Session 20-21 Final - Open Economy Macroeconomics

OPEN ECONOMY
MACROECONOMICS
SESSION 20-21
RECENT REPO HIKE
Inflation was above 6% since January 2022
Repo rate was raised by 190pp to 5.90% (since May)
December 7 hike by another 35pp to 6.25%
Was last repo rate hike guided by some external sector considerations?
Dr. Amaresh Samantaraya 2

INDIAN CURRENT MONETARY POLICY

US AND INDIAN INTEREST RATES

BACKGROUND
• Economic analysis of overall output/income, general prices,
employment, gross savings and investment, etc.
Macroeconomics • Role of monetary and fiscal policy
• Open economy differs from a closed economy in that goods and

services (and capital) can cross border
Open Economy
• Foreigners demand part of domestically produced goods
Macroeconomics • Part of aggregate demand is satisfied by foreign goods

KEY INPUTS
• Consists of mixture of consumption, investment and government spending
• Depends on domestic income, exchange rate, relative prices and other
Imports determinants of C, I & G
• Consists of goods and services produced at home, and sold abroad

• Depends on foreign income, exchange rate, relative prices and other
Exports determinants of foreign C, I & G
• Profitable opportunities at home and abroad & relative return

Capital • Stability of exchange rate, and tax treatment
flows

AD-AS FRAMEWORK FOR OPEN
ECONOMY
• Closed economy: C + I + G
AD • Open economy: C + I + G + NX
• Y = A.F(K, L); Kt+1 =Kt + It+1 + δKt

AS • It+1 = St+1 + Net Capital Inflow
• Interest rate and net capital inflow

Exchange
rate • Net exports

Macroeconomic
Policy &
Fixed & Flexible Exchange Rate
Exchange Rate
Trade and System
Balance of
Payments

FOREIGN TRADE &
B A L A N C E O F P AY M E N T S

INTERNATIONAL TRADE & FINANCE
No country lives in isolation today – not even North Korea
Cross-border flow of goods & services, finance and people
Already exposed to NX as part of aggregate demand
Key issues related to the external sector to be introduced

TO BE INTRODUCED …
1. Balance of Payments (BoP) and its key components
2. International capital flows
3. Foreign exchange rate
i. Demand and Supply – determination of exchange rate
ii. Exchange rate and net exports
4. Monetary policy and exchange rate regime

KEY INGREDIENTS
Exports & Imports
Foreign investment
Balance of Payments

EXPORTS & IMPORTS
• Domestically produced goods and services sold abroad
• In 2018, US’s exports at $ 2.5 trillion close to 9.7% of GDP
Exports • In 2019-20, India’s merchandise exports at $ 320.4 billion were 11.2% of GDP
• Domestically consumed goods and services, those produced abroad

• In 2018, US’s imports at $ 3.1 trillion close to 12.0% of GDP
Imports • In 2019-20, India’s merchandise imports at $ 477.9 billion were 16.6% of GDP
• Exports over Imports or Net Exports

• US trade deficit at $621 billion in 2018 was close to 2% of its GDP
Trade
balance • Indian trade deficit was close to 5.4% of its GDP

FOREIGN TRADE – INDIA (US $ MILLION]
600000
500000
400000
300000
200000
100000
0
-100000
-200000
-300000
Exports Imports Trade Balance
FOREIGN TRADE – INDIA [AS % OF GDP]
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Exports-GDP Imports-GDP

ROLE OF INVISIBLES IN INDIA
Proceeds from invisible trade partly offset severity of
India’s trade deficit (same for US, too)
India’s current account receipts in 2019-20 at 22.4% of

GDP, as compared to CA payments of 23.2% of GDP
CAD of 0.8% of GDP not a matter of concern

INDIA’S CURRENT ACCOUNT
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
CAReceipts-GDP CAPayments-GDP

