Open Economy Macroeconomics
Open Economy Macroeconomics tests balance-of-payments accounts, exchange-rate changes and their trade effects.
Balance of payments and exchange rates
BoP records all economic transactions between residents and the rest of the world. Current account includes goods, services, income and transfers; capital account includes foreign investment, loans and changes in reserves. A current account deficit must be financed by capital inflows or reserve depletion. The exchange rate is the price of foreign currency in domestic currency.
In a flexible rate, depreciation (a market fall) makes exports cheaper and imports dearer; appreciation does the opposite. Devaluation is a deliberate official reduction under a fixed rate; revaluation is the opposite. The nominal rate is actual; the real exchange rate adjusts for price levels. Purchasing power parity is a long-run benchmark.
Worked example
An Indian exporter sells goods worth $10,000. At ₹80/$, receipts are ₹8,00,000; at ₹85/$, they become ₹8,50,000. Rupee depreciation raises export earnings in rupees and may improve the trade balance if export demand is elastic. If the current account deficit is $40 billion and net capital inflows are $30 billion, reserves fall by $10 billion.
Traps
Depreciation of the rupee is not inflation; it is a fall in the external value of the currency. A current account surplus is not the same as a BoP surplus. Do not put portfolio investment in the current account. Depreciation helps exporters but hurts importers; the net effect depends on elasticities. Official reserve changes are part of BoP accounting.