The Open Economy: The External Sector

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The Open Economy
The External Sector


Global Economic Integration through:

– (1) Opening up international trade in goods and services – (2) Opening up international movement of labour

– (3) Opening up international movement of capital

Macroeconomic policy focuses on (1) and (3)

In a globally integrated world, macroeconomic policies of a country have repercussions on other economies too


The extent of these repercussions depends on
– (a) size of international trade in a country’s GDP,
– (b) how mobile is the capital between the countries, and – (c) the exchange rate regime

– Different exchange rate regimes – External balance of payments account – Open economy macroeconomic policy issues

Exchange Rates

Exchange rate is the price of one (domestic) currency in relation to another (foreign) currency

The market where the various currencies are traded is called the foreign exchange market

Determinants of Exchange Rates
1) Interest rates: determines the attractiveness of a country as an investment avenue Higher the investment inflow, higher the value of the domestic currency

2)Price levels: high inflation rate means lower the purchasing power of the currency and lower the value of currency 3) Growth rate: High growth rate attracts more foreign investment and improves the value of the currency 4) Other economic factors: like fiscal deficit, competitiveness of a country’s exports, etc.

Types of Exchange Rates (Regimes)
The main exchange rate regimes are three:

(a) Flexible (or floating) exchange rate: the value of domestic currency in relation to the foreign currency is determined based on demand for and supply of currencies. (b) Fixed exchange rate: the value of a currency is fixed in terms of other currencies (by the Central Bank) and does not change according to demand and supply (c) Managed float is a combination of fixed and flexible exchange rate systems

Balance of Payments (BoP) Account

The Balance of Payments (BoP)

BoP is a systematic record of all economic transactions between the residents of a country and the residents of the rest of the world, carried out in a specific period of time, usually a year.

It is a classified statement of all the receipts of residents of a country from foreigners and payments by residents to foreigners

The Balance of Payments (BoP)

BoP is a double book entry

That is, every transaction is entered twice, once as a credit item and once as a debit item 

The general rule: – If a transaction earns foreign exchange for the nation, it is a credit and recorded as a plus item

– If the transaction involves spending foreign exchange, it is a debit and recorded as a negative item – E.g.: Exports are credit and imports are debits

Components of BoP
BoP Account is usually divided into two major account headings: A. Current Account B. Capital Account

A. Current Account: includes
(1) merchandise trade account – exports and imports (Physical/visible goods) (2) Invisibles  (a) services – Travel and tourism (visits of tourists) – Transportation – Financial & other services including insurance – Govt. not included elsewhere (embassies, consulates) – Miscellaneous (includes software exports)  (b) investment income (dividends, interests, profits…)  (c) transfer payments – Official and private (foreign aid, gifts, remittances,..)

(B) Capital Account- includes all transactions of financial nature (financial assets) 1. Foreign investment

Direct investment – capital buying physical assets

Portfolio investment – capital buying financial assets

2. Loans
 

Bilateral or multilateral loans received/paid by the government Commercial borrowings/repayments of private sector

3. Banking capital

Changes in the foreign assets and liabilities of commercial banks authorized to deal in foreign exchange NRI investments

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