Open Economy Macro-

Economics
Sub-Prime Mortgage Crisis
• Impacted our Exports.
• Imports were very much there due to our dependency on oil imports.
• Our Foreign exchange reserves got depleted. Rupee Depreciated and
Dollar Appreciated.
• Our Imports became expensive and it let to inflation in the economy.
• Our GDP was impacted due to negative trade balance and inflation.
• This led to severe stagflation.
The Question is why did this crisis happen? Was it under our control?
The Question is why did this crisis happen? Was it under our control?

• It happened because of the crisis in America and our dependency on

global markets.
• It wasn’t under our control because we will in an open economy were
we have to depend upon other countries around the world for our
product and service requirements.
When the FED reserve increases the interest
rates in US, our stock market is at risk. Why?
• When more capital flows out of our country and less capital comes in,
what does that lead to ?
• Obviously it will lead to the reduction in foreign exchange reserves
and our stock market gets affected as capital flows out.
In this chapter, we will
study macro-economic
variables like Exports,
Imports, Trade
Balance, Net Capital
Outflow, Exchange
rates and how
exchange rates are
determined.
You as an Indian Resident, participate in the Global Market for goods and services as well as capital.

For goods and services, you participate in Exports and Imports.

For Capital, you invest in NYSE and Americans invest in BSE and NSE.

We participate in the Global Markets for trading in goods and services as well as capital.

We participate in Global Business because Trade makes

everyone better off.
The International Flows of Goods and
Capital
• The Flow of Goods: Exports, Imports, and Net Exports
• Exports are goods and services that are produced domestically and
sold abroad, and imports are goods and services that are produced
abroad and sold domestically.
• Net Exports= Value of the countries exports-Value of countries
imports. It is also known as Trade Balance.
• If the Exports are more than the imports, it is considered to be Trade
Surplus (NX>0), If the imports are more than exports, it is considered
as Trade Deficit (NX<0). If exports are equal to imports, it is
considered balanced trade (NX=0).
What are the factors that affect a country’s
trade balance?
• Taste of domestic and foreign consumers. (If Indians are in awe of GUCCI,
Armani, Versace, then Imports will be higher. If americans are in awe of
Alphonos, basmati, tata nano, then exports will be high).
• The prices of goods at home and abroad.
• Exchange Rate (If 48 Rupees can buy goods of 1$), then imports will be high.
(If 75 Rupees can buy goods of 1$ then imports will be low). (If 1$ is able to
buy goods of 75 rupees, then exports will be high). (If 1$ is able to buy goods
worth 48 rupees, exports will be low).

• What is better for Trade Surplus, Rupee Appreciation or Rupee Depreciation?

What are the factors that affect a country’s
trade balance?
• The incomes of consumers at home and abroad
• The cost of transporting goods from country to country
• Government policies toward international trade
The Flow of Financial Resources: Net Capital Outflow

• The term net capital outflow refers to the difference between the
purchase of foreign assets by domestic residents and the purchase of
domestic assets by foreigners:
• Net capital outflow = Purchase of foreign assets by domestic residents
- Purchase of domestic assets by foreigners.
• NCO>0 if purchase of foreign assets by domestic residents is more
than purchase of domestic assets by foreigners.
• NCO<0 if purchase if domestic assets by foreigners is greater than
purchase of foreign assets by domestic residents.
 Foreign Assets
Foreign
NYSE
Residents
FDI
Domestic
residents More
Domestic Assets
than
BSE/NSE
More capital is flowing out, than capital coming in. FDI
NCO > 0, Net capital outflow is more than inflow

Foreign
Residents Foreign Assets
NYSE
FDI
Domestic Assets
Domestic
BSE/NSE
residents
FDI
More
than

More capital is flowing in, than capital going out.

