MACROECONOMICS – NOTES – B. Com 2nd Semester (CBCS) Unit 4 – Open Economy

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Unit 4

Open Economy


Flows of goods and capital, saving and investment in a small and a large open economy

Open economy is an important concept of International Macroeconomics. Openness is measured by the ratio of a country’s exports or imports to its GDP. In recent years all major market economies have increasingly opened their borders to foreign trade and foreign capital. The result is a growing share of output and consumption involved in international trade.

Every country has its own choice that whether the economy will be open or closed. Open economy indicates trade with a domestic country and with the rest of the world where as closed economy indicates trade barriers of a domestic country with rest of the world. In case of an open economy the national income accounts identity of a country can be expressed as:

Y=C+I+G+X-M …………………… (1)

Where, Consumption refers to Household expenditure on various goods and services. Goods are of three types: non-durables, durables and services.

Investment refers to capital goods, which are purchased for producing mainly consumer goods in the economy. Government purchases are the various goods and services purchased by the central, state and the local governments. Transfer payments such pension funds does not include in the GDP since they does not account for any production. In an open economy the national income identity includes the Net Export (NX) which is the difference between exports and imports. The national income accounts identity shows how the domestic output, domestic spending and net exports are related. In particular,

NX= Y- (C+I+G) ………………………. (2)

Net Exports=Output-Domestic Spending

This equation shows that domestic spending need not be equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive.

The Income identity in equation 1 can also be expressed as :

Y= C+S+T ………………………. (2)

Now from equation (1) and (2), we get,


Or, S+T=I+G+X-M

Or, S+T+M=I+G+X

This implies that the sum total of leakages from the circular flow of income=the sum total of injections in to the circular flow.

Another interpretation of the above identity

The above equation can be expressed as:

I + G + X = S + T + M

Or, I = S + (T – G) + (M – X)

Total Investment=Household savings+ budget surplus + trade deficit

Savings and Investment in a Small and a Large Open economy

A closed economy country does not have to bother about the BOP of the foreign countries and there is no favorable or unfavorable BOP. Whereas in an open economy such favorable and unfavorable BOP has considerable effect on the country as well as on the economy. Thus an open economy suffers from trade deficit if its imports exceed its exports, in which case it can borrow financial capital from other countries or from the international capital markets.

A small open economy has been considered with perfect capital mobility. In the context of international capital flows, a small country is the one which has no influence over the world rate of interest. The term perfect mobility refers to the fact that the people of a country can borrow or lend freely in the absence of government intervention in the world capital markets.

Due to perfect capital mobility, the domestic rate of interest r is the same as that of the world rate of interest r*. Both the domestic and world rate of interest is determined by savings and investment.

Exchange Rates

Exchange rate is the rate at which the currency of one country is exchanged for the currency for another country. According to David Ricardo, international trade is a highly organized system of barter. In his theory of comparative cost advantage, the commodities and money is not used as a medium of exchange. However, in modern times the world has changed and thus the relevant concept is the exchange rate.

Nominal and real exchange rate: It is the exchange rate of a currency against any other. It is thus a bilateral concept.

Effective exchange rate (EER): It is weighted average of nominal rates, the weights being the shares of the respective countries in the trade of the country for which the EER is being calculated.

Real Exchange rate: It is designed to measure the rate at which home goods exchange for foreign goods rather than the rate at which currencies themselves are traded.


Real effective exchange rate: This is the overall RER for the economy. It is the weighted average of the RERs for all its trade partners, the weights being the shares of the respective countries in its foreign trade. It may be interpreted as the quantity of domestic goods which is to be given up to get one unit of a given basket of foreign goods.

The Balance of Trade is equal to net capital outflow, which in turn, equals S-I. Saving depends on C, G and T. Investment depends on both the domestic and the world rate of interest. In a world of perfect capital mobility, there is only one rate of interest.

