Chapter 6: Open Economy Macroeconomics

Transactions that are carried out by the monetary authority of a country which makes changes in official reserves is known as official reserve transaction or ORT. These transactions include the purchase and sale of currency in the exchange market for other assets and foreign currencies. By selling foreign currencies in the exchange market during periods of deficit and purchasing them during surplus periods. The increase and decrease in the official reserve are called the balance of payments surplus and deficit, respectively.

The importance of official reserve transactions in balance of payments are the following:

1. They help in adjusting deficit or surplus in the balance of payments

2. Purchasing of own currency is regarded credit item in the balance of payments, whereas selling is regarded as a debit.

The nominal exchange rate is defined as the relative price of two currencies. It means how many units of domestic currency need to be utilised to purchase a unit of foreign currency and vice versa. The real exchange rate measures how much quantity of goods can be purchased with domestic currency for a similar price in terms of foreign currency. It measures foreign prices with respect to domestic prices, or it can be said as the ratio of foreign prices to domestic prices. For e.g., if 1 kg of rice can be purchased with 4 USD, then how much rice can be purchased in India considering the price of rice in India is Rs. 20 per kg?

Real exchange rate is more relevant in cases of buying domestic and foreign goods

Solution coming soon.

In the Gold standard system, gold is considered a common unit to measure another nation’s currency in other words value of a currency was defined in terms of gold. The exchange rates were fixed in upper and lower limits, and it was allowed to fluctuate within those limits. Therefore, exchange rates became stable under the gold standard, and due to this reason, all countries maintained their individual stock of gold which was used for currency exchange.

In a flexible exchange rate regime, the rate of exchange is determined on the basis of demand and supply. The equilibrium is attained when demand and supply are equal to each other.

In this figure, X-axis represents demand for foreign currency while the Y-axis represents exchange rates. Demand curve DD is sloping downward, which shows the inverse relationship between the rate of exchange and demand for foreign currency. The supply curve SS is upward sloping which shows the positive development of the rate of exchange and supply of foreign currency. E is the point where the equilibrium exchange rate is reached.

A managed floating system is a system where exchange rates fluctuate on a day-to-day basis. The role of a central bank in such a system is to maintain balance by purchasing of foreign exchange when the floating rate is low in order to raise its rate and similarly selling foreign exchanges when the floating rate is high in order to bring the rate down.

No, both concepts are not the same as demand for domestic goods means demand for goods that are produced domestically in both domestic and international markets, whereas domestic demand for goods means domestic demand for goods that are produced domestically or internationally. Demand for domestic goods is a broader concept that includes domestic demand for goods.

Marginal propensity to import is the change in import values which is brought about by additional income of the country. It is the extent to which a country’s import increases/decreases in relation to the change in GDP.

Here we see that M = 60 + 0.06Y

Now, m = 0.06 (Marginal propensity to import)

Aggregate demand function is negatively affected by the marginal propensity to import. Therefore, with increasing income, there is a decrease in aggregate demand as additional income is spent on importing foreign products.