Open Economy∗

Divya Gupta

Economics II

∗
Please note that the slides are not substitutes to classroom discussions and main
reading(s).
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References

Goodwin: Chapter 29
Mankiw: Chapters 17 and 18
Cypher and Dietz: Chapter 15

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The Open Economy
A country’s economy is ‘open’ if it exports and imports large amounts
relative to its GDP and relatively ‘closed’ if it exports and imports
relatively small amounts, or does not engage in any trade at all.
Hence, while modern economies are mostly open, the degree of
openness differs across nations.
Governments can try to control the degree of openness or ‘closedness’
of their economy through a variety of policy tools:
Trade Ban: a law preventing the import or export of goods or services
Trade Quota: a restriction on the quantity of a good that can be
imported or exported. An import quota helps domestic producers by
shielding them from lower-price competition. Not as extreme as a
complete trade ban.
Tariffs: taxes on imports or exports. Tariffs are taxes paid to the
government of the importing country by the importing company or
entity, not by the exporting country. Import tariffs provide monetary
benefit to the government that imposes them.
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Balance of Payments

The flows of foreign exchange payments into and out of a country are
summed up in its balance of payments (BOP) account.
The balance of payments, thus, measures all the outflows and inflows
of foreign currency across the national borders of a country in
transactions with the rest of the world (ROW) over some period of
time, usually a year, but often calculated quarterly or even monthly.
Outflow of foreign currency: Imports or lendings to the rest of the
world (ROW)- a negative entry
Inflow of foreign currency: Exports or borrowings from ROW - a
positive entry
The balance of payments (BOP) is composed of three parts: the
current account balance, the capital and financial account balance,
and net errors and omissions.

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Current Account
Current Account Balance: measures the outflows and inflows of
foreign exchange of a country vis-a-vis the rest of the world for
current transactions - that is, sales and purchases of goods and
services. Such as the purchase of cars or insurance, or contracting
services, or payments on international loans.
The current account is simply a measure of an economy’s spending
and income balance with the ROW.
The overall balance of trade measures the net trade of all goods and
services of a country with the rest of the world (ROW).
A surplus in the balance of trade means that the foreign exchange
earned from all exports sold to the ROW exceeded the foreign
exchange spent on imports from the ROW
When a country spends more foreign exchange on imports than it
earns from its exports, the country will have a deficit in the balance of
trade.
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Current Account (contd.)

In addition to the balance of trade, current account also includes:

Factor income receipts and payments - Income earned (a positive
value) in foreign currency and the payments of foreign exchange (an
outflow, hence a negative value) from flows of interest, profits and
dividends, and employee compensation that are the result of loans and
investments made in or by other countries.
Current transfer receipts and payments - such as remittances etc.
However, the balance of trade is the biggest largest item in the
current account. Therefore, a deficit on current account is almost
always due to the deficit on balance of trade.
Hence, from now, whenever we say a current account deficit - it
implies a trade deficit - that is, imports are higher than exports.

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Capital Account

The capital and financial account or simply the capital account measures an
economy’s borrowing from and lending to the ROW.
When one nation receives a foreign currency loan from another nation or
when an individual, business or government acquires a loan from a bank or
other financial intermediary or even another individual located in a foreign
country, a positive inflow of foreign exchange is recorded on the financial
account of the borrowing economy.
For the lending country, there is an outflow (a negative value) on the
financial account identically equal to the amount of that lending.
Capital account records the net change of assets and liabilities during a
particular year.
In addition to the loans taken from (+ve inflow) and given to the ROW (-ve
outflow), capital account also includes:

