Open Economy Macroeconomics – Class 12 Economics notes, important questions and MCQs

Chapter overview

An open economy trades goods, services and financial assets with other countries. These transactions are recorded in the balance of payments, which has a current account and a capital account. The price of one currency in terms of another is the exchange rate, which may be fixed, flexible or managed. Changes in the exchange rate affect exports, imports and the economy.

Balance of payments

• The balance of payments (BoP) is a record of all economic transactions between residents of a country and the rest of the world in a year.
• Current account: trade in goods (visible trade), trade in services (invisibles), income flows and transfers such as remittances; trade balance = exports − imports of goods.
• Capital account: foreign direct investment, portfolio investment, external borrowings and changes in foreign exchange reserves.
• Autonomous transactions are done for their own sake; accommodating transactions (official reserve changes) cover the BoP gap.

Exchange rate systems

• Flexible (floating) exchange rate: determined by demand and supply of foreign exchange in the market.
• Fixed exchange rate: set by the government or central bank; changing it is called devaluation or revaluation.
• Managed floating: market-determined, but the central bank intervenes to reduce sharp fluctuations; India has followed this system since the early 1990s.

Effects of exchange rate changes

• Depreciation of the rupee (more rupees per dollar) makes exports cheaper and imports costlier, which can increase exports.
• Appreciation of the rupee makes imports cheaper and exports costlier.
• Demand for foreign exchange comes from imports, foreign travel and investment abroad; supply comes from exports, foreign tourists' spending, remittances and foreign investment.

Key terms

Balance of payments

a systematic record of all economic transactions of a country with the rest of the world in a year

Current account

the part of BoP recording trade in goods and services, income and transfers

Capital account

the part of BoP recording transactions in financial assets and liabilities

Exchange rate

the price of one currency in terms of another

Depreciation (currency)

a fall in the value of the domestic currency under a flexible exchange rate

Important questions with answers

Quick revision

• BoP: current account + capital account.
• Trade balance = exports − imports of goods.
• Flexible, fixed, managed floating exchange rates.
• Depreciation boosts exports; appreciation boosts imports.

Exam tips

• Make a two-column chart: items in the current account vs items in the capital account.
• Remember: depreciation and devaluation both reduce a currency's value; depreciation is market-driven, devaluation is a government decision.

Practice MCQs

1. A record of a country's transactions with the rest of the world is the

   1. budget
   2. national income
   3. balance of payments
   4. trial balance
   Show answer

   Answer: (c) balance of payments. It covers a year.

2. Trade in goods is also called

   1. invisible trade
   2. transfers
   3. capital transactions
   4. visible trade
   Show answer

   Answer: (d) visible trade. Goods can be seen and recorded at customs.

3. The price of one currency in terms of another is the

   1. interest rate
   2. tax rate
   3. repo rate
   4. exchange rate
   Show answer

   Answer: (d) exchange rate. Example: rupees per dollar.

4. Foreign direct investment is recorded in the

   1. current account
   2. budget
   3. trade balance only
   4. capital account
   Show answer

   Answer: (d) capital account. It is a financial asset transaction.

5. Remittances sent home by Indians working abroad are recorded in the

   1. capital account
   2. fiscal deficit
   3. reserves only
   4. current account
   Show answer

   Answer: (d) current account. They are current transfers.

6. An exchange rate determined by demand and supply in the market with central bank intervention is

   1. fixed
   2. managed floating
   3. barter
   4. gold standard
   Show answer

   Answer: (b) managed floating. India follows this system.

7. If the rupee depreciates against the dollar, Indian exports become

   1. costlier for foreigners
   2. cheaper for foreigners
   3. banned
   4. unaffected
   Show answer

   Answer: (b) cheaper for foreigners. Foreigners get more rupees per dollar.

8. Which increases the supply of foreign exchange in India

   1. imports of oil
   2. foreign tourists spending in India
   3. Indians studying abroad
   4. repayment of foreign loans
   Show answer

   Answer: (b) foreign tourists spending in India. Tourists bring in foreign currency.