International linkages

International linkages
 Open economy means the economy is open to
exports and imports.
 Perfect capital mobility means there is no restriction
on capital flows into and out of the country.
Balance of payments (BOP)
 BOP is the record of the transactions of the residents
of a country with the rest of the world.
 There are two main accounts in the BoP:

– the current account and

– the capital account
 International linkages
Balance of payments (BOP)
 Current account records trade in goods and services,
income as well as transfers.
– Current a/c convertibility of rupee – no restrictions on availability
of foreign currency for current a/c transactions.
 Capital account records purchases and sales of assets
such as stocks, bonds and land.
– Perfect capital mobility (capital a/c convertibility) means no
restrictions on capital a/c transactions.
 Status of Indian Rupee:
– Fully convertible on current a/c; partially convertible on capital
a/c
 India’s BoP ($million) (Net)
2008-9
A.CURRENT ACCOUNT
B. CAPITAL ACCOUNT
1. Foreign Investment (a+b)
a) Foreign Direct Investment
b) Portfolio Investment
2.Loans
3. Banking Capital
4.Other capital
Total Capital Account
C. Errors & Omissions
D. Overall Balance
2007-08 2006-07
-29,817 -17,403 -9,766
3,462 44,806 15,541
17,496 15,545 8,479
-14,034 29,261 7,062
5,001 41,962 24,534
-2,925 11,757 1,913
3,608 9,506 3,791
9,146 108,031 45,779
591 1,536 593
-20,080 92,164 36,606
 India’s BoP ($million) (Net)
2008-9 2007-08 2006-07
A.CURRENT ACCOUNT
I. Merchandise -119,403 -90,060 -63,171
II.Invisibles 89,586 72,657 53,405
Total Current Account (I+II) -29,817 -17,403 -9,766
International linkages
Fixed and flexible exchange rates
 Fixed exchange rate: Exchange rate is
fixed by the central bank. Central bank
stands to buy and sell domestic currency in
forex mkt. at the fixed exchange
 Flexible exchange rate: the central banks
allow the exchange rate to adjust to equate
the supply and demand for foreign
currency.
International linkages
Fixed and flexible exchange rates
 Clean floating: the demand and supply of
currencies determines the exchange rate.
 Managed (dirty) floating: central banks
intervene in forex mkt. to influence
exchange rates.
 International linkages
 Under fixed exchange rate, BoP surplus =
Current account surplus + net private
capital inflow = increase in official
reserves
 Under flexible exchange rate, current
account surplus + net private capital
inflow =0
 International linkages
Fixed and flexible exchange rates
Definition of some terms
Devaluation and depreciation.
 Devaluation: Under a fixed exchange rate regime, the
price of foreign currencies is increased by official action
(domestic currency becomes cheaper).
– In July 1991, rupee devalued by 22% vis-à-vis US$
 A currency depreciates when, under floating rate
system, it becomes less expensive in terms of foreign
currencies.
 International linkages
Real exchange rate
 The real exchange rate is the ratio of foreign to
domestic prices, measured in the same
currency.
 Real exchange rate is defined as : ePf / P,
where P and Pf are the domestic and foreign
price levels and ‘e’ is the nominal exchange rate
(domestic currency per unit of foreign currency.)
 It measures a county’s competitiveness in
international trade.
International linkages
Purchasing power parity (PPP)
 Two currencies are said to be at PPP when one
unit of domestic currency can buy the same
basket of goods at home and abroad.
 When there is PPP, real exchange rate, R=ePf/P
=1
 On a percentage change basis over time, PPP
can be stated as follows:
% change in exchange rate = domestic inflation–
foreign inflation
Foreign trade and IS-LM framework
NX = X – Q
Exports (X)
X = f (Yf, R)
Imports (Q)
+ + Q = f (Y, R)
R will  if e Pf or P
+ -

NX = f (Y, Yf, R)
- + +
•Real exchange rate depreciation improves the trade
balance.
Foreign trade and IS-LM framework(contd.)
AD in open economy:
 Increase (decrease) in NX shifts IS to the right
(left). For example, real depreciation and increase
in foreign income shifts IS to the right.

