NCERT Solutions for Class 12 Economics Chapter 6: Open Economy Macroeconomics

An excess of import of goods, services and transfers over total exports of goods, services and transfers is called as current account deficit. This situation makes a country debtor to all other nations of the world. But this generally cannot be considered an alarming situation because countries can be having deficits which is used for increasing productivity and exports in future.

 

 

 

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

 

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.

 

On comparing the two equations and the denominators of the two multipliers, it can be concluded that multiplier in an open economy is smaller than the closed economy as denominator of open economy is greater than the closed economy.

 

Exchange rate plays an important role in the level of trade taking place in a country. In this question we see that country A is having a higher inflation than B. As exchange rate is fixed in this context it will be beneficial for the country A to import goods from country B and for B to export goods to country A. Therefore, country A will be experiencing trade deficit as import is more than export and similarly country B will experience trade surplus as there is more export and comparatively less imports.

 

Therefore, equilibrium income is Rs. 560

 

Savings and income are equal at equilibrium level in an economy while in an open economy savings and investments are different.

Y = C + I + G + X – M

NX = NX = X – M

Y = C + I + G + NX

Y – C – G = I + NX (eq.1)

Y – C – G can be regarded as national savings (S) or the net national income which is obtained after all consumption and government spending.

Therefore, it can be written that

Y – C – G = S

Or, S = I + NX

S = Private Savings (Sp) + Government Savings (Sg)

Now

S = Sp + Sg

Sp + Sg = I + NX (as S = I + NX)

NX = Sp + Sg – I (eq.2)

We know,

Sp = Y – C – T

Sg = T – G

Putting the values in eq.2 we get

NX = Y – C – T + T – G – I

NX = Y – C – G – I

G = Y – C – I – NX

Now subtracting T from both sides

G – T = Y – C – I – NX – T

G – T = Y – C – T – I – NX

G – T = (Sp– I) – NX

Where, NX = X – M

G – T = (SP– I) – (X – M)

 

 

The following exchange rate arrangements helped bring stability to external accounts:

1. Crawling peg is a system of continuous and regular adjustments that allows a variation of 1% at any given time.

2. Under the system of wider bands, adjustments are allowed in fixed exchange rates. A variation of 10% is applied between the currencies of any two countries. A country can depreciate its currency to improve the Balance of payments. It will lead to an increase in demand for domestic goods as the purchasing power of other currencies increases which results in more exports.

3. The third type is called managed floating, where the government has the authority to make changes in the exchange rate as per situation. The variation is not limited, unlike the previous two measures.