MACROECONOMIC

ENVIRONMENT
9. Open Economy
Macroeconomics

Introduction
Most economies are open economies and trade
with each other significantly.
National economies are becoming more closely
interrelated, and thus macroeconomic changes in
one economy percolate to other economies and
vice versa.
We want to understand different aspects of key
linkages among open economies.

Introduction

Economies are linked through two broad channels1. Trade in goods and services : Exports and Imports

Trade affects our IS-LM framework.

A countrys exports to foreign countries increases demand for

domestically produced goods.

A countrys imports are goods that are consumed at home but

are produced abroad. Imports are a leakage from the circular
flow of income.

IS-LM needs to be modified accordingly.

Since IS-LM is affected by trade, any factor which affects our

exports & imports needs to be examined also (i.e. exchange

Introduction

Economies are linked through two broad channels2. Finance

Indian residents can hold Indian assets OR assets in foreign

countries.

Portfolio managers shop the world for the most attractive

yields.

As international investors shift their assets around the world,

they link assets markets here and abroad. This affects
income, exchange rates, and the ability of monetary policy to
affect interest rates.

This factor, therefore, has to be added to the IS-LM model.

The Balance of Payments

Balance of payments: the record of the transactions of
the residents of a country with the rest of the world.
Two main accounts:
- Current account: records trade in goods and services,
as well as transfer payments.
- Capital account: records purchases and sales of assets,
such as stocks, bonds, and land.
Any transaction that gives rise to a payment by a countrys residents
is a deficit item (-) in that countrys balance of payments.
Any transaction that gives rise to income for a countrys residents is
a surplus item (+) in that countrys balance of payments.

Balance of Payments (BPM5)

Visible

All goods
Services : insurance, shipping, aviation, tourism.

Current
Account

Investment Earnings : rent, dividends, interest

Invisible

Government Overseas Expenditure: military, and

diplomatic
Transfer Payments : gifts, aid.

Capital Account
(Includes Official
Financing)

Foreign Exchange
Reserves
(Balancing Account)

Purchase/sale of long-term assets

Short-term bank deposits
Official borrowing(+) or lending(-) from/to IMF &
Foreign Central Banks.
Sale of (+), or addition(-) to official reserves (Gold
& Foreign Currencies). A + sign shows depletion
of reserves. A - sign shows addition of reserves.

How The External Accounts Balance

Capital Account in BOPs includes - transactions of countrys private sector
- official borrowing/lending transactions
Individuals and firms have to pay for what they buy
abroad.
i.e a current account deficit can be financed through by:
- by pvt residents selling off assets abroad or
borrowing abroad or
- by the govt which runs down its reserves of FE selling
foreign currency in the FE market.

How The External Accounts Balance

If there is a current account surplus then - the pvt sector may use the FE reserves it receives to pay off
debt or buy assets abroad or
- central bank can buy the (net) foreign currency earned by
the pvt sector and add that currency to its official reserves.
Overall BOP = [current account + capital account + FE
reserves account].
i.e BOP surplus = current account surplus + net capital inflow
= increase in official reserves
If both current account and capital account are in deficit, then the
BOP is in deficit ( implies decrease in FE reserves).
When one account is in surplus and the other is in deficit by exactly
the same amount, the Overall BOP is zero. Overall BOP = zero
always since foreign ex. reserves account balances it out.

INDIA : EXTERNAL SECTOR

BOPs, Exchange Rates And Interest Rates

When goods markets are open, domestic
consumers must decide whether to buy
domestic goods or to buy foreign goods.
-This decision depends upon the nominal
exchange rate and on the real exchange rate
(which shows the price of domestic goods
relative to foreign goods).
The choice between domestic assets and
foreign assets depends upon comparative
domestic and foreign roi and expected
depreciation of the domestic currency.

How The Exchange Rate Affects BOPs?

Some Fundamentals First
The nominal exchange rate is the price of one currency in terms
of another.
It can be quoted in two waysRs55 = $1 (direct quote) or
$0.018 = Re1 (indirect quote).
Convention is to express the foreign currency in terms of the
domestic currency, i.e Rs55 = $1 (i.e direct quote).
If the exchange rate FALLS, i.e from Rs55=$1 to Rs50=$1, the
Re appreciates.
If the exchange rate RISES, i.e from Rs55=$1 to Rs60=$1, the
Re depreciates.

