Open-Economy Macroeconomics- NCERT Notes UPSC

Influence of Foreign Trade on Aggregate Demand (AD)

Aggregate demand is the total demand for goods and services within a particular market. Foreign trade can influence the AD in the country in two ways: 

• First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing AD. 
• Second, our exports to foreigners enter as an injection into the circular flow, increasing AD for goods produced within the domestic economy. 

Exchange Mechanism in Foreign Trade

• Generally, the economic agents involved in foreign trade accept currencies that are relatively stable (the value of the currency does not change frequently) and have international acceptance. 
• Different currencies have different values. Thus, in order to facilitate foreign trade, the government announced that the national currency will be freely convertible at a fixed price into another asset.
• It requires the credibility of the issuing authority and a guarantee to transfer purchasing power in the hands of even the international holders of the currency. 
• This is generally ensured by allowing for the convertibility of the currency into some common form of asset. 
• In modern times currencies are interpreted in terms of exchange rates that is the price of one currency in terms of another currency. 

There are two aspects of this commitment that has affected its credibility:

• The ability to convert freely in unlimited amounts and the price at which this conversion takes place. The international monetary system has been set up to handle these issues and ensure stability in international transactions. 
• With the increase in the volume of transactions, gold ceased to be the asset into which national currencies could be converted. 

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Balance of Payments (BoP)

It is a record of the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year. 

There are two main accounts maintained under BoP which are the current account and the capital account. 

Current Account

• It is the record of trade in goods and services and transfer payments. 
• There are three main components in the current account which are, trade in goods, trade in services and transfer payments. 

Components of Current Account

• Trade in goods includes exports and imports of goods. 
• Trade in services includes factor income and non-factor income transactions. 
• Transfer payments are the receipts which the residents of a country get for ‘free’, without having to provide any goods or services in return. They could be given by the government or by private citizens living abroad.
• Balance on Current Account: Current Account is in balance when receipts on the current account are equal to the payments on the current account. 

• A surplus current account means that the nation is a lender to other countries. 
• A deficit current account means that the nation is a borrower from other countries.

• Balance on current account has two components such as the balance of trade and ·balance on Invisibles.
• Balance of trade (BoT): It is the difference between the value of exports and the value of imports of goods of a country in a given period of time. 

• Export of goods is entered as a credit item in BoT, whereas import of goods is entered as a debit item in BoT.
• Surplus BoT or Trade surplus will arise if the country exports more goods than what it imports. Whereas deficit BoT or Trade deficit will arise if a country imports more goods than what it exports.
• Balance of Invisibles (BoI): It is also referred to as net invisibles. It is the difference between the value of exports and the value of imports of Invisibles of a country in a given period of time.

• Invisibles include services, transfers and flows of income that take place between different countries. 
• Services trade includes both factor and non-factor income. Factor income includes net international earnings on factors of production (like labour, land and capital). 
• Non-factor income is the net sale of service products like shipping, banking, tourism, software services, etc.

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Capital Account

• It records all international transactions of assets. An asset is any one of the forms in which wealth can be held, for example, money, stocks, bonds, Government debt, etc. 
• There are three main components of a capital account which are an investment, external borrowings and external assistance. 

Components of Capital Account

• Purchase of assets is a debit item on the capital account. If an Indian buy a UK Car Company, it enters capital account transactions as a debit item (as foreign exchange is flowing out of India). The sale of assets like the sale of a share of an Indian company to a Chinese customer is a credit item on the capital account.
• Balance on Capital Account: Capital account is in balance when capital inflows (like receipt of loans from abroad, sale of assets or shares in foreign companies) are equal to capital outflows (like repayment of loans, purchase of assets or shares in foreign countries). 

• Surplus in capital account arises when capital inflows are greater than capital outflows.
• Deficit in the capital account arises when capital inflows are lesser than capital outflows.

Surplus and Deficits in the Balance of Payments

• A country that has a deficit in its current account (spending more than it receives from sales to the rest of the world) must finance it by selling assets or by borrowing from abroad. 
• Thus, any current account deficit must be financed by a capital account surplus, that is, a net capital inflow. 

