Open Economy Macroeconomics

An open economy is one that trades with other countries — it has exports, imports and flows of money across its borders. (A closed economy, by contrast, has no foreign trade.) Almost every real economy, including India's, is open. To keep track of all its dealings with the rest of the world, a country prepares the Balance of Payments (BoP) — a systematic record of all economic transactions between the residents of a country and the rest of the world in a year.

The BoP has two main accounts:

• The current account — records trade in goods and services and other current flows. It has two parts: merchandise trade (the export and import of goods, called visibles) and invisibles (services like software, tourism and shipping, plus income and transfers like remittances). The balance of just the goods part is the balance of trade (BoT).
• The capital account — records flows of capital, i.e. borrowing, lending and investment between the country and the world (foreign investment, loans, banking capital).

So the current account is about income and spending with the world (mainly trade), while the capital account is about assets and liabilities (capital movements). A country is said to have a BoP surplus if its receipts from abroad exceed its payments, and a deficit if payments exceed receipts. The BoP gives a complete picture of a country's economic relationship with the rest of the world.

To trade with other countries, we must exchange our currency for theirs. The foreign exchange market is where currencies are bought and sold, and the exchange rate is the price of one currency in terms of another — for example, ₹83 per US dollar. Like any price, in a free market the exchange rate is set by the demand for and supply of foreign exchange.

• The demand for foreign exchange (e.g. dollars) comes from those who need foreign currency — importers (to buy foreign goods), people travelling or studying abroad, and investors sending money out. The demand curve slopes downward: when the foreign currency is cheaper (fewer rupees per dollar), people demand more of it.
• The supply of foreign exchange comes from those who bring foreign currency in — exporters (paid in dollars), foreign tourists, and foreign investment and remittances. The supply curve slopes upward: when the foreign currency is dearer (more rupees per dollar), more is supplied.

The exchange rate settles where the two curves cross — the equilibrium exchange rate, where the demand for and supply of foreign exchange are equal:

Countries manage their exchange rates in different ways. The main exchange rate systems are:

• Fixed exchange rate — the government/central bank fixes the rate and keeps it constant by buying or selling foreign exchange. It gives stability and certainty for trade, but the central bank must hold large reserves to defend the rate.
• Flexible (floating) exchange rate — the rate is left to the free market, set by the demand for and supply of foreign exchange, and it changes from day to day. It needs no reserves to defend, but can be volatile.
• Managed floating — a mixture used by most countries (including India): the rate floats freely most of the time, but the central bank intervenes (buys or sells forex) to smooth out big swings. This combines flexibility with some stability.

When the value of a currency changes, the words depend on the system:

• Under a flexible system, a market fall in the rupee's value is depreciation (the rupee buys fewer dollars; it takes more rupees per dollar) and a rise is appreciation.
• Under a fixed system, a deliberate official lowering of the currency's value is devaluation, and an official raising is revaluation.

The economic effect is the same in both cases: when the rupee weakens (depreciates/devalues), imports become costlier (so petrol and foreign goods cost more) but exports become cheaper and more competitive abroad; when the rupee strengthens, the opposite happens. So exchange rates connect the domestic economy to the world — completing our study of macroeconomics in an open economy.