Economics for Managers

External Sector/Open
Economy
Learning Objective

 At the end of this session, you should be

able to:
– Understand and analyze the impact on
businesses of international trade and currency
markets
Open Economy

 Does it make sense for every country to be

self-reliant? To be closed to the ROW?
Open Economy

 Does it make sense for every country to be self-

reliant?
 Not if another country had an absolute advantage in
producing a good; for example a country might have
natural resources (like palm oil, rare earths) which
makes it almost imperative by the other country to
import these goods
 But what if you were better in everything than rest of
the world?
Ricardo 1817

 1817: England protectionist

 THE STORYLINE: Two countries, England and
Portugal
 Portugal is more productive in making both wine and
cloth
Ricardo 1817

Portugal England
1. Wine Production/ 8000 8000
Year
Manpower 80 120
2. Cloth Prod/ Year 9000 9000
Manpower 90 100

What should
Portugal do?
Ricardo 1817: Absolute Advantage

Portugal England
Wine Production/ Year 8000 8000
Manpower 80 120
Cloth Prod/ Year 9000 9000
Manpower 90 100
Wine: Productivity 100 66.67
Cloth: Productivity 100 90

Portugal has an absolute advantage in both

goods. So what should the two countries
decide?
Ricardo 1817: Absolute Advantage

Portugal England
Wine Production/ Year 8000 8000
Manpower 80 120
Cloth Prod/ Year 9000 9000
Manpower 90 100
Wine: Productivity 100 66.67
Cloth: Productivity 100 90

Further assume limited resources:

both countries have only 1200
workers each
Ricardo 1817: Comparative
Advantage

 Though Portugal is better at both making

wine and cloth, in which does it have a
greater advantage?
Ricardo 1817: Comparative
Advantage

 Though Portugal is better at both making wine and cloth, in

which does it have a greater advantage?
 Portugal has a comparative advantage (more better) in making
wine, and England has a comparative advantage (less worse)
in making cloth
– (100-66.67) > (100-90)

Portugal enjoys higher productivity in both, but relatively more

in wine making
Theory of comparative advantage
using ‘opportunity costs’.

Portugal’s o/c of wine: 1 [ 100/100]

Eng’s o/c of wine : 1.349 [ 90/66.7]
Portugal’s o/c of cloth: 1 [ 100/100]
Eng’s o/c of cloth : 0.74 [ 66.7/90]
Ricardo 1817: Closed to ROW

 If each of the two decided to be self reliant in

both wine and cloth, and decided to commit
700 workers to wine making and 500 workers
to cloth making, what would be the total
‘world’ output of wine and cloth, and the
country-wise production
 Wine: Portugal 70,000 England 46,667
 Cloth: Portugal 50,000 England 45,000 So?
Ricardo 1817: Open to ROW

 Ricardo’s important contribution to

economics. What if each country stuck to
doing what it is has a comparative advantage
in?
 Commit all (1200 workers) scarce resources
to their best use (opportunity cost concept)
 Wine: Portugal ?? England ??
 Cloth: Portugal ?? England ??
Ricardo 1817: Open to ROW

 Ricardo’s important contribution to

economics. What if each country stuck to
doing what it is comparatively better at?
 Wine: Portugal 120,000 England 0
 Cloth: Portugal 0 England 108,000
versus the self-reliance story
 Wine: Portugal 70,000 England 46,667
And
 Cloth: Portugal 50,000 England 45,000 then
?
Ricardo 1817: Trade!

 Ricardo’s important contribution to economics. What

if each country stuck to doing what it is
comparatively better at?
Suppose
 Wine: Portugal 120,000 England 0 Portugal is
willing to
 Cloth: Portugal 0 England 108,000 trade 50000
versus the self-reliance story of wine for
50000 of
 Wine: Portugal 70,000 England 46,667 cloth. What
 Cloth: Portugal 50,000 England 45,000 would be the
result?
Ricardo 1817: Trade!