Current account + Capital account = 0

• In this case, in which a country is said to be in a balance of payments equilibrium, the current account deficit is financed entirely by international lending without any reserve movements. 
• Alternatively, the country could use its reserves of foreign exchange in order to balance any deficit in its balance of payments. 
• The reserve bank sells foreign exchange when there is a deficit. This is called an official reserve sale. 
• The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus). We note that official reserve transactions are more relevant under a regime of fixed exchange rates than when exchange rates are floating. 

Autonomous Transactions

• It is also called “above the line” items in BoP.
• International economic transactions are called autonomous when transactions are made due to some reason other than to bridge the gap in the balance of payments, that is when they are independent of the state of BoP. 
• The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments. 

Accommodating Transactions 

• It is also called “below the line” items in BoP. It depends, on whether there is a deficit or surplus in the balance of payments.
• They are determined by the gap in the balance of payments. 
• They are also determined by the net consequences of the autonomous transactions. 
• Since the official reserve transactions are made to bridge the gap in the BoP, they are seen as the accommodating item in the BoP (all others being autonomous).

The Foreign Exchange Market

It is the market in which national currencies are traded for one another. The rate at which the price of one currency is determined in terms of another is called the foreign exchange rate or forex rate.

Demand for Foreign Exchange

• The demand for foreign exchange arises due to various reasons such as purchasing goods, sending gifts abroad or purchasing financial assets of a certain foreign country. 
• A rise in the price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign good. This reduces demand for imports and hence the demand for foreign exchange also decreases. 

Supply of Foreign Exchange: 

• Supply of foreign exchange arises due to the inflow of foreign currency flows into the home country.  
• The reasons are exports by a country lead to an inflow of forex, foreigners send gifts or make transfers, and the assets of a home country are bought by the foreigners. 
• A rise in the price of foreign exchange will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant. 
• This increases India’s exports and hence the supply of foreign exchange may increase.

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Determination of the Exchange Rate

Various countries use different methods to determine the exchange rates. These methods are as follows: 

Flexible Exchange

• It is also known as floating exchange rate.
• Under this system, the exchange rate is determined by the market forces of demand and supply. 
• In a completely flexible system, the Central banks do not intervene in the foreign exchange market. 
• An increase in exchange rate implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased and vice-versa.

• When the price of domestic currency (rupee) in terms of foreign currency (dollar) decreases, it is called the depreciation of the domestic currency.
• Similarly, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is called appreciation of the domestic currency.

• In a flexible exchange regime, the market determines the currency exchange rate. The exchange rate is typically determined at the equilibrium point on the demand and supply curve. 
• More demand for foreign goods may increase the exchange rate because more of domestic currency has to be paid in order to obtain a unit of foreign currency.

Fixed Exchange Rates

• In this system, the Government fixes the exchange rate at a particular level. 
• The government can maintain any exchange rate in the economy. But it will be accumulating more and more foreign exchange so long as this intervention goes on.
• Devaluation: It makes the domestic currency cheaper for foreigners by fixing a higher exchange rate than the current one. It is done to encourage exports.
• Revaluation: When the government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system

Demerits and Merits of Flexible and Fixed Exchange Rate Systems

Demerits of Fixed Exchange Rate System

• In order for this system to work, there must be credibility that the government will be able to maintain the exchange rate at the level specified. 
• In case of a deficit in BoP, governments will have to intervene to take care of the gap by use of their official reserves. 
• In case people learn that the amount in these reserves is insufficient to do so they would begin to doubt the ability of the government to maintain the fixed rate. 
• This may give rise to speculation of devaluation. When this belief translates into aggressive buying of one currency thereby forcing the government to devalue, 
• It is said to constitute a speculative attack on a currency. Fixed exchange rates are prone to these kinds of attacks.

Managed Floating Exchange Rate System: 

• It is also known as dirty floating exchange rate.
• It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part). 
• In this exchange rate regime, RBI intervene in the market to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. 
• Official reserve transactions are, therefore, not equal to zero. 

Exchange Rate Management: The International Experience and Evolution 

• From around 1870 to the outbreak of the First World War in 1914, the prevailing system to determine the exchange rate of various currencies was the gold standard. 
• Under it, all currencies were defined in terms of gold.
• Each country in the framework of this system, committed to guarantee the free convertibility of its currency into gold at a fixed price.
• This also made it possible for each currency to be convertible into all others at a fixed price. 
• Exchange rates were determined by its worth in terms of gold.
• To maintain the official parity each country needed an adequate stock of gold reserves. 
• All countries on the gold standard had stable exchange rates.
• However, certain problem arose under this system: 

• World prices were at the mercy of gold discovery.
• Subsequently, with mine being unable to produce sufficient gold, the world prices started to fall. 
• This gave rise to social unrest in many countries. 
• Some alternate ways emerged such as: 
• For a period, silver supplemented gold introducing ‘bimetallism’. 