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Capital Account (contd.)
Investments from and investments in ROW. This includes foreign direct
investment, foreign portfolio investment, foreign institutional investment etc.
Official sales and purchases of foreign exchange reserve assets. You can
think of an economy’s total official foreign exchange reserves as a form of
“savings” in the form of foreign currencies.
An inflow of investment can be considered a type of loan as the inflow of
foreign exchange contributes to total investment in the country, increases
income and thus, potentially, permits an expansion of current consumption
and investment. It also must be “paid” for in the sense that if profits are
earned or dividends paid, there will be an outflow of foreign exchange from
the borrowing economy.
Overall, thus,
Balance of Payments = current account balance + capital account
balance + net errors and omissions.
Note that Net Errors And Omissions portion of the BOP is one way to capture a whole range of
transactions between one country and ROW, mostly if not always illegal, that no official
statistics will ever be able to capture: the marketing of illegal drugs and narcotics, gun-running,
money-laundering operations, and capital flight.
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BOP problem
What does it mean to say that a country has balance of payment problem?
Even though BOP = 0 always, because it’s an accounting identity, it does
not necessarily mean that any country with BOP= 0 will not face any crisis
in lieu of that.
The relative signs and specific values in each account are important.
For example, if a country is running a current account deficit it means that
the country will be obliged to borrow foreign exchange from the ROW or
reduce its own official foreign exchange reserves to finance the excess of
foreign exchange spending over foreign exchange income.
Thus, the economies that run current account deficits and are spending
more foreign exchange than they are earning will have positive capital
account balances that reflect the necessary “borrowing” to finance the
current account deficit.
Similarly, economies that have positive current account balances, meaning
they are earning more foreign exchange than they are spending, typically
may be expected to have negative capital account balances which indicate
that they are “lenders” of foreign exchange to the ROW
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BOP problem (contd.)

Whether the borrowing takes the form of loans from foreign governments,
banks, multinational corporations, individuals, or some other institution, the
loan is denominated in a foreign currency and must be repaid in that same
foreign currency in the future.
If the borrowing takes the form of portfolio or direct foreign investment,
there is still a foreign exchange obligation in the future to pay profits and
dividends to the foreign investor.
Too much indebtedness is bad signal for international lenders.
Other bad signals include- Very large Current account deficit, too much
depletion in official reserves
Thus, when the possibility of borrowing and of using foreign exchange
reserves to finance a current account deficit are both exhausted, a country
will no longer be able to run a current account deficit, and this typically
marks a full-blown balance of payments crisis.

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Equality between NX (net exports) and NFI (net foreign
investment)
Conceptually, we have already mentioned how a current account deficit will
automatically give rise to a capital account surplus.
Let’s elaborate on it with the help of a simple world consisting of only two
countries - A and B.
In this world, suppose A’s exports are greater than its imports - current
account surplus.
By default, it implies that since there are just two countries - country B
must have its imports greater than its exports - current account deficit.
Country B is, therefore, spending more (in terms of foreign exchange) on
exports, than it is earning from its imports.
How is it financing this extra spending?
By taking a loan from country A - capital account surplus for country B
(loan taken) and capital account deficit for country A (loan given).
Thus, for country A: NX = NFI, that is, since its net exports are positive, it
is exactly equal in value to the net foreign investment, say A has bought
some bonds from B - to give a loan to country B, thus indicating NFI > 0.
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Macroeconomic equilibrium in an open economy
Remember, in equilibrium, Y = AD
In a four-sector economy, this implies: Y = C + I + G + (X − M).
Let’s say: G = GC + GI , that is, the government expenditure is on both
consumption items as well as investment items.
Taking all the consumption items on the left-hand side, we get:
Y − C − GC = I + GI + NX
Left-hand side indicates total domestic savings and right-hand side indicates
total domestic investment (I + GI ) plus Net Exports, i.e. Stotal = Itotal + NX
As discussed earlier, if a country’s NX > 0 indicating a current account
surplus, it implies that it is loaning out the excess of foreign exchange
indicating a net capital outflow or net foreign investment in lieu of foreign
bonds bought.
Thus,
Stotal = Itotal + NFI
Envisage the above equation from the point of view of market for loanable
funds, it indicates that total domestic funds economy are either invested
domestically or internationally.
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Prices of international transactions
Nominal Exchange rates

A country’s bilateral exchange rate is the number of units of a foreign

currency that can be obtained for each unit of the domestic currency or,
alternatively, the number of units of the domestic currency required to buy
one unit of some foreign currency.
In simple words, an exchange rate is the price of domestic currency quoted
in terms of the foreign currency.
Each country has many bilateral exchange rates, one for each country with
which it trades, has financial transactions, or to which its citizens travel or
from which visitors arrive.
This is called Nominal Exchange Rate, which is the price of one currency in
terms of another currency.
It implies the rate at which one currency can be traded with other.
So, if 1$ is equal to Rs. 80, one can say price of 1$ in terms of rupees is 80.
Or; price of 1 rupees = 1
80 $.

