INTERNATIONAL TRADE, CAPITAL FLOWS &

EXCHANGE RATE: LECTURE IN

OPEN ECONOMY MACROECONOMICS

Mridul Saggar
(Professor of Practice, IIMK)

questions & correspondence: [email protected]

May 13, 2023 EPGP Economic Environment Lecture-7: IIM, Kozhikode

 What will we study today?
2

▪ Why does international trade take place and what are the gains from it?
▪ Should we trade in widgets or in dollars?
▪ What is nominal and real exchange rate?
▪ What is Purchasing Power Parity?
▪ Under what conditions, exchange rate depreciation can help improve trade balance?
▪ Puzzles in open economy macroeconomics
▪ Balance of payments accounting
▪ Current and capital account liberalization (OECD vs IMF view)
▪ Sudden surges, sudden stops & capital flow reversals: The challenge of capital flow management
 Why does International Trade Take Place?
3

▪ Ricardian Theory: As countries differ in their technology to produce goods and services,
they specialize in the product they have comparative advantage in even if they do not have
an absolute advantage in that product. In the LHS example, Portugal has absolute
advantage in producing both cloth & wine but if labour is immobile, then both countries can
gain by producing as per the comparative advantage. England can use 220 hrs of labour to
produce 2.2 units of cloth (i.e 220/100) and Portugal can use 170 hrs of labour to produce
2.125 units of wine (i.e.170/80). Both countries are better off if England trades a unit of
cloth for in between 5/6 to 9/8 units of Portuguese wine.
▪ Heckscher-Ohlin Theory: As countries differ in their resource endowments skills and
abilities of a country’s workforce, the natural resources available within its borders
(minerals, farmland, etc.), and the sophistication of its capital stock (machinery,
infrastructure, communications systems), the basis of trade can be comparative advantage
in resource endowments. Countries in which capital is relatively plentiful and labour
relatively scarce will tend to export capital-intensive products and import labour-intensive
products, while countries in which labour is relatively plentiful and capital relatively scarce
will tend to export labour-intensive products and import capital-intensive products. It is
relative endowmnt (i.e. capital per worker) that matters.
▪ Strategic Trade Theory: Following Brander and Spencer, literature has proliferated using
microeconomic models and game theory to describe strategic interactions between firms in
an international oligopoly (small number of firms) matter for trade and how national policies
and government interventions play a key role affecting these strategic interaction giving
advantage to firms in trade.
 Trade in Widgets or Trade in Dollars?
4

▪ The Asian financial crisis started amid banking fragilities in Thailand when on
July 2, 1997, with its currency under speculative attack, Thailand abandoned
the peg of Thai Baht with US dollar. An unprecedented contagion followed in
East Asia with capital flight from the region and some other parts of the world
▪ In 1998, Prof. Jagdish Bhagwati wrote an article in Foreign Affairs, The
Capital Myth: The Difference between Trade in Widgets and Trade in Dollars.
▪ The article written in the backdrop of the Asian Financial Crisis (AFC) (1997-
998) argued that trade in widgets (i.e goods; widgets literally are small
unnamed mechanical devices) has first order gains, while gains from trade in
dollars (i.e. capital) are much smaller and of second order importance and
carry sizable risks
▪ IMF was at that point was pushing for capital account convertibility to be
To EMEs pushed as a goal for its membership, but was forced to backtrack in the face of
evidence from the AFC that it could be risky and the arguments that gains
from merchandise trade outstripped the gains from capital flows that carried
large risks.
▪ However, trade in capital assets (financial/ capital flows) also have large gains
arising from international risk sharing that allows consumption smoothing.
However, they carry risks of financial crisis/ collapses that impose huge costs.
 Nominal and Real Exchange Rates & Purchasing Power Parity (PPP)
5
Reference rates
as on 12th May 2023
▪ NOMINAL EXCHANGE RATES: It is the price of one currency in
INR / 1 USD : 82.1606 terms of another; (e.g direct quotes of reference rates on LHS; indirect
INR / 1 GBP : 102.9407 quote e.g. will be 1 INR=0.0122 USD)
INR / 1 EUR : 89.8163
INR / 100 ▪ SPOT AND FORWARD RATES: A spot exchange rate is the price of
: 60.9800
JPY one currency for another when traded immediately, or "on the spot". A
forward rate is the settlement price of one currency for another that
takes place at a predetermined date in future. Typically, forward
exchange rates are quoted for 3/ 6/ 9/ 12-months forward. NOTE: A
foreign exchange market is considered efficient if forward rates are the
optimal predictor of future spot rates
▪ REAL EXCHANGE RATES (RER): RER between two currencies is
the product of the nominal exchange rate (e.g the Indian rupee cost of a
US dollar) and the ratio of prices between the two countries; i.e. RER =
eP*/P, where, e is the nominal dollar/rupee exchange rate, P* is the
average price of a good in the U.S. and P is the average price of the
good in India.
▪ RER and PPP: Ex: INR/USD=80; Price of Toyota Camry: US$30,000
in the U.S., but Rs50 lakh in India; then Real Exchange Rate of
INR/USD is 0.48; but if price of Camry falls to Rs 24 lakh in India, real
exchange rate will fall to unity. Absolute Purchasing Power Parity
(PPP) then holds.
 Marshall-Lerner Condition:
When should you devalue currency to improve trade balance?
6