DIRECTION OF TRADE INDIA -
EXPORTS
35.0
1992-93 2000-01 2010-11 2019-20
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Africa Asia China EU USA UAE UK
DIRECTION OF TRADE INDIA -
IMPORTS
40.0
1992-93 2000-01 2010-11 2019-20
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Africa Asia China EU USA UAE UK

KEY ITEMS OF INDIA'S FOREIGN TRADE (2019-20)
• Engineering goods: 18.8%
• Gems & Jewelry: 16.0%
• Petroleum products: 15.8%
Exports • Readymade garments: 6.0%
(merchandise) • Drugs & Pharmaceuticals: 5.0%
• Petroleum, Crude and Products: 36.7%

• Capital goods: 18.9%
• Electronic goods: 6.9%, Machinery other than Electrical & Electronics: 5.2%
Imports • Gold and Silver: 7.4%
(merchandise) • Pearls, Precious, and Semi-precious stones: 5.3%

FOREIGN INVESTMENT
• Investment that occurs when a firm runs a part of its operations abroad
– tangible assets like factories
• Or, owns all or part of another company abroad
FDI • Often makes economic sense for business – helps broaden market and
can cut wage costs
• Buy financial assets abroad – stocks, government securities

• Investment in domestic financial assets funded by foreign sources
• Motive – greater returns and diversification reducing overall risks
FPI • Mainly involves transfers between bank accounts

60000
50000
US $ million
40000
30000
20000
10000
FDI to India FDI from India

50000
40000
US $ million
30000
20000
10000
-10000
-20000
Net FPI Net FDI

STABILITY OF FDI
FPI generally flows across the borders fairly quickly –
involves transfers across the bank accounts
Rapid movement of funds across border can easily

overwhelm a small country’s financial markets
FDI is more stable – one cannot pick up a factory and

move it across the border

B A L A N C E O F P AY M E N T S &
ITS IDENTITY

BALANCE OF PAYMENTS (BoP)
• Statement of Accounts on cross-border transactions
BoP of goods and services as also financial flows
• Merchandise trade – exports & imports of goods

Current
account
• Invisibles – exports & imports of services
• Flow of capital – debt creation

Capital
account
• FDI, FII, ECB, Bank Deposits, etc.

BOP INDIA – SUMMARY (USD MILLION)
Item / Year 2019-20 1992-93
I. Merchandise - A) Exports, f.o.b. 320431 18869
I. Merchandise - B) Imports, c.i.f. 477937 24316
I. Trade balance (A-B) -157506 -5447
II. Invisibles, net 132850 1921
III. Current account (I+II) -24656 -3526
IV. Capital account (A to F) 84154 2936
A) Foreign Investment 56558 557
B) External assistance, net 3856 1859
C) Commercial borrowings, net 21680 -358
D) Rupee debt service -69 -878
E) NRI deposits, net 8627 2001
F) Other capital -6498 -245
V. Overall balance (III+IV) 59498 -590
VII. Reserves (increase -/ decrease +) -59498 -698
BALANCE OF PAYMENTS IDENTITY
US had a trade deficit of $891 bio in 2019 – how is it
able to sustain such high level of deficit?
Such large deficit could be sustained due to large

capital account surplus -
BoP Identity is an equation showing equality between

value of Net Exports and Net Capital Outflows

BOP IDENTITY
• C+Spvt+T+M = C+I+G+X
Y=AD • Spvt + (T – G) = I + (X – M)
• Pvt Saving + Govt Saving = S = I + NX

S • Loanable fund: S = I + NCO
• NX = NCO
Identity • NX or CAD need to be financed by capital account surplus

HOW BOP IDENTITY IS ACHIEVED
• Assume, India exported readymade garments worth Rs. 100 crore
Exports • The exporters can use the proceeds in two ways
• Rs. 100 crore can be used to buy foreign assets worth Rs.100 crore
1 • NX = NCO = Rs.100 crore
• Rs. 100 crore can be used to buy foreign goods worth Rs.100 crore
2 • NX = NCO = Nil

