This page contains the NCERT Economics class 12 chapter 6 Open Economy Macroeconomics from Book II Introductory Macroeconomics. You can find the solutions for the chapter 6 of NCERT class 12 Economics, for the Short Answer Questions, Long Answer Questions and Projects/Assignments Questions in this page. So is the case if you are looking for NCERT class 12 Economics related topic Open Economy Macroeconomics question and answers.
Exercises
1. Differentiate between balance of trade and current account balance.
Aspect
Balance of Trade (BoT)
Current Account Balance
Definition
Balance of Trade refers to the difference between the value of a country’s exports and imports of goods only.
Current Account Balance includes the Balance of Trade but also encompasses trade in services, net income from abroad, and net current transfers.
Components
Includes only the export and import of physical goods.
Encompasses trade in goods (same as BoT), trade in services, primary income (like dividends, interest), and secondary income (like remittances).
Scope
Narrower in scope, focusing solely on goods.
Broader in scope, covering a wider range of economic transactions with the rest of the world.
Indicators
Indicates the country’s position in terms of its physical goods traded.
Reflects the country’s overall economic transactions including goods, services, and income flows.
Surplus/Deficit
A surplus (or deficit) in BoT means the country exports more (or less) goods than it imports.
A surplus (or deficit) in the current account means the country’s total exports of goods, services, and income are greater (or less) than its total imports.
Economic Impact
Mainly reflects the competitiveness of a country’s manufacturing and export sectors.
Indicates the country’s broader economic relations and sustainability, including its attractiveness for service sector and investment income.
2. What are official reserve transactions? Explain their importance in the balance of payments.
Definition: Official reserve transactions refer to the changes in the foreign currency reserves held by a country’s central bank or monetary authority. These transactions are part of the balance of payments and represent the buying or selling of foreign currencies to influence the value of the domestic currency.
Importance in the Balance of Payments:
1.
Exchange Rate Stability: Official reserve transactions are crucial for maintaining the stability of a country’s exchange rate. By buying or selling foreign currency, the central bank can influence the domestic currency’s value, preventing excessive fluctuations.
2.
International Confidence: A healthy level of foreign reserves instills confidence among international investors and trading partners. It signals that the country can meet its international obligations and support its currency if needed.
3.
Buffer Against Economic Shocks: Reserves act as a buffer against external economic shocks, such as sudden capital outflows or balance of payments crises. They provide a source of foreign currency to meet international payment obligations without destabilizing the domestic economy.
4.
Monetary Policy Tool: Reserve transactions are a tool for implementing monetary policy. For example, selling foreign currency and buying domestic currency can help control inflationary pressures.
5.
Indicator of Economic Health: The level and changes in official reserves are closely watched as indicators of a country’s economic health and its ability to engage in international trade and finance.
6.
Balance of Payments Adjustment: These transactions help in adjusting the balance of payments. If a country has a deficit in its current account, it can use its reserves to fund this deficit temporarily.
7.
Managing Liquidity: In times of financial crisis or when there is a shortage of liquidity in the market, the central bank can release foreign reserves to ensure the smooth functioning of the financial system.
In summary, official reserve transactions play a vital role in maintaining economic stability, instilling confidence in the economy, and managing international financial interactions as part of 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.
Aspect
Nominal Exchange Rate
Real Exchange Rate
Definition
The nominal exchange rate is the rate at which one country’s currency can be traded for another country’s currency.
The real exchange rate adjusts the nominal exchange rate by the relative prices of a similar basket of goods between the two countries.
Expression
Expressed as the amount of foreign currency that can be purchased with one unit of domestic currency (or vice versa).
Expressed as the ratio of the price of goods in the domestic country to the price of goods in a foreign country, after adjusting for the nominal exchange rate.
Focus
Focuses on the current market value of currencies.
Focuses on the purchasing power of currencies for buying goods and services.
Influence
Influenced by factors like interest rates, inflation, and market speculation.
Influenced by changes in price levels and inflation rates in the respective countries.
Fluctuations
More prone to short-term fluctuations due to market dynamics.
Reflects long-term economic fundamentals and purchasing power parity.
Use
Used for financial transactions, currency conversions, and international transfers.
Used to compare the cost of living between countries and to assess trade competitiveness.
