TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 14

Open economy
National economies are becoming more closely interrelated
Economies are linked through two broad channels
1. Trade in goods and services
2. Finance

Open Economy
Balance of Payments (BOP)
IMF and SDRs
Exchange rate:
Nominal Exchange Rate
Real Exchange Rate
Exchange rate Indices
Nominal Effective Exchange Rates (NEER)
Real Effective Exchange Rates (REER)

The Balance of Payments

Is a summary of nations financial relationship with the rest of the world
It is a systematic record of all economic transactions between the
economic unit (household, firm and Govt.) of one country and the rest of
the world.
BOP is a book keeping system which records both sides of any transaction
involving a domestic resident and abroad resident
Credit (Sources of forex)
Debit (Use of forex)

BOP Accounts
Current account

Capital account

Measures the flow of goods and

services and income across national
borders
Export of goods
Imports of goods
Invisibles:
Services
Income
(Unilateral) Transfers

Measures capital outflow and inflow

into the economy
External Assistance
ECB (External commercial borrowings)
Financial investment
FDI, portfolio investment
Short term debt
Other capital flows: NRI deposits

Reserve Account/Financial Account

It comprises of holdings of monetary gold, special drawing rights,
reserves of IMF members held by the IMF, and holdings of foreign
exchange under the control of monetary authorities
The International Monetary Fund (IMF) is an international
organization of 188 countries working to foster global monetary
cooperation, exchange-rate stability, including by making financial
resources available to member countries to meet balance-ofpayments needs

External Accounts Must Balance

In an accounting sense, debit = credit. BOP always balances (surplus in
current account will be matched by deficits in capital account).
BOP = Current Account + Capital Account
= Changes in international reserves
0= Current Account + Capital Account
Current Account = (- Capital Account )
Current account + Capital account = 0 (1)

Errors and Omissions

Net errors and omissions constitute a residual category needed to
ensure that accounts in the balance of payments statement sum to
zero.
Capital + Financial Account balance = (- Current account)
Net errors and omissions = financial account - the balances on the
current and capital accounts

Source: RBI

Exchange Rates
It is the rate at which different currencies are traded
It is the price of one currency in terms of another
It can be quoted directly or indirectly

Example:
1 US $ = INR 65 (Base currency is US $; direct quotation of INR)
1 INR = 0.0153 US $ (Base currency is INR; indirect quotation of INR)

Nominal Exchange Rates (NER)

NER, E = INR / USD (Direct way, America way)
No. of domestic currency per unit of foreign currency
If E = 63 (it means you need INR 63 to buy 1 USD)
If E = 65
Therefore, foreign currency (USD) is becoming stronger relative to domestic currency:
Domestic currency has depreciated
If E = 60 ???

Real Exchange Rates (RER)

The real exchange rates are nothing but the nominal exchange rates
multiplied by the price indices of the two countries
RER = NER (indirect quote)* (Domestic price/ foreign price)
E (real) = E * (Domestic price/ foreign price)

Nominal and Real Effective Exchange Rates

(NEER and REER)
They are basically exchange rate indices
India trade with many countries
INR can be expected to be appreciated with some currency or
depreciated with respect to some other currency

Nominal Effective Exchange Rates (NEER)

The weighted average of bilateral nominal exchange rates of the home
currency in terms of foreign currencies.
The weights are determined by the importance a home country places on
all other currencies traded within the pool, as measured by the balance of
trade.
NEER (6 currency: Indian rupee is measured against 6 big currencies, Dollar
Hong Kong dollar, Euro, Pound sterling, Japanese Yen, Chinese Renminbi)

Real Effective Exchange Rates (REER)

REER is the weighted average of nominal exchange rates, adjusted for
inflation.
It is an index of a country's real exchange rate, a single number which gives
some reference or benchmark about trade competitiveness in relation to
the rest of the world as a whole, rather than just individual countries.
If the REER > 100, then Indian goods are relatively less competitive in
the export market and vice versa.

Nominal and Real Effective Exchange Rates

(NEER and REER)
They are basically exchange rate indices
India trade with many countries
INR can be expected to be appreciated with some currency or
depreciated with respect to some other currency

Nominal Effective Exchange Rates (NEER)

The weighted average of bilateral nominal exchange rates of the home
currency in terms of foreign currencies.
The weights are determined by the importance a home country places on
all other currencies traded within the pool, as measured by the balance of
trade.
NEER (6 currency: Indian rupee is measured against 6 big currencies, Dollar
Hong Kong dollar, Euro, Pound sterling, Japanese Yen, Chinese Renminbi)

Source : RBI