Introduction of the module

 In module 4 and 6, we had focused on income determination in a different sectors of

economy.
 At this stage of our analysis, we are in a position to go a step further and discuss the other
important aspects which pertain to an open economy.
 Today, all economies are open and dealing in transactions with the rest of the world.
 They all are involved in the export and import of goods and services. They are also engaged
in borrowing and lending in the financial markets of the different countries.
 All these different countries have their own currencies, which are generally legal tender
only within the territories of the country. The rupee is acceptable within India where as the
dollar is acceptable within the US economy.
 The problem occurs when one country trades with another.
 This problem can be solved be fixing the rate of exchange between the different currencies.
 In this module we will discuss how open economy operates and what are various issues in
its equilibrium.
 Also, the determination of the foreign exchange rate
FOREIGN EXCHANGE
• The foreign exchange (also known as FX or forex) market is a global
marketplace for exchanging national currencies against one another.
• Market participants use forex to hedge against international currency and
interest rate risk, to speculate on geopolitical events, and to diversify portfolios,
among several other reasons.
• Major players in this market tend to be financial institutions like commercial
banks, central banks, money managers and hedge funds.
 Several countries that engage in trade also have their own domestic currencies
which are regarded as the legal tender in their domestic territory.
 In order to engage in trade, these countries have to participate in trade with
each other.
 Foreign Exchange Market:
 A market where foreign currencies are purchased and sold by individuals,
firms, commercial banks and the central banks of different countries.
Types of Foreign Exchange Transaction
 Foreign Exchange transactions are of two types:
 1. Spot transaction: It is the one where the seller of the foreign exchange has
to deliver the exchange to the buyer on the spot, that is, within two days of the
deal.
 2. Forward transaction: It is the one which involves an agreement between
the buyer and the seller to purchase or sell a fixed amount of currency for a
predetermined rate at a specified date in the future.
 Functions of the foreign exchange market:
 1. International transfer of purchasing power between different countries.
 2. Provision of credit for foreign trade
 3. Hedging risks of foreign exchange: Hedging is an attempt at covering the
risk involved in a foreign exchange transaction through a forward transaction.
Other concepts
 1. Arbitrage: Simultaneous buying and selling of different currencies in different
foreign exchange markets to take advantage of the difference in prices.
 Professional traders employed by money market, banks and other financial
organizations seek to profit from small differences in the price of foreign exchange in
different markets. Whenever the foreign-exchange market is not in equilibrium,
professional traders can profit through arbitraging money.
2. Speculation: Activity related to sale and purchase
of forex in which risk is undertaken to take
advantage of the fluctuations in exchange rate.
3. Currency board: Arrangement under which the
central bank of the country holds enough amount of
forex to back, in a fixed ratio, each and every unit of
domestic currency.
4. Dollarization: A situation in which the country
abandons its own currency to embrace a strong
currency like dollar.
 Exchange Rate
 Exchange rate is the rate at which one country’s currency exchanges for another
country’s currency.
 Price at which the residents of one country conduct trade with the residents of the
other country.
 One can distinguish between nominal exchange rate and real exchange rate
The nominal exchange rate E is defined as the number of units of the domestic
currency that can purchase a unit of a given foreign currency
(Rs. 75= $1).
Appreciation of the currency (Rs.74 = $1).
Depreciation of the currency (Rs.76 =$1).
 By contrast, the real exchange rate R is defined as the ratio of the price level
abroad and the domestic price level, where the foreign price level is converted
into domestic currency units via the current nominal exchange rate.
R=(E.P*)/P, where the foreign price level is denoted as P* and the domestic price
level as P.
Things to note
A decrease in R is termed appreciation of the real exchange rate, an increase
is termed depreciation.
The real rate tells us how many times more or less goods and services can
be purchased abroad than in the domestic market for a given amount.
In practice, changes of the real exchange rate (also called terms of trade)
rather than its nominal level are important.
Numerical Problem 1
If Rs.75 = $1
Chips in US=$3, in India Rs. 100
𝑷𝒇 𝟑
R=N∗ = 75 ∗ = 𝟐. 𝟐𝟓
𝑷𝒅 𝟏𝟎𝟎
Now if rupee depreciates Rs.80 = $1
Chips in US=$3, in India Rs. 100
𝑃𝑓 3
R=N∗ = 80 ∗ = 2.4
𝑃𝑑 100
Rise in R (depreciation of rupee) Indian exports increase as more Indian
produced goods can be bought with $1.
Two nominal exchange rate systems
1. Flexible exchange rate: exchange rate fluctuates freely without the government
intervention.
2. Fixed exchange rate: exchange rate does not fluctuate in response to the changes in
economic conditions. The exchange rate is maintained through govt. intervention in forex
market and also by CB by buying and selling of currencies.
History of forex:
 After the second world war, there was a need for new international monetary and economic
system.
 The Bretton Woods System was put in place in the year 1944. The countries adopted a fixed
exchange rate system in which each country pegged its currency to dollar.
 The IMF and World Bank emerged as a result of this newly found economic system.
 However, this system was short lived due to series of exchange rate crisis that ensued.
 Thus, the Bretton Woods system was officially dissolved in 1971. The dollar was devalued.
 The major industrial nations in the world adopted flexible exchange rate in 1973.
 Thus, as of today while some countries operate under flexible exchange rate others operate
under floating exchange rate regime. While some lie in between.
Exchange rate Systems
Two major exchange rate systems:
1. Fixed Exchange rate system- A fixed exchange rate is a regime
applied by a government or central bank that ties the country's
official currency exchange rate to another country's currency or the
price of gold. The purpose of a fixed exchange rate system is to keep
a currency's value within a narrow band.
2. Flexible Exchange rate system: Flexible exchange rates can be
defined as exchange rates determined by global supply and demand of
currency. In other words, they are prices of foreign exchange
determined by the market, that can rapidly change due to supply and
demand, and are not pegged nor controlled by central banks.
Advantages of Fixed Exchange rate regime
1.Eliminates risk and uncertainties associated with international business
transactions.
2. Easier to implement in comparison to floating exchange rate system.
3. Acts as a safety net against inflation.
4. Disciplines country’s monetary authority.
5. Facilitates movement of capital between countries by providing stability
6. Discourages Speculation
Disadvantages of Fixed exchange rate system:
1. Monetary policy is less effective
2. It is rigid
Advantages of Flexible Exchange rate regime
1. Independent formulation of macroeconomic policies is possible
2. Allows monetary and fiscal policy to attain goals of employment and price
stability
3. Corrects for BOP disequilibrium
Disadvantages of Flexible exchanges rate system:
1. Increases the uncertainty regarding future exchange rates.
2. May encourage speculation
3. Could lead to inflationary spirals.
Foreign Exchange rate determination in flexible exchange rate system
Demand for foreign exchange ($) to make payments for:
1. Import of commodities.
2. Import of services
3. Interest payments, royalties payments to be made to foreigners by
Indians
4. Exports of short term or long term capital
5. Gift to foreigners
6. Gold imports
Demand curve for foreign exchange
Forex
rate
(Rs/$)
Depreciation makes
imports costly and
exports cheaper
60

