Open Economy Macroeconomics

An open economy trades goods, services and financial assets with other countries, so its consumers, firms and government are linked to world markets through exports, imports, foreign investment and the exchange rate. In this chapter you will study the balance of payments, a systematic record of all economic transactions between residents of a country and the rest of the world in a year. You will learn its two main parts: the current account, covering trade in goods, services, income and transfers, and the capital account, covering foreign investment, loans and banking capital, and the meaning of trade balance and current account deficit. You will distinguish autonomous from accommodating transactions and understand surpluses and deficits in the balance of payments and the role of foreign exchange reserves. The chapter explains the foreign exchange market, how demand for and supply of foreign currency determine the exchange rate under a flexible system, the meaning of depreciation and appreciation, devaluation and revaluation, and the managed floating system followed by India.

Detailed Worksheet: Open Economy Macroeconomics Section A - Definitions (10 marks) 1. Define balance of payments. Name its two main accounts. (2 marks) 2. Distinguish between balance of trade and balance on current account. (2 marks) 3. What are autonomous transactions and accommodating transactions in the balance of payments? (2 marks) 4. Define the foreign exchange rate. Distinguish between a fixed and a flexible exchange rate. (2 marks) 5. Distinguish between depreciation and devaluation of a currency. (2 marks) Section B - Calculations and Applications (15 marks) 6. From the following data (Rs crore), calculate the balance of trade and the balance on current account: exports of goods 500, imports of goods 700, exports of services 300, imports of services 150, net transfers received 80. (3 marks) 7. The exchange rate changes from Rs 80 per US dollar to Rs 84 per US dollar. Calculate the percentage depreciation of the rupee, and the change in the rupee cost of importing goods worth 1,000 US dollars. (3 marks) 8. The demand for US dollars in India is Qd = 1,000 - 10e and the supply is Qs = 200 + 6e, where e is rupees per dollar and Q is in million dollars. Calculate the equilibrium exchange rate and quantity. (3 marks) 9. A country has a current account deficit of Rs 50,000 crore and a capital account surplus of Rs 30,000 crore (with no errors and omissions). Calculate the overall balance of payments position and explain how it will be settled. (3 marks) 10. An Indian shirt is priced at Rs 1,600. Calculate its dollar price at exchange rates of Rs 80 per dollar and Rs 64 per dollar. Explain how appreciation of the rupee affects Indian exports. (3 marks) Section C - Diagrams (10 marks) 11. Draw a diagram showing the determination of the equilibrium exchange rate in a flexible exchange rate system, with the demand and supply curves of foreign exchange. Explain why the demand curve slopes downward. (4 marks) 12. Draw a diagram showing the effect of an increase in demand for foreign exchange (for example, more imports) on the exchange rate. (3 marks) 13. Draw a chart showing the structure of the balance of payments: current account (visible trade, invisibles: services, income, transfers) and capital account (FDI, portfolio investment, loans, banking capital). (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. Explain the sources of demand for and supply of foreign exchange. Why does the supply curve of foreign exchange slope upward? (5 marks) 15. The Indian rupee depreciated against the US dollar. Analyse the effects on (i) Indian exporters of software, (ii) students going abroad for studies, (iii) oil import bills and inflation and (iv) foreign tourists visiting India. (5 marks) 16. Compare the fixed and flexible exchange rate systems on four bases. Explain the managed floating system and how the RBI uses foreign exchange reserves to prevent sharp swings in the rupee. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show working for every calculation with units. Draw neat, labelled diagrams.