How The Exchange Rate Affects BOPs?

Some Fundamentals First
Two Types Of Exchange Rate Regimes

Fixed Ex Rate System : Ex. rate is a fixed price in terms of domestic

currency.

In a fixed exchange rate system central banks stand ready to meet all
demands for foreign currency at a fixed price in terms of domestic currency.

The central bank finances the excess demands for foreign currency (in
case of BOP deficit) by running down their reserves of foreign currency and
vice versa.

Foreign central banks hold reserves to sell (to the pvt sector) when they
have to intervene in the foreign exchange market.
Intervention: the buying or selling of foreign exchange by the central
bank.

How The Exchange Rate Affects BOPs?

Some Fundamentals First
When countries operate under fixed exchange
rates, that is, maintain a constant exchange rate
between them, two other terms used are:
Revaluations, rather than appreciations, which are
decreases in the exchange rate (from Rs55=$1 to
Rs50=$1) and
Devaluations, rather than depreciations, which are
increases in the exchange rate (from Rs55=$1 to
Rs60=$1).

How The Exchange Rate Affects BOPs?

Some Fundamentals First
Two Types Of Exchange Rate Regimes
Flexible Ex. Rate Systems : Under this system the demands
for and supplies of foreign currency are equated through
movements in ex. rates.
In a flexible (floating) exchange rate system, central banks
allow the exchange rate to adjust to equate the supply and
demand for foreign currency.
Under clean floating, there is no central bank intervention and
the BOP is zero.
i.e Current account + Capital account = 0
Under dirty floating, central banks sometimes intervene to
keep sharp changes in ex. rates in check. i.e. BOP may be in
surplus or in deficit under dirty floating.

How The Exchange Rate Affects The Volume Of

Net Exports?
In general, imported goods are priced and paid for in
foreign currency.
- A depreciation of the Re will tend to decrease volume of
imports (since they become costlier in local Re terms).
- An appreciation of the Re will tend to increase volume of
imports (since they become cheaper in local Re terms).
In general, exports are priced and paid for in Rupees.
- A depreciation of the Re will tend to increase the volume
of Indian exports (by making them cheaper abroad).
- Similarly, an appreciation of the Re will tend to decrease
the volume of Indian exports (by making them costlier
abroad).

How The Exchange Rate Affects The Value Of

Net Exports?
A depreciation of the rupee will increase the volume of exports and
will decrease the volume of imports.
However, BOPs is measured in terms of VALUE of imports and
exports in rupees.
Exports : A Re depreciation will increase the volume of exports and
also increase the value of exports measured in rupees.
Similarly, a Re appreciation will decrease the volume of exports
and also decrease the value of exports (measured in rupees).
Imports : A Re depreciation has 2 effects on imports
1) The volume of imports will fall (since they become costlier in Re
terms).
2) The domestic cost of imports is pushed up.
These 2 effects have opposite impacts on the Re VALUE of
imports.
That is, the impact of ex. rate depreciation or appreciation on value
of imports is uncertain.

How The Exchange Rate Affects The Value Of

Net Exports?
The Marshall Lerner Condition
The M-L condition states that, starting from a
position of balance, a small depreciation will
lead to a BOTs surplus if, and only if, the sum of
the mod value of import elasticity and the mod
value of export elasticity is more than 1.

The j Curve Effect On Trade Balance

Trade
balance
after Re
depre.

Most imports and exports

occur in order to fulfil orders
placed weeks or months
earlier.
j curve effect

Immediately following a rupee

depreciation, volume of imports
and exports remain unchanged.
However, imports must be paid
for now at a higher price when
orders are executed.

Months following
In time, the vol of imports falls
depreciation
and that of exports rises and
BOPs end up showing improvement
In 1991, India witnessed a j curve effect
after a few months post depreciation
when Re was devalued from Rs17.90 a $
of Re (assuming M-L condition holds).
to Rs24.50 a $ (1992) to Rs30.6 a $ (1993).