NCO < 0, Net capital inflow is more than outflow
What are the factors that affect a country’s
Net Capital Outflow?
• The real interest rates paid on foreign assets
• The real interest rates paid on domestic assets
• The perceived economic and political risks of holding assets abroad
• The government policies that affect foreign ownership of domestic
assets
The Equality of Net Exports and Net Capital Outflow

• An important but subtle fact of accounting states that, for an economy as a

whole, net capital outflow (NCO) must always equal net exports (NX):
NCO = NX
Suppose Deval Akrekar is a software engineer who makes a computer software and
sells in to a US firm for 10,000 $. What is he going to do with this 10,000$?
1. You can use it buy a US bond worth 10,000$. So NCO>0
2. Suppose you buy an American Product (So Import=Export), NX=0, NCO=0
3. Or you can go to the bank and exchange the dollars into rupees, what will the
bank do with the dollars, it will give it to someone who wants to invest abroad
or buy anything from abroad, in that case again NCO>0.

In all cases NX=NCO.

The previous example was about a person, but
same is the case with countries in the case of trade
• If NX>0, NCO>0. If a country is exporting more than importing, it will
be using the foreign exchange for buying foreign assets.
• When NX<0, If a country is importing more than it exports, how will it
be meeting its foreign exchange requirements, it would be selling its
domestic assets abroad to buy foreign exchange . NCO<0.
• The international flow of goods and services and the international
flow of capital are two sides of the same coin.
Saving, Investment, and Their Relationship to the International Flows

Y=C+I+G+NX

So for a country
Savings is whatever is left after C and G

Y-C-G= I+NX
S= I + NX
Because NX=NCO, S=I+NCO
When Savings = I, NCO = O and When Savings>I, NCO>0
 Y = C + I + G + NX

Y-C-G= I + NX
S= I + NX
S=I
NCO=0

S>I , NCO>1 S= I + NCO

IF NX> 0, NCO>0
TRADE SURPLUS BALANCED TRADE TRADE DEFICIT

EXPORTS > IMPORTS EXPORTS = IMPORTS IMPORTS > EXPORTS

NX>0 NX=0 NX < 0
NCO>0 NCO=0 NCO < 0
Y>C+I+G Y=C+I+G Y < C+I+G
SAVINGS>INVESTMENT SAVINGS=INVESTMENT SAVINGS <INVESTMENT
Trade Surplus TRADE DEFICIT

Exports>Imports IMPORTS>EX BALANCED

PORTS TRADE
NX>0
NX<0 EXPORTS=IMP
NCO>0 ORTS
Y>C+I+G NC0<0
Y<C+I+G NX=0
Savings>Investment NC0=O
Savings<Inves
tment Y=C+I+G
SAVINGS=INVE
STMENT
The Prices for International Transactions:
Real and Nominal Exchange Rates

• The nominal
exchange rate is the
rate at which a
person can trade the
currency of one
country for the
currency of another.
• 1$ = 75 Rupees
Suppose you go to a bank to Suppose you go to a bank to
buy 1 Dollar and they ask buy 1 Dollar and they ask
you for Rs.55. you for Rs.55.

After 6 Months, you go After 6 Months, you go

again to buy 1 Dollar, they again to buy 1 Dollar, they
ask you Rs.75 ask you Rs.45

This mean rupee has This mean rupee has

depreciated and dollar has appreciated and dollar has
appreciated depreciated
Real Exchange Rate
• The real exchange rate is the rate at which a person can trade the
goods and services of one country for the goods and services of
another.

• Real exchange rate = Nominal exchange rate X Domestic price

Foreign price
For example:

1 Bushel of Japanese Rice is available at 16,000 Yen, and 1 bushel of American rice is sold at $100, and the nominal
exchange rate is 80 yen per dollar.

Real exchange Rate: 80 x 100

_________ = 8000/16,000 = 1/2
16,000

(Which means 1 bushel of american rice is equal to half bushel of japanese rice)

convert the prices into a common currency, if you are taking

yen below, you have to convert american price into yen price
Tanvi’s uncle is living in US and is coming to India next month. Tanvi wants to purchase an Iphone 8s pro max, in
india the price is 1,24,704. In US it is sold at 1,099 $.

The Nominal Exchange rate is 1$ = 72.76 INR

What shoud Tanvi do, buy it from India, or ask her uncle to get it for her from abroad?

(72.76 x 1,099) = 79,963

----------- = ------------ .64 (The price in India higher)

1,24,704 1,24,704

convert the prices into a common currency, if you are taking Indian price below, you
have to convert the american price into indian price