NCERT Solutions For Class 12 Economics Chapter 11
Open Economy Macroeconomics

Some of the exchange rate arrangements that countries have entered into to bring stability in their external accounts are as follows:

1. Managed floating exchange rate:

Managed floating exchange rate is the rate of exchange which is determined by the market forces of demand and supply but monetary authorities influence it by buying and selling foreign currencies. Thus, this exchange rate combines the features of both the fixed exchange rate and flexible exchange rate. Today most of the countries are following managed floating foreign exchange rate.

2. Crawling peg exchange rate:

Crawling peg exchange rate is a system of exchange rate under which currencies with some fixed exchange rate are allowed to make adjustment within a band of rates; normally this band is of 1%.

3. Currency board system:

Under this system, countries fix their exchange rates relative to an important trading partner.

If the exchange rate between two countries A and B is fixed, and inflation is higher in country A than in country B, the exports of country B will increase and  imports of country A will increase, leading to trade surplus for country B and trade deficit for country A.

In closed economy both demand for domestic goods and domestic demand for goods are the same.

But in Open economy, they have different meanings. In an open economy, the demand for domestic goods refers to the demand for goods produced in the domestic country, in both domestic as well as foreign market. And the domestic demand for goods refers to the demand for goods in domestic market, produced in both domestic country or in foreign country.

Yes, central bank need to intervene in managed floating system. Managed floating exchange rate combines the features of both the fixed exchange rate and flexible exchange rate. In an attempt to moderate exchange rate movements central banks intervene to buy and sell foreign currencies whenever they feel that such actions are appropriate. This is mostly done in order to act as a buffer against economic shocks and soften their effects on the economy.

In case of Proportional income tax (tY), the consumption function C is written as,

Current account deficit refers to excess of total imports of goods and services and inflow of unilateral transfers over total export of goods and services and outflow of unilateral transfers. It shows the borrowings of the country from rest of the world.

No a current account deficit should not be considered as a cause for alarm because many countries deliberately maintains current account deficit as a measure to improve the productivity and exports in future. Increase in investments income from rest of the world in domestic country helps in building infrastructure and growth prospects for the future.

Given, M= 60+0.06Y

Marginal propensity to import refers to the fraction of income that is spent on imports.

From the above equation we can say the marginal propensity to import is equal to 0.6.

Marginal propensity to import is inversely related to the aggregate demand function. As income increases, aggregate demand falls because; the increased income is used for import foreign goods and not spent on purchased domestic goods.

The transactions which cause changes in official reserves, undertaken by the monetary authority of a country are called official reserve transactions. In order to finance the deficit in current account (spending more abroad than it receives from sale to rest of the world), the country could engage in official reserve transactions. That is, running down its reserves of foreign exchange, in case of deficit by selling foreign currency in foreign exchange market.

Official reserve transactions play an important role in Balance of payments. It helps to bring a balance in overall balance of payments. In case of balance of payments surplus, the surplus amount of BOP is added in official reserves of foreign exchange. And in case of deficit in BOP, the deficit is financed from the official reserves of the foreign exchange by the monetary authority of the country. The increase (decrease) in the official reserves is called the overall balance of payments surplus (deficit).

Given:

C = 40 + 0.8YD

T = 50

I = 60

G = 40

X = 90

M = 50 + 0.05Y

(a) Equation for equilibrium income:

Hence equilibrium income is 560.

(b) Net exports= Exports(X) - Imports (M)

X= 90

M= 50 +0.05Y

Putting the value of Y in the above equation of M, we get,

M= 50 +0.05 x 560

M= 50+ 28

M= 78

Net exports = X-M

i.e. NX= 90-78

NX= 12

C. When government purchases increases from 40 to 50

In a closed economy, there are three sources of demand for domestic goods, Consumption (C), domestic Investment (I) and government spending (G)

Hence we can write

In an open economy, exports (X) constitutes an additional source of demand for domestic goods and services  from abroad and is added to aggregate demand. Imports (M) supplements supply in domestic market and reduce the demand for domestic goods and services, hence should be subtracted from the aggregate demand.

Rearranging the equation we get,

Y= C+I+G+X-M

The demand for imports depends on the income and has an autonomous component as well, so we can write

Looking at the denominators of two multiplier closed and open economy multipliers, we can conclude that open economy multiplier is smaller than closed economy multiplier as the denominator in open economy multiplier is greater that of denominator of closed economy multiplier.

Given,

C=100 + 0.75YD

I = 500

G= 750

Taxes T= 20 % of income i.e. 20/100Y

X = 150,

M = 100 + 0.2Y.

We know that,

Y= C+I+G+X-M

Y= 100 + 0.75[Y-(20/100)Y]+500+750+150-(100+0.2Y)

Y=1400 + 0.75Y - 0.15Y - 0.2Y

Y= 1400+0.4Y

0.6Y=1400

Y= 1400/0.6

y=7000/3

Y= 2333.33

Budget Deficit or surplus is calculated by taking the difference between Government receipts and government expenditure.

Government expenditure = 750

Government receipts = taxes = 20/100Y

Government receipts =20/100 x 7000/3 = 1400/3

Government receipts = 466.66

Since here government receipts i.e. taxes collected are less than government expenditure there is budget Deficit which is equal to 750 minus 466.66

i.e.

Budget Deficit = 283.33

To calculate trade deficit or surplus we will calculate the net exports (NX) for the economy.