50
Demand for foreign
exchange

F’ F Amount of for exchange($)

Points to note
The slope and shape of demand curve will depend on the following:
1. Elasticity of demand for imported goods.
If the ed is high, then any increase in price will lead to a steep fall in demand
eg. Luxury goods.
If ed is low, then increase in price will lead to a small fall in demand . Eg.
Necessities.
2. Presence of import competing industries in domestic country.
3. Time required: short run reallocation of resources is not possible too
quickly so the elasticity of demand to price changes would be low. In the
long run, this would change.
Supply of foreign exchange: payments made by foreigners to the residents of the
country within a specified period.
1. Exports of commodities
2. Interest and dividend payments made on securities in US owned by
Indians.
3. Gifts from foreigners
4. Import of short term and long term loans.
5. Gold exports
Supply curve of foreign Exchange
supply of
Forex foreign
rate exchange
(Rs/$)
Increase in price of
dollar (in terms of
depreciation of rupee)
60
leads to increase in
supply of dollars.
50

Supply for foreign

exchange

F F1
Amount of foreign
exchange($)
Points to note
The shape and slope of supply curve of forex depends on the elasticity of
india’s exports to US
1. If the elasticity of demand for India’s exports is greater than unit, the
supply curve for forex is upward sloping
Exchange rate equilibrium
 Under flexible exchange rate, the equilibrium rate of exchange is determined
at a point at which demand for forex is equal to supply of forex.
This increase in
 It is determined by the unregulated market forces. DD for forex leads
Determination of Exchange rate under Flexible Exchange rate to depreciation
system. Supply of forex of domestic
currency. Hence,
E’ is new
equilibrium
Rs per dollar exchange rate
60
E’

E
50
New DD

Demand for
forex

Amount of forex
F F’ (dollars)
Fluctuations in Exchange rate
1. Trade conditions in the country
2. Changes in interest rate in domestic economy
3. Arbitrage operations
4. Stock Exchange influences
Determination of Exchange rate under Fixed Exchange rate system.