Relevance in Deciding to Buy Domestic or Foreign Goods:
If I have to decide whether to buy domestic goods or foreign goods, I believe that the real exchange rate would be more relevant when deciding whether to buy domestic goods or foreign goods. This is because the real exchange rate provides a more accurate measure of the relative prices of goods in different countries. It takes into account the purchasing power of currencies, which is essential for comparing the actual cost of goods domestically versus those available from foreign sources. By considering the real exchange rate, a consumer or business can make a more informed decision about where goods can be purchased more economically, factoring in the true value of their money in different markets.
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).
Given that
1.25 yens
= 1 Rupee
⇒ 1 yen
{= \dfrac{1}{1.25}\text{ rupees}}
{= \dfrac{100}{125}\text{ rupees}}
{= \dfrac{4}{5}\text{ rupees}}
= 0.8 rupees
∴ The nominal exchange rate {e} is 0.8
It is also given that
Price Level in Japan {P_J}
= 3
Price Level in India {P_I}
= 1.2
So, the Real Exchange Rate {(RER)} is calculated as
{RER}
{\text{= Nominal Exchange Rate} × \dfrac{\text{Price Level in Foreign Country}}{\text{Price Level in Home Country}}}
{= e × \dfrac{P_J}{P_I}}
{= 0.8 × \dfrac{3}{1.2}}
{= 8 × \dfrac{3}{12}}
= 2
This implies that the price of Japanese goods in terms of Indian goods is 2 times their price in India.
5. Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
Under the gold standard, each country set a value for its currency in terms of gold, and exchange rates were determined by these gold values. This system created a natural mechanism for achieving balance of payments equilibrium through the flow of gold.
Mechanism for BoP Equilibrium under Gold Standard:
1.
Trade Imbalances and Gold Flows:
–
When a country had a trade surplus, it meant that it was exporting more than it was importing. This surplus led to an inflow of gold from other countries, increasing the country’s gold reserves.
–
Conversely, a trade deficit (importing more than exporting) would lead to an outflow of gold to other countries, reducing the country’s gold reserves.
2.
Adjustment in Money Supply:
–
An increase in gold reserves (from a trade surplus) would typically lead to an increase in the money supply, as gold was used to back the currency. This increase in money supply would then lead to inflation, raising domestic prices.
–
A decrease in gold reserves (from a trade deficit) would lead to a decrease in the money supply, causing deflation and a decrease in domestic prices.
3.
Restoring Equilibrium:
–
Higher prices in a surplus country would eventually make its goods less competitive in international markets, leading to a reduction in exports and an increase in imports. This shift would gradually reduce the trade surplus and the inflow of gold.
–
Lower prices in a deficit country would make its goods more competitive, leading to an increase in exports and a reduction in imports. This change would help to reduce the trade deficit and slow the outflow of gold.
4.
Long-Term Equilibrium: These adjustments in trade and gold flows would continue until the trade balances of the countries were restored to equilibrium. The system was largely self-regulating, as the flows of gold automatically led to changes in money supply and price levels, which then influenced trade balances.
Under the gold standard, this automatic mechanism functioned without the need for active government intervention in the foreign exchange market. The system relied on the natural movement of gold and the resulting adjustments in national economies to maintain balance of payments equilibrium.
6. How is the exchange rate determined under a flexible exchange rate regime?
Under a flexible exchange rate regime, the exchange rate is determined by the market forces of demand and supply for the respective currencies in the foreign exchange market. This system is also known as a floating exchange rate system. The main points regarding the determination of exchange rates under this system are as follows:
1.
Market-Driven: In a flexible exchange rate system, the value of a currency is not fixed by the government or a central bank. Instead, it fluctuates freely based on market dynamics.
2.
Demand and Supply Factors: The demand for a currency is influenced by factors such as:
–
The need to purchase goods and services from the country of that currency.
–
The desire to invest in that country’s financial assets.
–
Remittances or gifts sent abroad in that currency.
–
Speculation about future movements of the currency’s value.
Similarly, the supply of a currency is influenced by factors such as:
–
Exports from the country, which require foreigners to purchase the country’s currency.
–
Foreign investment into the country.
–
The country’s residents purchasing foreign goods and services or investing in foreign assets.
3.
Equilibrium Exchange Rate: The exchange rate is established at the point where the demand for a currency equals its supply. This equilibrium can shift due to changes in the economic fundamentals affecting demand and supply.
