NCERT Textbooks

Adam Smith (1723 – 1790) Regarded as the father of modern Economics. Author of Wealth of Nations.

Aggregate monetary resources Broad money without time deposits of post office savings organisation (M3).

Automatic stabilisers Under certain spending and tax rules, expenditures that automatically increase or taxes that automatically decrease when economic conditions worsen, therefore, stabilizing the economy automatically.

Autonomous change A change in the values of variables in a macroeconomic model caused by a factor exogenous to the model.

Autonomous expenditure multiplier The ratio of increase (or decrease) in aggregate output or income to an increase (or decrease) in autonomous spending.

Balance of payments A set of accounts that summarise a country’s transactions with the rest of the world.

Balanced budget A budget in which taxes are equal to government spending.

Balanced budget multiplier The change in equilibrium output that results from a unit increase or decrease in both taxes and government spending.

Bank rate The rate of interest payable by commercial banks to RBI if they borrow money from the latter in case of a shortage of reserves.

Barter exchange Exchange of commodities without the mediation of money.

Base year The year whose prices are used to calculate the real GDP.

Bonds A paper bearing the promise of a stream of future monetary returns over a specified period of time. Issued by firms or governments for borrowing money from the public.

Broad money Narrow money + time deposits held by commercial banks and post office savings organisation.

Capital Factor of production which has itself been produced and which is not generally entirely consumed in the production process.

Capital gain/loss Increase or decrease in the value of wealth of a bondholder due to an appreciation or reduction in the price of her bonds in the bond market.

Capital goods Goods which are bought not for meeting immediate need of the consumer but for producing other goods.

Capitalist country or economy A country in which most of the production is carried out by capitalist firms.

Capitalist firms These are firms with the following features (a) private ownership of means of production (b) production for the market (c) sale and purchase of labour at a price which is called the wage rate (d) continuous accumulation of capital.

Cash Reserve Ratio (CRR) The fraction of their deposits which the commercial banks are required to keep with RBI.

Circular flow of income The concept that the aggregate value of goods and services produced in an economy is going around in a circular way. Either as factor payments, or as expenditures on goods and services, or as the value of aggregate

Consumer durables Consumption goods which do not get exhausted immediately but last over a period of time are consumer durables.

Consumer Price Index (CPI) Percentage change in the weighted average price level. We take the prices of a given basket of consumption goods.

Consumption goods Goods which are consumed by the ultimate consumers or meet the immediate need of the consumer are called consumption goods. It may include services as well.

Corporate tax Taxes imposed on the income made by the corporations (or private sector firms).

Currency deposit ratio The ratio of money held by the public in currency to that held as deposits in commercial banks.

Deficit financing through central bank borrowing Financing of budget deficit by the government through borrowing money from the central bank. Leads to increase in money supply in an economy and may result in inflation.

Depreciation A decrease in the price of the domestic currency in terms of the foreign currency under floating exchange rates. It corresponds to an increase in the exchange rate.

Depreciation Wear and tear or depletion which capital stock undergoes over a period of time.

Devaluation The decrease in the price of domestic currency under pegged exchange rates through official action.

Double coincidence of wants A situation where two economic agents have complementary demand for each others’ surplus production.

Economic agents or units Economic units or economic agents are those individuals or institutions which take economic decisions.

Effective demand principle If the supply of final goods is assumed to be infinitely elastic at constant price over a short period of time, aggregate output is determined solely by the value of aggregate demand. This is called effective demand principle.

Entrepreneurship The task of organising, coordinating and risk-taking during production.

Ex ante consumption The value of planned consumption.

Ex ante investment The value of planned investment.

Ex ante The planned value of a variable as opposed to its actual value.

Ex post The actual or realised value of a variable as opposed to its planned value.

Expenditure method of calculating national income Method of calculating the national income by measuring the aggregate value of final expenditure for the goods and services produced in an economy over a period of time.

Exports Sale of goods and services by the domestic country to the rest of the world.

External sector It refers to the economic transaction of the domestic country with the rest of the world.

Externalities Those benefits or harms accruing to another person, firm or any other entity which occur because some person, firm or any other entity may be involved in an economic activity. If someone is causing benefits or good externality to another, the latter does not pay the former. If someone is inflicting harm or bad externality to another, the former does not compensate the latter.

Fiat money Money with no intrinsic value.

Final goods Those goods which do not undergo any further transformation in the production process.

