Open Economy Macroeconomics – AHSEC Class 12 Macroeconomics Chapter 6

Based on the AHSEC Class 12 Macroeconomics textbook, “An Introduction to Macroeconomics,” here is the comprehensive study material for Chapter 6: Open Economy Macroeconomics, written in English for English medium students.

Chapter 6: Open Economy Macroeconomics

Chapter Summary

Concept of an Open Economy:
An open economy is one that interacts freely with other countries in the world through trade in goods, services, and financial assets. This is in contrast to a closed economy, which has no foreign trade. The three main linkages in an open economy are:

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1. Output Market Linkage: Countries can trade goods and services with each other (imports and exports).
2. Financial Market Linkage: Investors can buy financial assets (like stocks and bonds) from other countries.
3. Labour Market Linkage: Labour can move between countries (immigration and emigration), though this is often restricted.

The Balance of Payments (BoP):
The Balance of Payments (BoP) is a systematic record of all economic transactions between the residents of a country and the rest of the world in a given period. It has two main accounts:

1. Current Account: This records transactions relating to the export and import of goods (Balance of Trade), services (Balance of Invisibles), and unilateral transfers (like gifts and grants).
2. Capital Account: This records all international transactions of assets, such as foreign investment (FDI, FII), loans, and banking capital.

The BoP must always balance. A deficit in the current account must be financed by a surplus in the capital account or by a decrease in the country’s official foreign exchange reserves.

Foreign Exchange Rate:
The foreign exchange rate is the price of one currency in terms of another (e.g., $1 = ₹83). There are different systems for determining this rate:

1. Flexible/Floating Exchange Rate: The exchange rate is determined by the market forces of demand and supply for foreign currency, without any intervention from the central bank.
2. Fixed Exchange Rate: The government or central bank fixes the exchange rate at a particular level. To maintain this rate, the central bank must buy or sell foreign currency whenever the market rate deviates.
3. Managed Floating Exchange Rate: This is a hybrid system. The exchange rate is determined by the market, but the central bank intervenes to prevent excessive fluctuations and maintain stability.

Income Determination in an Open Economy:
In an open economy, aggregate demand (AD) is given by: AD = C + I + G + NX, where NX is Net Exports (Exports – Imports). Because imports depend on income, they act as a leakage from the circular flow, which reduces the value of the multiplier. The open economy multiplier is: 1 / (1 – c + m), where ‘c’ is the MPC and ‘m’ is the marginal propensity to import.

Complete Textual Question Answers (Exercise)

1. Differentiate between the balance of trade and the current account balance.
Answer:

• Balance of Trade (BoT): It is the difference between the value of a country’s visible exports (goods) and visible imports (goods). It is a narrow concept.
• Current Account Balance: It is a broader concept. It includes the Balance of Trade, as well as the balance of invisible trade (trade in services) and the balance of unilateral transfers (gifts, grants, etc.).
  Therefore, the Balance of Trade is just one component of the Current Account Balance.

2. What are official reserve transactions? Explain their importance in the Balance of Payments.
Answer: Official reserve transactions refer to the buying and selling of foreign currencies from the official reserves held by a country’s central bank (like the RBI).
Importance: These transactions are crucial for balancing the BoP account. When there is an overall deficit or surplus in a country’s BoP (from autonomous transactions), the central bank uses its official reserves to settle the difference. A BoP deficit is settled by selling foreign exchange, which decreases the official reserves. A BoP surplus leads to a purchase of foreign exchange, which increases the reserves. Thus, they are the final balancing item in the BoP.

3. Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.
Answer:

• Nominal Exchange Rate: This is the price of one currency in terms of another, without any adjustment for the price levels in the two countries. For example, $1 = ₹83.
• Real Exchange Rate (RER): This is the relative price of goods between two countries. It is the nominal exchange rate adjusted for the ratio of the price levels in the two countries. Formula: RER = (e × P) / P_f, where ‘e’ is the nominal rate, ‘P’ is the domestic price level, and ‘P_f‘ is the foreign price level.

Relevance: The real exchange rate is more relevant for deciding whether to buy domestic or foreign goods. This is because it measures the purchasing power and tells you how many units of a foreign good you can get for one unit of a domestic good. It reflects the actual cost competitiveness between countries.

4. Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods).
Answer:
Given:

• Nominal Exchange Rate (e) = 1.25 Yen per Rupee
• Foreign (Japanese) Price Level (P_f) = 3
• Domestic (Indian) Price Level (P) = 1.2

The formula for the real exchange rate (RER) is: RER = (e × P) / P_f
RER = (1.25 × 1.2) / 3
RER = 1.5 / 3
RER = 0.5
This means that half a unit of Japanese goods can be exchanged for one unit of Indian goods.

5. Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
Answer: Under the gold standard, each country defined its currency in terms of a fixed amount of gold. If a country had a trade deficit, it had to pay for its excess imports with gold. This outflow of gold would reduce the money supply in the deficit country, causing prices to fall. Lower prices would make its exports cheaper and imports more expensive, automatically correcting the trade deficit. The opposite would happen in a country with a trade surplus.

6. How is the exchange rate determined under a flexible exchange rate regime?
Answer: Under a flexible (or floating) exchange rate regime, the exchange rate is determined by the market forces of demand and supply in the foreign exchange market. The equilibrium exchange rate is the rate at which the quantity of a foreign currency demanded equals the quantity supplied. There is no official government or central bank intervention.

7. Differentiate between devaluation and depreciation.
Answer:

• Devaluation: This is a deliberate downward adjustment of a country’s currency value by the government under a fixed exchange rate system.
• Depreciation: This is the fall in the value of a country’s currency in the foreign exchange market due to market forces of demand and supply under a flexible exchange rate system.
  The key difference is that devaluation is an official government act, while depreciation is a market-driven outcome.

8. Would the central bank need to intervene in a managed floating system? Explain why.
Answer: Yes, the central bank needs to intervene in a managed floating system. In this system, while the exchange rate is largely determined by market forces, it can sometimes experience excessive volatility (large and rapid fluctuations). Such volatility creates uncertainty and can be disruptive to international trade and investment. Therefore, the central bank intervenes by buying or selling foreign currency to “manage” or smooth out these fluctuations and maintain stability in the exchange rate.

9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
Answer: No, they are not the same.

• Demand for Domestic Goods: This refers to the total demand for goods produced within a country. It includes consumption, investment, and government spending on domestic goods, plus exports (foreign demand for domestic goods).
• Domestic Demand for Goods: This refers to the total spending by a country’s residents (households, firms, government). It includes their demand for both domestic goods and imported goods.

10. If M = 60 + 0.06Y, what is the marginal propensity to import? What is the relationship between the marginal propensity to import and the aggregate demand function?
Answer:

• The marginal propensity to import (m) is 0.06. It represents the fraction of additional income that is spent on imports.
• Relationship: The marginal propensity to import reduces the slope of the aggregate demand function. In a closed economy, the slope of the AD function is the MPC (c). In an open economy, the slope becomes (c – m). The higher the value of ‘m’, the flatter the AD curve becomes, as a larger portion of any increase in income “leaks out” of the economy to pay for imports.

11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Answer: The open economy multiplier is smaller because of the leakage caused by imports. In an open economy, a portion of any increase in income is spent on imported goods (determined by the marginal propensity to import, ‘m’). This expenditure does not generate further income within the domestic economy; it “leaks out.” In a closed economy, all induced consumption spending stays within the domestic circular flow. Because of this leakage, each subsequent round of spending is smaller in an open economy than in a closed one, resulting in a smaller overall multiplier effect.

• Closed Economy Multiplier = 1 / (1-c)
• Open Economy Multiplier = 1 / (1-c+m)

12. Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes.
Answer: In an open economy with proportional taxes, the multiplier formula is:
Multiplier = 1 / [1 – c(1-t) + m]
Where:

• c = Marginal Propensity to Consume (MPC)
• t = Proportional tax rate
• m = Marginal Propensity to Import

13. Suppose C = 40 + 0.85YD, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y. Calculate (a) equilibrium income, (b) the balance of trade at equilibrium income, (c) what happens to equilibrium income and the balance of trade when government purchases increase from 40 to 50?
Answer:
(a) Equilibrium Income (Y):
Y = C + I + G + X – M
Y = [40 + 0.85(Y – T)] + 60 + 40 + 90 – (50 + 0.05Y)
Y = 40 + 0.85(Y – 50) + 140 – 0.05Y
Y = 180 + 0.85Y – 42.5 – 0.05Y
Y = 137.5 + 0.80Y
Y – 0.80Y = 137.5
0.20Y = 137.5
Y = 137.5 / 0.20 = 687.5

