Unit 5: Open Economy

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Balance of Payments

The Balance of Payments (BOP) is a systematic statement that records all economic transactions (involving goods, services, income, and assets) between the residents of one country and the rest of the world during a specific period (usually one year).

Key Principles:

• Double-Entry Bookkeeping: Every transaction is recorded twice—once as a Credit (+) and once as a Debit (-).
  • Credit (+): Any transaction that leads to an *inflow* of foreign currency. (e.g., Exports, Foreign Investment in our country).
  • Debit (-): Any transaction that leads to an *outflow* of foreign currency. (e.g., Imports, Our investment abroad).
• In theory, the BOP always "balances": Total Credits = Total Debits. A "deficit" or "surplus" refers to a specific *part* of the BOP.

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Current and Capital Account

The BOP is broadly divided into two main accounts:

1. Current Account

This account records transactions related to the current flow of goods, services, and income. It includes:

1. Trade in Goods (Visible Trade):
   • Exports of physical goods (+)
   • Imports of physical goods (-)
2. Trade in Services (Invisible Trade):
   • Exports of services (+) (e.g., tourism, software services, shipping)
   • Imports of services (-) (e.g., Indians travelling abroad)
3. Net Income:
   • Factor income *from* abroad (+) (e.g., profits, interest, wages earned by residents abroad)
   • Factor income *paid* to abroad (-) (e.g., profits, interest paid to foreign investors)
4. Net Unilateral Transfers:
   • One-way transfers received (+) (e.g., foreign aid, remittances from abroad)
   • Transfers paid (-) (e.g., donations to other countries)

2. Capital Account

This account records transactions that involve the purchase or sale of assets (both real and financial). It represents changes in the country's foreign assets and liabilities.

1. Foreign Investment:
   • Foreign Direct Investment (FDI): Long-term investment involving control (e.g., a foreign company building a factory in India (+)).
   • Foreign Portfolio Investment (FPI): Short-term, financial investment (e.g., a foreign fund buying Indian stocks (+)).
2. Loans:
   • External Commercial Borrowing (+)
   • Repayment of loans (-)
3. Changes in Official Reserves:
   • This is the "balancing" item. It is the account of the central bank (e.g., RBI).
   • If there is a BOP deficit, the RBI must *sell* foreign currency (e.g., $). This sale is a *credit* (+) entry, which makes the BOP balance to zero.

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Balance of Trade

The Balance of Trade (BOT) refers *only* to the balance of visible trade (i.e., the export and import of physical goods).

BOT = Value of Goods Exports - Value of Goods Imports

• BOT Surplus (or Trade Surplus): Goods Exports > Goods Imports.
• BOT Deficit (or Trade Deficit): Goods Imports > Goods Exports.

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Disequilibrium in BOP

A BOP Disequilibrium refers to a persistent surplus or deficit in the "autonomous" parts of the BOP (i.e., the Current Account and Capital Account *combined*).

It is "settled" by the movement of the central bank's Official Reserves.

• BOP Deficit:
  • Meaning: Autonomous *outflows* (Debits) are greater than autonomous *inflows* (Credits).
  • Result: The central bank must *sell* foreign currency (e.g., $) from its reserves to finance the deficit. The country's official reserves decrease.
• BOP Surplus:
  • Meaning: Autonomous *inflows* (Credits) are greater than autonomous *outflows* (Debits).
  • Result: The central bank *buys* the excess foreign currency. The country's official reserves increase.

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Methods of correction of BOP

If a country has a persistent BOP deficit, it must take corrective action. The main methods are:

1. Expenditure-Switching Policies

These policies aim to *switch* domestic and foreign spending away from foreign goods and towards domestic goods.

• Devaluation (under fixed) or Depreciation (under floating):
  • Action: Making the home currency cheaper (e.g., moving from $1=₹80 to $1=₹85).
  • Effect: Makes exports cheaper for foreigners (boosting X) and makes imports more expensive for residents (reducing M). This improves the Current Account.
• Trade Barriers:
  • Tariffs: A tax on imported goods, making them more expensive.
  • Quotas: A physical limit on the quantity of imported goods.

2. Expenditure-Reducing Policies

These policies aim to *reduce* overall aggregate demand (and income) in the economy, which in turn reduces the demand for imports.

• Contractionary Monetary Policy:
  • Action: Central bank raises interest rates.
  • Effect: Slows down investment (I) and consumption (C), reducing overall income (Y). A fall in Y leads to a fall in imports (M).
• Contractionary Fiscal Policy:
  • Action: Government cuts its spending (G) or raises taxes (T).
  • Effect: Reduces aggregate demand, lowers income (Y), and thus reduces import spending (M).

3. Exchange Controls

The government directly rations or limits the amount of foreign currency available to the public for imports or travel.

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Exchange Rate and Determination of Equilibrium Exchange Rate

What is an Exchange Rate?

The Exchange Rate (e) is the price of one country's currency in terms of another.
Example: $1 = ₹83 (This is the price of a dollar in terms of rupees).

Determination of Equilibrium (under a Floating System)

The equilibrium exchange rate is determined by the market forces of demand and supply in the foreign exchange market (e.g., the market for US Dollars).

• Demand for Dollars:
  • Who: By Indians who need dollars to pay for foreign things.
  • Source: Indian importers, Indians travelling abroad, Indians investing in the US.
  • Curve: Downward-sloping. If the exchange rate is low (e.g., $1=₹70), dollars are cheap, so Indians will demand more of them to buy more US goods.
• Supply of Dollars:
  • Who: By foreigners who need rupees to pay for Indian things.
  • Source: Indian exporters (who earn $), foreign tourists in India, foreign investors in India.
  • Curve: Upward-sloping. If the exchange rate is high (e.g., $1=₹90), foreigners get more rupees for their dollars, so they are incentivized to buy more Indian goods, thus supplying more dollars.

Equilibrium (e*): Occurs where the Demand curve for dollars intersects the Supply curve for dollars. At this rate, the quantity of dollars demanded equals the quantity supplied.

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Types of Exchange Rate Systems

This describes the role a government or central bank plays in determining the exchange rate.

Feature	1. Fixed (Pegged) System	2. Flexible (Floating) System	3. Managed (Dirty) Float
How is 'e' set?	By the government or Central Bank at an official "par value."	Purely by market forces of Demand and Supply. No intervention.	Mostly by Demand and Supply, but the central bank intervenes occasionally.
Central Bank Role	Must intervene. Buys/sells foreign currency from its reserves to maintain the fixed rate.	Does not intervene. Official reserves are not used.	Intervenes to "smooth out" volatility or prevent the rate from moving too far, too fast.
Key Terms	Devaluation: A deliberate *lowering* of the official value. Revaluation: A deliberate *raising* of the official value.	Depreciation: A *fall* in value due to market forces (e.g., demand shifts left). Appreciation: A *rise* in value due to market forces.	(A hybrid of the other two).
Pros	Stability, certainty (good for trade and investment).	Automatic BOP correction, independent monetary policy.	"Best of both worlds": stability without losing all monetary independence.
Cons	Needs large reserves, loss of independent monetary policy.	High volatility, uncertainty (can hurt trade).	Can be unstable, lacks transparency.
Example	Bretton Woods system (1944-1971), China (historically).	(Purely theoretical, no country is 100% floating).	Most major economies today (USA, UK, India, Eurozone).