Firms Economic units which carry out production of goods and services and employ factors of production.

Fiscal policy The policy of the government regarding the level of government spending and transfers and the tax structure.

Fixed exchange rate An exchange rate between the currencies of two or more countries that is fixed at some level and adjusted only infrequently.

Flexible/floating exchange rate An exchange rate determined by the forces of demand and supply in the foreign exchange market without central bank intervention.

Flows Variables which are defined over a period of time.

Foreign exchange Foreign currency, all currencies other than the domestic currency of a given country.

Foreign exchange reserves Foreign assets held by the central bank of the country.

Four factors of production Land, Labour, Capital and Entrepreneurship. Together these help in the production of goods and services.

GDP Deflator Ratio of nominal to real GDP.

Government expenditure multiplier The numerical coefficient showing the size of the increase in output resulting from each unit increase in government spending.

Government The state, which maintains law and order in the country, imposes taxes and fines, makes laws and promotes the economic wellbeing of the citizens.

Great Depression The time period of 1930s (started with the stock market crash in New York in 1929) which saw the output in the developed countries fall and unemployment rise by huge amounts.

Gross Domestic Product (GDP) Aggregate value of goods and services produced within the domestic territory of a country. It includes the replacement investment of the depreciation of capital stock.

Gross fiscal deficit The excess of total government expenditure over revenue receipts and capital receipts that do not create debt.

Gross investment Addition to capital stock which also includes replacement for the wear and tear which the capital stock undergoes.

Gross National Product (GNP) GDP + Net Factor Income from Abroad. In other words GNP includes the aggregate income made by all citizens of the country, whereas GDP includes incomes by foreigners within the domestic economy and excludes incomes earned by the citizens in a foreign economy.

Gross primary deficit The fiscal deficit minus interest payments.

High powered money Money injected by the monetary authority in the economy. Consists mainly of currency.

Households The families or individuals who supply factors of production to the firms and which buy the goods and services from the firms.

Imports Purchase of goods and services by the domestic country to the rest of the world.

Income method of calculating national income Method of calculating national income by measuring the aggregate value of final factor payments made (= income) in an economy over a period of time.

Interest Payment for services which are provided by capital.

Intermediate goods Goods which are used up during the process of production of other goods.

Inventories The unsold goods, unused raw materials or semi-finished goods which a firm carries from a year to the next.

John Maynard Keynes (1883 – 1946) Arguably the founder of Macroeconomics as a separate discipline.

Labour Human physical effort used in production.

Land Natural resources used in production – either fixed or consumed.

Legal tender Money issued by the monetary authority or the government which cannot be refused by anyone.

Lender of last resort The function of the monetary authority of a country in which it provides guarantee of solvency to commercial banks in a situation of liquidity crisis or bank runs.

Liquidity trap A situation of very low rate of interest in the economy where every economic agent expects the interest rate to rise in future and consequently bond prices to fall, causing capital loss. Everybody holds her wealth in money and
speculative demand for money is infinite.

Macroeconomic model Presenting the simplified version of the functioning of a macroeconomy through either analytical reasoning or mathematical, graphical representation.

Managed floating A system in which the central bank allows the exchange rate to be determined by market forces but intervene at times to influence the rate.

Marginal propensity to consume The ratio of additional consumption to additional income.

Medium of exchange The principal function of money for facilitating commodity exchanges.

Money multiplier The ratio of total money supply to the stock of high powered money in an economy.

Narrow money Currency notes, coins and demand deposits held by the public in commercial banks.

National disposable income Net National Product at market prices + Other Current Transfers from the rest of the World.

Net Domestic Product (NDP) Aggregate value of goods and services produced within the domestic territory of a country which does not include the depreciation of capital stock.

Net interest payments made by households Interest payment made by the households to the firms – interest payments received by the households.

Net investment Addition to capital stock; unlike gross investment, it does not include the replacement for the depletion of capital stock.

Net National Product (NNP) (at market price) GNP – depreciation.

NNP (at factor cost) or National Income (NI) NNP at market price – (Indirect taxes – Subsidies).

Nominal exchange rate The number of units of domestic currency one must give up to get an unit of foreign currency; the price of foreign currency in terms of domestic currency.

Nominal (GDP) GDP evaluated at current market prices.

Non-tax payments Payments made by households to the firms or the government as non-tax obligations such as fines.