X = 150

M = 100 + 0.2Y

Putting the value of Y in import equation we get

M= 100 + 0.2 (7000/3)

M =100 + 466.66

M= 566.66

NX= X-M

Putting the values in the above equation,

NX= 150 - 566.66

NX= -416.66

Since NX, i.e. net export is negative; it implies there is trade deficit equal to 416.66.

Given exchange rate between the Rupee and the dollar in the year 2010 was Rs 30=1$

The prices have doubled in India over 20 years and remained fixed in US.
So according to the purchasing power parity theory, the new exchange rate between dollar and
rupee in the year 2030 was Rs 60=1$.

Flexible exchange rate is the rate which is determined at a point where the demand for and supply of foreign exchange are equal. This implies at equilibrium demand for foreign exchange (say US $) is equal to Supply of foreign exchange (US $). It is also known as floating exchange rate. The determination of exchange rate under flexible exchange rate regime can be explained with the help of following Fig.

In the figure, DD is the demand curve for the foreign exchange (i.e. US $). It is downward sloping indicating that there is an inverse relationship between price of foreign exchange (i.e. exchange rate) and demand for foreign exchange. The rationale behind this relationship lies in the fact that rise in the price of foreign exchange (exchange rate) will raise the cost of foreign goods in terms of rupee. This will make the foreign goods more expensive, as a result imports will fall and so does demand for foreign exchange.

In the above figure, SS is the supply curve of foreign exchange which is upward sloping, showing direct relationship between price of foreign exchange (exchange rate) and supply of foreign exchange. This implies, if exchange rate increases, the supply of foreign exchange also increases. It is because the value of rupee depreciates which make domestic goods cheaper to foreigners. Hence their demand increases leading to an increase in supply of foreign exchange.

The point at which the DD curve and SS curve intersect gives the point of foreign exchange equilibrium (i.e. Point E), point R corresponding to this point E on y axis gives the equilibrium exchange rate or the price of dollar in terms of rupees and point Q corresponding to E on x-axis gives the quantity of foreign exchange traded (demanded or supplied).

At this dollar rupee exchange rate (R), market is cleared, i.e., demand for foreign exchange and supply of foreign exchange (US $) is equal.

The gold standard which was the personification of fixed exchange rate system prevailed from around 1870 to the outbreak of the First World War in 1914. Under gold standard all currencies were defined in terms of gold, and some were actually made of gold. Gold was taken as a common unit for measuring other country’s currency.  Under this system each participant country committed the free convertibility of its currency into gold at a fixed price. Exchange rate between two currencies was determined by its worth in terms of gold (or its actual gold content, where the currency was made of gold). It was fixed between an upper and a lower limit, under which it was allowed to fluctuate. (Limits were set on the basis of the costs of melting, shipping and recoining between the two currencies). All the countries had stable exchange rates under the gold standard.

Now since the exchange rates were fixed, the gold standard caused the price levels around the world to move together. This phenomenon occurred mainly through an automatic bop adjustment mechanism called price-specie-flow mechanism.

Let see how this mechanism worked.

If the stocks of gold went down in a country, all prices and costs would fall commensurately and no one in the country would be affected. Also with cheaper goods at home, the imports would fall and exports will rise. The countries from which it would be importing and making payments in gold would face an increase in prices and costs so their now expensive exports would fall and their imports from the first country would go up. The result of this price-specie flow mechanism is normally to improve the bop of the country losing gold, and worsen the bop of the country with favourable trade balance; until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow. This equilibrium is stable and self correcting. Thus, fixed exchange rates were maintained by an automatic equilibrating mechanism under gold standard.

Price level in foreign country (Japan) = 3

Price level in domestic country (India) = 1.2

We will first calculate Nominal exchange rate e,

We know that Price of 1.25 yen = 1 Rupee

⇒ e i.e. Price of 1 yen = 1/1.25 Rupees

⇒ e= 100/125= 4/5 Rupees

⇒ e= 4/5 Rupee

Now, we can calculate real exchange rate as

Real exchange rate = ePf/P

Real exchange rate =4/5 (3/1.2) = 2

Hence, the real exchange rate between India and Japan is 2.

Nominal exchange rate: It refers to the price of foreign currency in terms of domestic currency. It is the amount or number of units of domestic currency that is required to get 1 unit of foreign currency. For example: ₹ 66.75 are required to get 1$. It is called Nominal rupee- dollar exchange rate.

Real Exchange rate: It refers to the relative price of foreign goods in terms of domestic goods or the ratio of foreign price to domestic prices. It is defined as the Real exchange rate = eP_f/P,

Where, P = domestic price level, P_f = Price level in foreign country and e = rupee price of foreign exchange or nominal exchange rate.

Real exchange rate is often taken as a measure of a country’s international competitiveness. If real exchange rate is equal to 1, the currencies of two countries are at purchasing power parity, i.e. goods cost the same in the two countries when measured in same currency.

For example: If a cell phone cost $ 200 in the US and the nominal exchange rate is ₹ 60 per US dollar, given the real exchange rate as 1, the cost of the same cell phone in India is eP_f i.e. ₹ (60 x 200) = ₹ 12000.

In case the real exchange rate is greater than one it means goods abroad have become more costlier than at home.

Real exchange rate takes into account the inflation differential between countries.

Hence, if we have to decide whether to buy domestic goods or foreign goods, real exchange rate will be more relevant.