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Prices of international transactions
Real Exchange rates

Real Exchange Rate is the rate at which a basket of goods and services can be
traded across two nations.
Since the prices of a basket of goods and services for each nation are quoted in
terms of their domestic currencies, and the rate of exchange between two
currencies is decided by the ongoing exchange rates, the real exchange rate (R)
depends on all these parameters - prices in domestic country (P), prices in foreign
country (P ∗ ) and the nominal exchange rate (e). Thus, R = e PP∗
For example, consider the relative price of ‘rice’ in two countries. Suppose in India,
price of rice = Rs 200 per kg (P) and in the US, price of rice = $8 per kg (P ∗ );
and nominal exchange rate (e): 1$ = Rs 80.
In order to make a comparison of the price of rice between US and India, we’ll
need to convert one of the two prices in terms of a common currency.
Expressing US price in terms of Rs = Rs 640 per kg. Hence, we can conclude that
rice is more costly in the US, compared to India.
Alternatively, one could simply look at the real exchange between the two
1 200
countries: R = 80 ( 8 ) = 0.3125
This implies that price of rice is 0.312 times the price of US, or, rice is 0.312 times
cheaper in India than in the US.
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Appreciation/ Depreciation

Appreciation refers to an increase in the value of a currency as

measured by the amount of foreign currency it can buy.
If a dollar buys more rupees, there is an appreciation of the dollar,
and depreciation of the rupee.
Depreciation refers to a decrease in the value of a currency as
measured by the amount of foreign currency it can buy.
If a dollar buys less rupees, there is a depreciation of the dollar and
appreciation of the rupee.

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Types of Exchange Rate Regimes

Exchange rate values are determined in different ways in different

countries.
Exchange rates can be regulated solely by the free market and the
forces of supply and demand, called a floating exchange rate;
Or, determined by a government at a set value (or range of values)
relative to other currencies, called a fixed exchange rate;
Or, the exchange rate value can be determined by an intermediate
mix of government regulation and the forces of supply and demand in
the market.
The way in which exchange rate values are determined for a particular
country is referred to as its ‘exchange rate regime’.

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Freely Floating Exchange rates
If a country chooses to operate with a freely floating exchange rate regime, the
nominal value of the exchange rate relative to other currencies will depend solely
upon the demand for and the supply of the domestic currency on the foreign
exchange market.
Currencies are traded against each other in foreign exchange market.
One can apply the demand and supply model to understand the working of the
foreign exchange market, as follows:
The quantity of dollars (domestic currency) traded is given on the horizontal
axis, and the ‘price’ of a dollar is given on the vertical axis, in terms of the
number of rupees (foreign currency) it takes to buy a dollar.
In an idealized foreign exchange market, exchange rate is determined by the
interaction of demand and supply.

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Factors affecting Flexible Exchange Rates
As stated previously, in a freely floating exchange rate regime, the exchange rate is
determined by factors affecting demand for and supply of domestic currency in the
foreign exchange market.
Factors affecting demand for dollar (domestic currency):
Extent of imports from US (domestic economy): demand for dollar by
foreign countries to pay for the imports of goods and services from the US.
Extent of capital inflow into US: demand for dollars by foreign countries to
invest in US by buying US’s stocks and bonds, for which they need to pay in
terms of dollars
Factors affecting supply of dollars:
Extent of exports to the US or imports by US: Importers in US will be willing
to supply dollar to exchange for the foreign currency to buy goods and
services from foreign country.
Extent of capital outflow from the US: Investors of US willing to supply dollar
to exchange for foreign currency, so that they can buy bonds and stocks in
that foreign country, or simply invest in or lend to that foreign country.
(Please note, for every unit of dollar demanded there is some rupee that is supplied
and vice versa.)
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Fixed Exchange Rate

Many countries have tried to control the value of their currencies in

order to create a more predictable environment for foreign trade. The
strictest kind of control is a fixed exchange rate system.
Starting in 1944, many countries, including the United States, had
fixed exchange rates under what is known as the Bretton Woods
system .
In a nut shell, in this system, participating countries committed to fix
the value of their currencies against US dollar and US government
committed to fix the value of US dollar against gold.
The exchange rates in such a system, however, do not usually remain
perfectly fixed. For one thing, it is impossible to literally fix an
exchange rate, because the central bank would need to have perfect
(and continuously perfect) information about all trades.

