The Open Economy MacroeconomicsDr. Shylajan, C.S

Topics of DiscussionThe Open EconomyWhy do countries trade with each other?The Principle of Absolute and Comparative AdvantageOpening up and economic growthWhy countries impose restrictions on international trade? Protectionism Vs Free-TradeEconomic impacts of protectionismEconomic effects of Import TariffWTO vs. Anti-WTO

The Open EconomyHow external sector impacts macroeconomic variables (AD=C+I+G+X-M)Global economic integration through opening up

International trade in goods and servicesInternational movement of labourInternational movement of capital

The Open EconomyWhen economy engages in international trade is called open economy

Nations export and import goods, services and financial capital

Measure of openness: ratio of a countrys exports and imports to its GDP

Asian economies openness and their economic growth

Asian economys dependence on external sector and Asian Crisis

Economic Basis for international tradeWhy do countries trade with each other?

Absolute advantage explanation

Comparative advantage explanation

Expanded trading opportunities

Decreasing cost of production (economies of scale)

Diversity in natural resources and differences in tastes

Cheaper wage (in India and China for instance)

Principle of Absolute and comparative advantage

One country has an absolute advantage over its trading partners in the production of a number of goods

International specialization benefits a nation

Comparative advantage

Each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost

Comparative advantage (Necessary labour for production of 2 goods) An ExampleProductIndia US

1 Unit of Food1 hour3 hours

1 unit of Clothing2 hours4 hours

India has absolute advantage in both goods.India has comparative advantage in foodIndian labour productivity is twice in clothing and thrice in food

Comparative advantage

Each country will benefit if it imports those goods which it produces at relatively high cost.

Protectionismvs Free TradeWhy governments impose restrictions on international trade (imports for instance)?

Restrictions on international trade

Tariffs, quotas and ban

Protectionism

Protecting domestic industries

Is protectionism sound economic policy?

Is free trade a sound economic policy?

Why?

Free-Trade vs. Protectionism-No international trade scenario

Free Trade scenario

Impacts of Import Tariff on Price, Domestic supply and Employment

Topics of DiscussionThe Balance of PaymentsComponents of BOPCurrent Account Capital AccountNumerical ProblemsBOP scenario in IndiaImplications of Current Account Deficit

Balance of Payments

A statistical statement that systematically summarizes the economic transactions of an economy with the rest of the world

There are 2 accounts

Current and Capital accounts constitute a country's balance of payments

Current Account & Capital AccountCurrent Account (1 + 2)1.Merchandisea. ExportsB. Imports

2.Invisiblesa. Services (travel, transportation, insurance)b. Transfers (donations from non-residents, grants from other govts)c. Investment Income

Investment income (inflow)Interest received on loans to non-residents

Dividend/profit received by Indians on foreign investment

Interest received on fixed deposits etc

Capital AccountAll transactions of financial natureForeign financial assets and liabilities

Foreign investmentExternal Assistance (World Bank, ADB etc)Commercial borrowings from international banksCommercial banks assets and liabilitiesNon-resident depositsRupee Debt Services (principal repayments of the past borrowings and total interest payments on all types of borrowings)Short term loansCapital Account

Numerical ProblemQ1. Assuming that the following information provides the Balance of Payments of an Economy for a particular year.

Numerical Problem( a) Compute

(1)Trade Balance Current Account Balance Capital Account Balance and Overall Balance of Payments

Numerical ProblemExternal Assistance to the country2500External Assistance by the country4000Transfers received2000Transfers made50Merchandise Exports15200Merchandise Imports17025Export of Services4500Import of Services2550FDI from abroad250FDI abroad40Short-term loans from abroad70Short term loans abroad 250

Numerical Problem(Solution)Current Account:Merchandise Exports15200Merchandise Imports17025Export of Services4500Import of Services2550Transfers received 2000Transfers made50

Numerical ProblemSolution:

Net export of goods =(-1825)Net export of services =(+1950)Net Transfers=(+1950)Current Account Balance=1950+1950-1825Current Account Balance is positive (+2075)

Numerical ProblemCapital Account:

FDI from abroad 250 FDI abroad 40Short-term loans from abroad 70Short term loans abroad 250

External Assistance to the country 2500External Assistance by the country 4000

Numerical ProblemCapital Inflow = 250+ 70 + 2500

= 2800Capital Outflow = 40 +250 + 4000

= 4290

Capital Account Balance = (-1490)

Capital outflow is more than inflow

Balance in Current Account + Balance in Capital Account = (2075 -1490)

= +585

BOP Scenario in IndiaAll the years, India had negative Current Account balance.In years 2001, 02 and 03 we had positive Current Account BalanceMain reason: Higher net invisibles incomeFrom 1994-95 onwards our net invisible income is increasing

BOP Scenario in IndiaRemittances to India growing rapidly since 1991One of the largest recipients of remittances in the developing worldWhat are the determinates of remittances?Indian settled in abroad, crisis, political uncertainty, geopolitical tensions, economys growth, reduction in duty on import of gold, Higher oil prices etc

BOP Scenario in IndiaAgain in 2004-05 we have Current Account Deficit (due to more merchandise imports)

Major reason: Higher import bill. Both oil and non-oil import

Indias trade deficit more than tripledIn 2009, we will have more trade deficit, why?

BOP Scenario in India

Rise in price of domestic goods (inflation) may make exports relatively expensive

Then it may lead to trade deficit

What are the implications of current account deficit?

How can we reduce current account deficit?

BOP Scenario in IndiaWe have to depend debt and foreign investments to finance the Current Account DeficitCommercial borrowingsFIIsRecently Capital Account inflows rose sharplyThat is why our foreign reserves rose sharply

BOP Scenario in IndiaWe need to use capital inflows for creating productive capacities and to promote export not for unproductive transfer payments

But Can we use our FER for investing in infrastructure? Why, why not?

We should not depend on capital flows to cover past capital flow commitments

Exchange RatesRate at which a currency can be bought against another currency

Value is determined by DD and SS

Exchange Rates

The types of Foreign Exchange Rate Regime

Floating Exchange Rates, Fixed Exchange Rates and Managed Exchange Rate system

SummaryExternal sector and its effects on an economyCurrent account deficitBalance of payment