LM0 LM0
i
i

IS1 IS0
IS0 Y IS1
Y
 International linkages
The balance of payments and capital flows
 BP = NX(Y,Yf,R) + CF (i- if)

 Capital account balance depends on interest rate

differential. Trade balance depends on Y,Yf and R.
External equilibrium: the BP curve
 The equil. condition for external sector is BoP = 0.

 The BP curve represents combination of interest and

income at which there is external equilibrium(BoP=
0).
 International linkages
BP curve under perfect capital mobility (PCM)
 BP curve will be flat for small open economies.
Because the domestic interest rate (i) = foreign
interest rate (if)
Otherwise, there will be huge capital inflows (if i>if)
or or huge capital outflows (if i<if)

i
BP curve

Y
International linkages
Internal and external balance
 Internal balance requires goods market and
money market equilibrium.
 External balance means that BoP=0.

 Internal + external balance implies that IS and

LM should intersect on the BP curve.
 In addition, output should be at full
employment level (in the long run).
International linkages
PCM: Internal and external balance
i LM0

E0
i0 = if BP = 0

IS0

Y0 Y
Fixed Exchange Rate

Monetary and Fiscal Policies

Fixed exchange rate
 Commitment to fixed exchange rate
requires intervention from central bank
in the forex market
 If BoP is in surplus (deficit), central
bank has to buy (sell) forex. This leads
to increase (decrease) in money supply
International linkages
Monetary policy under fixed exchange rate
i LM0
LM1
E0
i0 = if BP = 0

i1 E1

IS0

Y0 Y

PCM
No  in Y. Monetary policy is ineffective
International linkages
Fiscal policy under fixed exchange rate

i E1 LM0
i1 LM1
E0 E2
i0 = if BP = 0

IS1
IS0

Y0 Y2 Y

Y rises. Fiscal policy is effective

Flexible Exchange Rate

Monetary and Fiscal Policies

International linkages
Monetary policy under flexible exchange rate
LM0
i
LM1
E0
E2
i0 = if BP = 0
i1 E1
IS1
IS0

Y0 Y2 Y

Monetary policy is effective – Y rises

International linkages
Fiscal policy under flexible exchange rate
i LM0
E1
i1
E0
i0 = if BP = 0

IS1
IS0

Y0 Y

No  in Y. Fiscal policy is ineffective

International linkages
Summary of fiscal and monetary policy under
PCM
Policy Fixed Exchange Flexible
Rate Exchange Rate
Monetary Ineffective Effective
Policy
Fiscal Policy Effective Ineffective
Competitive depreciation
 Under flexible exchange rate, expansionary
monetary policy leads to depreciation, NX
increases
 In the foreign countries the NX decreases
(demand decreases).
 Depreciation merely shifts demand – can
trigger competitive policies from other
countries – Currency War erupts.
 Coordinated fiscal and monetary policies are
required if recession is world-wide.
 Case study: The Exchange Rate
Mechanism
Background to ERM Collapse (1993)
 EU countries followed fixed exchange rate during
1979-93 – called as ERM
 Post-unification, Germany followed fiscal expansion
to prop up the economy of erstwhile east Germany.
 To control inflation, Bundesbank tightened monetary
policy.
 Together these policies led to rising German interest
rates.
 DM was under pressure of appreciation against other
currencies following German Unification.
The Exchange Rate Mechanism
 Other countries urged Germany to cut
interest rates –German central bank
refused
 Other countries did not want to raise their
interest rates.
– France was going through recession – could
not afford interest rate rise (u=12%).
– UK and Italy were experiencing
unemployment, inflation.
ERM Crisis
 In 1992 UK spent over £6bn trying to keep
the currency within the narrow limits of the
peg to DM
 Speculators bet against Pound Stg
 Alternatives for UK:
– Raise interest rates
– Float the Pound Stg.
– Re-adjust the peg
The Exchange Rate Mechanism
Collapse, July 1993
 Other currencies were facing pressure
of depreciation against DM.
 European central banks had sold DM
65b on July 27 and 28 to defend parity.
 Bundesbank failed to cut interest rate
on July 29,1993.
 Aug.2, 1993: Band for exch. Rate
widened to +/- 15% : virtual free float.