 Ricardo’s important contribution to economics. What

if each country stuck to doing what it is
comparatively better at? Suppose Portugal
 Wine: Portugal 70,000 England 50000 is willing to trade
50000 of wine for
 Cloth: Portugal 50000 England 58,000 50000 of cloth.
What would be
versus the self-reliance story the result? Is this
a likely scenario?
A more likely
 Wine: Portugal 70,000 England 46,667 ‘terms of trade’?
 Cloth: Portugal 50,000 England 45,000
Ricardo 1817: Trade!

 Ricardo’s important contribution to economics. What

if each country stuck to doing what it is
comparatively better at? Suppose Portugal
 Wine: Portugal 73,333 England 46667 is willing to trade
46667 of wine for
 Cloth: Portugal 63000 England 45,000 63000 of cloth.
What would be
versus the self-reliance story the end result? Is
this a likely
scenario? A more
 Wine: Portugal 70,000 England 46,667 likely ‘terms of
trade’?
 Cloth: Portugal 50,000 England 45,000
Ricardo 1817: Trade!

 Ricardo’s important contribution to economics. What

if each country stuck to doing what it is
comparatively better at?
 Wine: Portugal 73,000 England 47000
 Cloth: Portugal 60000 England 48,000
More likely
versus the self-reliance story
 Wine: Portugal 70,000 England 46,667
 Cloth: Portugal 50,000 England 45,000
Theory of Trade

 If the two countries decide to trade, The price

range will be (read the text Pg 54) “between
the two (opportunity) costs”.
Specialization and International
Trade

 Ricardo showed that if countries specialized

according to their comparative advantage the total
output of all goods would be higher (the size of pie
increases)
 And then through international trade countries could
exchange the goods (slice the pie) to finally arrive at
a situation where all countries gain as compared to a
situation of no specialization, and no trade.
 Some Trade Blocs...Regional Comprehensive
Economic Partnership- Did India become a
member?- not for exam!!
Balance of Payments

 Remember: Y = C+G+I+(X-M)
Product Exp/demand
 Kotak Securities: “In a globalized world, no country is
self-sufficient. Every country purchases and sells
goods and services to another. This includes both
public and private transactions. The balance of
payments calculates the value of these transactions.”
 https://www.kotaksecurities.com/ksweb/Meaningful-
Minutes/Indias-balance-of-payments-5-things-to-kno
w
Balance of Payments: India, 2018-19

 What would the heads of this statement be?

What is the nature of exchange between
countries?
Some basics

 Debit and credit- Double entry book keeping

 Debit affects the supply of domestic currency
 Credit affects the demand of the domestic
currency.
 Imports is a ‘-’ entry; and exports is a ‘+’entry
 So If you have a net -: the currency will
depreciate- ss is greater than dd.
 If you have a net + : currency appreciates –
dd is greater than ss.
Some Basics

 There are two broad heads of A/C:

- current A/C: records transactions largely in
Goods, services/invisibles Trade A/C

- Capital A/C: records capital flows

Changes in Official Reserves(if it
has this head)
The BOP statement is always in balance- left
to equilibrate either through the market or
The elements of BOP
https://www.imf.org/external/pubs/
ft/bopman/bopman.pdf

Current Account:
Debit Credit
Goods & services
Transfers
Total + or –
Current Account Balance: Surplus or deficit;
also referred to as CAB
Exports is + entry and imports is a - entry
Capital A/C…referred to also as
Financial A/C

-The Capital account covers all transactions associated

with changes of ownership in the foreign financial assets
and liabilities of an economy. They are further classified
into:
-Direct Inv: An investor obtaining a ‘lasting interest’ in the Co.-a
long term relationship
-Portfolio Inv
-Reserves -These are foreign financial assets available to, and
controlled by, the monetary authorities for financing or regulating
payments imbalances or for other purposes. Reserve assets consist
of monetary gold, SDRs, reserve position in the Fund, foreign
exchange, and other claims.
Balance of Payments: India, 2018-19