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Fixed Exchange Rate (contd.)
Further, when exchange rates are fixed, the adjustment to a new
equilibrium exchange rate value cannot take place, since the exchange
rate value is locked in at some pre-determined level.
Suppose a US-Sri Lanka exchange rate, where US dollar is the
domestic currency and Sri Lankan rupee is the foreign currency. Now,
if the demand for dollars increases and the supply curve of dollars
remains unchanged, there will be an unmet demand for dollars in the
foreign exchange market.
A shortage of dollars and a simultaneous surplus of the Sri Lankan
rupee at the current fixed exchange rate is the result.
Therefore, Illegal and quasi-legal foreign exchange markets, so-called
“black or gray or parallel markets”, are likely to emerge.
The greater the discrepancy between the fixed exchange rate value
and its equilibrium value, the more likely that such markets will
materialize and the greater will be the quantity of transactions taking
place in these secondary markets.
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Collapse of the Bretton Wood System
What the countries that participated in the Bretton Woods conference did - and
countries today that fix their currency generally do - is set a “band” or range
around a “target rate” and allow the “fixed” rate to fluctuate within this band.
Over the long term, the target rate within the band can change, at the
government’s discretion. When a government lowers the level at which it fixes its
exchange rate, what is called a devaluation occurs, and when it raises it, a
revaluation takes place.
But the system can be undermined if there are too many changes, and when key
currencies such as the dollar come under too much selling pressure, a fixed
exchange rate system can break down. This is what happened to the Bretton
Woods system in 1972.
When the United States suffered large currency outflows, the U.S. eliminated gold
convertibility and allowed the currency to float, which was quickly followed by
other major countries floating their currencies also.
After the Bretton Woods system ended, many countries moved to a “floating”
system, while others tried to exert some management over their currencies. Such
management is performed by trying to maintain certain target exchange rates, by
“pegging” the currency to a particular foreign currency or by letting it “float” but
only within certain bounds (something like the Bretton Woods system, only with a
much wider band).
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Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is an economic theory that states
residents of one country should be able to buy the goods and services
at the same price as inhabitants of any other nation over time.
PPP depends on the law of one price, that states that once the
difference in exchange rates is accounted for, then everything would
cost the same.
‘Purchasing power’ refers to the value of money in terms of the
quantity of goods it can buy; and ‘Parity’ means equality. Thus, PPP
states that a unit of a currency must have the same real value in
every country.
Thus, for PPP to hold true, we must have R = 1 (why?).
Hence, the PPP theory states that the nominal exchange rates
between two countries must reflect the relative prices of a basket of
goods and services in those countries.
∗
For PPP to hold true: R = 1, i.e. 1 = e PP∗ , implying, e = PP
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Limitations of PPP
PPP, however, is not true in the real world on a day-to-day basis because:
There are differences in transportation costs, taxes, and tariffs.
Some things, such as land and services (like haircuts), can’t be shipped.
Not everyone throughout the world has the same access to international
trade. For example, someone in rural China can’t choose between every
good and service throughout the world.
Example, the Big Mac Index - created by the ‘The Economist’, to compare
the price of the “Big Mac” burger sold by Mc Donald’s across the world.
The PPP predicted nominal exchange rates between two countries must be
the one makes the cost of the Big Mac the same in the two countries.
Finding: The predicted and actual exchange rates were not exactly the same
across all countries.
Having said that, perhaps one day Amazon.com and other online retailers can
enable real purchasing power parity.
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Model of the Open Economy
From the previous discussions so far, we know:
S = I + NFI (equation A)
NX = NFI (equation B)
Let’s now depict the above two equations graphically.
As already discussed earlier, equation A can be depicted with the help
of a diagram for the market of loanable funds, where the supply curve
indicates S, whereas the demand curve, now, indicates the total
demand - domestic (I ) as well as international (NFI ). See figure
below:

