Chapter 6 Open Economy Macroeconomics

The transactions carried by monetary authority of a country, which cause changes in official reserves, transactions (ORT). These transactions are carried through purchase or sale of currency in the exchange market for foreign currencies or other assets. The reserves are drawn by selling foreign currencies in the exchange market during deficits and foreign currencies are purchased during surplus.

When the official reserves increases or decreases, it is called overall balance of payments surplus or deficit respectively.

Importance of ORT in balance of payments:

1. Purchase of a country’s own currency is a credit item in the balance of payments; Whereas, sale of the currency is a debit item.
2. It helps to adjust the deficit and surplus in balance of payments.

Nominal exchange rate is the price of one currency in terms of another. It is the amount of domestic currency required to buy one unit of foreign currency. For example a rupee- dollar exchange rate of Rs 45 means that it costs 45 rupees to buy 1 dollar. Real exchange rate is the ratio of foreign prices to domestic prices. In other words, it measures foreign prices relative to domestic prices.

Real exchange rate

Where Pf - price level of foreign currency

P - Price level of domestic currency
e - Nominal exchange rate

For example, if a watch costs $40 in US and the nominal exchange rate is 50 per US dollar, then, with a real exchange rate of 1, it should cost Rs 2,000 (ePf = 50 × 40 = Rs2000) in India.

If, I were to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate takes the inflation differential among the countries into account and is also used as an indicator of a country's competitiveness in the foreign trade.

Price level in foreign country: (Japan) Pf = 3

Price level in home country: (India) P = 1.2

Now, real exchange rate

Price of 1.25 yen = 1 rupee

Price of 1 yen = =

Therefore,

So, real exchange rate

= 2

Therefore, the real exchange rate is 2.

Under the gold standard system, gold was taken as a common unit for measuring other country’s currency. Thus, the value of a currency was defined in terms of gold. The exchange rate in an open market was determined by its worth in terms of gold. It was fixed in lower limits and upper limits, under which it was allowed to fluctuate. So, the exchange rate became stable under the gold standard. All the countries maintained stock of gold to exchange currency.

Under a flexible exchange rate regime, the rate of exchange is determined by the forces of demand and supply. In other words, the equilibrium rate of exchange occurs where demand and supply are equal to each other. This can be illustrated with the help of the given figure:

In the figure, x-axis represents demand for and supply of foreign currency and y-axis represents the exchange rate. DD is the demand curve that is downward sloping, showing an inverse relationship between the rate of exchange and demand for foreign currency. Whereas, the supply curve is upward sloping, showing a positive relationship between the rate of exchange and the supply of foreign currency. E is the equilibrium rate of exchange, where the demand equates the supply of foreign exchange (OR).

Now, if the exchange rate rises to OR1, then the supply exceeds the demand, forcing the exchange rate to fall back to OR. On the contrary, if the exchange rate falls to OR2, there is excess demand over supply. Hence, the rate of exchange rises from R2 to R.

Hence, the equilibrium exchange rate (OR) is determined by demand and supply of foreign currency.

Managed floating system is a combination of two systems - fixed and floating exchange rate systems. It calls for the government or central bank to intervene when the need for the same is needed. The government or the central bank helps in moderating the exchange rate movements by purchasing and selling of foreign currency. Thus, to avoid dirty floating, the government exercises its power to intervene, whenever the need arises.

In a closed economy, the demand for domestic goods and domestic demand for goods are similar terms. However, in an open economy, these two terms have different meanings. Demand for domestic goods includes both domestic and foreign demand for domestic goods. Whereas, domestic demand for goods refers to the domestic market demand of a country, that is either produced domestically or abroad (foreign countries).

Marginal propensity to import is the fraction of additional income spent on imports.

It is given that M = 60 + 0.06Y

Therefore, marginal propensity to import (m) = 0.06. It reflects induced imports; that is the part of the total imports, which is a function of income. Since the marginal propensity to import negatively affects the aggregate demand function, when income increases the aggregate demand decreases. This is because the additional income is spent on foreign goods and not on domestic products.