The Mundell-Fleming Model

Through his celebrated article “The Appropriate Use of Fiscal and Monetary Policy for Internal and External Stability”, Mundell stressed not only the need of a monetary-fiscal policy mix to achieve the internal and external stability but also attempted to provide an answer to a very crucial question concerning the policy priorities in different economic situations like internal unemployment and inflation coupled with external surplus or deficit. Murcas Fleming like Mundell discussed how monetary and fiscal policies work under the fixed and flexible exchange system when there is perfect capital mobility.

The Mundell-Flemming Model is based on the following assumptions-

  1. The changes in the size of budget surplus can be treated as an index of fiscal policy. A reduction in budget surplus implies the expansionary fiscal policy and vice-versa.
  2. The changes in the rate of interest can be viewed as an index of monetary policy. A fall in the interest rate denotes an expansionary monetary policy and vice-versa.
  3. The exports are exogenously given and imports are a positive function of income.
  4. The foreign capital is sensitive to the movements in the domestic rate of interest.
  5. There is perfect mobility of capital.

Given these assumptions the Mundell-Fluming model can be analyzed under four heads as described below.

Policy under Perfect Capital Mobility

In this case we have two situations, one under fixed exchange rate and the other under flexible exchange rate.

Perfect Capital Mobility and Fixed Exchange Rate

Fixed Exchange Rate and Fiscal Policy: This can be explained with the help of a diagram below.

In the figure 5 above, the economy is initially in equilibrium at point E1. The IS and LM curves intersect on the horizontal line BB which shows that due to perfect capital mobility, domestic rate of interest cannot get out of line with the fixed interest rate. Any expansionary fiscal action i.e. increase in government expenditure or a cut in taxes will shift the IS curve from IS1 to IS2. This in turn raises the rate of interest from r to r1. This leads to a massive inflow of capital i.e. investors buy domestic bonds on a massive scale. In such a situation, the interest rate can be kept fixed only if RBI buys up dollars from the market in exchange for rupees. This action will in turn cause money supply to expand and the LM curve will shift to the right from LM1 to LM2. Thus the new and final equilibrium will be determined at E2 and the initial rate of interest r is restored and at this new equilibrium level there is a positive impact on income.

Fixed Exchange and Monetary Policy: This can be explained with the help of the figure 6 below.

The above figure shows how increase in money supply affects under fixed exchange rate. In the figure, with the increase in domestic money supply the LM curve shifts from LM1 to LM2 i.e. to the right. This in turn reduces the rate of interest from r to r1. The fall in the rate of interest will lead to massive capital flight from the domestic country. In order to keep the exchange rate fixed, the RBI will have to sell dollars for rupees from its stock. This will cause the domestic money supply to fall and the process will continue until LM shifts to LM1 i.e. to its initial position. The income has fallen back to the initial level. Thus, under perfect capital mobility and fixed exchange rate the monetary policy loses its effectiveness completely.

Perfect Capital Mobility and Flexible Exchange Rate

Flexible Exchange and Fiscal Policy: In case of flexible exchange rate the government does not intervene, the market forces set back the equilibrium. The impact of flexible exchange and full capital mobility is illustrated in figure 7 below.

In the above figure 7, the initial equilibrium point is at E1where IS1 and LM curves intersects ad the interest rate r is determined. With the expansionary fiscal policy the IS curve shifts rightward from IS1 to IS2. The LM being constant the new equilibrium rate of interest is r1. This higher interest rate will increase the capital inflow in the domestic country and the rupee will appreciate as a result. This in turn causes a decline in net export (NX) and shift the IS curve back to the left. Thus, the equilibrium will be restored only when the IS curve shift back to its original position. Thus, at rate of interest r the capital inflows and exchange rate appreciation will stop. The output is back to the initial level. Thus, in case of fiscal expansion in case of flexible exchange rate the fiscal policy is completely ineffective.

Flexible Exchange and Monetary Policy: The expansion of monetary policy and its policy implication are discussed with the help of the figure 8 below.