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Model of the Open Economy (contd.)
Based on the previous diagram, extrapolating the graph for just NFI, as a function
of interest rate, we see:

Likewise, equation B (i.e. NX = NFI) indicates the demand and supply of

domestic currency in the foreign exchange market. How? Let’s discuss:
If NX > 0, it means there is more demand for domestic goods in the ROW, as
exports are higher than imports. This implies, that the ROW has more demand for
domestic currency to be able to pay for our goods and services. Thus, our net
exports indicate the net demand for our domestic currency in the market for
foreign exchange.
Thus, NX can de drawn as a demand curve, which is downward sloping when
drawn in relation to the exchange rate. Because, when currency depreciates (i.e.
exchange rate goes down), the demand for exports, hence demand for our currency
in foreign market increases, and vice-versa.
Divya Gupta Open Economy∗ Economics II 25 / 37
Model of the Open Economy (contd.)

Similarly, NFI would indicate the supply of our domestic currency in

the foreign market, by way of giving out a loan to th ROW.
NFI, i.e. the supply curve, will be a vertical line, because: a) the
supply of domestic currency is a stock variable - which is decided by
the central bank; and b) NFI depends on the interest rates and not on
exchange rates.
Thus, we have:

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Equilibrium in the open economy
The equilibrium in an open economy is determined by the simultaneous
equilibrium in the two markets - that of market for loanable funds - which
determines an equilibrium interest rate; and that of market for foreign
exchange. This is depicted in the figure below:

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Effect of expansionary fiscal policy: Open economy
Recall from discussions in earlier modules that an expansionary fiscal policy
leads to a fiscal deficit.
If taxes are not raised alongside, an increase in govt. spending will need to
be financed by borrowings from the market for loanable funds.
This leads to an increase in demand, shifting the demand curve to right.
Alternatively, in an open economy, it can be viewed to have an impact of
reducing the supply of funds left available for domestic and foreign
investment, hence shifting the supply curve to the left. This is because, if a
part of domestic savings are being used to finance excess of govt.
expenditure, lesser of S will be left for meeting the demand for domestic I by
pvt. firms and NFI by ROW.
Either way, a rightward shift of demand curve; or a leftward shift of supply
curve - will clearly lead to an increase in interest rates in the market for
loanable funds (see panel (a) of figure on slide 29).
Note that while analysing the effect of fiscal deficit, you can draw either of the
shifts, the impact should be clear - which is to raise interest rates.
Divya Gupta Open Economy∗ Economics II 28 / 37
Effect of expansionary fiscal policy: Open economy
(contd.)
This increase in interest rates in market for loanable funds will lead to decrease in NFI
(see panel (b) of figure below).
A decrease in NFI, thus, shifts the NFI curve to left in the market for foreign exchange,
leading to increase in exchange rate implying appreciation of the currency.
This appreciation of the currency, hence, leads to a trade deficit. (why?)

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Effect of Expansionary Monetary Policy

Suppose that the central bank decides to use an expansionary monetary policy, by
lowering interest rates, in an attempt to stimulate aggregate demand.
The reduction in the interest rates of domestic economy is likely to drive away
some foreign financial capital.
If interest rates here fell, people abroad would be less inclined to buy government
bonds or put their money in the domestic country’s bank accounts.
As they sent their financial capital elsewhere, the demand for the domestic
currency would decrease.
A decrease in the demand for domestic currency would cause it to depreciate.
A depreciation implies that the domestic currency now buys fewer units of foreign
exchange, which discourages spending on imports - because imports have now
become relatively ‘expensive’.
Meanwhile, the fact that the domestic currency can be purchased for fewer units
of foreign exchange means that domestic goods have become ‘cheap’ for foreign
buyers, i.e. exports have become cheaper, implying increase in exports.
Overall, net exports increase, leading to increase in aggregate demand.

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Effect of Expansionary Monetary Policy (contd.)