Rs per dollar Supply of forex

Govt. could increase

the exchange rate in A B
Rs. 60 =$1 is the official Exchange rate set
order to boost exports. 60 by Govt.
At official exchange
rate, the supply of E Market determined exchange rate
50
forex is greater than
the demand by
amount AB.
Hence, the
government could
eliminate this excess
supply by buying Demand for
forex currency using forex
reserve assets like
gold. Amount of
forex (dollars)
 Balance of Payments
The BOP is summary statement of all the economic
transactions between the residents of the country and the
rest of the world in a year.
Payments made- Debit entry
Payments received- Credit entry
BOP transactions grouped under following categories:
1. Current Account
2. Capital Account
3. Official international reserve account
1. The Current Account: The current account balance (CAB)
is part of a country's financial inflow and outflow record. It is
part of the balance of payments, the statement of all
transactions made between one country and another. This
account broadly includes:
a. Balance of trade: Exports > Imports (Trade surplus) or the
reverse would be true.
b. Balance of invisibles: Difference between export and import of
services.
c. Unilateral transfers: Gifts, grants, personal remittance.
If total receipts are greater than payments then CAB surplus or if
reverse occurs you have a CAB deficit.
2. The Capital Account: Measures the outflow and inflow of capital into the economy.
Includes sales and purchases of assets such as stocks, bonds and land.
 Components of Capital Account includes
 Borrowings and Lendings to and from abroad – Includes all the transactions related
to borrowings from abroad by the government, private sector, etc.
 Investments to and from abroad – Includes all the investments by the rest of the
world in shares of Indian companies, real estate, etc. The investments to and from
abroad are:
Foreign Direct Investment - FDI consists of the purchase of an asset, which gives
direct control to the buyer over the asset. For example, purchase of land, building,
etc.
Portfolio Investment – It is the cross-border transactions and positions involving
equity or debt securities, other than direct investment or reserve assets. Ex - FII
(Foreign Institutional Investment).
 Change in Foreign Exchange Reserves - The financial assets of the government held
in the central bank are Foreign Exchange Reserves.
Inflow of capital- credit, outflow of capital –debit.
3. The Official International Reserve Account:
a. Foreign currencies
b. Gold
c. Special Depository Receipts: When country becomes
a part of IMF, it deposits a certain subscription as a
membership fee.
The transactions in the international reserve account
determines forex reserves which are required for settling
deficit in current and capital account.
Double Entry Book-Keeping
The central point of International payments is very simple:
If a country runs a deficit in its Current Account, spending more
abroad than it receives from sales to the rest of the world; the
deficit needs to be financed by selling assets or by borrowing
from abroad.
Thus, any current account deficit is necessarily financed by
offsetting capital inflows.
CAD + Net Capital inflow = 0
Example: US runs a CAD but a Capital account surplus for BOP to
be zero. China runs a current account surplus but a capital account
deficit to again establish BOP=0
Hence, its important to note that balance of payments of a
country will always balance.
So, how will a surplus or deficit (disequilibrium occur in
BOP). Changes in production pattern, shifts in capital or
demand, exchange rate fluctuations are some of the factors
that can lead to BOP disequilibrium.
Any disequilibrium in BOP is offset using
‘Accommodating transactions’ which makeup for any
deficit or surplus.
Accommodating transactions: Transactions that take
place for specific purpose of equalizing the balance of
payments from accounting point of view.
Examples of accommodating transactions: short term
movement of capital, gold movement and forex.
2. Autonomous transactions: Transactions that take place
independently of other items in the bop. Take place in both
current and capital account.
1. Current Account Autonomous transactions: Exports and
imports of G&S, unilateral transfers.
2. Capital Account Autonomous transactions: Long term
capital movements used for commercial purposes.
To determine whether BOP is in equilibrium, only autonomous
transactions are considered.
If total receipts from autonomous transactions = total payments;
BOP is balanced.
If total receipts from autonomous transactions = total payments;
BOP is not balanced.
Total receipts from autonomous transactions> total payments,
BOP is in surplus and vice- versa.
Any disequilibrium is offset by using accommodating
transactions .
Hence, the sum of accommodating and autonomous
transactions = 0
Net export and BOP equilibrium:

NX = X(Yf, R) – M(Y,R) =NX (Y, Yf, R)

Rise in foreign income (Yf), ceteris paribus, improves

home country’s trade balance.
A real depreciation (R) improves trade balance and
therefore increases AD
A rise in home income (Y) raises import spending and
hence worsens trade balance
The process of adjustment in the balance of payments
In case of a deficit in BOP, the analysis will be grouped
under two heads:
1. Expenditure reducing or expenditure changing
policies:
a. Monetary policy
b. Fiscal Policy
2. Expenditure switching policies
a. Devaluation: The elasticity Approach
b. Devaluation: The absorption Approach
1. Expenditure reducing or expenditure changing policies:
Aimed at bringing about a change in the AE in the country. To
simplify our analysis, we exclude autonomous capital
movements. Thus, the BOP can be written as :
B = Y –E;
B = BOP net
Y = Dom output
E = Dom expenditure
Y > E (Surplus in BOP)
Y< E (Deficit in BOP) (Deficit can be eliminated by increasing
output or reducing expenditure. In short run increasing output
is difficult hence government aims at reducing expenditure.
Y = E (BOP equilibrium)
Expenditure reducing policies can be broadly divided under two
categories:
Monetary and Fiscal policy:
1. Monetary policy: To tackle deficit in BOP a contractionary
MP is followed. It leads to increase in interest rates leading to
an increase in capital inflight.
Instruments of MP which are mostly used are:
a. Interest rates: If the Marginal Propensity to Import is high, any
anticipated reduction in interest rates during boom period will
trigger higher imports thereby worsening the BOP.
b. OMO: If CB sells bonds in OMO it sucks out the liquidity,
leading to rise in interest rates and fall in investments and
income. This will further curb imports and improve BOP.
Fiscal Policy:
Fiscal policies that can be used to reduce expenditure:
1. Increase indirect and direct taxes
2. Reduce C, I, G
To eliminate a deficit, country can pursue a contractionary
FP or MP
Both will lead to deflationary impact on national income and
decrease imports.
Also will have a positive impact on exports and import
competing industries.
2. Expenditure Switching policies: Devaluation- the
Elasticity approach:
The expenditure switching policies work mainly through
changing the relative price of imports and exports. This is
achieved through revaluation or devaluation.
One can use direct controls (import quotas), financial
controls and exchange restrictions as switching device.
Devaluation refers to a conscious decision by monetary
authorities to lower the value of the currency with respect
to price of gold.
In flexible ER system- deficit in BOP automatically
translates to depreciation or the value of one’s currency
reduces wrt other trading currencies and vice-versa.
In fixed ER system- Authorities have to consciously take this
decision.
Devaluation leads to changes in relative prices: A
devaluation of 10 percent
1. Increases the price of imports by 10 percent.
2. Decreases the price of exports by 10 percent.
The elasticity of demand for exports or imports will
determine the success of devaluation.
According to the Marshall Lerner condition, for a devaluation to
have a positive effect on a country’s bop, the sum of the absolute
values of the elasticity of demand for its exports and imports
should be greater than 1.
If this sum is less than one, then the country can improve its BOP
through revaluation
∆B = k Xf (e1m + e2m -1)
Where, ∆B = Change in trade balance
k = devaluation in percentage terms
Xf= value of exports in terms of foreign currency
e1m= ED for imports of devaluing country
e2m= ED for exports of devaluing country.
A devaluation leads to:
a. Increase in price of imports: If ED for imports is high then
import demand falls sharply with little rise in price. Example in
case of luxury items this stands true.
b. Decrease in price of exports: If ED for exports is high then
exports increase massively with little fall in prices. Example: if
country exports capital goods then this will be true.
For Marshall Lerner condition to hold:
1. The supply elasticities must be large
2. When devaluation takes place the trade balance should be in
equilibrium which again may not be the case.
 Mundell Fleming Model

