Class 12 Economics Notes Chapter 6 (Open Economy Macroeconomics) – Introduction MacroEconomics Book

Alright class, let's get straight into Chapter 6: Open Economy Macroeconomics from your NCERT textbook. This is a crucial chapter, especially for understanding India's interaction with the global economy, and frequently tested in government exams.

An Open Economy is one that interacts freely with other economies around the world. This interaction happens mainly in two ways:

1. Output Market: Trading goods and services (Exports, Imports).
2. Financial Market: Buying and selling financial assets (like stocks, bonds) across borders.
3. Labour Market: Though less free, movement of labour across borders also occurs.

This contrasts with a Closed Economy, which has no economic interaction with the rest of the world.

Key Concepts for Government Exams:

1. Balance of Payments (BoP)

• Definition: The BoP of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world during a given period (usually a year).
• Principle: It's based on the double-entry bookkeeping system. Every transaction has a credit (+) and a debit (-) entry. Theoretically, the BoP account always balances.
• Residents: Include individuals, firms, and the government. Embassies, foreign military personnel, tourists, migrant workers staying less than a year are generally considered non-residents.

Components of BoP:

The BoP account is broadly divided into two main accounts:

(A) Current Account: Records transactions related to trade in goods and services, income flows, and unilateral transfers.

• Trade in Goods (Visible Trade): Exports (+) and Imports (-) of physical goods.

  • Balance of Trade (BoT) or Trade Balance: Value of Exports of Goods - Value of Imports of Goods. Can be surplus (Exports > Imports) or deficit (Imports > Exports). Note: BoT is only a part of the Current Account.

• Trade in Services (Invisible Trade): Exports (+) and Imports (-) of services. Examples: Shipping, banking, insurance, tourism, software services.

  • Balance of Invisibles: Net earnings from services + Net income flows + Net transfers.

• Income Receipts and Payments (Factor Income): Rent, interest, and profits earned from assets owned abroad (+) or paid to foreigners owning assets domestically (-). E.g., Indian resident earns rent from property in the UK (+); A foreign company earns profit from its subsidiary in India (-).

• Unilateral Transfers (Current Transfers): Receipts (+) or Payments (-) which do not have a quid pro quo, like gifts, donations, personal remittances sent by workers abroad (+), or aid sent to another country (-).

• Current Account Balance (CAB): Sum of Balance of Trade + Balance of Invisibles (Net Services + Net Income + Net Transfers).

  • CAB Surplus: Credit side > Debit side (Receipts > Payments). Implies the nation is a lender to the rest of the world.
  • CAB Deficit: Debit side > Credit side (Payments > Receipts). Implies the nation is a borrower from the rest of the world.

(B) Capital Account: Records all transactions involving purchase or sale of assets (financial and non-financial) between residents and non-residents. These transactions affect the asset/liability status of the country.

• Foreign Investment:

  • Foreign Direct Investment (FDI): Purchase of assets (e.g., factories, buildings) abroad or acquiring substantial control (>10%) in a foreign company. Relatively stable. FDI inflow (+), FDI outflow (-).
  • Portfolio Investment / Foreign Institutional Investment (FII/FPI): Purchase of financial assets like stocks and bonds, without gaining significant control (<10%). More volatile. FPI inflow (+), FPI outflow (-).

• Loans:

  • External Commercial Borrowings (ECBs): Loans taken by Indian companies from foreign sources. Borrowing (+), Repayment (-).
  • External Assistance: Concessional loans or grants received by the government. Receipt (+), Repayment (-).
  • Short-term Trade Credit: Credits for financing imports/exports.

• Banking Capital: Changes in the foreign assets and liabilities of commercial banks.

• Other Capital Flows: Includes various other short-term and long-term capital movements.

• Capital Account Balance (KAB): Net inflow or outflow of capital.

  • KAB Surplus: Capital Inflows > Capital Outflows.
  • KAB Deficit: Capital Outflows > Capital Inflows.

(C) Errors and Omissions: A balancing item to account for statistical discrepancies and unrecorded transactions, ensuring the BoP account technically balances.

(D) Overall Balance of Payments:

• Overall BoP = Current Account Balance + Capital Account Balance + Errors & Omissions
• BoP Surplus: Overall balance is positive. This leads to an increase in the country's Official Foreign Exchange Reserves.
• BoP Deficit: Overall balance is negative. This leads to a decrease in the country's Official Foreign Exchange Reserves.

