Open Economy

Dr. Akshay Dhume

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 Balance of Payments (BOP)
• The balance of payments (BOP) is a statement of all
transactions made between entities in one country and the rest
of the world over a defined period of time, such as a quarter or
a year.
• Captures economic transactions – foreign receipts & payments
and financial inflows and outflows arising out of international
transaction – with the rest of the world (ROW)
• Main purpose – understand international economic position of
the country – help government reach decision on fiscal and
monetary policies on one hand and trade policies on the other.

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 Double Entry Book-Keeping System
• Credit:
– Transactions that give rise to receipts (exports)
– Payments for imports
– Transactions that give rise to receipts (loan)
• Debit:
– Receipts from exports
– Transactions that give rise to payments (imports)
– Reserves (loan receipts)

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Double Entry Book-Keeping System (Contd.)

• Assume Alcoa, exports US$2.0m worth of bauxite to and is

paid for the bauxite by depositing US$2.0mn to Alcoa's bank
account. Table below shows the entries that would be made in
Jamaica's balance of payments

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Double Entry Book-Keeping System (Contd.)

• Jamaica imports US$150 million worth of oil. BoP of Jamaica

the oil import is recorded as a debit entry, as it gives rise to a
payment by a resident to a non-resident.

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Double Entry Book-Keeping System (Contd.)

• Assume that Jamaica borrows US$100 million dollars from

the World Bank and the proceeds of the loans are deposited at
the Bank of Jamaica (BOJ)

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 Purpose of BoP
• Yields necessary information on the strengths and
weaknesses of the country with respect to the external sector
• Analyzing BoP accounts of previous years helps in
understanding overall gains and losses from international
transactions – determine whether composition and direction
of international trade and capital movement have improved
or deteriorated the economic condition of a country
• Provide direction/foundation for policy formulation –
persistent high deficit may cause financial bankruptcy –
appropriate action in terms of policy formulation is
necessary to resolve the problem

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 Balance of Payments Accounts
Current Account Capital Account
• Export and import of • Inflow and outflow of
goods and services capital
• Current transactions • Capital transactions
change current level of change capital stock of
consumption or income the country which has
(nominal) long-term implications
• (Generally) Flow • (Generally) Stock
variable variable

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Current Account Items

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 Current Account Items (Contd.)
• Classification of items
– Visible Items: Merchandise trade – Exports and
imports
– Invisible transactions (Items 2-8): Receipts and
payments on account of foreign travel,
transportation, insurance, investment income,
official and private transfers
– ‘Unrequited items’ or ‘unilateral transfers’: gifts,
donations, military aids, technical assistance, etc.

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 Balance of Trade
• Net Balance of visible trade

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 Capital Account
• Short-term capital movement
– Purchase of short-term foreign securities
• Treasury bills
• Commercial bills
• Acceptance bills
– Speculative purchase of foreign currency
– Cash balance held by foreigners for security to
hedge the uncertainty arising due to wars, political
uncertainty, etc.

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 Capital Account
• Long-term capital movement
– Direct investment in shares and bonds
– Direct investment in real estate and corporate investment in plant,
building and equipment on which investor holds a controlling power
– Portfolio investment, including all stocks and bonds
– Amortization of capital
– Foreign Direct Investment
– Foreign Institutional Investment (FII)/Foreign Portfolio Investment
(FPI)
(Investment abroad is debit item because it causes outflow of foreign
exchange – inflow of foreign capital is a credit item as it results in inflow
of foreign exchange)

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 Capital Account
• Inflow and outflow of gold and foreign
exchange reserves
– Maintained as safeguard against large and
prolonged current account deficit
– Stabilize the exchange rate of the home country
– Make payments in case there is payment deficits
on current account
– Forex reserves increase or decrease depending on
net balance of other transactions

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BoP Accounting System in India

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 Assessment of Balance of Payments
• BoP accounting based on double-entry booking system –
always in balance
• Closer look
– Deficit on current account is offset either by a surplus on
capital and financial account
– Surplus on current account is offset by a matching deficit on
capital and financial account
• Often a surplus/deficit in BoP – BoP Disequilibrium
• BoP Disequilibrium – assessed on the basis of difference
between Autonomous and Induced Transactions

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 Autonomous Transactions and
Accommodating/Induced Transactions

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Assessment of BoP Disequilibrium
• Disequilibrium of Surplus Nature

– Results in
• Increase in capital account surplus
• Increase in foreign exchange reserves
• Disequilibrium of Deficit Nature

– Results in
• Sale of foreign assets
• Borrowing abroad – results in foreign indebtness

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 Causes and Kinds of BoP Disequilibrium

• Inflation and Disequilibrium

• Business Cycles and Disequilibrium
• Structural Change and Disequilibrium
• Short-term Disequilibrium Factors

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 Causes and Kinds of BoP Disequilibrium
(Contd.)
• Inflation and Disequilibrium
– Inflation raises domestic prices
– Imports are relatively cheaper than domestically
produced goods
– Export become more expensive for foreigners
– Leads to BoP Deficit