(in USD billions)

Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

I. Goods
and
Services
Ia. Goods 309 469 -160 337.2 517.5 -183.3
Balance of Payments: India, 2018-19

(in USD billions)

Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

I. Goods 504.1 586.5 -82.5 545.2 643.6 -98.3

and
Services
Ia. Goods 309 469 -160 337.2 517.5 -183.3

Ib. 195.1 117.5 77.6 208 126.1 81.9

Services
Balance of Payments: India, 2018-19
(in USD billions)
Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

I. Goods 504.1 586.5 -82.5 545.2 643.6 -98.3

and
Services
Ia. Goods 309 469 -160 337.2 517.5 -183.3

Ib. Services 195.1 117.5 77.6 208 126.1 81.9

II. Primary 18.9 47.5 -28.7 21.8 50.7 -28.9

Income
III. 64.9 6.9 62.5 76.6 6.6 70
Secondary
Income
Current 592.4 641 -48.7 643.7 700.9 -57.2
Account (-1.8%) (-2.1%)
Balance
Balance of Payments: India, 2018-19
(in USD billions)

Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

Current 592.4 641 -48.7 643.7 700.9 -57.2

Account (-1.8%) (-2.1%)
Balance

And then?
Balance of Payments: India, 2018-19
(in USD billions)

Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

Current 592.4 641 -48.7 643.7 700.9 -57.2

Account (-1.8%) (-2.1%)
Balance

And then?

RBI: “A deficit in the current account is

sustainable when financed by foreign
capital inflows involving transfers of
both non-financial and financial assets
between residents and non-residents”
Balance of Payments: India, 2018-19
(in USD billions)
Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

Current 592.4 641 -48.7 643.7 700.9 -57.2

Account (-1.8%) (-2.1%)
Balance
IV
Financial
Flows
IV a FDI

IVb FPI

IV c
Others

And so?
Balance of Payments: India, 2018-19
(in USD billions)
Item 2017-18 2018-19

Credit Debit Net Credit Debit Net

Current 592.4 641 -48.7 643.7 700.9 -57.2

Account (-1.8%) (-2.1%)
Balance
IV
Financial
Flows
IV a FDI

IVb FPI

IV c
Others
V Change
in Foreign
Reserves
Fixed and Flexible exchange rate
regimes
Is the exchange rate fixed or
flexible?

 Where there is excess supply of domestic currency

(over Demand), there are two possibilities:
 You let the market react to this imbalance-
Depreciation: Flexible/floating exchange rate. The
Central bank does not need reserves!
 Or the country chooses to intervene and match the
excess SS with extra DD by selling its foreign
exchange reserves and thereby maintain its
exchange rate.: Fixed ex rate. You need reserves.
 In between? Float, managed rate , managed
Float…
History of Indian Exchange rates

 Fixed exchange rate- linked to a basket of

currencies- till the 90-91 BOP Crisis
 After that, we got into a flexible exchange
rate regime……a brief narration as to why
and how………
Where are we now? India

 Maybe we can call it a ‘corrupted’ Market rate

or a ‘float’ where in the rate is allowed to
fluctuate but all the time, can be intervened
upon by the RBI.
 Therefore Reserves are important.
 Reserves have it been dipped into time and
again?
 Do you have a safe level of reserves?
Where do you look for looming
BOP crisis?

 If you find the reserves are being dipped

into,..
 If there are no inflows and therefore no build
up of reserves
DEVALUATION OR DEPRECIATION.
Depreciation/devaluation is ok if

 The trade basket is elastic and can

immediately react to change in exchange
rates. The exchange rate comes to
equilibrium.

