Macroeconomics – Chapter 6 (Open Economy Macroeconomics)

• Open economy: interacts with other countries through various means.

• Closed economy: no linkage with the rest of the world.

• Linkages in an open economy:

1. Financial Market

2. Labour Market

3. Output Market

Output Market – trade in goods and services with other countries.
Financial Market – purchase of financial assets from other countries.
Labour Market – firms hire labour from other countries when needed.

• Buying foreign goods → leakage from circular flow, decreases aggregate demand.

• Exports → injection into circular flow, increases domestic income.

• International monetary system ensures stability in international transactions.

• Exchange rate: price of one currency in terms of another.

Balance of Payments (BOP)

• Records transactions in goods, services, transfer payments, and assets between residents of a country and the rest of the world (usually for a year).

• Two main accounts:

1. Current Account

2. Capital Account

Current Account – records trade in goods, services, and transfer payments.

• Imports → expenditure from our country, income for foreign country → decreases domestic demand.

• Exports → income for our country → increases domestic demand.

Balance on Current Account

• In balance when receipts = payments.

• Surplus → nation is a lender to other countries.

• Deficit → nation is a borrower from other countries.

Components:

1. Balance of Trade (BOT)

2. Balance on Invisibles

Balance of Trade (BOT)

• Difference between value of exports and imports of goods in a given period.

• BOT is balanced when exports = imports.

• Surplus BOT → exports > imports.

• Deficit BOT → imports > exports

Net Invisibles in Economics

• Definition:
  Net Invisibles represent the difference between the value of invisible exports and invisible imports of a country during a given period.

• Invisible Trade:
  Refers to international transactions involving services and non-tangible products that do not appear directly in physical production.
  Examples include:

  • Shipping services

  • Banking and financial services

  • Insurance

  • Tourism Consultancy and IT services

  • Capital flows (interest, dividends, remittances)

• Importance:

• Helps balance the current account when merchandise trade shows a deficit.

• Reflects the strength of a country’s service sector and global financial linkages.

• Plays a crucial role in economies with strong service exports (e.g., India’s IT sector).