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 Causes and Kinds of BoP Disequilibrium
(Contd.)
• Business Cycles and Disequilibrium
– Business cycles may be confined to a country or group of countries or it
may be global
– If business cycle is global, most countries most countries face inflation
or recession almost simultaneously
– But countries differ in economic size – imports and exports are affected
in varying degree
– Some countries accumulate trade surplus, while others have trade deficit
– Countries with high marginal propensity to import incur trade deficit
during inflationary phase and surplus during moderate and recessionary
phase
– This is known as cyclical disequilibrium

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 Causes and Kinds of BoP Disequilibrium
(Contd.)
• Structural Change and Disequilibrium
– Structural change may be caused by depletion of natural
resources, change in technology, change in industrial
structure and change in tastes and preferences
– Such changes affect country’s capacity to export and
propensity to import
– Countries lagging behind in technological and industrial
development find it difficult to face international
competition due to high production costs
– Impact on exports/imports cause BoP disequilibrium

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 Causes and Kinds of BoP Disequilibrium
(Contd.)
• Short-term Disequilibrium Factors
– Crop Failure
– Rapid growth of population in food-deficient
countries causing import of large quantity of food
– Ambitious development plans requiring heavy
import of technology, machinery, etc.
– Attempt to imitate economically advanced
economies

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 Policy Measures
• Expenditure Changing Policy
– Policy aimed at changing aggregate expenditure in the domestic economy
– Reducing or Increasing Expenditure
– Suppose we want to tackle problem of BoP deficit – Focus on expenditure reducing
– Types
• Monetary Policy
– Central Bank – increase interest rate – leads to reduction in consumption and
investment
– Reduction in Money Supply
• Fiscal Policy
– Increase taxes – leads to reduction in disposable income and consumption
spending
– Reduction in government expenditure – leads to reduction in AD as
government expenditure component in AD reduces

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 Policy Measures (Contd.)
• Expenditure Switching Policy
– Switch to domestic expenditure from imported goods to domestic goods or the other
way round – Works through change in relative prices of imported and domestic goods
– Suppose we want to tackle problem of BoP deficit – focus on switch to domestic
expenditure from imported goods
– Monetary Policy
• Main tool – exchange rates
– Devaluation (Fixed exchange rate system)
– Depreciation (Flexible exchange rate system) – by reducing interest rate or
increasing money supply
• Make imports more expensive relative to domestically produced goods
– Fiscal Policy
• Tariff Policy
– Imposition of tariffs – price of imports increase – domestic buyers opt
domestically produced goods

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 Effectiveness of Devaluation: Marshall-
Lerner Conditions
• Marshall-Lerner Conditions
– Devaluation of exchange rate will eventually lead to a net
improvement in trade balance provided that sum of price
elasticity if demand for exports and imports (in absolute
terms) is greater than unity

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 Effectiveness of Devaluation: Empirical
Evidence and J-Curve Effect
• Marshall-Lerner conditions generally hold for most of
industrial nations in long-run but not in the short-run
• Reason:
– Short-run deterioration in BoP is caused by faster increase in
import prices than export prices
– Quantities imported and exported do not change much –
existing deals cannot be reversed – importers have to import at
post-devaluation (higher) prices causing higher import bill
– Long-run: Imports↓ and Exports↑ - trade balance deterioration
is reversed and over time BoP improve
• Overall trend is plotted – produces J-shape curve

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J-Curve

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Foreign Exchange Rate

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 Determinants of Exchange Rate
• Domestic Prices
• Real Income
• Rate of Interest
• Structural Change
• Political Stability
• Speculation

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 Exchange Rate Regime
• Fixed
– Adjustable Peg
– Crawling Peg
– Currency Board
– Unified Currency
• Managed Float
• Flexible/Floating

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 Exchange Rate Regime (Contd.)
• Fixed Exchange Rate System
– Authorities fix the exchange rate between domestic currency and a foreign currency
with a provision of fluctuation of rate within a small upper and lower margin
• Adjustable Peg
– Exchange rate is fixed for extended periods, usually within a narrow margin, but
adjusted if the pressure is not withstandable
• Crawling Peg
– Central bank allows a gradual adjustment of the exchange rate by intervening in the
currency market in small measure but on continuous basis
• Currency Board
– Exchange rate is irrevocably fixed by the board
• Unified Currency
– Independent currency is abandoned and some other currency is adopted

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 Exchange Rate Regime (Contd.)
• Floating Exchange Rate System
– A floating exchange rate is a regime where the
currency price of a nation is set by the forex
market based on supply and demand relative to
other currencies
• Managed Float
– Combination of fixed and floating exchange rate
system

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 Macroeconomic Adjustment Under Fixed
Exchange Rate Regime (Case 1)
• Assume overall balance is
negative – outflow (demand
for forex) > inflow (supply of
forex)
• Price of foreign currency ↑
relative to domestic currency
• Pressure on currency to
depreciate
• Policymakers are required to
design policy to arrest
deprecation of domestic
currency

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 Macroeconomic Adjustment Under Fixed
Exchange Rate Regime (Case 2)
• Assume overall balance is
positive – outflow (demand
for forex) < inflow (supply of
forex)
• Price of foreign currency ↓
relative to domestic currency
• Pressure on currency to
appreciate
• Policymakers are required to
design policy to arrest
appreciation of domestic
currency

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