J Curve Effect
The theoretical basis of the J-curve comes from M-L condition.
Goods tend to be inelastic in the short term, as it takes time to change
consuming patterns. Thus, devaluation is likely to worsen the trade
balance initially. In the long term, consumers adjust to the new prices,
and trade balance improves.
The J curve is evident in India, 2010-12. The Re depreciated from
Rs45.5 to a $ (in 2010) to Rs54.4 to a $(in 2012). There was some
improvement in the CAB during 2010-11 due to a strong pick-up in
exports mainly led by diversification of trade. However, it did not
sustain. Trade balance again came under pressure during 2011-12 as
slowdown in advanced economies spilled over to emerging economies
compounded by sharp increase in inelastic oil and gold imports.

J curve, India, 2010 to 2012

Economic survey, 2014-15

Determination Of Exchange Rate

Is determined by supply and demand for dollars ($) in
the FE markets.
Supply and demand for $ comes from current account
transactions, capital account flows and govt intervention.
Supply of $ comes from the + elts in BOPs Indian
exports; foreign investors who want to buy Indian assets
or open a bank account in India (in Rs); Indian govt
buying Rs (by selling dollars).
Demand for $ comes from the - elts in BOPs Indian
imports; Indian investors who want to purchase foreign
assets abroad or open a bank account abroad (in $);
Indian govt selling Rs (thus replenishing its $ reserves).

Determination Of Exchange Rate

Ex
Rate
Rs/1$

Supply of $ by
Indian exporter

a) An improvement in technology in
India resulting in increase in
demand for Indian goods.

Re appreciates
$ depreciates

What is the effect of the

following on the Ex. rate?

b) An increase in rate of inflation

India.

Demand for $
by Indian importer
Quantity of $

Ex. rate expressed as Rs50=$1.

Ex. rate falls as we move down
on Y axis from Rs50=$1 to
Rs45=$1, implying appreciation
of Re (or depreciation of $) as
we move down on Y axis.

in

c) An increase in roi in India.

d) Discovery of precious stones in
Gujarat.
e) Selling of dollar reserves by the
Indian govt.
f) A decrease in gold imports in India

Policy Measures Taken To Save The Rupee, 2013

The Reserve Bank of India will provide dollars directly to state oil
companies in its latest attempt to shore up a currency that has
slumped to a record low (August 28, 2013).

The RBI will open a special window for banks to swap foreign currency nonresident (FCNR) dollar deposits at a fixed rate of 3.5% per annum for the
tenor of the deposits. The facility will be available for deposits of a minimum
tenor of three years. The swap window will be open until the 30th of
November 2013 (September 5, 2013).

The RBI has also allowed banks to raise 100% of unimpaired Tier 1
capital through overseas borrowings a measure that could lead to
banks raising more funds in the overseas markets to meet capital
requirements (September 5, 2013).

Policy Measures Taken To Save The Rupee

RBI has permitted MNCs to enhance stake in companies within the

stipulated FDI norms without its permission (Sept 10, 2013).

Henceforth trade with other emerging economies will be conducted in local

currency and not in dollars (Sept 13, 2013).

RBI governor Rajan has rolled back the overseas investment limit for Co. to
400% of their net worth, and increased remittances for students, a move that
can help ease investors' fears of more curbs on capital outflows (Sept 5,
2013). In August 2013, in a bid to shore up the rupee, former RBI chief
Subbarao had limited overseas investment by Indian Cos to 100% of their
net worth from 400%. The central bank had also cut overseas remittances by
Indians to $75,000 a year from $200,000.

Govt Plans Sovereign Wealth Fund, Sep 17, 2013 : for management of
excessive foreign ex reserves & stabilization of volatile commodity receipts.

Changes In Exchange Rate

1) BOPs position (under flexible ex. rate system)
2) In the SR, capital flows (under flexible ex. rate
system) and govt intervention (under fixed ex.
rate system) are other key factors determining
ex. rates.
3) In the LR, the determinants of ex. rate of a
country are productivity and inflation (under
flexible ex. rate system).

Changes In Exchange Rate

1. BOPs position (under flexible ex. rate system).

If a country has a BOP deficit, there is excess

demand over supply of $. There will be a
tendency for ex. Rate (Re) to depreciate and
correct BOP disequilibrium on its own.

