Session 18 - 20

OPEN ECONOMY
(INTERNATIONAL)
MACROECONOMICS

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 Balance of Payment (BoP) Accounts

A nation’s BoP is summary statement of all

economic transactions between residents of that
nation and residents of the outside world that have
taken place during a given period of time.

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 Why BoP Relevant?

• National Income determination in an open

economy
Foreign Trade Multiplier

• International transmission of disturbances

External shocks
 Format of BoP Accounts
Merchandise exports A
Merchandise imports B
Merchandise Trade Balance C=A-B
Services D
Transfer payments E
Investment income F
Current A/c Balance G=C+D+E+F
Foreign direct investment H
Other Long-term capital I
Basic Balance J=G+H+I
Short-term capital K
Official Balance L=J+K
Reserve settlement balance M=L
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• Under pegged exchange rate system, any net
deficit in the balance of payments must be
absorbed by the official reserves.

• Under floating system, more credits than debits

(i.e., a BoP surplus) will either increase reserves or
cause upward valuation of the currency or both.

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The BoP surplus is equal to the current a/c surplus plus the capital
a/c surplus

Current Account
Merchandise trade
Private and Government
Invisibles/Services
Travel; Transportation; Insurance; Investment income; Miscellaneous
services; Transfer payments

Capital Account

Private capital
Long-term & Short-term;
Government capital
Loans, Amortisation, Rupee debt service and Miscellaneous
Banking capital

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 BoP Equilibrium condition

(a) Exports + Borrowing abroad = demand for rupee

= supply of foreign exchange

(b) Imports + Lending abroad = supply of rupee =

demand for foreign exchange

BoP is in equilibrium if (a) = (b)., i.e., if (X-M)

+(borrowing - lending abroad) = 0
Exports - imports + capital inflows - capital outflows
 Official reserves = 0

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BoP Imbalances & Exchange Rate Adjustment

International Monetary Equilibrium

• Supply>demand for `  depreciation
(Intervention: Sell $)
• Supply<demand for `  appreciation
(intervention: Buy $)
• BoP surplus/deficits can be corrected by
variations in exchange rate.
• Exchange rate variations allow countries to
control their own money supply.
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 Exchange Rate
What is exchange rate?
How it is determined?

• Fixed Exchange Rate System

• Floating Exchange Rate System
• Managed Floating System

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 Exchange rate system and
macroeconomic policies
• Impossible trinity
It is not possible for the central bank to achieve three objectives viz.,
interest rate, exchange rate and capital flow (money supply) simultaneously
• Under fixed exchange rate system central bank cannot
conduct an independent monetary policy
With fixed exchange rate and high capital mobility, the interest rates must
be closely aligned.
• Under flexible system exchange rate operates as a
shock absorber.
Domestic prices and output are insulated from external disturbances

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 The Impossible Trinity
• It is not possible for the central bank to achieve the three objectives viz., manage
exchange rate, free capital flow, and manage interest rate simultaneously.

• Once the doors of capital flows are opened, market forces will determine the
exchange rate and interest rate.

• If central bank wants to have say in both exchange rate and interest rate, it will have
to place restrictions on the capital flow.

Free capital flow

The Inconsistent Trinity

At a certain time country
could have a combination
of any two of the three
Fixed exchange rate conditions Independent monetary policy

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 Purchasing Power Parity and
Real Exchange Rates
• PPP exchange rate
Domestic Price (Pd )
Exchange Rate (S) 
Foreign Pr ice (Pf )

• Real Exchange rate

Pd
Real exchangerate (R) 
S Pf

• If real exchange rate equals 1, currencies are at PPP.

• If R is greater (lesser) than 1, the domestic currency
is overvalued (undervalued).

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 IS-LM in the Open Economy
• The open economy IS curve:

Y = domestic spending (DS=C+I+G) + external

spending (NX=X-M)

Y = DS(Y, r) + NX(Y, Yf, S)

• A Rise in Yf improves home country’s X-M and raises AD.

• A real depreciation of the home currency improves its X-M
and increase AD.
• A rise in home Y raises M and hence worsens its trade balance
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 AD AD=Y
The Goods Market and the (b) The AD and Output
A+b(1-t)Y-βr1
IS Curve in an Open
Economy A-βr1 ∆(X-M) A+b(1-t)Y-βr1

A-βr1

(a) The Investment Function

Output, Y
Interest rate, r

Interest rate, r

(c) The IS curve

r1 r1 ■E ■
I(r) IS
I(r1) Investment, I Y1 Y2 Output, Y

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 BoP and Free Capital Mobility

• BoP = Current a/c (NX) + Capital a/c (CF)

• BoP = NX(Y, Yf, S) + CF(r – rf)

• Internal and external balance

Refer to DFS, figure 13-4, p. 308

• Monetary and fiscal policies in an open economy

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 Mundell-Fleming Model
• Perfect capital mobility and fixed exchange rate
• Fig. 13-5, p. 311
• Monetary policy is infeasible
• Fiscal policy is effective

• Perfect capital mobility and flexible exchange rate

• No intervention required
• BoP position not affecting money supply
• Fiscal policy is ineffective and monetary policy is
feasible
• Fig. 13-7, p. 316; fig. 13-8, p.317 16
Macroeconomic Policies for Correction of BoP Deficits

Deliberate Measures Automatic Correction

Expenditure-changing Policies:
Fiscal Policies
Monetary Policies
Expenditure-switching Policies:
Trade Policies
Exchange Rate Policies
Exchange Control
Financial Policies:
Capital Controls
Debt Policies
Interest Rate Policy 17
 References
• DFS, Macroeconomics, Chapter 13.
• “Balance of payments accounts and exchange
rate”, chapter13_BoP-note,@google drive.

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