The Open Economy

The External
Sector
 Introduction
 Global Economic Integration through:
– (1) Opening up international trade in
goods and services
– (2) Opening up international movement of
labour
– (3) Opening up international movement of
capital
 Macroeconomic policy focuses on (1)
and (3)
 In a globally integrated world,
macroeconomic policies of a country
 Introduction
 The extent of these repercussions depends
on
– (a) size of international trade in a country’s
GDP,
– (b) how mobile is the capital between the
countries, and
– (c) the exchange rate regime(system)
 Discussion
– Why do countries trade with each other?
– External balance of payments account
– Different exchange rate regimes
–
 Why do countries trade with each other?
 Unequal distribution of natural resources
 Difference in Technology
 Different Preferences:
– Americans prefer Basmati rice grown in India
 Cost Advantages:
– Cost of production for the same product
differs among different locations
– Better explained by the Theory of Absolute
Advantage and the Theory of Comparative
Advantage
 Theory of Absolute Advantage
 Propounded by Adam Smith
 Assume, two countries, country A and
country B
Producing only two commodities, x and
y
 Suppose, A can produce x cheaper than
B, and B can produce y cheaper than A
 Means, A has an absolute advantage in
the production of x and B in the
production of y
 Theory of Absolute Advantage
 Both countries will gain from the trade
– Results in specialization
– Increases productivity
 But what happens if A has absolute
advantage in the production of both x
and y?
 i.e., if A can produce x cheaper than B
and it can produce y much cheaper
than B
 Should A produce both x and y and B
nothing?
 The Comparative Advantage Theory
 The globe will be better off if A concentrates on
the production of y, which it can produce much
cheaper than B and B concentrates on the
production of x which it can produce relatively
less expensively than A
 Even if countries do not have an absolute
advantage, they can gain from trade by
allocating resources based on their comparative
advantage and trade with each other
 Theory by David Ricardo
 Comparative Advantage - Illustration
 Labour requirements (opportunity cost in the
bracket)
India US
Textiles 3 (1/2) 2 (2)
PCs 6 (2) 1 (1/2)