If a country has a BOP surplus, there is excess

supply over demand for $. The currency (Re)
will tend to appreciate to correct its BOP
disequilibrium.

Changes In Exchange Rate

2. Government intervention (under fixed ex. rate system) and capital
flows in the SR (under flexible ex. rate system).

Under fixed ex. rate system, a BOP deficit or surplus does not affect
ex. rate. The govt intervenes in FE mkts and its reserves change.
-If BOP is in surplus, it implies there is excess supply of $ at the
fixed ex. rate (and pressure on Re currency to appreciate).
However, RBI will step in and start supplying more Rs (by buying
foreign currency, $) till new higher supply meets demand for $ at old
ex. rate.
-In case of BOP deficit, there is more demand for $ at the fixed ex.
rate (and pressure on Re currency to depreciate). However, RBI
intervenes and buys up Rs (by selling foreign currency, $) till dem =
new higher supply (of $) at old fixed ex. rate.

Under flexible ex. rate system, ex. rate is determined freely by

demand & supply for $ & govt does not intervene directly in FE
markets.
-However, govt may intervene indirectly and increase roi; capital will
flow in country, supply of $ will increase causing value of Re to
appreciate and vice versa.

Govt Intervention Under Fixed Ex. Rate

(BOP Surplus)

Ex.
rate
Rs/1$

Supply of $
Excess ss of $ (BOP surplus)

Fixed
ex.rate

New dem for $ (RBI buying $)

Dem for $

$s

Determination Of Exchange Rate In The LR

3)

In the LR, the determinants of ex. rate of a country are

productivity and inflation (under flexible ex. rate
system).
If a country becomes more productive relative to other
countries, its exports will increase and imports will
decrease leading to appreciation of its currency (to
restore eqn in its current account).
In the LR, mkt forces ensure that the ex. rate moves
towards PPP.
Two currencies are at PPP when a unit of domestic
currency can buy the same basket of goods at home
or abroad. This means in the LR, real ex rate, R = 1.

The Exchange Rate in the Long Run

In the long run, the exchange rate between a pair of countries is

determined by the relative purchasing power of currency within each
country
Two currencies are at purchasing power parity (PPP) when a
unit of domestic currency can buy the same basket of goods at
home or abroad.
The relative purchasing power of two currencies is measured
by the real exchange rate.
eP
R f
The real exchange rate, R, is defined as
P , where Pf
and P are the price levels abroad and domestically,
respectively.
If R =1, currencies are at PPP
If R > 1, goods abroad are more expensive than at home
If R < 1, goods abroad are cheaper than those at home

The Exchange Rate in the Long Run

In the LR, mkt forces prevent the ex. rate
from moving too far from PPP (because in
the LR, depreciation leads to high inflation
(cost push+demand pull) and/or inflation
leads to depreciation).
The PPP theory states that if prices
change, then nominal ex. rates will adjust
so that real ex. rates stay the same.

Exchange Rate System In India

The Re was historically linked to .
Under Bretton Woods system (1944 -1971), as a member of IMF, India
declared its par value of Re in terms of gold. The corresponding Resterling rate was fixed at 1GBP=Rs18.
Bretton Woods system collapsed in 1971. Re was delinked from and its
Ex. rate was fixed at 1$=Rs7.50.
After Smithsonian Agreement in 1971, Re was delinked from $ and again
linked to .
In 1975, Re was delinked from . Re was linked to a weighted basket of
currencies to ensure stability of the Rupee, and avoid the weaknesses
associated with a single currency peg. Currency selection and weight
assignment was left to the discretion of the RBI and not publicly
announced.
On March 1, 1992, LERMS was adopted. This would allow market forces
to play a bigger role in determining ex. rate of Re.

EXCHANGE RATE MANAGEMENT IN INDIA (at present)

Indias exchange rate policy has been & is being guided
guided by the broad principles of careful monitoring and

Today India is following a managed float system which is a

system between a freely floating one and a fully managed
one.

Source : Economic survey, 2013-14

Downward movement shows depreciation.

