Open Economy Macroeconomics — Class 12 Economics

An open economy interacts with the rest of the world through trade in goods and services, financial assets and (to a limited extent) labour. The Balance of Payments (BoP) records all transactions between residents and the rest of the world over a period. It has two main accounts: the current account, which records trade in goods (the balance of trade) and services, plus net income and transfers (the invisibles); and the capital account, which records international transactions in assets such as foreign investment, loans and borrowings. A current account deficit must be financed by a capital account surplus or by drawing down foreign-exchange reserves; official reserve transactions are accommodating items while others are autonomous. The foreign exchange rate is the price of one currency in terms of another, set in the foreign exchange market by the demand for and supply of foreign currency. Under a flexible (floating) exchange rate the rate is market-determined, and a rise in the rate is a depreciation of the domestic currency while a fall is an appreciation. Under a fixed exchange rate the government pegs the rate, and changing it is called devaluation or revaluation; most countries today use a managed floating system. The chapter also introduces purchasing power parity and the open-economy national income identity , the marginal propensity to import , and the smaller open-economy multiplier .