Open Economy Macroeconomics

Official Reserve Transactions refer to the transactions by the Central Bank (like RBI) that cause changes in its official reserves of foreign exchange. These include buying or selling foreign currency in the exchange market.

Importance: They act as the accommodating item in the Balance of Payments (BoP). If there is a BoP deficit, the Central Bank sells foreign exchange reserves to fill the gap. If there is a surplus, it buys foreign exchange to add to reserves, thus balancing the BoP.

Relevance: The Real Exchange Rate is more relevant for deciding whether to buy domestic or foreign goods because it measures the true relative price (competitiveness) of goods between two countries.

Given:
Exchange Rate: 1.25 Yen = 1 Rupee.
Price in Japan ($P_f$) = 3.
Price in India ($P$) = 1.2.

Step 1: Nominal Exchange Rate ($e$)
We need price of foreign currency (Yen) in domestic currency (Rupees).
$e = \frac{1}{1.25} = 0.8$ Rupees per Yen.

Step 2: Real Exchange Rate ($\varepsilon$)

Real Exchange Rate = 2

(Interpretation: Japanese goods are twice as expensive as Indian goods in real terms).

Under the Gold Standard, BoP equilibrium was achieved via the Price-Specie-Flow Mechanism:

1. If a country had a BoP Deficit, it had to pay gold to foreigners.
2. Outflow of gold $\rightarrow$ Money Supply in domestic economy falls.
3. Prices in domestic economy fall (Deflation).
4. Domestic exports become cheaper and imports become expensive.
5. Exports rise, Imports fall $\rightarrow$ Deficit is corrected automatically.

Under a flexible (floating) regime, the exchange rate is determined by the market forces of Demand and Supply of foreign exchange.

• Demand: Comes from importers, tourists going abroad, and investors buying foreign assets. (Inverse relationship with price).
• Supply: Comes from exporters, foreign tourists visiting, and foreign investors. (Direct relationship with price).

The equilibrium rate is where the Demand curve intersects the Supply curve.

Yes. A Managed Floating system (or “Dirty Float”) is a hybrid of fixed and flexible systems.

Why: While market forces determine the rate daily, the Central Bank intervenes (buys/sells foreign currency) to prevent excessive volatility or extreme fluctuations that could harm the domestic economy.

No, they are different:

• Domestic Demand for Goods: Total spending by domestic residents on goods, regardless of where they are produced ($C + I + G$). It includes imports ($M$).
• Demand for Domestic Goods: Spending on goods produced within the country. It includes foreign spending on our goods ($X$) but excludes our spending on foreign goods ($M$).

(a) In the equation $M = \bar{M} + mY$, the coefficient of $Y$ is the Marginal Propensity to Import ($m$).
Here, MPI = 0.06.

(b) Relationship: The MPI is negatively related to the slope of the Aggregate Demand function in an open economy.

Slope of AD = MPC – MPI (assuming simple model). A higher MPI reduces the value of the multiplier, making the AD curve flatter.

In an open economy, a part of the increase in income is “leaked” out to purchase imports ($M$). This reduces domestic spending in each round of the multiplier process.

• Closed Economy Multiplier: $\frac{1}{1-c}$
• Open Economy Multiplier: $\frac{1}{1-c+m}$

Since $m > 0$, the denominator in the open economy is larger, resulting in a smaller multiplier.

Derivation:

Multiplier: $$ K = \frac{1}{1 – c(1-t) + m} $$

(a) Equilibrium Income ($Y$):

Equilibrium Income = 560

(b) Net Exports ($NX$) at Equilibrium:

$$ NX = X – M = 90 – (50 + 0.05 \times 560) $$

$$ NX = 90 – (50 + 28) = 90 – 78 = 12 $$

Net Export Balance = 12 (Surplus)

(c) G increases from 40 to 50 ($\Delta G = 10$):

Multiplier $K = \frac{1}{1 – c + m} = \frac{1}{1 – 0.8 + 0.05} = \frac{1}{0.25} = 4$

$\Delta Y = \Delta G \times K = 10 \times 4 = 40$. New $Y = 560 + 40 = 600$.

New Imports $M = 50 + 0.05(600) = 80$.

New $NX = 90 – 80 = 10$.

Equilibrium income rises by 40; Net Export surplus falls by 2.

Change: $\Delta X = 100 – 90 = 10$.

Effect on Income:

$\Delta Y = \Delta X \times K = 10 \times 4 = 40$.

New Equilibrium Income = $560 + 40 = \mathbf{600}$.

Effect on Net Exports:

New $X = 100$. New $Y = 600$.

New $M = 50 + 0.05(600) = 50 + 30 = 80$.

New $NX = 100 – 80 = \mathbf{20}$.

(Original NX was 12. Change in NX = +8).

Given:
Year 2010 Rate ($e_0$): Rs 30 = $1.
Inflation: Prices in India doubled ($2P$), Prices in USA constant ($P$).

Logic (PPP Theory): If domestic prices double while foreign prices stay the same, the domestic currency must depreciate by half to maintain the same purchasing power.

Exchange Rate in 2030: Rs 60 = $1

If Country A has higher inflation than B, goods in Country A become relatively expensive compared to B.

• Exports: A’s exports fall because they are costlier for foreigners.
• Imports: A’s imports rise because B’s goods are cheaper.

Result: Since the exchange rate is fixed (it cannot depreciate to correct this), Country A’s Trade Balance will deteriorate (move towards deficit).

Not always. It depends on the cause:

• No Alarm: If the deficit is due to import of capital goods/machinery that will increase future production and exports, it is healthy development.
• Alarm: If the deficit is due to excessive consumption imports or if it is unsustainable (cannot be financed by capital inflows), it can lead to a debt trap or currency crisis.

1. Equilibrium Income ($Y$):

2. Budget Deficit ($G – T$):

$T = 0.2 \times 2333.33 = 466.67$

$BD = 750 – 466.67 = \mathbf{283.33}$

3. Trade Deficit ($M – X$):

$M = 100 + 0.2(2333.33) = 100 + 466.67 = 566.67$

$TD = 566.67 – 150 = \mathbf{416.67}$

Countries have adopted various arrangements to ensure stability:

1. Crawling Peg: The currency is pegged (fixed) but adjusted periodically in small amounts in response to economic indicators (e.g., inflation).
2. Managed Floating (Dirty Float): The Central Bank intervenes in a flexible market to smoothen excessive fluctuations without targeting a specific rate.
3. Currency Board: A rigid commitment to exchange domestic currency for a specific foreign currency at a fixed rate.
4. Common Currency (e.g., Euro): Countries abandon individual currencies to adopt a single stable currency, eliminating exchange rate risk within the union.