Open market operation Purchase or sales of government securities by the central bank from the general public in the bond market in a bid to increase or decrease the money supply in the economy.

Paradox of thrift As people become more thrifty they end up saving less or same as before in aggregate.

Parametric shift Shift of a graph due to a change in the value of a parameter.

Personal Disposable Income (PDI) PI – Personal tax payments – Non-tax payments.

Personal Income (PI) NI – Undistributed profits – Net interest payments made by households – Corporate tax + Transfer payments to the households from the government and firms.

Personal tax payments Taxes which are imposed on individuals, such as income tax.

Planned change in inventories Change in the stock of inventories which has occurred in a planned way.

Present value (of a bond) That amount of money which, if kept today in an interest earning project, would generate the same income as the sum promised by a bond over its lifetime.

Private income Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world.

Product method of calculating national income Method of calculating the national income by measuring the aggregate value of production taking place in an economy over a period of time.

Profit Payment for the services which are provided by entrepreneurship.

Public good Goods or services that are collectively consumed; it is not possible to exclude anyone from enjoying their benefits and one person’s consumption does not reduce that available to others.

Purchasing power parity A theory of international exchange which holds that the price of similar goods in different countries is the same.

Real exchange rate The relative price of foreign goods in terms of domestic goods.

Real GDP GDP evaluated at a set of constant prices.

Rent Payment for services which are provided by land (natural resources).

Reserve deposit ratio The fraction of their total deposits which commercial banks keep as reserves.

Revaluation A decrease in the exchange rate in a pegged exchange rate system which makes the foreign currency cheaper in terms of the domestic currency.

Revenue deficit The excess of revenue expenditure over revenue receipts.

Ricardian equivalence The theory that consumers are forward looking and anticipate that government borrowing today will mean a tax increase in the future to repay the debt, and will adjust consumption accordingly so that it will have the
same effect on the economy as a tax increase today.

Speculative demand Demand for money as a store of wealth.

Statutory Liquidity Ratio (SLR) The fraction of their total demand and time deposits which the commercial banks are required by RBI to invest in specified liquid assets.

Sterilisation Intervention by the monetary authority of a country in the money market to keep the money supply stable against exogenous or sometimes external shocks such as an increase in foreign exchange inflow.

Stocks Those variables which are defined at a point of time.

Store of value Wealth can be stored in the form of money for future use. This function of money is referred to as store of value.

Transaction demand Demand for money for carrying out transactions.

Transfer payments to households from the government and firms Transfer payments are payments which are made without any counterpart of services received by the payer. For examples, gifts, scholarships, pensions.

Undistributed profits That part of profits earned by the private and government owned firms which are not distributed among the factors of production.

Unemployment rate This may be defined as the number of people who were unable to find a job (though they were looking for jobs), as a ratio of total number of people who were looking for jobs.

Unit of account The role of money as a yardstick for measuring and comparing values of different commodities.

Unplanned change in inventories Change in the stock of inventories which has occurred in an unexpected way.

Value added Net contribution made by a firm in the process of production. It is defined as, Value of production – Value of intermediate goods used.

Wage Payment for the services which are rendered by labour.

Wholesale Price Index (WPI) Percentage change in the weighted average price level. We take the prices of a given basket of goods which is traded in bulk.

With consumers and firms having an option to buy goods produced at home and abroad, we now need to distinguish between domestic demand for goods and the demand for domestic goods.

National Income Identity for an Open Economy

In a closed economy, there are three sources of demand for domestic goods – Consumption (C ), government spending (G), and domestic investment (I ). We can write

Y = C + I + G (6.2)

In an open economy, exports (X) constitute an additional source of demand for domestic goods and services that comes from abroad and therefore must be added to aggregate demand. Imports (M) supplement supplies in domestic markets and constitute that part of domestic demand that falls on foreign goods and services. Therefore, the national income identity for an open economy is

Y + M = C + I + G + X (6.3)

Rearranging, we get

Y = C + I + G + X – M (6.4)