J-curve effect ▪ for a currency devaluation to lead to an improvement (e.g

reduction in deficit) in the current account, the sum of price
elasticity of exports and imports (in absolute value) must be
greater than unity.
i.e PEXD (price elasticity of export demand)+PEMD
(price elasticity of import demand)>1
e.g.: PEXD is 0.3 & PEMD is 0.6
then a devaluation of the currency should worsen the
trade balance.
▪ Empirical evidence suggests the elasticity of demand for exports
and imports tends to be inelastic in the short run, but more elastic
in the long run. Therefore, a devaluation often worsens the current
account in the short term but improves it in the long-term
e.g.` lon-run elasticities are as follows:
PEXD is 0.5 & PEMD is 0.7 then a devaluation can then
devaluation can help improve trade balance in the long-run
as J-curve effect takes place
 Six puzzles in International/ Open Economy Macroeconomy
& the Impossible trinty
7

▪ The Puzzle of Home bias in trade

▪ The Feldstein-Horioka puzzle
▪ The Puzzle of Home bias in equity portfolios
▪ The international consumption correlations
▪ The Purchasing Power Parity (PPP) puzzle
▪ The Exchange Rate Disconnect Puzzle

IMPOSSIBLE TRINTY or TRILEMMA IN OPEN ECONOMY MACROECONOMICS

▪ The impossible trinity (also known as the trilemma) is a concept in international economics which states
that it is impossible to have all three of the following at the same time:
▪ a fixed or stable exchange rate
▪ Free capital mobility (absence of capital controls)
▪ an independent monetary policy that is set only on domestic economy considerations
 Balance of Payments
8

It is a summary record of transactions of residents with rest of world (RoW) during a

given period. It essentially captures cross-border transactions with a bird’s eyeview

▪ CA- Current account records sale and purchase of goods and services and
transfer payments.
▪ KA- Capital account records capital transfers/trade of non-produced non-financial
assets
▪ FA - Financial account records sales and purchase of assets - creates
assets/liability - transactions by private sector and reserve transactions
(intervention) by central bank in FX market

▪ Must balance in payments: CA+KA + FA = 0

▪ if a country has no assets to sell, if it has no forex reserves to use up, and if
nobody lends, the country has to achieve balance in CA
 Balance of Payments
9

▪ Main objective of economic policy is to achieve high economic growth, full employment, price stability and
bop equilibrium – to grow consistently at full production capacity (or full employment).

▪ tracks flow of currency/monetary assets coming in and out of a nation

▪ Shows the extent of dependence of the country economic development on the financial saving of RoW.

▪ Y=C+I+(X-M) (Y-C)=I+ (X-M) S=I+ (X-M) S-I= (X-M) = CAB

▪ so if saving=investment, then CAB=0, if I>S, CAB is in deficit ; if I<S, CAB is in surplus

▪ Usefulness of CAB - indicates whether economy is generating enough savings to finance domestic
investment.

▪ Deficit in BoP if persist for long, sustainability could be the issue - affecting economic growth, employment
and price stability - would require necessary corrective actions

▪ Great importance in the determination of monetary and fiscal policy. Deficits have a strong impact on
inflation through its effects on ex-rate/expectations. Ex-rate depr may lead to expectations of further depr,
discourging capital inflows, encourage outflows - speculative attack – imports become expensive –
imported inflation.

▪ Today, BoP statistics not only used in determination of economic policy but are widely employed by
business enterprises e.g. tourist statistics developments are widely used by like hotel and transport firms.
Trade statistics are used by commercial enterprises to determine their size in the market for certain goods
or ascertain potential trade opportunities.
 Balance of Payments
10

▪ Main objective of economic policy is to achieve high economic growth, full employment, price stability and
bop equilibrium – to grow consistently at full production capacity (or full employment).

▪ tracks flow of currency/monetary assets coming in and out of a nation

▪ Shows the extent of dependence of the country economic development on the financial saving of RoW.