(E) Official Reserve Transactions: These are transactions carried out by the monetary authority (RBI in India) involving changes in its holdings of foreign exchange assets (foreign currency, gold, SDRs). These are accommodating transactions undertaken to settle the BoP surplus or deficit.

• A BoP surplus leads to an increase (credit entry) in official reserves.
• A BoP deficit leads to a decrease (debit entry) in official reserves.

Autonomous vs. Accommodating Transactions:

• Autonomous Transactions: Undertaken for their own sake, usually for profit or income motives (e.g., exports, imports, FDI, FPI, commercial loans). These occur 'above the line' and determine the BoP surplus or deficit.
• Accommodating Transactions: Undertaken solely to cover the gap (surplus or deficit) arising from autonomous transactions (e.g., changes in official reserves, borrowing from IMF). These occur 'below the line'.

2. The Foreign Exchange Market & Exchange Rate

• Foreign Exchange Market: The market where national currencies are traded for one another.
• Foreign Exchange Rate: The price of one currency expressed in terms of another currency. E.g., $1 = ₹83.
  • Nominal Exchange Rate: The rate as quoted, without adjusting for inflation.
  • Real Exchange Rate (RER): Measures the relative price of goods across countries. RER = (Nominal Exchange Rate × Foreign Price Level) / Domestic Price Level. RER = e * (P_f / P_d). An increase in RER implies domestic goods have become relatively cheaper (increase in competitiveness), leading to higher exports and lower imports.
  • Nominal Effective Exchange Rate (NEER): Weighted average of bilateral nominal exchange rates of the home currency against currencies of its major trading partners. Weights are based on trade shares.
  • Real Effective Exchange Rate (REER): Weighted average of bilateral real exchange rates. It adjusts NEER for relative price level changes between the home country and its trading partners. REER is a key indicator of a country's international competitiveness. REER > 100 often suggests overvaluation / loss of competitiveness.

Determination of Exchange Rate (under Flexible System):

• Determined by the forces of demand and supply for foreign exchange.
• Demand for Foreign Exchange (e.g., US Dollars): Arises from:
  • Imports of goods and services from the US.
  • Indian residents wanting to purchase assets (financial/physical) in the US.
  • Remittances/gifts sent abroad.
  • Speculation (expecting the dollar to appreciate).
  • Tourism abroad.
  • Repayment of loans to foreigners.
  • Demand curve is downward sloping: Higher exchange rate (more rupees per dollar) makes foreign goods/assets more expensive, reducing demand for dollars.
• Supply of Foreign Exchange (e.g., US Dollars): Arises from:
  • Exports of goods and services to the US.
  • Foreigners wanting to purchase assets in India (FDI, FPI).
  • Remittances/gifts received from abroad.
  • Speculation (expecting the dollar to depreciate).
  • Foreign tourism in India.
  • Borrowing from abroad.
  • Supply curve is upward sloping: Higher exchange rate (more rupees per dollar) makes Indian goods/assets cheaper for foreigners, increasing supply of dollars.
• Equilibrium Exchange Rate: Where Demand for Forex = Supply of Forex.

Changes in Exchange Rate (under Flexible System):

• Depreciation: A decrease in the value of the domestic currency in terms of foreign currency (e.g., rate changes from $1=₹80 to $1=₹83). Caused by increased demand or decreased supply of foreign exchange. Makes exports cheaper and imports costlier.
• Appreciation: An increase in the value of the domestic currency in terms of foreign currency (e.g., rate changes from $1=₹80 to $1=₹78). Caused by decreased demand or increased supply of foreign exchange. Makes exports costlier and imports cheaper.

3. Exchange Rate Systems:

• Flexible (Floating) Exchange Rate System: Exchange rate is determined by market forces (demand and supply) without government intervention.
  • Advantages: Automatic BoP adjustment, freedom in monetary policy.
  • Disadvantages: Volatility, uncertainty, potential for speculation.
• Fixed (Pegged) Exchange Rate System: The government or central bank fixes the exchange rate at a particular level against another currency or a basket of currencies. The central bank must intervene (buy/sell foreign exchange) to maintain this rate.
  • Advantages: Stability, promotes trade and investment.
  • Disadvantages: Need for large reserves, loss of monetary policy independence, potential for speculative attacks.
  • Devaluation: A deliberate downward adjustment of the official exchange rate by the government under a fixed system. (Similar effect to depreciation).
  • Revaluation: A deliberate upward adjustment of the official exchange rate by the government under a fixed system. (Similar effect to appreciation).
• Managed Floating Exchange Rate System (Dirty Float): A hybrid system where the exchange rate is primarily market-determined, but the central bank intervenes occasionally to moderate excessive fluctuations or steer the rate towards a desired level. This is the system currently followed by India and most major economies.

