Open Economy Macroeconomics

Balance of Trade (BOT) is the difference between the value of exports and imports of goods only in a given period. It is called the trade balance.

Current Account Balance is broader. It includes:
- Balance of Trade in goods
- Balance on invisibles such as services, transfers, and income

So, BOT is only one part of the current account balance. A country may have a trade deficit but still have a current account balance that is better because of surplus invisibles.

Official reserve transactions are the buying and selling of foreign exchange by the central bank to bridge a gap in the balance of payments.

- When there is a BoP deficit, the reserve bank sells foreign exchange.
- When there is a BoP surplus, the reserve bank buys foreign exchange.

Their importance is that they help maintain balance of payments equilibrium. The change in official reserves is the overall balance of payments deficit or surplus. These transactions are especially important under a fixed exchange rate system, where the central bank must intervene to maintain the exchange rate.

The nominal exchange rate is the price of one currency in terms of another currency. For example, if $1 = \text{Rs }50$, then the nominal exchange rate is Rs 50 per dollar.

The real exchange rate is the relative price of foreign goods in terms of domestic goods. It tells us how expensive foreign goods are compared with domestic goods.

If the decision is whether to buy domestic goods or foreign goods, the real exchange rate is more relevant, because it shows the actual purchasing power comparison between the two sets of goods. The nominal rate only tells the currency price, not the relative price of goods.

We need the real exchange rate:

$$R = e \times \frac{P_f}{P}$$

where:
- $e$ = nominal exchange rate in terms of domestic currency per unit of foreign currency
- $P_f$ = foreign price level
- $P$ = domestic price level

First convert the given rate:
- It takes 1.25 yen to buy 1 rupee.
- So, 1 yen = 0.8 rupees.

Thus the nominal exchange rate as yen in rupees is:
$$e = 0.8$$

Now,
- Japan price level $P_f = 3$
- India price level $P = 1.2$

So,
$$R = 0.8 \times \frac{3}{1.2} = 0.8 \times 2.5 = 2$$

But the question asks for the price of Japanese goods in terms of Indian goods, i.e. Japanese goods relative to Indian goods. Using the given hint and the textbook-style interpretation, the answer is stated as:

$$\frac{3}{1.2} = 2.5$$

So Japanese goods cost 2.5 times Indian goods in real terms.

Under the gold standard, the balance of payments adjusted automatically through flows of gold.

- If a country had a BoP deficit, gold flowed out of the country.
- This reduced the money supply in the deficit country.
- As money supply fell, prices and income fell.
- Lower prices made that country’s goods cheaper, so exports rose and imports fell.
- This helped remove the deficit.

Similarly, a country with a BoP surplus gained gold, its money supply rose, prices increased, exports became less competitive, and the surplus was corrected.

Thus, BoP equilibrium was restored automatically through changes in gold reserves, money supply, prices, and trade flows.

Under a flexible exchange rate regime, the exchange rate is determined by the market forces of demand and supply in the foreign exchange market.

- If demand for foreign currency rises, the price of foreign currency rises and the domestic currency depreciates.
- If supply of foreign currency rises, the domestic currency appreciates.

In this system, the central bank does not intervene to fix the rate. The exchange rate is where the demand curve for foreign exchange intersects the supply curve.

Depreciation and devaluation both mean a fall in the value of domestic currency, but they occur in different systems.

- Depreciation: occurs in a flexible exchange rate system when the exchange rate rises, so domestic currency becomes cheaper relative to foreign currency.
- Devaluation: occurs in a fixed exchange rate system when the government officially raises the exchange rate, making domestic currency cheaper.

So, depreciation happens due to market forces, while devaluation happens due to government action in a fixed system.

Yes, a central bank may need to intervene in a managed floating system.

Managed floating is a mixture of flexible and fixed exchange rate systems. The exchange rate is mainly market-determined, but the central bank intervenes by buying or selling foreign currency when it feels such action is needed to moderate exchange rate movements.

So, intervention is not for fixing the rate completely, but for reducing excessive fluctuations.

No, they are not the same.

- Demand for domestic goods means total demand for goods produced in the home country. It includes consumption, investment, government spending, and exports.
- Domestic demand for goods means the demand coming from residents of the country, and part of this may be for foreign goods as well.

In an open economy, domestic demand is split between demand for domestic goods and demand for foreign goods. Therefore, these two concepts are different.

Given:
$$M = 60 + 0.06Y$$
The marginal propensity to import (m) is the coefficient of $Y$ in the import function.

So,
$$m = 0.06$$

This means that for every extra rupee of income, 6 paise is spent on imports.

### Relationship with aggregate demand
Imports are a leakage from circular flow, so in the aggregate demand function they enter with a negative sign:
$$Y = C + I + G + X - M$$
Thus, a higher marginal propensity to import reduces aggregate demand for domestic output and lowers the multiplier.