In case of a closed economy, equilibrium level of income is given by

Y = C + cY + I + G
Or, Y - cY = C + I + G
Or, Y (1 - c) = C + I + G

Or, 

Let, (C + I + G) = A1

In the case of an open economy, equilibrium level of income is given by

Y = C + cY + I + G + X - M - mY
Or, Y - cY - mY = C + I + G + X
Or, Y (1 - c - m) = C + I + G + X

In the case of proportional tax, the equilibrium income would be

Y = C + c (1 - t) Y + I + G + X - M - mY
Y - c (1 - t) Y + mY = C + I +G + X - M
Y[1 - c (1 - t) +m] = C + I + G + X – M

Autonomous expenditure (A) = C + I + G + X - M

Therefore, open economy multiplier with proportional taxes

C = 40 + 0.8YD
T = 50
I = 60
G = 40
X = 90
M = 50 + 0.05Y

(a) Equilibrium level of income

Y = C + c (Y - T) + I + G + X - M – mY

     = 560

(b) Net exports at equilibrium income 

NX = X - M - My

= 90 – 50 -0.05×560
= 40 – 28 =12

(c) When G increase from 40 to 50,

Net export balance at equilibrium income

NX = X - (M - mY)
= 90 - 50 + 0.05 × 600
= 40 - 30 = 10

C = 40 + 0.8 YD
T = 50
I = 60
G = 40
X = 100
M = 50 + 0.05Y 

Equilibrium income (Y)

Net export balance NX = X - M - 0.05Y

= 100 - 50 - 0.05 × 600
= 50 - 0.05 × 60
= 50 - 30 = 20

In a closed economy, savings and investments are equal at equilibrium level of income.

However, in an open economy savings and investments differ.

Y = C + I + G + X - M
Or, Y = C + I + G + NX [As NX = X - M]
Or, Y - C - G = I + NX
Or, S = I + NX

Savings in an economy include private savings (S_p) and government savings (S_g).

So, S_p + S_g - I
Or, NX =S_p+ S_g – I
SP = Y - C - T SR = T - G

Or, NX = (Y - C - T) + (T - G) - I
Or, NX = Y - C - T +T - G - I
Or, NX = Y - C - G - I
Or, G = Y - C - I - NX
Or, G - T = Y - C - I - NX - T [Subtracting T from both sides]
Or, G - T = Y - C - T - I - NX
Or, G - T = (S_p - I) - NX
Or, G - T = (S_g- I) - (X - M) [NX = X - M]

Country A has a higher inflation than country B. Since, the exchange rate is fixed, it is advantageous for country B to export goods to country A. Similarly, it is advantageous for country A to import goods from country B. On the other hand, it would be expensive for country A to export goods to country B. Thus, country A will have trade deficit as it will import more goods as compared to exports, from country B. Country B will import less goods as compared to exports, from country A. Hence, there is a trade surplus in country B.

Current account deficit is the excess of total imports of goods, services and transfers over total exports of goods, services and transfers. This situation makes a country debtor to the rest of the world. But, this cannot be always treated as a cause for alarm because countries might be running in deficits (current account) to increase productivity and exports in future. Also, more investment will help in building capital stock, which in future will lead to rise in output.

C = 100 + 0.75 YD
I = 500
G = 750
X = 150
M = 100 + 0.2 Y

Equilibrium income (Y) = C + c (Y - T) + I + G + X - M – mY

Since NX is negative, it implies trade deficit.

To combine the two extreme positions, `fixed' and 'flexible', the following exchange rate arrangements are used by governments to bring stability in external accounts:

1. Wider Bands

A system that allows adjustment in fixed exchange rate is referred to as wider bands. It permits only 10% variation between the currencies of any two countries. For example, a country can improve its balance of payments (BOP) deficit by depreciating its currency, which leads to increase in demand for domestic goods due to increase in purchasing power of other currencies. This further leads to the increase in exports, hence improving the BOP.

2. Crawling Peg

Crawling peg system allows continuous  and  regular adjustments in the exchange rate. Only 1% of variation is allowed at a time.

3. Managed Floating

Managed floating is a scheme under which the government can intervene to vary the exchange rate when the situation demands so. There is no specific limit of variation as in crawling peg and wider bands.