Y = C + I + G + NX (6.5)

where, NX is net exports (exports – imports). A positive NX (with exports greater than imports) implies a trade surplus and a negative NX (with imports exceeding exports) implies a trade deficit. To examine the roles of imports and exports in determining equilibrium income in an open economy, we follow the same procedure as we did for the closed economy case – we take investment and government spending as autonomous. In addition, we need to specify the determinants of imports and exports. The demand for imports depends on domestic income (Y) and the real exchange rate (R ). Higher income leads to higher imports. Recall that the real exchange rate is defined as the relative price of foreign goods in terms of domestic goods. A higher R makes foreign goods relatively more expensive, thereby leading to a decrease in the quantity of imports. Thus, imports depend positively on Y and negatively on R. The export of one country is, by definition, the import of another. Thus, our exports would constitute foreign imports. It would depend on foreign income, Yf , and on R. A rise in Yf will increase foreign demand for our goods, thus leading to higher exports. An increase in R, which makes domestic goods cheaper, will increase our exports. Exports depend positively on foreign income and the real exchange rate. Thus, exports and imports depend on domestic income, foreign income and the real exchange rate. We assume price levels and the nominal exchange rate to be constant, hence R will be fixed. From the point of view of our country, foreign income, and therefore exports, are considered exogenous (X = X ). The demand for imports is thus assumed to depend on income and have an autonomous component
M = M + mY, where M > 0 is the autonomous component, 0 < y =" C" y =" A" y =" A">
Equilibrium Output and the Trade Balance

We shall provide a diagrammatic explanation of the above mechanisms and, in addition, their impact on the trade balance. Net exports, (NX = X – M), as we saw earlier, depend on Y, Yf and R. A rise in Y raises import spending and leads to trade deficit (if initially we had trade balance, NX = 0). A rise in Yf , other things being equal, raises our exports, creates a trade surplus and raises aggregate income. A real depreciation would raise exports and reduce imports, thus increasing our net exports.

Change in Prices:
Next we consider the effects of changes in prices, assuming the exchange rate to be fixed. If prices of domestic products fall, while say foreign prices remain constant, domestic exports will rise, adding to aggregate demand, and hence will raise our output and income. Analogously, a rise in prices of a country’s exports will decrease that country’s net exports and output and income. Similarly, a price increase abroad will make foreign products more expensive and hence again raise net exports and domestic output and income. Price decreases abroad have the opposite effects.

Exchange Rate Changes:
Changes in nominal exchange rates would change the real exchange rate and hence international relative prices. A depreciation of the rupee will raise the cost of buying foreign goods and make domestic goods less costly. This will raise net exports and therefore increase aggregate demand. Conversely, a currency appreciation would reduce net exports and, therefore, decrease aggregate demand. However, we must note that international trade patterns take time to respond to changes in exchange rates. A considerable period of time may elapse before any improvement in net exports is apparent.


Having considered accounting of international transactions on the whole, we will now take up a single transaction. Let us assume that an Indian resident wants to visit London on a vacation (an import of tourist services). She will have to pay in pounds for her stay there. She will need to know where to obtain the pounds and at what price. Her demand for pounds would constitute a demand for foreign exchange which would be supplied in the foreign exchange market – the market in which national currencies are traded for one another. The major participants in this market are commercial banks, foreign exchange brokers and other authorised dealers and the monetary authorities. It is important to note that, although the participants themselves may have their own trading centres, the market itself is world-wide. There is close and continuous contact between the trading centres and the participants deal in more than one market. The price of one currency in terms of the other is known as the exchange rate. Since there is a symmetry between the two currencies, the exchange rate may be defined in one of the two ways. First, as the amount of domestic currency required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of Rs 50 means that it costs Rs 50 to buy one dollar, and second, as the cost in foreign currency of purchasing one unit of domestic currency. In the above case, we would say that it costs 2 cents to buy a rupee. The practice in economic literature, however, is to use the former definition – as the price of foreign currency in terms of domestic currency. This is the bilateral nominal exchange rate – bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound. However, returning to our example, if one wants to plan a trip to London, she needs to know how expensive British goods are relative to goods at home. The measure that captures this is the real exchange rate – the ratio of foreign to domestic prices, measured in the same currency. It is defined as