4.
Fluctuations and Volatility: Exchange rates under this system can be volatile, changing frequently based on short-term factors like news, speculation, and market sentiment.
5.
Central Bank Intervention: While central banks in a flexible exchange rate system do not usually intervene to maintain a specific exchange rate level, they may occasionally enter the market to buy or sell their currency to prevent excessive fluctuations or to achieve certain economic objectives. This is known as a managed float or dirty floating.
6.
Independence in Monetary Policy: One significant advantage of the flexible exchange rate system is the independence it provides to a country in conducting its monetary policy, as there’s no need to maintain a fixed exchange rate.
In summary, under a flexible exchange rate regime, the value of a currency is determined by market forces and can fluctuate based on various economic and speculative factors, with limited intervention by central banks.
7. Differentiate between devaluation and depreciation.
The following is differentiation between devaluation and depreciation:
Aspect
Devaluation
Depreciation
Definition
Devaluation refers to a deliberate decrease in the value of a country’s currency relative to another currency, gold, or a standard, implemented by the government or monetary authority in a fixed exchange rate system.
Depreciation is the decrease in the value of a currency due to market forces, such as demand and supply, in a flexible exchange rate system.
Control
It is a controlled and deliberate action by the government or the central bank.
It occurs naturally due to market dynamics without direct government control.
Exchange System
Occurs under fixed or pegged exchange rate systems.
Occurs under flexible or floating exchange rate systems.
Mechanism
The government or central bank adjusts the fixed or pegged exchange rate to a lower value.
Market factors like trade balances, investment flows, and speculation lead to changes in the currency value.
Economic Impact
Often used to correct a balance of payments deficit, make exports cheaper, and control trade imbalances.
Indicates changes in economic fundamentals like inflation rates, interest rates, or changes in the economic outlook of a country.
This table provides a clear distinction between devaluation and depreciation based on their definitions, control mechanisms, exchange systems, how they are implemented and their economic impacts.
8. Would the central bank need to intervene in a managed floating system? Explain why.
Central Bank Intervention in a Managed Floating System
In a managed floating exchange rate system, which is a mixture of flexible and fixed rate systems, central banks do occasionally intervene. The reasons for this intervention are as follows:
1.
Moderating Exchange Rate Movements: Central banks intervene to buy and sell foreign currencies to moderate exchange rate movements. This is especially the case when such movements are rapid and could potentially disrupt economic stability.
2.
Preventing Excessive Fluctuations: The goal of intervention is often to prevent excessive fluctuations in the exchange rate that could harm the domestic economy. This includes avoiding rapid depreciation or appreciation of the currency.
3.
Balancing Market Forces with Policy Goals: While the exchange rate in a managed float is primarily determined by market forces of demand and supply, central banks step in to align the exchange rate with broader economic policy goals, such as controlling inflation, maintaining competitiveness, or achieving certain targets in the balance of payments.
4.
Supplementing Market Mechanisms: The intervention by central banks in a managed floating system is a supplement to, rather than a replacement for, the market mechanisms. The market still plays a significant role in determining the exchange rate.
5.
Flexibility and Independence: This system provides governments with more flexibility compared to a fixed exchange rate system and does not require maintaining large reserves of foreign exchange. It also allows for some level of independence in monetary policy.
In summary, in a managed floating exchange rate system, central bank intervention is necessary to moderate exchange rate movements, prevent excessive fluctuations, and align the exchange rate with economic policy goals, while still allowing market forces to play a significant role.
9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
No, the concepts of demand for domestic goods and domestic demand for goods are not the same. They represent different aspects of economic demand within an open economy. The differences can be summarised as follows:
Aspect
Demand for Domestic Goods
Domestic Demand for Goods
Definition
The total demand for goods and services produced within a country.
The demand by residents of a country for all goods and services, irrespective of where they are produced.
Includes
Domestic consumption and demand from abroad (exports).
Domestic consumption of both locally produced goods and imported goods.
Focus
On the output of the domestic economy (used locally and exported).
On all goods consumed within the country, regardless of their origin.
Relevance in Economic Analysis
Important for understanding the external demand for a country’s products and its impact on the economy.
Crucial for analyzing overall consumption patterns within a country and its impact on imports and local industries.
Example
Demand in India and other countries for textiles produced in India.
Demand in India for electronics, including those made in India and those imported from other countries.
