporters to make more money.
• The exchange rate can be maintains through intervention.
• Devaluation refers to some government action that increases the exchange rate (thereby making domestic currency cheaper)..
• Revaluation refers to occur when the government decreases the exchange rate (thereby making domestic currency costlier.

Merits and Demerits of Flexible and Fixed Exchange Rate Systems

• A fixed exchange rate system needs credibility that will maintain the exchange rate at the level specified.
• If there is a deficit in the BoP, governments will have to intervene by use of its official reserves.
• People may doubt the ability of the government to maintain the fixed rate if the amount of reserves is inadequate.
• Governments are prone to speculative attacks.
• A flexible exchange rate system gives the government more independence since they don't have to intervening.
• Movements in the exchange rate automatically take care of the surpluses and deficits in the BoP.

Managed Floating

• It is a mixture of a flexible and a fixed rate system.
• Central banks intervene to buy and sell foreign currencies to moderate exchange rate movements.