 If not, it is concerning.
The BOP Identity & the GDP

 Y = C+G+I+(X-M)
 Y = C+G+I+NX; NX = Net Exports
 NX = NCO (Net Capital Outflow)

Think China,
Think USA
The BOP Identity & the GDP

 Y = C+G+I+(X-M)
 Y = C+G+I+NX; NX = Net Exports
 NX = NCO (Net Capital Outflow)

Think China,
Think USA
The BOP Identity & the GDP

 Y = C+G+I+(X-M)
 Y = C+G+I+NX; NX = Net Exports
 NX = NCO (Net Capital Outflow)
Think China, Think
USA
Exposure to U.S debt:
China $1.06 Trillion in 21-22
The BOP Identity & the GDP

 Y = C+G+I+(X-M)
 Y = C+G+I+NX; NX = Net Exports
 NX = NCO (Net Capital Outflow)
 https://www.statista.com/statistics/246420/m
ajor-foreign-holders-of-us-treasury-debt/
Optional:The BOP Identity & the
GDP

 Y = C+G+I+(X-M)
 Y = C+G+I+NX; NX = Net Exports
 Y-C-G = I + NX
 S = I + NX
 S = I + NCO
At the end of the day….

 The accounting BOP statement had to be in

balance: NX = NCO: remember the identity.
 Current A/C + Capital(financial)A/C = 0
 They have to balance either through
reserves-Fixed exch rate(so reserves is a
must) or through a flexible exchange rate
regime.
Exchange Rates

 What is today’s exchange rate of the INR

versus USD? ~ Rs.75/$
 What was it two years back? ~ Rs.69/$
– Thus, over the year the INR has depreciated vis-
à-vis the USD
Exchange Rate Theories

 An introduction to exchange rate theories…

The Economist:

 The Big Mac in Britain: £3.29

 The Big Mac in US: $5.66
 Actual nominal exchange rate: 0.74£/$
 Implied Exchange Rate?
The Economist: Read It?

 The Big Mac in Britain: £3.29

 The Big Mac in US: $5.66
 Actual nominal exchange rate: 0.74£/$
 Implied Exchange Rate = 3.29/5.66 =0.58£/$
 Extent of undervaluation =(.74-.58)/.74 = 21.6%
A person in US buys a Big Mac, paying $5.66 (exchanges $5.66 for a Big Mac), takes it
to UK (assume no transaction costs) and sells it for £3.29 (exchanges a Big Mac
for £3.29). Therefore effectively, the person has exchanged $5.66 for £3.29, giving
an implied exchange rate of 0.58 £/ $
Nominal Exchange Rates

 What is today’s exchange rate of the INR

versus USD? ~ Rs.75/$
 This is the ‘nominal exchange rate’
 Expressed as units of foreign currency per
INR (p.383) this is (1/75) $/ Re
Real Exchange Rates

 Nominal exchange rate = 1/75 $/Re

 Big Mac Price in India = Rs.190
 Big Mac Price in US = $5.66
 Therefore, Real Exchange Rate
= [(1/75) * 190]/5.66 = .448 American Big Mac/
Indian Big Mac
Nominal exchange rate = 1/75 $/Re
Price of Indian Big Mac = Rs.190 = (190*(1/75) = $2.53
Therefore, price of Indian Big Mac is only 44.8% (2.53/5.66) of the price of
American Big Mac
Or in The Economist’s language the Rupee is undervalued by 55.2%
Real Exchange Rates

 Therefore, Real Exchange Rate

= [(1/75) * 190]/5.66 = .448
 Therefore, Real Exchange Rate = (e*PI)/PA*
 RER is therefore a function of nominal exchange rate and the price of the
goods in the two countries measured in their local currencies (p.384) and
measures the rate at which a person can trade the good for the good in another
country (p383)
 Instead of one good the RER can be defined for the economy as a whole,
replacing the price of the single good by price indices. Therefore we get RER =
(e*P)/P*
Purchasing Power Parity

