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Chapter 6, Open Economy Macroeconomics
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Open economy and three types of linkages, Modern economies are not closed ones, they are open economies., An Open economy is an economy which has economic relations with other countries of the world with regard to goods and services, financial assets etc., Open economies create three types of linkages namely, Product market linkage, Financial market linkage and , Factor market linkage
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Product Market Linkages, Consumers and firms have the opportunity to choose between, domestic and foreign goods. This is the product market linkage, which occurs through international trade.
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Financial Market linkages, Investors have the opportunity to choose between domestic and foreign assets. This constitutes the financial market linkage., In an open economy investors can buy financial securities like bonds and shares.
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Factor market linkage., Firms can choose where to locate production and workers to choose where to work. This is the factor market linkage., Even though factors of production enjoy free movement, in effect, they are controlled by immigration and investment regulations.
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Leakage and Injection, Foreign trade influences Indian aggregate demand in two ways., When India imports, money flows from India to countries from which we import. This is a leakage from circular flow of income and expenditure within the economy. This reduces aggregate demand., When India exports, money flows into India. This is the injection to the circular flow of income. This increases aggregate demand., Therefore, the volume of imports and exports is an important factor determining aggregate demand. The volume of trade is an indicator of the openness of an economy., Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. In 2013-14, this was 44.1 per cent for the Indian Economy. There are several countries whose foreign trade proportions are above 50 per cent of GDP.
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Balance of Trade (BoT), International trade has two dimensions namely imports and exports., When we export, we earn foreign exchange, and when we import, foreign exchange flows out of the country., The difference between the value of visible import and visible exports is called Balance of Trade., Visible refers to the items that are recorded at the ports. Eg. Machinery, raw materials, textiles, agricultural products., Invisible items refers to services and they are not included in the balance of trade., Eg. Banking , shipping, insurance ,Earnings from software, IT enabled services money sent home by Indian working abroad
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Trade Surplus and Trade Deficit., If the value of a country’s exports is greater than that of its imports, that country has Trade surplus. This is called favourable balance of trade., If the value of exports is less than the value of imports, the country has a Trade Deficit. This is called unfavourable balance of trade.
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Balance of Payments (BoP), The balance of payments (BoP) record the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year., It is a more comprehensive term that BoT, It includes both visible items and invisible items.
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BoT Vs BoP, Balance of Trade is the record of visible exports and visible imports. It includes only visible items, It includes only visible items, Excludes capital account, Narrower concept, May be surplus, deficit or balanced, Balance of payments is the record of all monetary transactions with the rest of the world. It includes visible and invisible items., Both visible and invisible items, Includes capital account, Broader concept, Always balanced.
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Balance of Payments Accounting, Double entry book keeping system is used in balance of payments accounting., Any transaction that causes outflow of foreign exchange is recorded on the debit side .This bears a negative symbol(-), Any transaction that causes inflow of foreign exchange is recorded on the credit side. Its symbol is Positive(+)., BoP has four accounts namely, Current Account, , Capital Account,, Official /Reserve Settlement Account and, Errors and Omissions.
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Current Account., Receipts from current account transactions are called current receipts., Expenditure on current account transactions are called current expenditure., If a country’s current receipts are more than current expenditure it is called current account surplus. , If a country’s current expenditure is more than current receipts , it is called current account deficit., If current account receipts and current account expenditure are equal, it is called current account balanced.
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Current Account
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Capital Account, Capital account shows flow of capital, All transactions like lending, borrowing and investment come under capital account. , Lending's and borrowings include both short term and long term transactions, Investment includes both direct investment and portfolio investment., If the capital receipts into a country are more than the capital receipts out of the country, it is called capital account surplus., If the capital receipts into a country are less than the capital receipts out of the country, it is called capital account deficit., Current account deficit is financed through capital account surplus.
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Official Reserve Account/Official Settlement Account, Excess of foreign exchange receipts over foreign exchange expenditure results in surplus. This surplus is treated as reserves and shown in the reserve account. , The official reserve account of a country indicates, changes in country’s reserve assets during a year., It consists of foreign currencies, gold and special Drawing Rights (SDRs)., When current account and capital account are taken together, surplus or deficit is solved from the official reserve account. Therefore balance of payments is always balanced.
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Errors and Omissions, Certain errors and omissions arise due to inaccurate and incomplete information. This is recorded in the Errors and Omissions Account.
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Autonomous and Accommodating Transactions, All international financial transactions taken up independently without considering balance of payments are called Autonomous Transactions., All financial transactions made by the people with the objective of consuming more and making profits are called autonomous transactions., Eg. Export, Import, portfolio investment, capital investment etc, Autonomous transactions are also called above the line items in Balance of payments
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Accommodating transactions, Transactions in the official Reserve Account are called accommodating transactions. It is the effect of autonomous transactons., Accommodating transactions are also called below the line items in the Balance of Payments, Eg. Changes in foreign exchange reserves of the official reserve account, changes in gold and changes in SDR
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Balance of Payment Equilibrium, When a country’s foreign exchange earnings from autonomous transactions in a year are equal to its foreign exchange expenditure, it is called Balance of Payment Equilibrium. (Foreign exchange income is equal to foreign exchange expenditure), When inequality occurs, it will be BoP disequilibrium. , If autonomous income is more than autonomous expenditure , it is called BoP Surplus and if autonomous expenditure is more than autonomous income, it is called BoP Deficit. , BoP surplus is called favorable balance of payment and BoP deficit is called unfavorable balance of payment