The previous discussion can be summarised as follows:

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Capital Flight

Capital Flight refers to sudden departure of financial assets on a large scale from
domestic country to other countries.
This usually occurs because of geopolitical events including economic volatility or
political instability, capital controls, or deliberate currency devaluation.
Investors pull out their financial assets and deposit them in safe havens.
Reasons for Capital Flight:
Debt: When investors fear that the economy is in extreme debt and wont be able to
repay them.
Macroeconomic Instability: When Aggregate Supply and Aggregate Demand do not
match, then investors fear recession in the economy and thus a situation of liquidity
trap.
Expectation of devaluation: Investors fear that since exchange rate has been
overvalued for a long time, in sometime the government will start devaluing the
exchange rate. That would render their financial assets valueless.
Political Instability: Sudden change in political conditions of the economy indicating
instability in future.
Fall in GDP Rate
Excessive Inflation (Unstable Economy)

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Effect of Capital Flight
Recall: S = I + NFI
The above equation indicates the status of a nation which is a net
lender.
If for this country, NX > 0, then by logic explained earlier, it has
excess of foreign exchange which it can lend in the foreign market,
which indicates that NFI > 0 - this is because, in return for the
domestic country’s lendings to the ROW, the domestic country is, in
a way, buying foreign assets, say bonds, hence NFI > 0.
The reverse is true for a nation which is a net borrower, i.e. which is
already running a trade deficit, implying that NX < 0, hence,
implying that NFI < 0, because it needs to sell foreign assets, to meet
its borrowing demands.
Thus, for borrowing nations, we have: S + NFI = IU. This implies
that now the country is meeting its investment demands from
domestic funds (S) and some borrowings from the rest of the world
(NFI).
Divya Gupta Open Economy∗ Economics II 33 / 37
Effect of Capital Flight (contd.)
The situation of capital flight happens when a country already has a lot of foreign
capital (or borrowings from ROW).
Thus, for this country, when capital flight happens (due to any reason discussed in
earlier slides), it leads to an increase in NFI.
Now recall, NFI indicates net lendings of a nation, i.e. lending minus borrowing.
Thus, NFI can increase either when lendings increase or when borrowings decrease.
In the given case of capital flight, the country’s borrowings are suddenly wiping
out because ROW are withdrawing their funds from the domestic economy and
putting them in safe havens.
Thus, due to capital flight, NFI will increase, leading to a rightward shift of the
demand curve in the market for loanable funds.
Alternatively, the effect of capital flight can also be viewed as a leftward shift of
the supply curve. Recall, for a borrowing nation, S + NFI = I , the left-hand side
of which indicates total supply of funds from domestic funds and foreign funds.
Capital flight leads to depletion of foreign funds, hence, supply curve shifts
leftward.
Either way - demand curve shifts outward or supply curve shifts leftward - the
effect is to increase interest rates in the market for loanable funds (see panel (a) in
figure on slide 36).
Divya Gupta Open Economy∗ Economics II 34 / 37
Effect of Capital Flight (contd.)
In panel (b) of figure on slide 36, not only does the interest rate increase due to
the movement in the market for loanable funds, the NFI also shifts parallely,
because this time, the increase in NFI is happening due to an exogenous factor of
capital flight.
This leads to a decrease in exchange rate in the market for foreign exchange (see
panel (c) on slide 36). This may moderate the effect of trade deficit, but may not
necessarily be true. Why?
Since the situation of capital flight mostly happens to middle-income and
developing nations, their trade account deficit may not reduce due to a
depreciation of the currency, which makes exports cheaper and imports expensive.
Imports of developing countries are mostly necessities which they will have to
import to be on the trajectory of growth. Thus, the import expenditure increases
due to depreciation.
On the other hand, since developing countries export primary products which are
price inelastic, the demand for their exports doesn’t go up even if the price for
exports goes down. This leads to a decline in export revenue.
Hence, overall, a capital flight situation only worsens the trade deficit for the
developing nation.
Divya Gupta Open Economy∗ Economics II 35 / 37
Effect of Capital Flight (contd.)

Divya Gupta Open Economy∗ Economics II 36 / 37

 ALL THE BEST!

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