RBI INTERVENTION, FOREIGN EXCHANGE MARKETS, 2011-12 and 2012-13

RBI sells $ to control depreciation of Re. It buys $ to control appreciation of the Re.

RBI INTERVENTION, FOREIGN EXCHANGE MARKETS, 2010-11 and 2011-12

RBI sells $ to control depreciation of Re. It buys $ to control appreciation of the Re.

The Impossible Trinity (From M-F Model)

What is Impossible Trinity?
the hypothesis in open economy macroeconomics
that it is not possible to have all 3 of the following:
- A fixed exchange rate (i.e exchange rate stability).
- Free capital movement (i.e capital mobility).
- An independent monetary policy (i.e price stability).
It is possible for a country to have only two of
these or it has to accept some tradeoffs.

The Impossible Trinity : An Example

Suppose a country is growing and in order to grow further
would need to increase its investments. So far, its savings
have been enough and now it needs foreign savings as well.
As a result, the policymakers liberalise capital flows (inwards
and outwards) in the country. Given this choice, the
hypothesis says the country can either look at exchange rate
stability or price stability but not both. Why?

Now suppose, the country is India whose currency is the

Rupee and it has both objectives price and exchange rate
stability. To achieve former, it has to monitor its money
supply and for latter, too, it has to monitor its money supply.
As capital inflows are allowed, foreign investors take
exposure in India and bring their dollars, convert it
into rupees and invest it.

The Impossible Trinity : An Example

As a result the demand for the domestic currency (Re) goes up.
Ideally as demand goes up so should the price, implying exchange
rate should appreciate (or go up from Rs 45 per dollar to say 40).
But as ex. rate is fixed, the Central bank needs to maintain the
level and instead gives the foreign borrower the desired rupees
and keeps the dollars with itself (i.e buys FE in return for Rs).
Now, as supply of rupees increases in the economy so does
inflation (too much money chasing few goods). As inflation stability
is also an objective the entire thing comes on its head, hence the
impossibility of making all 3 objectives work together.
Note that higher inflation can also be controlled by sterilizing the
flows i.e. Central Banks issue govt. securities and suck the money
supply. But this implies loss of control over ex rate. Also that is not
a long-term solution as govts are supposed to direct their
expenditure towards enhancing capital base of the country and not
for monetary and exchange rate stability.

Some Country Examples

Since 1983, the Hong Kong dollar has been anchored to the
US dollar using a currency board whereby the Hong Kong
monetary base in circulation is backed by US dollar reserves.
At the same time, the currency is fully convertible. As a result,
inflation fluctuates regularly in Hongkong with monetary policy
being too tight or too easy (free capital, fixed ex rate, no price
stability).
The Singapore dollar is closely linked to a basket of other
currencies, with some flexibility within a narrow band and a
general upward trend. Like Hong Kong, it has an open capital
account and is fairly restricted when it comes to monetary
policy (free capital, fixed ex rate, no price stability).
China, on the other hand, pegs the renminbi to the dollar
while also trying to implement its own policies; consequently,
its forced to keep a closed capital account (capital flows not
free, fixed ex rate, control over inflation).

CPI IN HONG KONG

Some Country Examples

Western economies have chosen to have fully floating
foreign exchange markets, in which their central banks
rarely intervene.
Countries such as Australia and New Zealand have
chosen domestic price stability in the form of an inflation
target, and accept a high degree of exchange rate
volatility (free capital, no control over ex rate, price
stability).
Korea has the freest currency (since 1997) and a
relatively open capital account with lot of control on an
independent monetary policy. Inflation rate is within 23.5%, well within control from 1999 to 2014 (free capital,
no control over ex rate, price stability).

CPI IN SOUTH KOREA

Impossible Trinity
A very strong view in economic circles is
that have free capital inflows, and have a
stable monetary policy & let the currency
float.

Fuller Capital Account Convertibility In

India
Capital account currency convertibility refers to the
freedom to convert the domestic currency into
other internationally accepted currencies and vice
versa.
The Tarapore report, which the Reserve Bank of
India sponsored in 1997 and 2006 set out several
important conditions which it said ought to be
satisfied before full capital account liberalization
could be contemplated. These conditions refer to a
stronger financial sector (NPAs should not be more
than 5% of total advances, CRR to be 3%); the
adoption of inflation targeting (3%-5%) and bringing
the fiscal deficit under control (to 3.5% of GDP).

