Chapter 6 External sector

Exports Transaction:
1. Domestic goods and services sold abroad
2. Earning is in $; $ comes in to the country; We earn foreign exchange; increase in forex
Forex Receipt : Credit item on BOP
Conversion

1. Foreigners need ₹ to pay for domestic goods

2. Demand for ₹
3. So need to convert $ to ₹
4. Supply of forex to get ₹ , demand for ₹
impact on Currency Demand

1. Exports increase supply of forex and demand for ₹

2. If exports are more than imports, demand for ₹ is more than demand for $
3. So ₹ appreciates against $
.Imports Transaction:
1. Foreign goods bought into the country
2. Payment is in $ ; $ goes out of the country ; We give up foreign exchange to buy goods ;
forex out go/decrease in forex
Forex Payment: Debit item on BOP
Conversion

1. To be paid in $
2. we have ₹ but need $ to pay for the goods
3. Demand for $
4. need to convert ₹ to $
5. Supply of ₹ to get $ , demand for $
impact on Currency Demand

1. Imports increase supply of ₹ and demand for $

2. If imports are more than exports, demand for $ is more than demand for ₹
3. So $ appreciates against ₹
Export Import ($) Net Forex Receipts payments Deficit/surplus
($)
1 500 300 200 500 300 200 surplus
earned
2 400 700 300 Outgo 400 700 (300) deficit

NEER : weighted average of price of rupee in relation to all other currencies in the foreign trade of
India.

REER : nominal * (Pf/Ph)

Case 1 : fixed exchange rates , complete capital mobility

Fiscal policy : expansionary

1. Increase in GDP
2. Demand for money
 3. Supply is fixed
4. Interest rate go up
5. attracts capital inflows
6. upward pressure on currency
7. RBI keeps fixed exchange rate by absorbing extra forex
8. MB increases , money supply increases , interest rates fall
Increased output

Monetary policy – expansionary

1. Increase in money supply

2. Low interest rate
3. Capital will flow out
4. RBI sells forex to maintain fixed exch. Rate
5. MB decrease, money supply decrease
6. Exports do no increase since there is no change in exchange rate
Decreased output

Case 2 : flexible exchange rate and complete capital mobility

Fiscal policy : Expansionary

1. Increased GDP
2. Demand for money increases
3. Supply is fixed
4. Interest rates go up
5. Attracts capital inflows
6. Upward pressure on currency
7. Exchange rates are flexible .
8. Market adjustment takes place appreciating currency
9. Rise in domestic currency with in turn crowd out exports
10. Increase in G is offset by decrease in X in the GDP equation
No effect on the GDP,
fiscal expansionary policy is in effective in changing GDP
Monetary policy : Expansionary
1. Increase in money supply
2. Low interest rate
3. Capital will flow out
4. Currency depreciates
5. demand for domestic goods picks up
6. increases X

 increased output
 monetary policy is effective in changing GDP

case 3 : fixed exchange rates and capital control

Fiscal Policy expansionary
1. Increase GDP
2. Demand for money rise
3. Supply is fixed
4. Rise in interest rates
 5. Capital cannot flow in easily
6. M increases to meet the demand , M is +ve function of GDP
7. Exports suffer
8. Exchange rate fixed
9. Money supply will fall
10. interest rates rise
11. M starts to decrease
12. X-M balanced out

 Increase in GDP will be difference between increase in G and crowding out I

 Effective to the extent increase of G
Monetary policy : expansionary
1. Increase money supply
2. Decreased interest rates
3. Increased GDP
4. But capital cannot flow
5. M increases
6. X suffers
7. RBI intervenes to keep rate fixed
8. Decreased money supply
9. Interest rates will rise no additional capital inflow.

 Output cannot be met

 Monetary policy is ineffective in influencing GDP
Case 4 : Flexible exchange rate with capital control
Fiscal policy

1. Increased GDP
2. Increased Interest rates
3. Increased M
4. Currency depreciates
5. X and M are balanced out.

 Increase in GDP again will be difference between increase in G and crowding out of I.
 Fiscal policy Effective to the extent increase of G
Monetary policy : expansionary
1. Increase money supply
2. Decreased interest rates
3. Increased GDP
4. No change in capital movements
5. M increases , X decreases
6. Currency depreciates
7. X picks up

 Out put increases due to offshore demand

 Monetary policy effective