▪ Y=C+I+(X-M) (Y-C)=I+ (X-M) S=I+ (X-M) S-I= (X-M) = CAB

▪ so if saving=investment, then CAB=0, if I>S, CAB is in deficit ; if I<S, CAB is in surplus

▪ Usefulness of CAB - indicates whether economy is generating enough savings to finance domestic
investment.

▪ Deficit in BoP if persist for long, sustainability could be the issue - affecting economic growth, employment
and price stability - would require necessary corrective actions

▪ Great importance in the determination of monetary and fiscal policy. Deficits have a strong impact on
inflation through its effects on ex-rate/expectations. Ex-rate depr may lead to expectations of further depr,
discourging capital inflows, encourage outflows - speculative attack – imports become expensive –
imported inflation.

▪ Today, BoP statistics not only used in determination of economic policy but are widely employed by
business enterprises e.g. tourist statistics developments are widely used by like hotel and transport firms.
Trade statistics are used by commercial enterprises to determine their size in the market for certain goods
or ascertain potential trade opportunities.
 Pre-pandemic India’s Balance of Payments
11
(US$ Million)

April-June 2019 July-September October-December January-March April-March 2019-

2019 2019 2020 20
Net Net Net Net Net
1 Current Account -14977 -7553 -2605 584 -24550
1.A Goods and Services -26699 -18709 -14161 -13015 -72584
1.A.a Goods -46774 -39650 -36040 -35042 -157506
1.A.b Services 20075 20941 21879 22027 84922
1.B Primary Income -6270 -8822 -7361 -4827 -27281
1.C Secondary Income 17992 19978 18918 18427 75314
2 Capital Account -822 -100 -150 -19 -1092
3 Financial Account 15434 8535 2150 -1451 24668
3.1 Direct Investment 13993 7314 9743 11963 43013
3.2 Portfolio Investment 4843 2476 7829 -13745 1403
3.3 Financial derivatives 1521 257 134 2186 4099
3.4 Other investment 9061 3605 6044 16939 35650
Reserve assets (-
3.5 means accretion) -13984 -5118 -21601 -18794 -59498
3 Total assets/liabilities 15434 8535 2150 -1451 24668
4 Net errors and omissions 365 -882 605 886 974
 Pandemic Period India’s Balance of Payments
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USD Millions Quarter - Apr-Jun 2020 PR Quarter- Jul-Sep 2020 P First Half - Apr-Sep 2020 P
Credit Debit Net Credit Debit Net Credit Debit Net
A. CURRENT ACCOUNT
I. MERCHANDISE 52,352 63,119 -10,768 75,591 90,375 -14,784 1,27,943 1,53,495 -25,552
II. INVISIBLES (a+b+c) 70,114 40,135 29,978 75,364 45,072 30,292 1,45,478 85,208 60,270
a) Services 46,809 26,304 20,505 49,902 28,733 21,169 96,711 55,037 41,674
i) Travel 1,848 2,757 -909 2,020 2,737 -717 3,868 5,494 -1,626
ii) Transportation 4,867 4,216 651 5,410 4,759 651 10,277 8,975 1,302
iii) Insurance 565 378 187 590 537 53 1,155 915 239
iv) G.n.i.e. 148 330 -182 144 190 -46 292 520 -228
v) Software Services 22,622 1,849 20,773 25,069 2,769 22,299 47,690 4,618 43,073
vi) Business Services 11,282 11,514 -232 11,624 12,379 -755 22,907 23,893 -987
vii) Financial Services 1,009 1,062 -52 1,003 1,107 -104 2,013 2,169 -156
viii) Communication Services 707 304 403 661 355 306 1,368 659 708
b) Transfers 18,223 1,237 16,986 20,421 2,023 18,398 38,644 3,261 35,384
c) Income 5,082 12,594 -7,513 5,041 14,316 -9,275 10,123 26,910 -16,787
i) Investment Income 3,718 11,925 -8,207 3,596 13,615 -10,020 7,314 25,541 -18,227
ii) Compensation of
Employees 1,364 669 695 1,445 700 745 2,809 1,369 1,439
Total Current Account (I+II) 1,22,465 1,03,255 19,211 1,50,955 1,35,448 15,507 2,73,420 2,38,703 34,718
 India’s Balance of Payments: Some Contemporary issues
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▪ India has moved away distinctly from stressed

BOP with large CADs that prevailed till early
1990s.
▪ Current and especially capital account
liberalization has helped equilibrate BOP despite
large capital flows introducing an element of new
volatility that has posed macroeconomic
challenge for managing sudden surges, sudden
stops & capital flow reversals
▪ GIFT city emerging as a new offshore centre has
introduced new statistical and policy challenges
▪ Correction in commodity prices has helped India
come out of new BOP pressures in H2 of 2022-
23. CAD/GDP may stay well inside of 2.0% of
GDP against sustainable threshold of about 2.5%
of GDP