Open economy: Current account

and capital account

Lecture Section D, E and PGP- FIN_03

RAC Chair RAC Area Member RAC Cross-Area Member

Prof. Sumit Mitra Prof. Anubha S. Sinha Prof. Debabrata Chatterjee
 Learning objectives & outcomes

What is an Open Economy?

Current account, Capital account and Balance of
payment
Savings investment equality and current account
Effect of FDI, fiscal deficit and fiscal stimulus on
the equilibrium

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Current account
Current account surplus or deficit
Export of goods and services
Import of goods and services
Primary income (net)
Secondary income (Net)

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27/06/2023 Trade Deficit 4
Trade Gap widening

27/06/2023 CAD 5
Trade deficit

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Better CAD and Forex reserves ?

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Financial/ capital account
Financial account surplus/deficit
Direct investments
Portfolio investments
Financial Derivatives
Other Investments

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Balance of payments

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How can countries have large deficits: Balance of Payment
Balance of Payment identity: Value of net-exports = net capital outflow

Current account can be expressed in form of saving investment in a

country
In a closed economy
Y= C+I+G
I= Y-C-G (Consumption of private) (Government consumption)
Since savings = Invested in a closed economy
S= S private (Y-C) + S public (Y-S)
S=I
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Open economy ( Read Feldstein article in VC)
Now moving into an open economy
Y= C+I+G+NX
I +NX = Y-C-G
S= S private+ S public = Y-C-G
S= I+NX
People have a choice of investment: Investment in the domestic economy; Invest in the
rest of the world (Net capital outflow)
I +NCO = I+NX >>> NCO = NX
Therefore Current account balance: is a comprehensive measure of a country's external position
We can interpret a country's current account from what we call a savings and investment perspective.

Saving investment using current account

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Savings investment
 If CA <0 Investment is more than savings
FA>0 It has to be funded from the rest of the world ( obligation)

If CA>0 Savings is more than investment

FA<0 Savings must be invested in projects with higher ROI ( Acquiring assets)
Current account balance is a comprehensive measure of external position
It can also be interpreted as excess of saving over its investment
In the case of a deficit
 Country depends on external savers to fund part of its domestic investment expenditure
 Drop in savings in the domestic workers also mean that domestic residents are using
foreign financing to fuel unsustainable consumption boom.

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What are the determinants of financial account
 In a closed economy
Interest rate was determined by domestic investment curve and domestic saving
curve
In a open economy
Interest rate is determined by demand and supply of loanable funds
The demand for loanable funds comes from two sources
 Domestic investment
 International investment: Capital inflow ( other country investment in domestic
country) and Capital outflow ( domestic country investment in foreign
countries) ( Net capital outflow)

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Shape of demand and supply for loanable funds n
Demand for loanable funds= NCO + Domestic investment
Shape of demand for loanable funds depends on
• Interest rate
What will be the relationship?
• Negative relationship: Lower interest rate, cost of borrowing is
cheaper and higher investment in Domestic economy
• Lower interest means lower inflow and higher outflow ( higher NC0)

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Supply of loanable funds
Supply of loanable funds: Domestic savings: Private and public saving.
 Positively related to interest rate
 Domestic country can invest in foreign country using (domestic savings).
Then, Supply of loanable funds reduces in the domestic economy.

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Equilibrium

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Does demand for loanable funds shift in the economy?
Scenario 1
Effect of foreign direct investment
Foreign investors will push more money into India( Net outflow contracts)
Domestic investment is preferred and therefore less outflow to other countries
(NET outflow contracts)
Given the higher rate of net outflow contraction the I+NCO contracts to left
What is the effect
Lower interest rate (Shift of I+ NCO to left)
Domestic investment increases (Lower interest rate effect)
Lower NCO and higher domestic investment
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Fiscal deficit scenario
There is a fiscal deficit means Revenue is less than expenditure
Public savings = Public revenue
S= S private+ S public ( lower now as revenue is lower)
Effect of the left shift of saving
 Higher interest rate
 More incentive to invest in domestic investment as returns are higher
 Higher capital flows due to higher interest rate ( Balancing act)

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Fiscal policy and trade imbalance: Twin deficit
Can a higher fiscal deficit can have linkages to higher current account deficit?
It can be partially reflected in the current account
CA= S-I
CA= Sp- Ip ( private gap) + Sg-Ig ( Public gap)
Lets focus on Public Gap ( Savings are through taxes- Investment through government investment spending):
Operating balance
CA = Sp- Ip ( private gap) + Fiscal deficit
The framework
ꙘG ꙘY ꙘIM ꙘNX

Marginal propensity to import increases with additional Y through multiplier effect

A higher CA deficit
Secondly, the higher fiscal deficit means shift of savings to left: Causing higher interest rate and lower investment.
Lower net capital outflow is used to finance the government deficit rather than on pvt investment

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Readings for today
Widening trade deficit discussion

https://www.youtube.com/watch?v=BoyG70u037w&t=13s

Questions in the next slide

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Discussion: Mythili Sreenivasan : Indianomics
Trade deficit and Rupee fail

Background: Trade deficit is around 2-3%

Why Dr Reddy thinks it is more?
What is the sustainable level of current account deficit?
Does the current situation can lead to BOP crisis?
Friday class DISCUSSION
Why does Currency further depreciate with the widening CAD?
Why Sajith Chinoy thinks this is not a one quarter problem and why removing volatile commodities provide
us?
What are the reasons for higher CAD? What is expenditure switching?
Why they argue that INR is overvaluation? Why due to think a 69-71 band is good for exporters and
importers?
How to control CAD / Suggestions
Calibrated exchange rate, Fiscal deficit and RBI monetary policy
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