 The relative price of one PC is 2 textiles in India

(6/3), while it is ½ textiles in the US
 Hence, PC is relatively cheaper in the US
 In the case of relative price of textiles, the reverse
is the case
 US specializes in PCs
 Gains from Trade
(a) International trade brings in
efficiency in production and
consumption, and
(b) It provides a market for goods and
services
 The above discussion on trade
assumes that there is no restrictions
on trade
 But in real life trade restrictions in
Effects of Trade and Protectionism
Effect of trade on domestic demand and
supply
 If the international price of a commodity is lower
than the domestic price there is always possibility
of trade
 Due to cheaper imports, domestic prices will go
down, domestic supply also reduce and domestic
demand goes up
 Affects domestic industry, so, govt. may impose
restrictions on international trade
 Either by limiting the number of units of the product
that can be imported by putting a quota or by
imposing a tariff
 Imposition of tariff increases the price of the
 Exchange Rates
 Exchange rate is the price of one (domestic)
currency in relation to another (foreign)
currency
 The market where the various currencies are
traded is called the foreign exchange market
 Balance of
Payments (BoP)
Account
The Balance of Payments (BoP)
 BoP is a systematic record of all
economic transactions between the
residents of a country and the
residents of the rest of the world,
carried out in a specific period of
time, usually a year.
 It is a classified statement of all the
receipts of residents of a country from
foreigners and payments by residents
to foreigners
 The Balance of Payments (BoP)
 BoP is a double book entry
That is, every transaction is entered
twice, once as a credit item and once as
a debit item
 The general rule:
– If a transaction earns foreign exchange for
the nation, it is a credit and recorded as a
plus item
– If the transaction involves spending foreign
exchange, it is a debit and recorded as a
 Components of BoP
Major groups of accounts:
A. Current Account: includes
(1) merchandise trade account
– exports and imports (Physical/visible goods)
(2) Invisibles
 (a) services
– Travel and tourism (visits of tourists)
– Transportation
– Financial & other services including
insurance
– Govt. not included elsewhere (embassies,
consulates)
– Miscellaneous (includes software exports)
 (b) investment income (dividends, interests,
profits…)
(B) Capital Account- includes all transactions of
financial nature (financial assets)
1. Foreign investment
 Direct investment – capital buying physical assets
 Portfolio investment – capital buying financial assets
2. Loans
 Concessional loans
 Commercial borrowings
3. Banking capital
 Changes in the foreign assets and liabilities of
commercial banks authorized to deal in foreign
exchange
 NRI investments
4. Rupee debt service by way of obligation to
repay foreign loan/interests in rupees
5. Other capital, mostly the delayed receipts on
 (C) Errors and Omissions
 Discrepancies may crop up between debits and
credits because of data lags (timing) and other
estimation problems
 A negative value indicates that receipts are
overstated or payments are understated or both,
and vice versa
(D) Monetary Movements (Reserve Account)
 Record of India’s transactions with IMF
 India’s foreign currency reserves, basically consists
of RBI holdings of gold and foreign currency assets
 Drawings from IMF (a kind of borrowing) and from
foreign exchange reserves are credit items
 Payments made to IMF or additions to existing
 INDIA: Balance of Payment Accounts, Apr-Jun, 2009
Item Credit Debit Net
I. Trade Account 38,789 64,775 -25,986
II. Invisible Account 38,684 18,505 20,179
Services 22,389 13,351 9,038
Investment Income 2,951 4,688 -1,737
Transfer Payments 13,344 466 12,878
III. Current Account (I + II) 77,473 83,280 -5,808
IV. Capital Account 78,489 71,753 6,736
Foreign Investments 48,238 33,136 15,101
Loans 13,038 16,395 -3,357
Banking Capital 15,577 18,942 -3,365
Rupee Debt Service 0 23 -23
Other Capital 1,636 3,256 -1,620
V. Errors and Omissions - 813 -813
VI. Overall Balance (III + IV) 155,961 155,846 115
VII Monetary Movements - 115 -115
Increase in Reserves - 115 -115
 Balance in the BoP Statement
 When all the components of BoP are
taken together, the balance of
payment should be in balance
i.e., credits should equal debits
 If the overall balance shows a surplus
(deficit), and RBI do not intervene,
then it will lead to an appreciation
(depreciation) of the rupee.
 Balance in the BoP Statement
 What does the manager make out of
the balance of payment statements?
 Key to understand the factors
determining the exchange rate
 Higher the share of exports in a
country’s GDP, faster will be
economic growth in response to
foreign demand
 The Balance of Payments (BoP)
 Balance of Payment (BoP) and Balance
of Trade (BoT)
 BoP is a much wider term in its
coverage compared to balance of trade
 Balance of trade refers to merchandise
exports and imports (visible trade)
only
 BoP refers to all economic transactions
– including visible and invisible (like
services, investment income, etc.)
 Concept of ‘Sterilization’
 The foreign exchange reserves of a
country have a strong impact on the
monetary policy of the central bank.
 Foreign exchange reserves are an
asset of the CB
 Any increase in assets increases the
liabilities
 Increase in liabilities increases the
high-powered money (monetary base)
 Concept of ‘Sterilization’
 The CB must interfere to curb this
expansion in money supply through
contractionary monetary policies
 Similarly, when there is an decrease in
foreign exchange reserves, the CB
should interfere through expansionary
monetary policy
 The contractionary or expansionary
monetary policies to correct the
imbalances created by changes in
Determinants of Exchange Rates
1) Interest rates: determines the attractiveness of a
country as an investment avenue
Higher the investment inflow, higher the value of
the domestic currency
2)Price levels: high inflation rate means lower the
purchasing power of the currency and lower the
value of currency
3) Growth rate: High growth rate attracts more
foreign investment and improves the value of the
currency
4) Other economic factors: like fiscal deficit,
competitiveness of a country’s exports, etc.
 Types of Exchange Rates (Regimes)
The main exchange rate regimes are
three:
(a) Fixed exchange rate: the value of a
currency is fixed in terms of other
currencies (by the CB) and does not
change according to demand and
supply
(b) Flexible (or floating) exchange rate:
the value of domestic currency in
relation to the foreign currency is