4. Purchasing Power Parity (PPP)

• A theory suggesting that in the long run, exchange rates should adjust to equalize the prices of identical goods and services (a 'basket of goods') in different countries.
• If a basket costs $100 in the US and ₹8000 in India, the PPP exchange rate would be $1 = ₹80.
• Deviations occur due to trade barriers, transportation costs, non-traded goods, and market imperfections.

Multiple Choice Questions (MCQs):

1. Which of the following is recorded on the credit side of the Current Account in India's BoP?
   a) Imports of machinery
   b) Remittances sent by an Indian worker from Dubai to India
   c) Indian investment in buying shares of a US company
   d) Repayment of a loan taken from the World Bank

2. Balance of Trade (BoT) refers to:
   a) Balance of visible and invisible trade
   b) Balance of exports and imports of goods only
   c) Balance of Current Account and Capital Account
   d) Balance of unilateral transfers

3. An increase in the foreign exchange rate (e.g., from $1 = ₹80 to $1 = ₹82) under a flexible exchange rate system is termed as:
   a) Devaluation
   b) Revaluation
   c) Depreciation
   d) Appreciation

4. Which of the following transactions is an example of a Capital Account transaction in India's BoP?
   a) Export of software services
   b) Import of crude oil
   c) An Indian company taking a loan from a London based bank (ECB)
   d) Interest received on loans given to Nepal

5. Autonomous transactions in the BoP are undertaken:
   a) To cover the BoP deficit or surplus
   b) Primarily for the motive of earning profit or income
   c) Only by the central bank
   d) Only involve the trade of goods

6. Under a fixed exchange rate system, if the BoP is in deficit, the central bank will:
   a) Buy domestic currency and sell foreign currency from its reserves
   b) Sell domestic currency and buy foreign currency to add to its reserves
   c) Increase the domestic interest rate immediately
   d) Devalue the currency

7. The Real Exchange Rate (RER) measures:
   a) The rate at which currencies trade in the spot market
   b) The weighted average of nominal exchange rates
   c) The relative price of foreign goods in terms of domestic goods
   d) The exchange rate adjusted for interest rate differentials

8. An increase in demand for imported goods in India will likely lead to:
   a) Appreciation of the Indian Rupee
   b) Decrease in the supply of foreign exchange
   c) Increase in the demand for foreign exchange
   d) A surplus in the Balance of Trade

9. 'Managed Floating' or 'Dirty Floating' refers to a system where:
   a) The exchange rate is strictly fixed by the central bank.

   • b) The exchange rate is determined purely by market forces with no intervention.
     c) The exchange rate is largely market-determined, but the central bank intervenes to manage volatility.
     d) The exchange rate is linked to the price of gold.

10. Which component of BoP acts as the balancing item to accommodate any surplus or deficit arising from autonomous transactions?
    a) Balance of Trade
    b) Current Account Balance
    c) Capital Account Balance
    d) Official Reserve Transactions

Answers to MCQs:

1. b) Remittances sent by an Indian worker from Dubai to India (Inflow, Credit side of Current Account)
2. b) Balance of exports and imports of goods only
3. c) Depreciation (Value of Rupee decreased)
4. c) An Indian company taking a loan from a London based bank (ECB) (Creates a liability, Capital inflow)
5. b) Primarily for the motive of earning profit or income
6. a) Buy domestic currency and sell foreign currency from its reserves (To meet the excess demand for foreign currency and maintain the fixed rate)
7. c) The relative price of foreign goods in terms of domestic goods
8. c) Increase in the demand for foreign exchange (Need more foreign currency to pay for imports)
9. c) The exchange rate is largely market-determined, but the central bank intervenes to manage volatility.
10. d) Official Reserve Transactions

Make sure you understand these concepts thoroughly. Focus on the components of BoP, the difference between current and capital accounts, how exchange rates are determined, and the different exchange rate regimes. Good luck with your preparation!