IS-LM model extended to open economy under perfect

capital mobility assumption.
Capital being perfectly mobile means investors can
purchase assets in any country they choose, with low
transaction costs and in unlimited numbers.
In cases when capital is mobile investors are willing to
move large amounts of funds across borders in search of
high returns
The recognition that interest rates affect capital flows and
bop (if interest rates are home are low, Indian investors
move their capital out of India in search of higher returns
thereby worsening bop) has important implications for
stabilization policy.
First, because Monetary Policy and Fiscal Policy affects
interest rates, the policies have an effect on capital
account and therefore bop
 Mundell Fleming Model under fixed exchange rates

E4
Surplus E3
underemployment Surplus
overemployment

Interest rates i=if BP=0

E1
Deficit, E2
underemployment Deficit,
overemployment

Full employment Yf* Income (Y)

Mundell Fleming Model under fixed exchange rates
Internal and external balance under fixed exchange rates:
Full employment is obtained at an output level Y*.
The internal balance schedule is vertical line at Y*(internal
sector).
Along BP=0, the bop is in equilibrium (external sector).
With perfect cap mobility, the bop can only be in
equilibrium when home interest rates equal those
abroad.
Thus, BP=0 is flat at the level of world interest rates.
Mundel Fleming under fixed rates and perfect capital
mobility: LM
i IS
LM’

E
i=if BP =0
i= I E’
Low

IS

Y Y OUTPUT
Under perfect capital mobility, the bop can be in
equilibrium only at interest rate i=if.
At even slightly higher rates, there are massive capital
inflows, at lower rates there are higher outflows.
An expansionary MP cuts interest rates, depreciates the
currency so the CB has to correct for this by buying domestic
currency thereby reversing the expansionary MP
A contractionary MP, increases IR, heavy capital inflows,
appreciation of domestic currency, again CB sells domestic
currency and contractionary MP is reversed.
So MP does not work
Mundel Fleming under fixed rates and perfect capital
mobility: LM
i IS
LM’

E’
I high
E
i=if BP =0

IS’
IS

Ylow Y Yhigh OUTPUT

However, under fixed exchange rate, FP is very effective.
With the initial equilibrium at E, Fiscal expansion moves
IS curve to right keeping LM same.
This will initially lead to rise in interest rates thereby
attracting capital inflows.
IR rises, capital flows in, currency appreciates. The CB
must now intervene by increasing MS.
MP expands thereby yielding a higher output.
Interest rates come back to their original level.
Mumndel Fleming under flexible rates and perfect capital
mobility: LM
i IS

E
i=if BP =0
E’

IS’
IS

Y OUTPUT
Effects of a rightward shift in IS curve: A rise in the foreign
demand for our exports will shift the IS curve to right.
But the IR then rises, leading to inflow of capital. This
appreciates the currency, we become less competitive in trade,
exports fall. Bop worsens. IS begins shifting backward. In the
end, fiscal expansion does not change output. It simply leads to
currency appreciation thereby offsetting the change in net
exports.
Now, if LM curve moves to right. The IR falls, capital flows out
of the country. Exchange rate depreciates. Net exports rise, IS
shifts to right. We settle at a higher income level. Hence MP is
very effective under flexible exchange rate.
Mumndel Fleming under flexible rates and perfect capital
mobility: LM
i IS
LM’

E
i=if BP =0
E’

IS’
IS

Y Y1 OUTPUT
Impossible trinity:
Twin Deficit :
Economies that have both fiscal deficit and CAD are referred
to having a twin deficit problem.
Fiscal deficit: G> T
Current Account deficit: Imports > Exports
Twin deficit hypothesis: Some economists believe that
budget deficits are correlated with large CAD
When nation runs out of money to fund its spending (i.e.
when taxes fall), it then turns to foreign investors for
borrowing, thus leaving a higher external deficit.
 Y= C+I+G+NX…(1)
If (s-I) remains
Yd= Y+TR-TA..(2) constant, G+TR-TA
increases then the net
Yd= C+S..(3) exports have to fall to
maintain the Income
So, C+S =Y+TR-TA equality.
C= Y+TR-TA-S…(2) Thus, we are faced with
a ‘Twin Deficit’
Substitute 4 in 1 we get, problem.
Y= C+I+G+NX( from 1)
Y= (Y+TR-TA-S)+I+G+NX
S-I = G+TR-TA+NX
Private sector
Government spending Net exports
When a nation runs out of money to fund its fiscal spending, it often
turns to foreign investors as a source of borrowing.
At the same time, the nation is borrowing from abroad, its citizens are
often using borrowed money to purchase imported goods.