An open economy is one that trades with other nations in goods and services and also in financial assets. Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. when goods move across national borders, money must move in the opposite direction.

Balance of Payments

The balance of payments (BoP) record 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 in the BoP - the current account and the capital account. Errors and Omissions constitute the third element in the BoP which is the balancing item reflecting the inability to record all international transactions accurately.

Current Account

The current account records exports and imports in goods and services and transfer payments. When exports exceed imports, there is a trade surplus and when imports exceed exports there is a trade deficit. Trade in services, denoted as invisible trade, includes both factor income and net non-factor income.

Transfer payments are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. They consist of remittances, gifts and grants.

The balance of exports and imports of goods is referred to as the trade balance. Adding trade in services and net transfers to the trade balance, you get the current account balance.

  • Import, Export (always negative, because India exports less than imports)
  • Income from abroad (interest, dividends, etc.)
  • Transfer (gifts, remittances from NRI to their families, etc; always positive for India)

Capital Account

The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc. Any transaction resulting in a payment to foreigners is entered as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive sign.

Balance of Payment (BoP) is the summary or account sheet that shows the cash flow between India and rest of the world. BoP is made up of two parts - current account and capital account. The BoP accounting system is similar to double entry book-keeping.

  • Foreign investment in India (FDI, FII, ADR, direct purchase of land, assets).
  • External commercial borrowing, external assistance, foreign loans, etc.
  • Portfolio investment

BoP Surplus and Deficit

A country that has a deficit in its current account must finance it by selling assets or by borrowing abroad. Thus, any current account deficit is of necessity financed by a net capital inflow.

Alternatively, the country could engage in official reserve transactions, running down its reserves of foreign exchange, in the case of a deficit by selling foreign currency in the foreign exchange market. The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus).

Foreign Exchange Market

The market in which national currencies are traded for one another. The major participants in this market are commercial banks, foreign exchange brokers and other authorized dealers and the monetary authorities.

The price of one currency in terms of the other is known as the exchange rate. It is measured as the price of foreign currency in terms of domestic currency. This is the bilateral nominal exchange rate. Real exchange rate is the ratio of foreign to domestic prices, measured in the same currency. If the real exchange rate is equal to one, currencies are at purchasing power parity.

Nominal Effective Exchange Rate (NEER) is a multilateral rate that represents the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade.

Flexible Exchange Rates

In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply.

Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s. Prior to that, most countries had fixed
or pegged exchange rate system, in which the exchange rate is pegged at a particular level.

Foreign Exchange Reserves

Prior to 1991, India followed License and import substitution strategy. During that era, foreign companies could not invest in India. Imported products attracted heavy custom duty. The private Indian companies were inefficient to compete in international market, so exports were also low.

During that time, incoming money (exports, investments) was very low. Hence, RBI was not able to build up huge Forex reserve. In 1991, the Forex reverses of India were about to exhaust. India had to pledge its gold to IMF and get loans.

Then, India had to open up its economy for private and foreign sector investment and remove the license raj to boost the incoming flow of dollars and other foreign currencies.

India’s foreign exchange reserves is made up of

  • Foreign Currency Assets (FCA)
  • Gold
  • Special Drawing Rghts (SDRs) of IMF
  • Reserve Tranche Position (RTP) in IMF

The level of Forex reserve is expressed in US dollars. Hence, India’s Forex reserve declines when US dollar appreciates against major international currencies and vice-versa.

National Income In Open Economy

In a closed economy, there are three sources of demand for domestic goods - Consumption (C ), government spending (G), and domestic investment (I). 

Y = C + I + G

In an open economy, exports (X) constitute an additional source of demand for domestic goods and services and therefore must be added to aggregate demand. Imports (M) supplement supplies in domestic markets.

Y = C + I + G + X - M

Y = C + I + G + NX