I N T E R N AT I O N A L ( C R O S S -
B O R D E R ) C A P I TA L F LO W S

BACKGROUND
Cross-border capital flows is many-fold of

cross-border trade flows
Has important implications for economic

growth of the source and destination

BENEFITS OF FOREIGN INVESTMENTS
• GDP of the host country goes up with trapping
1 foreign savings and raising overall investment at home
• GDP of the source country improves by gaining

2 higher return on their savings
• Movement of capital from place of low return to place

3 of high return makes the world more efficient

MODEL OF LOANABLE FUNDS
• Supply of loanable funds – domestic savings
• Demand for loanable funds – domestic investment
Closed • Interest rate – equilibrates any imbalance
economy
• Supply of loanable funds – domestic savings

• Demand for loanable funds – domestic investment & foreign
Open investment
economy • Interest rate (relative) – equilibrates any imbalance

HOW IT WORKS (NCO)
If domestic interest rate rises, without any change in world interest rate
Rise in capital inflow from abroad Less capital outflow from home
Net Capital Outflow (NCO) falls
Both domestic investment and NCO fall with rising interest rate
I+NCO is downward sloping

• How does the S & I+NCO change if there is flight to
safety to a country like US?

FLIGHT TO SAFETY
If there is adverse economic development elsewhere, and India is
considered to be relatively safe …
Capital flight to India from abroad – reduces NCO – shifts to left –

lowers interest rate in India
Lower interest rate reduces savings – movement along the S – curve
But augments domestic investment

• How government deficit does affect net exports and
I+NCO?

GOVERNMENT/FISCAL DEFICIT &
OVERALL INVESTMENT AT HOME
Increase in government deficit is akin to fall in government saving
Overall domestic savings fall Savings curve shifts left
Domestic interest rate goes up
Larger capital inflow Fall in domestic investment
Overall investment may fall – crowding out
Domestic and foreign savings are used to finance government spending

QUESTION
China owns $1.1 tio out of $23.4 tio of total US debt
in 2020 – it constitute close to 4.6%
China saves close to 50% of its GDP, as compared

to 18% for the US
How to explain this using loanable fund theory in an

open economy context

IMPLICATIONS
Higher propensity to save in China shifts saving curve to right
Lowers interest rate in China Higher NCO for China
China invests more on US treasury bills/notes
Greater flow of Chinese currency in American economy

Purchase of more Chinese goods - imports China-US trade imbalances
E X C H A N G E R AT E S

FOREIGN EXCHANGE RATE
Rate at which one currency is exchanged for another currency – Rs.74.23 per USD
or Rs. 86.58 per euro – can be expressed as reciprocal too (in decimals)
Like price of USD expressed in Rupees
As different currencies are accepted as medium of exchange in different

countries, an American need to buy Rupee currency notes to buy stuffs in India
Arbitrage – taking advantage of discrepancies in exchange rates – timely full-

information ensures uniform exchange rate across the global markets

0.0000
10.0000
20.0000
30.0000
80.0000
90.0000
100.0000
40.0000
50.0000
60.0000
70.0000
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
RUSD
1992-93
1994-95
Dr. Amaresh Samantaraya
1996-97
REURO
1998-99
2000-01
2002-03
2004-05
2006-07
2008-09
2010-11
2012-13
2014-15
FOREIGN EXCHANGE RATE - BILATERAL
2016-17
2018-19
51
2020-21
THE ALMIGHTY USD
USD is the global reserve currency – replaced Pound Sterling
Global investors looking for stable place to stash their savings prefer
US assets – treasury securities
62% of reserves held by central banks around the world is in form of

USD
Much of international trade is invoiced in USD, even when the trade

transaction is not against the US

FLUCTUATIONS IN EXCHANGE RATE
In forex markets, the bilateral exchange rates do not remain constant – they change tick by
tick
If, Rupee-USD changes from Rs.50/$ to Rs.60/$, the rate of depreciation can be 20% -
[(60-50)/50]*100
It implies USD appreciates vis-à-vis Rupee – relative value of USD goes up
A currency which appreciates can buy more stuff in the partner country, as compared to
the past
Movements in exchange rate can be explained using a market model