In essence, the demand for domestic goods is focused on the output of the domestic economy (both used locally and exported), whereas domestic demand for goods encompasses all goods consumed within the country, regardless of their origin. This distinction is important in understanding trade dynamics, as it highlights how a country’s economy interacts with the rest of the world in terms of both supply and demand.
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?
1.
Marginal Propensity to Import (MPI) Calculation:
●
In the given equation
{M = 60 + 0.06Y}
Here
– {M} represents imports, and
– {Y} represents national income or output.
●
The marginal propensity to import (MPI) is the coefficient of {Y} in the import function, which in this case is 0.06. This means that for every additional unit of income, imports increase by 0.06 units.
2.
Relationship Between MPI and Aggregate Demand:
●
In an open economy, the national income identity is
{Y = C + I + G + X – M}
where
– {C} is consumption,
– {I} is investment,
– {G} is government spending,
– {X} is exports, and
– {M} is imports.
●
Aggregate demand in an open economy consists of domestic demand (consumption, investment, government spending) plus net exports ({X – M}).
●
The MPI affects aggregate demand through its impact on net exports. A higher MPI means that a larger portion of additional income is spent on imports rather than domestic goods.
●
This results in a decrease in net exports, which in turn reduces aggregate demand. Specifically, as income increases, if imports (driven by the MPI) increase significantly, this can offset the domestic components of aggregate demand, leading to a lower overall impact on national income.
●
In essence, the marginal propensity to import is a crucial factor in determining how changes in national income translate into changes in aggregate demand in an open economy.
This relationship is fundamental in understanding how an economy interacts with international trade and how domestic economic activities are influenced by the propensity to import.
11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
The Open Economy Autonomous Expenditure Multiplier Smaller Than the Closed Economy One due to the following reasons:
1.
The Concept of Multiplier in Different Economies:
–
In a closed economy, the autonomous expenditure multiplier is calculated without considering international trade. The formula used is
{\dfrac{1}{1 - c}}
where
{c} is the marginal propensity to consume.
–
In an open economy, the formula for the multiplier becomes
{\dfrac{1}{1 - c + m}}
where
{m} is the marginal propensity to import.
2.
Effect of Imports ({m}): The inclusion of {m} (marginal propensity to import) in the formula for an open economy reduces the size of the multiplier (Since the value of a fraction becomes smaller when the denominator is increased due to addition of {m} to the denominator). This is because a portion of the induced consumption in response to an increase in autonomous expenditure is spent on imports rather than domestically produced goods.
3.
Leakage from the Circular Flow of Income:
–
In an open economy, an increase in income leads to an increase in imports. This constitutes an additional leakage from the circular flow of income, reducing the impact of an increase in autonomous expenditures on the domestic economy.
–
For example, if {c = 0.8} and {m = 0.3}, the multiplier in an open economy would be {\dfrac{1}{1 - 0.8 + 0.3} = \dfrac{1}{0.5} = 2}, compared to {\dfrac{1}{1 - 0.8} = \dfrac{1}{0.2} = 5} in a closed economy.
4.
Impact on Domestic Income: The increase in imports per unit of income is an additional factor that reduces the value of the autonomous expenditure multiplier in an open economy. This is because the induced effect on demand for domestic goods, and hence on domestic income, is smaller in an open economy due to spending on foreign goods.
In summary, the autonomous expenditure multiplier is smaller in an open economy compared to a closed economy because of the marginal propensity to import, which causes a leakage in the expenditure stream, leading to a smaller impact on domestic income for each unit increase in autonomous expenditures.
12. Calculate the open economy multiplier with proportional taxes, {T = tY}, instead of lump-sum taxes as assumed in the text.
Let’s substitute the give value {T = tY} into the formula for equillibrium income.