Suppose, the initial equilibrium is at point E1 where IS1 and LM1 curves intersect. At this point the interest rate r is determined and income is OY. Now, suppose there is an increase in money supply which in turn shifts the LM curve from LM1 to LM2. This in turn reduces the interest rate to r1 which leads to massive outflow of capital from the domestic country. Since the RBI does not intervene the rupee depreciates. Depreciation of rupee in turn increases export and hence reduces imports and as a result net export increases. Rise in net export causes the IS curve to shift rightward from IS1 to IS2. Final equilibrium is at E2 with r rate of interest. Thus, monetary policy has maximum impact on income under flexible exchange rate.

Interest Differential

An interest rate differential is a difference in interest rate between two currencies in a pair. If one currency has an interest rate of 3% and the other has an interest rate of 1%, it has a 2% interest rate differential. The use of interest rate differentials is of particular concern in foreign exchange markets for pricing purposes.

If you were to buy the currency that pays 3% against the currency that pays 1%, you would be paid on the difference with daily interest payments. This simple definition is known as the carry trade, earning carry on the interest rate differential. Developments in recent years have brought interest rate differentials to a new light that are worth investigating.

In general, an interest rate differential (IRD) weighs the contrast in interest rates between two similar interest-bearing assets. Traders in the foreign exchange market use IRDs when pricing forward exchange rates.

Based on the interest rate parity a trader can create an expectation of the future exchange rate between two currencies and set the premium, or discount, on the current market exchange rate future contracts.

Interest rate differentials simply measure the difference in interest rates between two securities. If one bond yields 5% and another 3%, the IRD would be 2 percentage points. IRD calculations are most often used in fixed income trading, forex trading, and lending calculations.

The interest rate differential is used in the housing market to describe the difference between the interest rate and a bank’s posted rate on the prepayment date for mortgages. The IRD is a key component of the carry trade. A carry trade is a strategy that foreign exchange traders use in an attempt to profit from the difference between interest rates, and if traders are long a currency pair, they may be able to profit from a rise in currency pair. Interest Rate Differential: A Trade Example The IRD is the amount the investor can expect to profit using a carry trade. Say an investor borrows $1,000 and converts the funds into British pounds, allowing him to purchase a British bond. If the purchased bond yields 7% while the equivalent U.S. bond yields 3%, then the IRD equals 4%, or 7% – 3%. This profit is ensured only if the exchange rate between dollars and pounds remains constant.

One of the primary risks involved with this strategy is the uncertainty of currency fluctuations. In this example, if the British pound were to fall in relation to the U.S. dollar, the trader may experience losses.

Additionally, traders may use leverage, such as a factor of 10-to-1, to improve their profit potential. If the investor leveraged his borrowing by a factor of 10-to-1, he could make a profit of 40%. However, leverage could also cause large losses if there are large movements in exchange rates.

Interest Rate Differential

A Mortgage Example: When homebuyers borrow money to purchase houses, there may be an interest rate differential. For example, say a homebuyer purchased a home and took out a mortgage at a rate of 5.50% for 30 years. Assume 25 years have passed and the borrower only has five years left in his mortgage term. The lender could use the current market interest rate it is offering for a five-year mortgage to determine the interest rate differential. If the current market interest rate on a five-year mortgage is 3.85%, the interest rate differential is 1.65%, or 0.1375% per month.

The Difference between IRD and Net Interest Rate Differential (NIRD)

The net interest rate differential (NIRD) is a specific type of IRD used in Forex markets. In international currency markets, the NIRD is the difference in the interest rates of two distinct economic regions.

For instance, if a trader is long the NZD/USD pair, he or she owns the New Zealand currency and borrows the US currency. These New Zealand dollars can be placed into a New Zealand bank while simultaneously taking out a loan for the same amount from the U.S. bank. The net interest rate differential is the difference in any interest earned and any interest paid while holding the currency pair position.



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