DEMAND FOR FOREIGN CURRENCY
1. Consumer preferences
– Demand from households, firms and government for foreign goods and services
– Consumption, investment and government expenditure
2. Interest rates
– High interest rates encourage inflow of foreign capital
– Similarly, relatively high US interest rates will result large capital outflow and
demand for more USD
3. Perceived risks
– Reduction in perceived risks on investment in a country - capital inflow
– US more stable, emerging countries perceived to be more risky
SUPPLY OF FOREIGN CURRENCY
1. Consumer preferences for domestic goods and
services
2. Rising of interest in India, relatively, will attract
foreign capital inflows
3. Reduced perceived risks and greater investors’
confidence will be critical for foreign capital
inflow to India

MODEL OF EXCHANGE RATE MARKET
• Interaction of demand for and

supply of foreign currency
determines equilibrium market
exchange rate
• Depreciation of currency raises net
exports – raises supply of foreign
currency & reduces demand

EXCHANGE RATE AND NET EXPORTS

• Toyota Prius Case 2003 – A Puzzle
• Dollar depreciation but no improvement in the US
Net Exports?

AN EXAMPLE: TOYOTA PRIUS
• Toyota Prius was released in US market in 2003 – first mass
produced hybrid gas/electric vehicle
• American import - raised supply of USD in exchange of Japanese
yen – supply curve shifted to right and USD depreciated
• Net export curve shifted to the left, as American increased
imports from Japan
• Depreciation of USD led to some increase in net exports –
partial shift of net export curve to the right
• Preference of greater preferences for Japanese cars was
counterbalanced by the effect of depreciation on net exports

ANOTHER EXAMPLE: A RISING INTEREST RATE
• A rise in interest rate will affect both demand & supply
– Higher demand for domestic assets abroad – shifting DD curve right
– Domestic investors will also hold more of domestic assets: shifting SS curve left
• The net effect will be net appreciation of domestic
currency
– Currency appreciation led to fall in net exports (in the right panel)
• Change in DD & SS may cause net change in availability

of domestic currency
– In the left panel, net change is ‘nil’
CAVEAT
Above results hold true if exchange

rate is market determined
If exchange rate is pegged, we will

have different results

FIXED & FLEXIBLE
E X C H A N G E R AT E
SYSTEMS

EXCHANGE RATE SYSTEMS/REGIMES
• Some countries allow the bilateral exchange rates to be
determined by market forces
Flexible • USD, Rupee, Euro,Yen, etc.
• Exchange rates are set by government

• To allow more predictability and stability
• Entails intervention and sterilization operations
Fixed • Extreme form: Dollarization

• Flexible Exchange Rate • Fixed Exchange Rate

ISSUES WITH FIXED EXCH. RATE
Maintenance of pegged exchange rate requires investors confidence on overall health
of the economy
Any doubt will lead to speculative attack, which is associated with self-fulling
prophecy (if CB has limited reserves)
Speculators sell domestic currency in exchange of USD – plentiful supply of USD

leads to depreciation of domestic currency, if CB does not have adequate reserves
Speculators can buy back domestic currency with USD, and can earn huge profit

MACROECONOMIC POLICY
&
E X C H A N G E R AT E

MONETARY POLICY IN AN OPEN
ECONOMY
• Monetary policy influences ‘interest rate’ – which in turn affects
Closed consumption and investment expenditure
economy
• Monetary policy induced interest rate changes alters net

international capital inflows, which in turn affect ‘exchange rate’
Open • Changes in ‘foreign exchange rate’ affect ‘net exports’
economy

RELEVANCE OF THE EXCHANGE RATE
REGIME
• Allows monetary policy independence, and the monetary authority
need not defend any exchange rate target
Flexible • Interest rate changes fully reflect in exchange rate changes
exchange rate
• Monetary expansion leads to depreciation of exchange rate