 “A good must sell at the same price in all locations” Law of one
price” , otherwise ….arbitrage!
 Big Mac: In India: Rs.190, in US $5.66, e the nominal exchange
rate = $ (1/75) per Rupee
 One rupee can buy 1/190 Big Mac in India, Rupee can be
exchanged to 1/75 $ and that can buy (1/75) / 5.66 Big Mac in
US. So, for the purchasing power of the Rupee and the $ to be
the same
– 1/190 has to be = (1/75) / 5.66
– Or 1/P = e/P* (e)
– Thus 1 = eP / P*
– Or e = P*/ P according to the Purchasing Power Parity
Purchasing Power Parity

 e = P*/ P according to the Purchasing Power

Parity
 Therefore if, for example money supply
increases and thus P increases, e falls (from
say 1/75 to 1/80) meaning domestic currency
depreciates
 PPP describes the forces that determine
exchange rates in the long run
The Economist:

 The Big Mac in Britain: £3.29

 The Big Mac in US: $5.66
 Actual nominal exchange rate: 0.74£/$
 Implied Exchange Rate?( or the equivalent of
the PPP Rate?)
economist.com/big-mac-index
 Burgernomics
The Big Mac index
 Our interactive currency comparison tool
The Economist:

 The Big Mac in Britain: £3.29

 The Big Mac in US: $5.66
 Actual nominal exchange rate: 0.74£/$
 Implied Exchange Rate = 3.29/5.66 =0.58£/$
 Extent of undervaluation =(.74-.58)/.74 = 21.6%
Implied Exch Rate is the PPP rate.
A person in US buys a Big Mac, paying $5.66 (exchanges $5.66 for a Big Mac), takes
it to UK (assume no transaction costs) and sells it for £3.29 (exchanges a Big
Mac for £3.29). Therefore effectively, the person has exchanged $5.66 for £3.29,
giving an implied exchange rate of 0.58 £/ $

BIG MAC INDEX

Macro adjustments under Fixed
exchange rate regime

 Lets consider a situation when a country has

an imbalance: CurrentA/C + capital a/c is
negative.
 So the country has a capital a/c outflow along
with a current a/c deficit.
 The country has a fixed exchange rate
regime.
 So the country has to sell forex reserves.
 Now how does the adjustment happen?
The process of adjustment

 Sells For exch and how it adjusts on the current a/c:

 -> decrease in Ms-> interest rates rise-> GDP falls ->
imports reduce-> currency dep and X-M improves.
(assuming that the trade basket is elastic)
Go on till currency Depreciation is arrested.
 How it adjusts on the capital a/c:
 -> decrease Ms-> interest rates rise compared to
relative int rates in other countries-> capital Inflow.
 Go on till currency depreciation is arrested
 Similar is the process when the country buys
forex.
Has no independence on Mon:
Policy under Fixed rate

 Therefore, under fixed exch rate regime, the

central bank’s sole objective is to maintain the
Fixed rate and so It has to sell/buy Forex
-> it has to buy / sell domestic currency-> and
therefore the rest of the chain.
So the Central bank has no independence
to follow its own monetary policy as the
domestic situation demands.
So…

 If you want independence on Monetary Policy, and if

there is freedom for capital to flow in and out, then A
Flexible Exchange Rate Regime is recommended.
“Unholy Trinity” or a “Trilemma”
Independent MP
Fixed exch Free capital
Independent Monetary Policy
rates Mobility
A thing of the past- Regimes of
fixed and Flexible exchange rates

 By and large market driven but like any other

market, there is one large player, Central
Bank, manipulating the supply and demand of
the domestic currency so that the market
driven rate can be at the desired levels.
 Pegged Rate

 China – an exception?
The Jigsaw

MARKETS TRADE POLICY DIRECT

Int Rates Inflation Exch Rates Govt Spending Taxes & Subsidies

MONETARY POLICY FISCAL POLICY

POLICY INTERVENTION: SUPPLY / DEMAND SIDE Smoothening of

B cycles

GDP, NI
Product = Income = Expenditure
 Indian Economy:
https://en.wikipedia.org/wiki/Economy_of_India

THANK YOU, FELLOW ECONOMISTS!