Real exchange rate = f eP P (6.1)

where P and Pf are the price levels here and abroad, respectively, and e is the rupee price of foreign exchange (the nominal exchange rate). The numerator expresses prices abroad measured in rupees, the denominator gives the domestic price level measured in rupees, so the real exchange rate measures prices abroad relative to those at home. If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency. For instance, if a pen costs $4 in the US and the nominal exchange rate is Rs 50 per US dollar, then with a real exchange rate of 1, it should cost Rs 200 (ePf = 50 × 4) in India. If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home. The real exchange rate is often taken as a measure of a country’s international competitiveness. Since a country interacts with many countries, we may want to see the movement of the domestic currency relative to all other currencies in a single number rather than by looking at bilateral rates. That is, we would want an index for the exchange rate against other currencies, just as we use a price index to show how the prices of goods in general have changed. This is calculated as the Nominal Effective Exchange Rate (NEER) which is a multilateral rate representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade (the average of export and import shares is taken as an indicator of this). The Real Effective Exchange Rate (REER) is calculated as the weighted average of the real exchange rates of all its trade partners, the weights being the shares of the respective countries in its foreign trade. It is interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.

Determination of the Exchange Rate

The question arises as to why the foreign exchange rate1 is at this level and what causes its movements? To understand the economic principles that lie behind exchange rate determination, we study the major exchange rate regimes2 that have characterised the international monetary system. There has been a move from a regime of commitment of fixed-price convertibility to one without commitments where residents enjoy greater freedom to convert domestic currency into foreign currencies but do not enjoy a price guarantee.

Flexible Exchange Rates

In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply. In a completely flexible system, the central banks follow a simple set of rules – they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market (and therefore, there are no official reserve transactions). The link between the balance of payments accounts and the transactions in the foreign exchange market is evident when we recognise that all expenditures by domestic residents on foreign goods, services and assets and all foreign transfer payments (debits in the BoP accounts) also represent demand for foreign exchange. The Indian resident buying a Japanese car pays for it in rupees but the Japanese exporter will expect to be paid in yen. So rupees must be exchanged for yen in the foreign exchange market. Conversely, all exports by domestic residents reflect equal earnings of foreign exchange. For instance, Indian exporters will expect to be paid in rupees and, to buy our goods, foreigners must sell their currency and buy rupees. Total credits in the BoP accounts are then equal to the supply of foreign exchange. Another reason for the demand for foreign exchange is for speculative purposes.

Let us assume, for simplicity, that India and the United States are the only countries in the world, so that there is only one exchange rate to be determined. The demand curve (DD) is downward sloping because a rise in the price of foreign exchange will increase the cost in terms of rupees of purchasing foreign goods. Imports will therefore decline and less foreign exchange will be demanded. For the supply of foreign exchange to increase as the exchange rate rises, the foreign demand for our exports must be more than unit elastic, meaning simply that a one per cent increase in the exchange rate (which results in a one per cent decline in the price of the export good to the foreign country buying our good) must result in an increase in demand of more than one per cent. If this condition is met, the rupee volume of our exports will rise more than proportionately to the rise in the exchange rate, and earnings in dollars (the supply of foreign exchange) will increase as the exchange rate rises.

However, a vertical supply curve (with a unit elastic foreign demand for Indian exports) would not change the analysis. We note that here we are holding all prices other than the exchange rate constant. In this case of flexible exchange rates without central bank intervention, the exchange rate moves to clear the market, to equate the demand for and supply of foreign exchange. If the demand for foreign exchange goes up due to Indians travelling abroad more often, or increasingly showing a preference for imported goods, the DD curve will shift upward and rightward. The resulting intersection would be at a higher exchange rate. Changes in the price of foreign exchange under flexible exchange rates are referred to as currency depreciation or appreciation. In the above case, the domestic currency (rupee) has depreciated since it has become less expensive in terms of foreign currency. For instance, if the equilibrium rupeedollar exchange rate was Rs 45 and now it has become Rs 50 per dollar, the rupee has depreciated against the dollar. By contrast, the currency appreciates when it becomes more expensive in terms of foreign currency. At the initial equilibrium exchange rate e*, there is now an excess demand for foreign exchange. The rise in exchange rate (depreciation) will cause the quantity of import demand to fall since the rupee price of imported goods rises with the exchange rate. Also, the quantity of exports demanded will increase since the rise in the exchange rate makes exports less expensive to foreigners. At the new equilibrium with e1, the supply and demand for foreign exchange is again equal.

Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency. Money in any country is an asset. If Indians believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds. For instance, if the current exchange rate is Rs 80 to a pound and investors believe that the pound is going to appreciate by the end of the month and will be worth Rs 85, investors think if they took Rs 80,000 and bought 1,000 pounds, at the end of the month, they would be able to exchange the pounds for Rs 85,000, thus making a profit of Rs 5,000. This expectation would increase the demand for pounds and cause the rupee-pound exchange rate to increase in the present, making the beliefs self-fulfilling. The above analysis assumes that interest rates, incomes and prices remain constant. However, these may change and that will shift the demand and supply curves for foreign exchange.