We know that, the equillibrium income {Y} is given as
{Y}
{= \overline{C} + c(Y - T) + \overline{I} + \overline{G} + \overline{X} - \overline{M} - mY}
{= \overline{C} + c(Y - tY) + \overline{I} + \overline{G} + \overline{X} - \overline{M} - mY}
{= \overline{C} + c(1 - t)Y + \overline{I} + \overline{G} + \overline{X} - \overline{M} - mY}
Re-arranging, we have
{Y - c(1 - t)Y + mY = \overline{C} + \overline{T} + \overline{G} + \overline{X} - \overline{M}}
Taking the autonomous component together (the entire expression on the right hand side) as {\overline{A}}, we have
{(1 - c(1 - t) + m)Y = \overline{A}}
{⇒ Y = \dfrac{1}{1 - c(1 - t) + m}\overline{A}}
So, we get the open economy multiplier as
{\dfrac{ΔY}{ΔA} = \dfrac{1}{1 - c(1 - t) + m}}
13. Suppose {C = 40 + 0.8Y_D}, {T = 50}, {I = 60}, {G = 40}, {X = 90}, {M = 50 + 0.05Y}
(a)
Find equilibrium income.
(b)
Find the net export balance at equilibrium income
(c)
What happens to equilibrium income and the net export balance when the government purchases increase from 40 and 50?
1. To Find the Equilibrium Income:
The national income identity in an open economy is {Y = C + I + G + X - M}.
Given that:
–
Consumption function, {C = 40 + 0.8Y_D} where {Y_D} is disposable income.
–
Taxes, {T = 50}.
–
Investment, {I = 60}.
–
Government spending, {G = 40}.
–
Exports, {X = 90}.
–
Imports, {M = 50 + 0.05Y}.
We know that Disposable income {Y_D = Y - T}.
Substituting these into the national income identity: {Y = C + I + G + X - M}, we get
{Y = 40 + 0.8(Y - 50) + 60 + 40 + 90 - (50 + 0.05Y)}
{⇒ Y = 40 + 0.8Y - 40 + 60 + 40 + 90 - 50 - 0.05Y}
{⇒ Y = 140 + 0.75Y}
{⇒ Y - 0.75Y = 140}
{⇒ 0.25Y = 140}
{⇒ \dfrac{25}{100} × Y = 140}
{⇒ \dfrac{1}{4} × Y = 140}
{⇒ Y = 140 × 4}
⇒ {Y = 560}
2. To Find the Net Export Balance at Equilibrium Income:
Net exports ({NX}) are calculated as {X - M}.
Substituting {Y = 560} from above into {M = 50 + 0.05Y}, we get
{M}
{= 50 + 0.05 × 560}
{= 50 + \dfrac{5}{100} × 560}
= 50 + 28
= 78
{∴ NX}
{= X - M}
= 90 – 78
= 12
3. To find the Effect of Increase in Government Spending:
When government spending increases from 40 to 50, we need to substitute {G = 50} into the national income identity {Y = C + I + G + X - M} and recalculate the equilibrium income. So, we have
{Y = 40 + 0.8(Y - 50) + 60 + 50 + 90 - (50 + 0.05Y)}
{⇒ Y = 40 + 0.8Y - 40 + 60 + 50 + 90 - 50 - 0.05Y}
{⇒ Y = 150 + 0.75Y}
{⇒ Y - 0.75Y = 150}
{⇒ 0.25Y = 150}
{⇒ \dfrac{25}{100} × Y = 150}
{⇒ \dfrac{1}{4} × Y = 150}
{⇒ Y = 150 × 4}
⇒ {Y = 600}
Substituting {Y = 600} from above into {M = 50 + 0.05Y}, we get
{M}
{= 50 + 0.05 × 600}
{= 50 + \dfrac{5}{100} × 600}
= 50 + 30
= 80
{∴ NX}
{= X - M}
= 90 – 80
= 10
So, When government spending increases from 40 to 50, the new equilibrium income rises to 600 and the net export balance decreases to 10.This analysis shows that an increase in government spending leads to a rise in equilibrium income and a decrease in the net export balance in this open economy model.
14. In the above example, if exports change to {X = 100}, find the change in equilibrium income and the net export balance.
When the exports increases to {X = 100}, we need to substitute {X = 100} into the national income identity {Y = C + I + G + X - M} and recalculate the equilibrium income. So, we have
{Y = 40 + 0.8(Y - 50) + 60 + 40 + 100 - (50 + 0.05Y)}
{⇒ Y = 40 + 0.8Y - 40 + 60 + 40 + 100 - 50 - 0.05Y}
{⇒ Y = 150 + 0.75Y}
{⇒ Y - 0.75Y = 150}
{⇒ 0.25Y = 150}
{⇒ \dfrac{25}{100} × Y = 150}
{⇒ \dfrac{1}{4} × Y = 150}
{⇒ Y = 150 × 4}
⇒ {Y = 600}
Substituting {Y = 600} from above into {M = 50 + 0.05Y}, we get
{M}
{= 50 + 0.05 × 600}
{= 50 + \dfrac{5}{100} × 600}
= 50 + 30
= 80
{∴ NX}
{= 100 - M}
= 100 – 80
= 20
So, When exports increase from 90 to 100, the new equilibrium income rises to 600 and the net export balance also increases to 20.This analysis shows that an increase in exports leads to a rise in equilibrium income and also an increase in the net export balance in this open economy model.