How Open Is Indias Capital Account?

Capital Account has become quite open and restrictions
on both inflows and outflows have been eased
significantly over time.
However, substantial govt control still exists limited
foreign investment is permitted in govt debt market;
registration requirements on foreign institutional
investors exist; sector limits on FDI exist.
Relative to its size, capital flows in India are quite
modest putting India at the low end in an international
comparison across emerging market economies.

Indias trade openness ratio increased to 0.55 in 2011 and stands at 0.50
in 2014 (world bank data).

In 2009-10 & 2010-11, total capital account(net) stands at 3.8% of GDPmp for India.

The NCFs increased from 2.2% of GDP in 19901991 to 3.63% in 20102011 and further to 4.84% in 201213.
Gross capital flows as a percentage of GDP, which reflect the true magnitude of capital flows into India, have
increased from 7% in 199091 to 29.38% in 201011 and further to 25.60% in 201213.
Much of the increase has been offset by corresponding capital outflow largely on account of FIIs portfolio
investment transactions, Indias investment abroad and repayment of external debt.
Capital outflow increased from 4.8% of GDP in 19901991 to 25.64% of GDP in 20102011 and to
20.76% of GDP in 20122013.

Capital Controls In India

In Sept 2015, RBI has increased the limit that

FPI can invest into GOI securities to 5% of the
outstanding stock by march 2018.

$30bn

$50mn

Capital Flow Control & Currency

Management In India

Indias Approach to the Impossible Trinity, 2014-15

Fixed Exchange Rate ; Independent Monetary Policy ; Free Capital

Flows any 2 out of the 3 are possible.

Indias Approach to the Impossible Trinity

India has opted for a middle solution as per the following:

(i) we let our exchange rate be largely market determined, but

intervene in the market to smooth excess volatility and/or to prevent
disruptions to macroeconomic stability;
(ii) our capital account is only partly open; while foreigners enjoy mostly
unfettered access to our equity markets, access to debt markets is
restricted; there are limits how much resident corporates and
individuals can take out for investment abroad, but the limits are
quite liberal; and
(iii) because of the liberalization on the exchange rate and capital
account fronts, we may forfeit some monetary policy independence.
What the middle solution also implies is that we have to guard on all
the three fronts with relative emphasis across the three pillars
shifting according to our macroeconomic situation.

A calibrated liberalisation approach

India has adopted a gradual approach towards capital account liberalisation,

prioritising the liberalisation of non-debt creating flows such as FDI and FIIs.
These flows involve risk sharing between foreign investors and the host
country and thus tend to be more stable than debt flows. While FDI and FII
flows have been steadily liberalised, debt flows are subject to numerous
restrictions. This has resulted in the share of debt liabilities in external
liabilities dropping from 1990 to 2007. Over the same period the share of
portfolio & FDI liabilities increased.

Despite the gradual liberalisation, Indias financial integration has steadily

gone up since 1991. Gross capital flows have increased nearly 22 times
from $42.7 billion in 1991-1992 to over $932.3 billion in 2010-2011. As a
share of GDP, this amounted to an increase from 7% to 30%.

India continues to lag behind other major emerging countries such as Brazil,
Korea and Russia both in terms of volume of capital flows and regulations
governing the flow of capital.

Managing Impossible Trinity, India

MI refers to the extent to which
domestic interest rate differs
from the foreign interest rate.
ERS refers to the movement of
the Rupee compared with other
major currencies.
KO refers to net capital flows
relative to GDP.
RES : change in reserves as a
% of GDP allows greater
flexibility with respect to ex. rate
& monetary mgment in the SR .
Phase 1 : 1997-2000
Phase 2 : 2001-2004
Phase 3 : 2005-2008
Phase 4 : 2009-2012

0 : indicates closed capital account,

0 : completely flexible exchange rate,
0 : zero monetary independence
0: zero reserve accumulation.

