Open Economy Macroeconomics

An economy trading with the world: the balance of payments, current and capital accounts, trade balance, exchange rates, depreciation and devaluation, and purchasing power parity.

Key ideas

• The balance of payments records all of a country’s transactions with the rest of the world in a year.
• The current account records trade in goods and services, incomes and transfers; the capital account records transactions in assets such as FDI, portfolio investment and loans.
• Exports minus imports of goods is the balance of trade; services, incomes and transfers are the invisibles.
• Autonomous transactions are made for their own sake; accommodating ones (official reserve changes) cover the gap that is left.
• Under a flexible rate, the exchange rate is set by the demand for and supply of foreign exchange; more demand for dollars makes the rupee depreciate.
• Depreciation is a market fall in a currency’s value; devaluation is a fall fixed by the government; managed floating lets the central bank limit swings.
• Purchasing power parity says that in the long run the exchange rate makes the same good cost the same in every country.

Remember

Watch out

• Saying the rupee appreciates when the rupee price of a dollar rises (it depreciates).
• Putting FDI in the current account (it belongs in the capital account).
• Mixing up depreciation (market) and devaluation (set by the government).

Worked example