15. Suppose the exchange rate between the Rupee and the dollar was ₹ 30 = 1 $ in the year 2010. Suppose the prices have doubled in India over 20 years while they have remained fixed in USA. What, according to the purchasing power parity theory will be the exchange rate between dollar and rupee in the year 2030.
According to the PPP theory, the exchange rate between two countries’ currencies should be equivalent to the ratio of their price levels. This theory assumes that in the absence of transportation costs and barriers to trade like tariffs, goods should have the same price when expressed in the same currency.
1.
Original Exchange Rate in 2010: ₹ 30 = $ 1.
2.
Price Change in India Over 20 Years: Prices in India have doubled.
3.
Price Change in the USA Over 20 Years: Prices in the USA have remained fixed.
To calculate the new exchange rate in 2030:
–
Let the original price level in India be {P} and in the USA be {P_{USA}}.
–
In 2010, {\dfrac{P}{P_{USA}} = 30}.
–
In 2030, prices in India have doubled, so the new price level in India is {2P}.
–
Prices in the USA remain the same, so {P_{USA}} is unchanged.
–
The new exchange rate according to PPP would be {\dfrac{2P}{P_{USA}}}.
Since {\dfrac{P}{P_{USA}} = 30}, doubling the price level in India would lead to the new exchange rate being {2 × 30 = 60}. Therefore, according to PPP theory, the exchange rate in 2030 would be ₹ 60 = $ 1. This means that the value of the rupee in terms of the dollar would have depreciated over these 20 years.
16. If inflation is higher in country A than in Country B, and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries?
When analyzing the impact of differing inflation rates on trade balance under a fixed exchange rate system, the following points are crucial:
1.
Higher Inflation Reduces Competitiveness:
–
If Country A experiences higher inflation than Country B, the prices of goods and services in Country A will increase more rapidly.
–
This makes Country A’s goods more expensive relative to Country B’s goods.
2.
Impact on Exports and Imports:
–
As Country A’s goods become more expensive, its exports are likely to decrease because its goods become less competitive in the international market.
–
Conversely, cheaper goods from Country B become more attractive to consumers in Country A, leading to an increase in imports from Country B.
3.
Effect on Trade Balance:
–
The increase in imports and decrease in exports in Country A will lead to a worsening of its trade balance, potentially resulting in a trade deficit.
–
In contrast, Country B, with lower inflation and therefore cheaper goods, may experience an improvement in its trade balance due to increased exports and reduced imports.
4.
Fixed Exchange Rate Complications:
–
Under a fixed exchange rate system, Country A cannot devalue its currency to make its exports cheaper and balance the trade.
–
The fixed exchange rate may exacerbate the trade imbalance, as the currency’s value does not adjust to reflect the inflation differential.
In summary, if inflation is higher in Country A than in Country B with a fixed exchange rate system, it is likely that Country A will experience a worsening trade balance due to reduced competitiveness of its exports and increased attractiveness of Country B’s cheaper imports.
17. Should a current account deficit be a cause for alarm? Explain.
Should a Current Account Deficit Be a Cause for Alarm?
1.
Understanding Current Account Deficit: A current account deficit occurs when a country’s total imports of goods, services, and transfers exceed its total exports. It essentially means that the country is spending more on foreign trade than it is earning and borrowing capital from foreign sources to make up the deficit.
2.
Factors Leading to Current Account Deficit: This deficit could be due to several reasons, such as a country importing more due to strong domestic demand, investing in capital goods for long-term growth, or facing higher prices for imported goods.
3.
Financing the Deficit: The deficit is typically financed through the capital account, which includes foreign investments and loans. As long as these inflows are invested in productive areas leading to future economic growth, a current account deficit might not be alarming.
4.
