Topic 8

Open Economy
Macroeconomics

Balance of Payments
Account
Balance of payments is divided
into five broad parts.
1. Current Account
2. Capital Account

3. Errors & Omissions

4. Overall Balance
5. Monetary Movements
Note:

Refer to the RBI tables for the details of Balance of Payments

Balance of Payments Account

Composition of Current Account and Capital
Account

1.

Current Account
Merchandise
Invisibles
a. Services
b. Transfers
c. Income

2. Capital Account

Foreign investment: FDI and FIIs etc

Loans: WB, IMF, Foreign Govt.
Banking Capital: from Commercial Banks,
HSBC, etc.
Rupee Debt Services: former Soviet block,
Refer
to the Capital
RBI tables. for the details of Balance of Payments Accoun
Other

Worlds Official reserves

Asia holds almost 64% of the world's
reserves, compared with the euro
area's 5% and America's 2%.
Japan has the largest reserves, but
China's stock, having tripled in the
past three years, is not far behind.
These figures include foreignexchange assets, special drawing
rights and reserve positions at the
IMF, but exclude gold. The amount
of reserves indicates a country's
ability to pay international
obligations. The dollar's position as
the world's main reserve currency
means that America does not need to
hold reserves as big as other
countries'. The Economist Aug 25th 2005

Y C + I + G + (X-M)
Injections
YC+S+T
Withdrawals
From the National Income identity
S + T I + G + (X-M)
Rewriting
(S I) (G T) + (X - M)
S-I gap Fiscal Deficit Trade Surplus
What will happen if any one of the
component of the identity changes?

Exchange Rate
Is the price of the foreign currency in
terms of the domestic currency. e.g, the
exchange rate between India and U.S.A.
can be expressed as

the indirect method/quote:

Rs.50/US$
direct method/quote (D):

Re 1/US$0.2

Types of Exchange
Rate
Fixed Exchange Rate: In fixed
exchange rate system, the exchange rate is
pegged at a particular level. And the central
bank of a country stands ready to buy/sell any
amount of foreign exchange at the prevailing
rate.

Flexible/Floating Exchange
Rate: In flexible exchange rate system, the
exchange rate is not pegged at a particular
level. It is determined by the market forces of
demand and supply of the foreign currency in
the foreign exchange market. Hence, under
this system, the exchange rate may fluctuate.

Floating: Clean and Managed

(Dirty) - Intervention
In a clean floating system, the exchange
rate is allowed to be determined
completely freely in the forex market.
However, this may lead to violent
fluctuations in the exchange rate which
may have adverse effects on the
economic health of a country. In order
to keep the fluctuations within
reasonable limits, the central bank
intervenes in the operation of the
foreign exchange market through
sell/purchase of for ex. This system of

Convention and Terminology

Conventionally the direct way of
expressing the exchange rate is
known as the exchange rate
between the currencies of two
countries. For example, the
exchange rate between India and
U.S.A. is
E = US$0.022/Re
(D)
Hence, the indirect way of
expressing the exchange rate,
according to this convention, is
1/E = Rs.46/US$
(ID)

Terminology: Devaluation and

Revaluation
Devaluation: Under the fixed exchange rate
system, if the central bank consciously effects
a fall in the value of the domestic currency in
terms of the foreign currency, it is said to be a
devaluation of the domestic currency. Thus if
E1 = US$0.022/Re falls to E2 =
US$0.020/Re, it is said to be a devaluation of
Indian rupee.
Thus in devaluation,
1/E1 = Rs.46/US$ rises to 1/E2 = Rs.50/US$
Revaluation: Opposite of devaluation is known
as the revaluation of the domestic currency.

The terms devaluation and revaluation

Terminology
Depreciation and Appreciation
Depreciation: Under the flexible exchange
rate system, if the value of the domestic
currency falls in terms of the foreign
currency because of the market forces of
demand and supply in the foreign
exchange market, it is said to be a
depreciation of the exchange rate.
Appreciation: Opposite of depreciation is
called the appreciation of the exchange
rate.

The terms depreciation and

Real and Nominal Exchange

Rates

International transactions are

influenced by international
prices. The two most
important international prices
are:
Nominal Exchange rate
Real Exchange Rate

The Nominal Exchange Rate

(NER)
The nominal exchange rate is
the rate at which a person can
trade the currency of one country
for the currency of another. It is
expressed in two ways:
-

In units of foreign currency per

Indian Rupee
In units of Indian Rupees per one
unit of the foreign currency

The Nominal Exchange Rate (NER)

Example: Assume the

exchange rate between the
Indian Rupee and Canadian
dollar is ten to one. One
Canadian dollar trades for
ten Indian Rupees or one
rupee trades for one tenth
of a Canadian dollar.
If the exchange rate
changes so that a Rupee
buys more foreign currency,
that change is called an
appreciation of the Rupee.
The opposite is called a
depreciation of the Rupee.

Exchange Rate market

Exchange Rate of Rupee

S(Rs)

e1

D(Rs)
O

Rs

Demand and Supply of Re

The Real Exchange Rate

(RER)
The real exchange rate is the ratio at
which a person can trade the goods and
services of one country for the goods
and services of another. Compare the
prices of the domestic goods and foreign
goods in the domestic economy.
Example: If a carton of German beer is
twice as expensive as Indian beer. Real
exchange rate is 1/2.

Calculating the Real Exchange

Rate
Real exchange rates are
derived from nominal rates.
Computing the real exchange
rate involves:
Real
Exchange
Rate

Nominal Exchange Rate

x Domestic Price
Foreign Price

Real Exchange Rate

Real exchange rate is the ratio of
the prices in the domestic country
to those in the foreign country
expressed in the foreign currency.
R = E(PD/PF)
where,
E: nominal exchange rate
PD: domestic price level
PF: foreign price level
Similarly,
1/R = (1/E)(PF/PD)

The Real Exchange Rate

- The real exchange rate is a key

determinant of how much a country

exports and imports.
- When a countrys real exchange rate
is low, its goods are cheap relative to
foreign goods, so consumers both at
home and abroad tend to buy more
of that countrys goods and fewer
foreign produced goods.

Real Exchange Rate

Real exchange rate measures a
countrys competitiveness in
international trade.
R < 1 which implies (1/R) > 1 indicates
that domestic prices are more
competitive.
R > 1 which implies (1/R) < 1 indicates
that domestic prices are less
competitive.

Effective Exchange Rate

Bilateral Exchange Rate
Exchange rate involving two countries is
called a bilateral exchange rate.
The number of independent (basic) bilateral
exchange rates among countries (two or
more) with different currencies equals one
less than the number of countries.
Multilateral Exchange Rate
A countrys combined independent (basic)
bilateral exchange rates with other
countries is called a multilateral exchange
rate.

The U.S.

German
y

Japan

Work Force Participation

in India

Source: NSSO Report 537, Govt. of

India

Total & Organised Sector Employment

(% per annum)
Employment &
Organised Sector

Employment (Million)

Growth Rate

1983

1988

1994

199900

1983
-94

19942000

Total Population

718.2

790

895.1

1004

2.12

1.93

Total Labour
Force

308.6

333.5

381.9

406.1

2.05

1.03

Total Employment

302.8

324.3

374.5

397

2.04

0.98

Organised Sector
Employment

24.01

25.71

27.4

28.11

1.2

0.53

Public Sector

16.46

18.32

19.44

19.41

1.52

-0.03

Private Sector

7.55

7.39

7.93

8.7

0.45

1.87