Open Economy Macroeconomics

Balance of Payments (BOP): • The Balance of Payments is a systematic record of all economic transactions between residents of a country and the rest of the world during a given period (usually one year). • It records all inflows and outflows of foreign exchange. • The BOP always balances in an accounting sense (credits = debits), but individual accounts may show surpluses or deficits. Structure of the BOP: 1. Current Account: • Records all transactions in goods, services, income, and current transfers. (a) Trade Account (Merchandise / Visible Trade): - Exports of goods (credit — inflow) and imports of goods (debit — outflow). - Trade Balance = Exports − Imports. If imports > exports → Trade Deficit. (b) Invisibles (Services and Transfers): - Services: Tourism, software exports, banking, insurance, transport. - Income: Remittances from Indians abroad, investment income. - Current Transfers: Foreign aid, gifts. • Current Account Balance = Trade Balance + Net Invisibles. • Current Account Deficit (CAD): Common in developing countries importing more than they export. 2. Capital Account: • Records transactions involving financial assets and liabilities — cross-border investment and borrowing. (a) Foreign Direct Investment (FDI): Long-term investment in businesses. (b) Foreign Portfolio Investment (FPI): Investment in stocks and bonds. (c) External Commercial Borrowings (ECB): Loans from foreign banks. (d) NRI deposits, short-term capital flows. • Capital Account Surplus can finance a Current Account Deficit. 3. Official Reserves Account: • Records changes in the country's foreign exchange reserves held by the central bank (RBI). • A fall in reserves implies the RBI is selling foreign exchange to support the currency. BOP identity: Current Account + Capital Account + Change in Reserves = 0

Exchange Rate: • The exchange rate is the price of one country's currency expressed in terms of another currency. • Example: ₹83 per US dollar means ₹83 is needed to buy 1 US dollar. • Appreciation: The domestic currency becomes more valuable (fewer rupees per dollar). • Depreciation: The domestic currency becomes less valuable (more rupees per dollar). Fixed Exchange Rate System: • The government (or central bank) sets and maintains the exchange rate at a fixed level. • The central bank must buy and sell foreign exchange as needed to maintain the fixed rate — uses its foreign exchange reserves. • Advantage: Exchange rate certainty encourages international trade and investment; reduces speculation. • Disadvantage: The central bank must hold large reserves; limits independent monetary policy; may result in over/undervaluation; vulnerable to speculative attack. • Example: India had a fixed exchange rate until 1991; the Bretton Woods system (1944–1973) was a fixed rate system. Flexible (Floating) Exchange Rate System: • The exchange rate is determined by the forces of demand and supply in the foreign exchange market — no government intervention. • Advantage: Automatic adjustment to external imbalances; central bank retains monetary policy independence. • Disadvantage: Uncertainty and volatility can harm trade and investment; speculative attacks possible. • Most major currencies today operate under a managed float (also called 'dirty float') — largely market-determined but with occasional central bank intervention. Causes of Exchange Rate Depreciation (Rupee weakens against dollar): 1. Higher imports / trade deficit: Greater demand for foreign currency to pay for imports → rupee weakens. 2. Capital outflows: Foreign investors withdrawing money from India → sell rupees, buy dollars → rupee depreciates. 3. Higher inflation in India relative to the US: Indian goods become less competitive → exports fall, imports rise → depreciation pressure. 4. Higher US interest rates: Attract capital away from India to the US → capital outflows → rupee depreciates. 5. Market speculation: If traders expect the rupee to fall, they sell rupees — a self-fulfilling prophecy.

Globalisation: • Globalisation is the process of increasing integration and interdependence among countries in terms of trade in goods and services, movement of capital, labour migration, and the spread of technology, information, and culture. • It is driven by: Reduction in trade barriers (tariffs, quotas), advances in communication and transportation technology, liberalisation of capital markets, and the growth of multinational corporations. In the Indian context: • India's engagement with globalisation deepened significantly after the 1991 economic liberalisation reforms — LPG (Liberalisation, Privatisation, Globalisation) — which opened the economy to foreign investment, reduced import tariffs, and deregulated industries. Positive effects on the Indian Economy: 1. High economic growth: The post-1991 era saw acceleration in India's GDP growth rate, with IT and services sectors becoming globally competitive. 2. Rise of the IT and services sector: India became the world's back-office — software exports, BPO, financial services. Cities like Bengaluru, Hyderabad, and Pune became global tech hubs. 3. FDI inflows: Foreign investment brought capital, technology, and managerial expertise. 4. Consumer benefits: Access to a wider variety of goods at lower prices due to imports and competition. 5. Employment generation: Particularly in export-oriented sectors (IT, garments, pharmaceuticals). 6. Technology transfer: Access to advanced technology from abroad boosted productivity. Negative/Challenging effects: 1. Inequality: The gains of globalisation have been unevenly distributed — urban, educated workers benefited more than rural, unskilled workers; income inequality has widened. 2. Vulnerability to global shocks: India's economy is now more exposed to global recessions (2008 financial crisis, COVID-19) and commodity price volatility. 3. Deindustrialisation concerns: Cheaper imports have hurt some domestic manufacturing industries (e.g., toy industry, certain textile segments). 4. Agrarian distress: Global price volatility can hurt Indian farmers competing with heavily subsidised foreign agricultural products. 5. Cultural homogenisation: Critics argue globalisation erodes local cultures and promotes a homogenised Western consumer culture.