Macroeconomics

Session 15: International Linkages

Dr. Jithin P
IIM Raipur
 Introduction
• It is assumed that the economy is closed-that it does not interact
with the rest of world.
• National economies are becoming more closely interrelated
• Economic influences from abroad have effects on the Indian
economy
• When the global economy(US, Euro Area etc.) moves into a
recession, it tends to pull down our economy
• When the global economy(US, Euro Area etc.) is in an expansion,
it tends to stimulate our economy
• When the Fed changes the monetary policy or US govt follows an
expansionary fiscal policy, it affects Rupee-dollar exchange rate,
interest rate, net exports, and GDP
There is a need to modify the IS-LM model so that it takes into
account linkages between domestic economy and the rest of the
world.
Introduction
Economies are linked through two broad channels
1. International Trade in goods and services (product market)
• When there is an increase in foreign demand for domestically produced goods → Some of the country’s
production is exported to foreign countries → an injection to the circular flow of income (X)
• When there is an increase in home country’s demand for foreign goods and services. → Some goods and
services produced abroad are imported to home country → a leakage from the circular flow of income
(M). (IS and LM model should be modified)
2. International Finance
• When there is an increase in demand for foreign assets, domestic residents buy foreign assets such as
foreign bonds, securities etc. to maximize their returns.
• Similarly, foreign residents have an option to make financial investment in India if Indian financial assets
are more attractive.
• When international investors reallocate (shifts) their assets around the world, they affect exchange rate,
competitiveness, and the ability of monetary policy to affect interest rates.
 Balance of payments
• Balance of payments is a record of the economic
transactions between the residents of one country
and the rest of the world.
• The main purpose of the balance of payments is to
inform the government of the international position
of the nation and to help it in its formulation of
monetary, fiscal, and trade policies.
• An international transaction refers to the exchange of
a good, service, or asset (for which payment is usually
required) between the residents of one nation and
the residents of other nations.
Balance-of-Payments
Accounting Principles
• International transactions are classified as credits or debits.
Credit transactions are those that involve the receipt of
payments from foreigners.
• the following transactions are credits (+), leading to the receipt
of payments from foreigners:
• Merchandise exports
• Transportation and travel receipts
• Income received from investments abroad
• Gifts received from foreign residents
• Aid received from foreign governments
• Investments in India by overseas residents
• Debit transactions are those that involve the making of
payments to foreigners.
 Balance of Payments Accounting Principles
• The following transactions are debits (-) because they involve
payments to foreigners:
• Merchandise imports
• Transportation and travel expenditures
• Income paid on investments of foreigners
• Gifts to foreign residents
• Aid given by the Indian government
• Overseas investment by Indian residents
 Current Account
Balance-of- • The current account of the balance of
payments refers to the monetary value of
Payments Structure international flows associated with
transactions in goods and services, investment
income, and unilateral transfers.
• The main components of the current account
are:
• Trade in goods
• Trade in services, Example: insurance and
services
• Investment incomes, Example: dividends,
interest and migrants' remittances from
abroad
• Net transfers, Example: International aid
If receipts are more(less) than payments in
current account, there is a current account
surplus (deficit).
 • Capital transactions in the balance of payments include all
international purchases or sales of assets.
• The term assets is broadly defined to include items such as
titles to real estate, corporate stocks and bonds,
government securities, and ordinary commercial bank
deposits.
• If receipts are more(less) than payments, in capital
Capital account account, capital account is in surplus. (deficit)
• If receipts in both current and capital account are
more(less) than payments, then the overall BOP is in
surplus(deficit)
Statistical Discrepancy: Errors and Omissions reflect the
imbalances resulting from imperfections in source data and
compilation of the balance of payments accounts.
Major Items of India's Balance of Payments
Overall BOP and change in foreign exchange reserves

• If a country has a deficit in its current account, it must finance it by

borrowing from abroad or selling assets.
• So a current account deficit has to be accompanied by either (a) a
capital account surplus ( net capital inflow)/borrowing from abroad
or (b) running down of its reserves of foreign currency/selling foreign
currency in the foreign exchange market.
• If the sum of current and capital accounts is greater than zero, the
overall BOP is in surplus. There is equivalent increase in foreign
exchange reserve.
• If the sum of current and capital accounts less than zero, the overall
BOP is in deficit. There is equivalent decrease in foreign exchange
reserve.
• If the sum of current and capital accounts equals zero, the overall
BOP is in balance. There is no change in foreign exchange reserve.
Exchange Rates
• The exchange rate between two countries is the price at which residents of
those countries trade with each other.
Nominal and Real Exchange Rates
• The nominal exchange rate is the relative price of the currencies of two
countries.
• For example, if the exchange rate between the Rupee and the Euro is 88
rupees per euro, then you can exchange 88 rupees for one euro in world
markets for foreign currency.
• exchange rate can be reported in two ways. If one dollar buys 80 rupees, then
one rupee buys 0.0125 dollar. We can say the exchange rate is 80 rupees per
dollar, or we can say the exchange rate is 0.0125 dollar per rupee.
• a rise in the exchange rate—say, from 80 to 100 rupees per dollar—is called an
appreciation of the dollar.
• a fall in the exchange rate is called a depreciation.
• The Indian Rupee depreciated by around 10% against the US dollar and the
rupee was the worst-performing Asian currency in 2022.
Euro to INR exchange rate
 The real exchange rate is the relative price of the
goods of two countries
• The real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of
Nominal and another. The real exchange rate is sometimes called
the terms of trade.
Real • Suppose an American car costs $25,000 and a
similar Indian car costs 4,000,000 rupees. To
Exchange compare the prices of the two cars, we must convert
them into a common currency
Rates • If a dollar is worth 80 rupees, then the American car
costs 80*25,000, or 2,000,000 rupees. Comparing
the price of the American car (2,000,000 rupees)
and the price of the Indian car (4,000,000 Rupees),
we conclude that the American car costs one-half of
what the Indian car costs.
 𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝑒 × 𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙𝑠

𝑃∗
R=𝑒×
𝑃
• Where, e=nominal exchange rate, i.e., the amount of domestic
currency required to buy one unit of foreign currency (e.g. Rs
Nominal and 80=$1), P*=price of the foreign good in foreign currency (e.g.$),
P=price of the domestic good in domestic currency (e.g. rupees)
Real Exchange →If R =1, goods at home and abroad cost the same amount of
expenditure.
Rates →If R > 1, goods abroad are more expensive than at home (
exports will increase and imports will decrease, or net exports
will increase)
→If R < 1, goods abroad are cheaper than those at home (
exports will decrease and imports will increase, or net exports
will decrease).
 Types of Exchange Rate
System

Fixed exchange rate system

• Under this system, the exchange rate for the
currency is fixed by the government. Thus, the
government is responsible for maintaining the
stability of the exchange rate.
• Each country maintains the value of its currency
in terms of some ‘external standard’ like gold,
silver, another precious metal, or another
country’s currency.
Changes in Demand and Supply: Exchange Rate
fluctuations in a Fixed Exchange Rate System
• In a fixed/pegged exchange rate environment, the exchange rate of a country is
fixed against a foreign currency (e.g. $1=Rs 50).
• The Central Bank is committed to maintain the pegged rate.
• Intervention is the buying and selling of foreign exchange by the central bank.
• An increase in domestic interest rate leads to an increase in supply of dollar.
• This leads to an increase in excess supply of dollar at the pegged exchange rate.
• The Central Bank buys the dollar, which, in turn, leads to an increase in bank
reserves.
• The buying of forex in the foreign exchange market leads to an increase in money
supply.
Exchange Rates
per US Dollar, 2000
to 2019 (Fixed ER
Regime)
Flexible Exchange rate system
• In a flexible exchange rate system, the value of the
currency is allowed to fluctuate freely as per the changes in
the demand and supply of the foreign exchange.
• Under this system, the exchange rate for the currency is
fixed by the forces of demand and supply of different
currencies in the foreign exchange market.
• This system is also called the Floating Rate of Exchange or
Free Exchange Rate. It is so because it is determined by the
free play of supply and demand forces in the international
money market.
• The exchange rate is determined through interactions of
banks, firms, and other institutions that want to buy and
sell foreign exchange in the foreign exchange market.
Flexible Exchange rate system
Demand for US dollars
• The demand for US dollar increases when there is an increase
in
• (a) India’s Demand for US goods and services (imports)
• (b) US interest rate relative to domestic interest rate (want to
buy US financial assets)
• (c) Expected change in exchange rate (depreciation of Rupee)
• All of them will shift the demand for dollar curve to right and
will lead to an increase in exchange rate (i.e. value of 1 dollar
increase from Rs 50 to Rs 55) It is called depreciation of rupee.
The rupee has depreciated by 10%.
Flexible Exchange rate system
Supply of US dollars
• The supply of US dollar increases when there is an increase
in
• US Demand for Indian goods and services (our exports)
• India’s interest rate relative to US interest rate (want to
buy Indian financial assets)
• Rupee is expected to appreciate
• All of them will shift the supply of dollar curve to right and
will lead to a decrease in exchange rate (i.e. value of 1 dollar
decreases from Rs 50 to Rs 45) It is called appreciation of
rupee.
Changes in Demand and Supply: Exchange Rate fluctuations in a
Managed Floating Exchange Rate System

• The managed floating exchange rate system is a mixture

of a flexible exchange rate system (the float part) and a
fixed exchange rate system (the managed part).
• It is also known as dirty floating.
• The 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.
• India has had a managed floating exchange rate system
since 1993.
What determines Net Exports?

• Net export (NX): The difference between export and

import. It is one of the important components of
aggregate demand.
• What determines net exports? How net exports
determine our GDP?
• In an open economy, domestic consumers, investors,
government have to make a decision: whether to buy
domestic goods or foreign goods .
• It depends on:(i) relative price or real exchange rate
(RER). The RER is the price of foreign goods relative to
the price of domestic goods, (ii) foreign income (Yf), and
domestic income (Y)
Net Exports
• Net exports, (X-M), is the excess of exports over imports
• NX depends on
✓ Domestic income, 𝑌
✓Foreign income, 𝑌𝑓
✓Real exchange rate, 𝑅
𝑁𝑋 = 𝑋 𝑌𝑓 , 𝑅 − 𝑀 𝑌, 𝑅 = 𝑁𝑋 𝑌, 𝑌𝑓 , 𝑅
• A rise in foreign income, other things being equal, improves the home
country’s trade balance and therefore raises the home country’s aggregate
demand.
• A real depreciation by the home country improves the trade balance and
therefore increases aggregate demand.
• A rise in home income raises import spending and hence worsens the trade
balance.