Managing Impossible Trinity, India

Indias policymakers have opted for the middle ground, juggling the policy
objectives as per the demands of the macroeconomic situation. For example,
the increase in ex. rate stability between 2000 and 2008 was associated with a
drop in MI. During this period, the RBI intervened heavily in the FE market to
prevent the rupee from appreciating in the face of strong capital inflows. Since
2008, however, India has witnessed a resurgence of MI with a decline in both
ex. rate stability and capital account openness.

RBI Intervention In FE Market

The number of months in which RBI purchased reserves were significantly higher than number of months when it sold reserves. This
implies that RBI has been intervening in an asymmetric manner by
buying reserves to prevent the rupee from appreciating but adopting a
hands-off approach during periods of depreciation. Above figure
explains asymmetric intervention by the RBI since 1998.

Advantages And Disadvantages Of Floating Ex

Rate System
Advantages
1.
Monetary policy can be conducted independently of other
countries without the need for controls on the movement of capital
(price stability, ex rate flexibility, capital mobility).
2.
A floating ex rate system will tend to move to automatically offset
a BOPs deficit or surplus (assuming that import and export
demands are sufficiently elastic).
3.
Since there is no need for govt to intervene in the FE markets, it
implies that there is no need for the central bank to hold large
amounts of gold and foreign currencies.
Disadvantages
1.
They introduce uncertainty into foreign trade transactions.
2.
Activities of currency speculators make ex. rates unnaturally
volatile and may require the govt to intervene to counteract this
volatility.

Advantages And Disadvantages Of Fixed Ex Rate System

Advantages
1.
They give greater certainty, and hence encourage trade with its gains.
2.
They can lead to lower inflation.
3.
Fixed ex rates are a step towards a single currency which will be
good for social, economic and political setup.
Disadvantages
1.
Rather than ex rate depreciating to cure a BOP deficit, the level of
domestic AD needs to be reduced.
2.
Reserves of gold and foreign currency are required to control the
currency ex rate.
3.
Fixed ex rates replace a continuous gradual depreciation (under
floating ex rates) with occasional large devaluations. Thus the
advantage of stability under fixed ex rates may be illusionary.
4.
Alternatively, fixed ex rates can be maintained by imposing controls
on capital flows (to check capital account speculation) together with
quotas and tariffs (in order to eliminate current account deficits). Both
methods are considered inefficient.
5.
The lack of independent monetary policy can be a problem.

Exercise 1
Use the following data to measure USAs balance on
merchandise trade; balance on current account;
balance on capital account and balance of payments.
There is no change in reserve assets held by govt and
official agencies.
1)
2)
3)
4)
5)
6)
7)
8)
9)

USA exports goods valued at $19,650.

USA imports merchandise valued at $21,758.
US citizens receive interest income of $3621 from
foreign investments.
Interest income of $1394 is paid on foreign- owned
assets in USA.
US citizens travel expenditures equal $1919.
Foreign travel in USA is $1750.
US unilateral transfers are $2388.
US capital outflow is $4174.
US capital inflow is $6612.

Exercise 2
The following transactions occurred in respect of Indias trade with
rest of the world during 2007. (All figures are in crores).
a)Oil worth Rs10,000 was exported.
b)Perfume worth Rs5,000 was imported.
c)Foreign tourists spent Rs3000 in India.
d)India donated Rs 1000 to developing countries.
e)Dividends from overseas companies equal to Rs 500 were received.
f)Overseas shares worth Rs150 were purchased.
g)Deposits worth Rs70 were made by transfers from foreign currency
accounts.
h)There was a balancing item of +Rs20.
i)A Rs 4000 loan from IMF was repaid.
Find (in Rs) Indias
i)visible trade balance; ii)balance of trade(goods & services);
iii)current account surplus or deficit; iv)BOPs;
v)change in
official reserves.

Exercise 3
Suppose C=47.50+0.85(Y-Tn); Tn=100; G=100;
I=100-5i; NX=50-0.1Y; M/P=100; L=0.20Y-10i.
iF=5%, and there is capital mobility.
a) Find equilibrium income and the roi.
b) Is there BOP equilibrium? What is the balance
on current account and capital account at
equilibrium income found in part (a)?
c) What effect will a Rs10 increase in govt
spending have on equilibrium income? On BOP
equilibrium?