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So far, we have simplified the analysis of income determination by assuming a closed economy. In reality, most modern economies are open. Interaction with other economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between domestic and foreign goods. This is the product market linkage which occurs through international trade. (ii) Investors have the opportunity to choose between domestic and foreign assets. This constitutes the financial market linkage. (iii) Firms can choose where to locate production and workers to choose where to work. This is the factor market linkage. Labour market linkages have been relatively less due to various restrictions on the movement of people through immigration laws. Movement of goods has traditionally been seen as a substitute for the movement of labour. We focus here on the first two linkages.
An open eco nomy is one that trades with other nations in goods and services and, most often, also in financial assets. Indians, for instance, enjoy using products produced around the world and some of our production is exported to foreign ountries. Foreign trade, therefore, influences Indian aggregate demand in two ways. First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing aggregate demand. Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for domestically produced goods. Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. In 2004-2005, this was 38.9 per cent for the Indian economy (imports constituted 17.1 per cent and exports 11.8 per cent of GDP). This is substantially higher than a total of 16 per cent that prevailed in 1985-86. However, in comparison to other countries, India is relatively less open. There are several countries whose foreign trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must move in the opposite direction. At the international level, there is no single currency that is issued by a central authority. Foreign economic agents will accept a national currency only if they are convinced that the currency will maintain a stable purchasing power. Without this confidence, a currency will not be used as an international medium of exchange and unit of account since there is no international authority with the power to force the use of a particular currency in international transactions. Governments have tried to gain confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing authority has no control. This other asset most often has been gold, or other national currencies. There are two aspects of this commitment that has affected its credibility – the ability to convert freely in unlimited amounts and the price at which conversion takes place. The international monetary system has been set up to handle these issues and ensure stability in international transactions. A nation’s commitment regarding the above two issues will affect its trade and financial interactions with the rest of the world. We begin section 6.1 with the accounting of international trade and financial flows. The next section examines the determination of price at which national currencies are exchanged for each other. In section 6.3, the closed economy income-expenditure model is amended to include international effects.
1. Differentiate between balance of trade and current account balance.
2. What are official reserve transactions? Explain their importance in the balance of payments.
3. Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.
4. Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).
5. Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
6. How is the exchange rate determined under a flexible exchange rate regime?
7. Differentiate between devaluation and depreciation.
8. Would the central bank need to intervene in a managed floating system? Explain why.
9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
10. What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship between the marginal propensity to import and the aggregate demand function?
11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Please refer to attached file for NCERT Class 12 Economics Open Economy Macroeconomics
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