Potential Concerns: However, a persistent current account deficit could indicate underlying economic problems, such as a country living beyond its means, a lack of competitiveness in international markets, or economic policies that might need adjustment.
5.
Overall Impact: The impact of a current account deficit on a country’s economy depends on factors like the reasons behind the deficit, how it is financed, and the overall state of the economy. While it’s not necessarily alarming in the short term, especially if it’s driven by growth-oriented investments, a long-term persistent deficit might require policy interventions.
6.
Conclusion: Therefore, while a current account deficit is not inherently alarming, it warrants careful monitoring and analysis to ensure that it reflects healthy economic activity and is sustainable in the long term.
18. Suppose {C = 100 + 0.75Y_D}, {I = 500}, {G = 750}, taxes are 20 per cent of income, {X = 150}, {M = 100 + 0.2Y}. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.
1. To Calculate the Equilibrium Income {(Y)}:
The national income identity in an open economy is {Y = C + I + G + X - M}.
Given that
The consumption function {C = 100 + 0.75Y_D} (where {Y_D = Y - T} and {T = 0.20Y} as taxes are 20% of income).
{I = 500}
{G = 750}
{X = 150}
{M = 100 + 0.2Y}
Substituting these values into the national income identity and solving for {Y} will give the equilibrium income.
So, we have
{Y}
{= C + I + G + X - M}
{= 100 + 0.75Y_D + I + G + X - M}
{= 100 + 0.75(Y - T) + I + G + X - (100 + 0.2Y)}
{= 100 + 0.75(Y - 0.20Y) + I + G + X - 100 - 0.2Y}
{= 100 + (0.75 × 0.8Y) + I + G + X - 100 - 0.2Y}
{= 100 + 0.6Y + 500 + 750 + 150 - 100 - 0.2Y}
{= 1400 + 0.4Y}
Re-arranging to solve for {Y}
{Y - 0.4Y = 1400}
{⇒ 0.6Y = 1400}
{⇒ \dfrac{6}{10}Y = 1400}
{⇒ Y = 1400 × \dfrac{10}{6}}
⇒ {Y = 2333.33}
2. To Calculate Budget Deficit or Surplus:
Now, the taxes are
{T}
{= 0.20Y}
= 0.20 × 2333.33
= 466.66
As it is given that {G = 750}, it implies that the government spendings are more than the taxes (750 > 466.66).
So, it implies that there is a budget deficit.
3. To Calculate Trade Deficit or Surplus (NX):
Net exports ({NX}) are calculated as {X - M}.
Now,
{M}
{= 100 + 0.2Y}
= 100 + (0.2 × 2333.33)
= 100 + 466.66
= 566.66
So,
{NX}
{= X - M}
= 150 – 566.66
= – 466.66
The trade balance is approximately -416.67, indicating a trade deficit since the value is negative.
These calculations suggest that in this economic model, the economy would have a budget deficit as well as trade deficit at the calculated equilibrium income level.
19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
1.
Flexible Exchange Rate System:
–
Under this system, also known as a floating exchange rate system, exchange rates are determined by market forces of demand and supply.
–
The advantage is that movements in the exchange rate automatically adjust to balance of payments (BoP) surpluses and deficits.
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Countries have greater independence in conducting their monetary policies as they do not need to intervene to maintain exchange rates.
2.
Managed Floating Exchange Rate System:
–
This is a hybrid system combining aspects of both flexible and fixed exchange rate systems.
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Also known as “dirty floating,” central banks intervene in the foreign exchange market to buy and sell foreign currencies to moderate exchange rate movements.
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This system allows for some level of market determination of exchange rates while still enabling governments to influence exchange rates to stabilize external accounts.
3.
Fixed Exchange Rate System:
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In a fixed exchange rate system, governments fix the exchange rate at a particular level.
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This system requires governments to maintain large reserves of foreign currency to manage the exchange rate.
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Fixed exchange rates can provide stability in international transactions but are prone to speculative attacks if the market doubts the government’s ability to maintain the rate.
4.
Use of Gold or Other National Currencies:
–
Historically, governments have tried to establish confidence by tying their currency to a stable asset like gold or other national currencies.
–
This commitment requires the ability to convert currency freely into the asset at a fixed price.
These arrangements reflect different approaches to managing a country’s external accounts, with each system having its merits and demerits in terms of stability, flexibility, and control over monetary policy.