(b) Balance of Trade (Net Exports, NX) at equilibrium:
NX = X – M = 90 – (50 + 0.05Y)
NX = 40 – 0.05(687.5) = 40 – 34.375 = 5.625 (Trade Surplus)

(c) Effect of G increasing to 50:
ΔG = 10. The multiplier (k) = 1 / (1-c+m) = 1 / (1-0.85+0.05) = 1/0.20 = 5.
ΔY = k × ΔG = 5 × 10 = 50.
New Equilibrium Income = 687.5 + 50 = 737.5.
New Net Exports (NX) = 40 – 0.05(737.5) = 40 – 36.875 = 3.125.
Income increases by 50, and the trade surplus decreases by 2.5.

14. In the above example, if exports change to X = 100, find the change in equilibrium income and the new balance of trade.
Answer:
Change in Exports (ΔX) = 100 – 90 = 10.
Change in Income (ΔY) = Multiplier × ΔX = 5 × 10 = 50.
New Equilibrium Income = 687.5 + 50 = 737.5.
New Net Exports (NX) = (New X – M) = 100 – (50 + 0.05 * 737.5) = 50 – 36.875 = 13.125.
Income increases by 50, and the trade surplus increases by 7.5.

15. Explain why G – T = (S – I) – (X – M).
Answer: This is a fundamental macroeconomic identity. We start with the equilibrium condition in an open economy: Y = C + I + G + X – M.
We also know that national income (Y) from the perspective of households is either consumed (C), saved (S), or paid as taxes (T). So, Y = C + S + T.
Equating the two expressions for Y:
C + I + G + X – M = C + S + T
Canceling ‘C’ from both sides, we get:
I + G + X – M = S + T
Rearranging the terms to match the question’s format:
(G – T) = (S – I) – (X – M)
This identity shows that the government budget deficit must be equal to the sum of the private sector’s savings-investment gap and the trade deficit.

16. If inflation is higher in country A than in country B, and the exchange rate is fixed, what is likely to happen to the trade balance between the two countries?
Answer: If inflation is higher in country A, its goods will become relatively more expensive than country B’s goods. With a fixed exchange rate, this means country A’s exports will become less competitive and decrease, while its imports from country B will become more attractive and increase. This will cause country A’s trade balance to worsen, leading to a larger trade deficit or a smaller trade surplus.

17. Should a current account deficit be a cause for alarm? Explain.
Answer: Yes, a persistent current account deficit can be a cause for alarm. It means a country is spending more than it is earning from the rest of the world. To finance this deficit, the country must either borrow from abroad or sell its assets to foreigners. If this continues for a long time, the country’s external debt will increase, leading to a larger burden of interest payments and potentially triggering a financial crisis if foreign lenders lose confidence. However, a temporary deficit, especially if it is used to finance productive investment that will boost future exports, may not be alarming.

18. Suppose C = 100 + 0.75YD, I = 500, G = 750, taxes are 20 per cent of income, X = 150, M = 100 + 0.2Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.
Answer:
Equilibrium Income (Y):
Y = C + I + G + X – M
Y = [100 + 0.75(Y – 0.2Y)] + 500 + 750 + 150 – (100 + 0.2Y)
Y = 100 + 0.75(0.8Y) + 1400 – 100 – 0.2Y
Y = 1400 + 0.6Y – 0.2Y
Y = 1400 + 0.4Y
Y – 0.4Y = 1400
0.6Y = 1400
Y = 1400 / 0.6 = 2333.33

Budget Deficit/Surplus:
Taxes (T) = 0.2Y = 0.2(2333.33) = 466.67
Government Spending (G) = 750
Budget Deficit = G – T = 750 – 466.67 = 283.33

Trade Deficit/Surplus:
Imports (M) = 100 + 0.2Y = 100 + 0.2(2333.33) = 100 + 466.67 = 566.67
Exports (X) = 150
Trade Deficit = M – X = 566.67 – 150 = 416.67

19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
Answer: To bring stability, countries have historically entered into fixed exchange rate arrangements.