• To defend exchange rate, CB needs to sale forex reserves in
Fixed exchange of domestic currency
exchange rate • Mopping up of domestic currency entails monetary contraction

MONETARY POLICY WITH FIXED EXCHANGE RATE

IMPOSSIBLE TRINITY
Free capital flows, fixed exchange rate and monetary
policy independence cannot be pursued simultaneously
Monetary policy effectiveness requires restrictions on cross-

border capital flows under fixed exchange rate regime
Or, flexible exchange rate regime under free flow of cross-

border capital
Small open economies adopt ‘exchange rate targeting’ sacrificing

monetary policy response to domestic developments

IS CHINESE YUAN OVERVALUED?
How China is able to maintain its exchange

rate peg?
Why Thailand was not able to defend baht from

speculative attack in 1997 (despite intervention in using
US $ 33 bio or 90% of its forex reserves)?

SPECULATIVE ATTACK & CURRENCY CRISIS

DISCUSSION

Session 20-21 Final - Open Economy Macroeconomics

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Session 20-21 Final - Open Economy Macroeconomics

Uploaded by

Copyright:

Available Formats

OPEN ECONOMY

Repo rate was raised by 190pp to 5.90% (since May)

December 7 hike by another 35pp to 6.25%

Dr. Amaresh Samantaraya 2

Dr. Amaresh Samantaraya 3

Dr. Amaresh Samantaraya 4

• Open economy differs from a closed economy in that goods and

Dr. Amaresh Samantaraya 5

• Consists of goods and services produced at home, and sold abroad

• Profitable opportunities at home and abroad & relative return

Dr. Amaresh Samantaraya 6

• Y = A.F(K, L); Kt+1 =Kt + It+1 + δKt

• Interest rate and net capital inflow

Dr. Amaresh Samantaraya 7

Dr. Amaresh Samantaraya 8

Dr. Amaresh Samantaraya 9

Cross-border flow of goods & services, finance and people

Already exposed to NX as part of aggregate demand

Key issues related to the external sector to be introduced

Dr. Amaresh Samantaraya 10

4. Monetary policy and exchange rate regime

Dr. Amaresh Samantaraya 11

Exports & Imports

Dr. Amaresh Samantaraya 12

• Domestically consumed goods and services, those produced abroad

• Exports over Imports or Net Exports

Dr. Amaresh Samantaraya 13

Dr. Amaresh Samantaraya 16

India’s current account receipts in 2019-20 at 22.4% of

CAD of 0.8% of GDP not a matter of concern

Dr. Amaresh Samantaraya 17

Dr. Amaresh Samantaraya 18

Dr. Amaresh Samantaraya 21

• Petroleum, Crude and Products: 36.7%

Dr. Amaresh Samantaraya 24

• Buy financial assets abroad – stocks, government securities

Dr. Amaresh Samantaraya 25

FDI to India FDI from India

Dr. Amaresh Samantaraya 26

Dr. Amaresh Samantaraya 27

Rapid movement of funds across border can easily

FDI is more stable – one cannot pick up a factory and

Dr. Amaresh Samantaraya 28

Dr. Amaresh Samantaraya 29

• Merchandise trade – exports & imports of goods

• Flow of capital – debt creation

Dr. Amaresh Samantaraya 30

Such large deficit could be sustained due to large

BoP Identity is an equation showing equality between

Dr. Amaresh Samantaraya 32

• Pvt Saving + Govt Saving = S = I + NX

Dr. Amaresh Samantaraya 33

Dr. Amaresh Samantaraya 34

Dr. Amaresh Samantaraya 35

Cross-border capital flows is many-fold of

Has important implications for economic

Dr. Amaresh Samantaraya 36

• GDP of the source country improves by gaining

• Movement of capital from place of low return to place

Dr. Amaresh Samantaraya 37

• Supply of loanable funds – domestic savings

Dr. Amaresh Samantaraya 38

Net Capital Outflow (NCO) falls

I+NCO is downward sloping