• Under fractional reserve banking the paper currency of countries was not entirely backed by gold; typically, countries held one-fourth gold against its paper currency. 
• Under gold exchange standard, countries although fixed their currency prices based on gold, but held little or no gold reserves instead, held the currency of some large country which was on the gold standard. 
• Post-World War 2 Bretton Woods Conference was held in 1944. It made the following changes in the International Exchange Rate Systems: 

• International Monetary Fund (IMF) and the World Bank were set up.
• A system of fixed exchange rates was re-established. 
• This was different from the international gold standard in the choice of the asset in which national currencies would be convertible.
• A two-tier system of convertibility was established at the centre of which was the dollar. 
• The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $35 per ounce of gold. 

• The second tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price (called the official exchange rate).
• A change in exchange rates was to be permitted only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a chronic deficit in the BoP of sizeable proportions.

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Reasons for introducing this system:

• Distribution of gold reserves across countries was uneven with the US having almost 70 per cent of the official world gold reserves. 
• A credible gold convertibility would have required massive re-distribution of gold reserves.
• It was believed that the existing gold stock would be insufficient to sustain the growing demand for international liquidity. 
• Post–World War II scenario, countries devastated by the war needed enormous resources for reconstruction, raising their imports which put pressure on their forex reserves to finance the BoP deficit. These reserves mainly consisted of US Dollars at that time. 

Problems with this system:

• The holdings of US Dollars by other countries, was in effect a liability for the US to convert dollars into gold whenever needed. 
• Such an extent of the liability in relation to its gold reserves could put convertibility in doubt. 
• The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. 
• This was called the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. 

Further Evolution

• In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF as a replacement to gold as an international reserve standard.
• However, SDRs were defined in terms of gold.
• At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, pound sterling). 
• It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. 
• The original instalments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade). 

Slowly many countries began to adopt the floating exchange rates, and IMF gave the freedom to countries to decide, if they wanted to go for a floating market-determined exchange rate, or peg (tie the exchange rate) their currencies to a particular asset like the SDR. 

The Current Scenario

• Today, the global exchange rate system is characterized by multiple kinds of regimes, involving free-floating exchange rates, pegging their exchange rates to other developed countries, introducing common currencies like Euro etc.   
• Most exchange rates fluctuate slightly on a day-to-day basis, with even those nations tilting towards fixed exchange rate systems, only specifying a certain range for their currency instead of actually fixing them. 
• Gold is now not being used for exchange rate purposes, instead, the prices of gold are controlled by demand and supply. 

Exchange Rate Management in India

• Post-independence, in line with Bretton Woods system Rupee, was pegged to the pound sterling. 
• The rupee was devalued by 36.5 per cent in June 1966. 
• The rupee was delinked from the pound sterling in September 1975, due to the breakdown of Bretton Woods system and declining share of UK in India’s trade.  
• During the period between 1975 to 1992, the exchange rate of the rupee was officially determined by the Reserve Bank within a nominal band of plus or minus 5 per cent of the weighted basket of currencies of India’s major trading partners.
• Requiring day-to-day intervention of the Reserve Bank, which resulted in wide changes in the size of reserves. 
• The exchange rate regime of this period can be described as an adjustable nominal peg with a band. 
• In the beginning of 1990s, the situation for India became problematic requiring reforms in line with IMF recommendations (explained in class 11th Notes).   
• Along with other reforms, there was a two-step devaluation of 1 8 –19 per cent of the rupee on July 1 and 3, 1991. 
• In March 1992, the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rates was introduced. 
• Under this system, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank and 60 per cent was to be converted at the market-determined rates.
• The dual rates were converged into one from March 1, 1993. 
• Current account convertibility was achieved in August 1994. Meaning that the Rupee could now by converted into any foreign currency at existing market rates for trade purposes for nay amount. 
• The exchange rate of the rupee thus became market-determined, with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases.

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