• The Gold Standard: Under this system, countries pegged their currencies to a specific amount of gold, which created fixed exchange rates between them. It provided stability but lacked monetary policy autonomy.
• The Bretton Woods System: After WWII, this system was established. Currencies were pegged to the U.S. dollar, which was, in turn, convertible to gold at a fixed price. This created a stable, “pegged-rate” system that facilitated post-war trade and recovery.
  These systems were designed to reduce exchange rate volatility and uncertainty, thereby promoting stable international trade and investment.

Previous Years’ AHSEC Question Answers (2015-2025)

Long Questions:

1. Distinguish between current account and capital account of the Balance of Payments. (AHSEC 2015, 2018, 2022)
Answer:

2. Discuss the merits and demerits of a flexible exchange rate system. (AHSEC 2016, 2020)
Answer:
Merits:

• Automatic Adjustment: It automatically corrects any disequilibrium (deficit or surplus) in the Balance of Payments through market-driven changes in the exchange rate.
• Monetary Policy Independence: The central bank is free from the obligation of maintaining a fixed rate, so it can use its monetary policy tools to address domestic economic issues like inflation or unemployment.
• No Need for Large Reserves: The government does not need to hold large stocks of foreign exchange reserves to intervene in the market.

Demerits:

• Uncertainty: Frequent fluctuations in the exchange rate create uncertainty for international traders and investors, which can discourage trade.
• Speculation: It can encourage speculative activities, where people buy and sell currency just to make a profit from rate changes, leading to more volatility.
• Inflationary Potential: A sharp depreciation can make imports more expensive, leading to cost-push inflation.

Short Questions:

1. What is the Balance of Trade? (AHSEC 2015)
Answer: It is the difference between the value of a country’s visible exports and visible imports.

2. What is the foreign exchange rate? (AHSEC 2016, 2019)
Answer: It is the rate at which one country’s currency is exchanged for another country’s currency.

3. Write two components of the current account of BoP. (AHSEC 2017)
Answer: (a) Balance of Trade (exports and imports of goods), (b) Balance of Invisibles (exports and imports of services).

4. What is devaluation? (AHSEC 2018)
Answer: It is the deliberate reduction in the value of a country’s currency by the government under a fixed exchange rate system.

5. What is an open economy? (AHSEC 2023)
Answer: An economy that engages in the free exchange of goods, services, and capital with the rest of the world.

6. What is meant by a current account deficit?
Answer: It occurs when a country’s total payments on the current account (for imports, services, transfers) exceed its total receipts.

7. Write one component of the capital account of BoP.
Answer: Foreign Direct Investment (FDI).

8. What is Purchasing Power Parity (PPP)?
Answer: A theory which states that, in the long run, the exchange rate between two currencies should adjust to equalize the price of an identical basket of goods and services in the two countries.

9. What is meant by speculation in the context of foreign exchange?
Answer: The act of buying or selling a currency with the sole motive of profiting from its future price movements.

10. What was the Bretton Woods System?
Answer: It was a system of pegged exchange rates established after World War II, where currencies were pegged to the US dollar, and the US dollar was pegged to gold.

10 Additional Most Important Question Answers

1. Question: Why does the BoP always balance in an accounting sense?
   Answer: Because it is prepared using the double-entry bookkeeping system, where every transaction has a corresponding credit and debit entry, ensuring the final balance is always zero.
2. Question: What are ‘Net Exports’?
   Answer: The value of total exports minus the value of total imports.
3. Question: If the exchange rate changes from $1 = ₹80 to $1 = ₹85, what has happened to the rupee?
   Answer: The rupee has depreciated.
4. Question: Why is there a demand for foreign currency?
   Answer: To pay for imports, to invest abroad, and to send gifts or transfers abroad.
5. Question: What are the sources of supply of foreign currency?
   Answer: From exports, from foreign investment, and from unilateral transfers received from abroad.
6. Question: Why is the open economy multiplier smaller than the closed economy multiplier?
   Answer: Because imports act as a leakage from the circular flow of income.
7. Question: The sum of the current account and capital account is equal to what?
   Answer: Zero, if official reserve transactions are included in the capital account.
8. Question: Which is a broader concept: trade deficit or current account deficit?
   Answer: Current account deficit, as it also includes the deficit in services and transfers.
9. Question: What type of exchange rate system does India currently follow?
   Answer: A managed floating exchange rate system.
10. Question: If a country’s income increases, what is the likely effect on its currency value?
    Answer: An increase in income leads to higher demand for imports, which increases the demand for foreign currency and can cause the domestic currency to depreciate.