Interest Rates and the Exchange Rate:
In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates. If we assume that government bonds in country A pay 8 per cent rate of interest whereas equally safe bonds in country B yield 10 per cent, the interest rate diferential is 2 per cent. Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.

Income and the Exchange Rate:
When income increases, consumer spending increases. Spending on imported goods is also likely to increase. When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency. If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports. In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency depreciating because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.

Exchange Rates in the Long Run:
The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation. Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.

If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar exchange rate should be Rs 50. To see why, at any rate higher than Rs 50, say Rs 60, it costs Rs 480 per shirt in the US but only Rs 400 in India. In that case, all foreign customers would buy shirts from India. Similarly, any exchange rate below Rs 50 per dollar will send all the shirt business to the US. Next, we suppose that prices in India rise by 20 per cent while prices in the US rise by 50 per cent. Indian shirts would now cost Rs 480 per shirt while American shirts cost $12 per shirt. For these two prices to be equivalent, $12 must be worth Rs 480, or one dollar must be worth Rs 40. The dollar, therefore, has depreciated. According to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates. If one country has higher inflation than another, its exchange rate should be depreciating.

However, we note that if American prices rise faster than Indian prices and, at the same time, countries erect tariff barriers to keep Indian shirts out (but not American ones), the dollar may not depreciate. Also, there are many goods that are not tradeable and inflation rates for them will not matter. Further, few goods that different countries produce and trade are uniform or identical. Most economists contend that other factors are more important than relative prices for exchange rate determination in the short run. However, in the long run, purchasing power parity plays an important role.
Fixed Exchange Rates

Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s. Prior to that, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level. Sometimes, a distinction is made between the fixed and pegged exchange rates. It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable – it may be changed. There is a common element between the two systems. Under a fixed exchange rate system, such as the gold standard, adjustment to BoP surpluses or deficits cannot be brought about through changes in the exchange rate. Adjustment must either come about ‘automatically’ through the workings of the economic system (through the mechanism explained by Hume, given below) or be brought about by the government. A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics. However, there is another option open to the government – it may change the exchange rate. A devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system. The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy. Most governments change the exchange rate very infrequently. In our analysis, we use the terms fixed and pegged exchange rates interchangeably to denote an exchange rate regime where the exchange rate is set by government decisions and maintained by government actions. We examine the way in which a country can ‘peg’ or fix the level of its exchange rate. We assume that Reserve bank of India (RBI) wishes to fix an exact par value for the rupee at Rs 45 per dollar (e1 in Fig. 6.3). Assuming that this official exchange rate is below the equilibrium exchange rate (here e* = Rs 50) of the flexible exchange rate system, the rupee will be overvalued and the dollar undervalued. This means that if the exchange rate were market determined, the price of dollars in terms of rupees would have to rise to clear the market. At Rs 45 to a dollar, the rupee is more expensive than it would be at Rs 50 to a dollar (thinking of the rate in dollar-rupee terms, now each rupee costs 2.22 cents instead of 2 cents). At this rate, the demand for dollars is higher than the supply of dollars. Since the demand and supply schedules were constructed from the BoP accounts (measuring only autonomous transactions), this excess demand implies a deficit in the BoP. The deficit is bridged by central bank intervention. In this case, the RBI would sell dollars for rupees in the foreign exchange market to meet this excess demand AB, thus neutralising the upward pressure on the exchange rate. The RBI stands ready to buy and sell dollars at that rate to prevent the exchange rate from rising (since no one would buy at more) or falling (since no one would sell for less).

Now the RBI might decide to fix the exchange rate at a higher level – Rs 47 per dollar – to bridge part of the deficit in BoP. This devaluation of the domestic currency would make imports expensive and our exports cheaper, leading to a narrowing of the trade deficit. It is important to note that repeated central bank intervention to finance deficits and keep the exchange rate fixed will eventually exhaust the official reserves. This is the main flaw in the system of fixed exchange rates. Once speculators believe that the exchange rate cannot be held for long they would buy foreign exchange (say, dollars) in massive amounts. The demand for dollars will rise sharply causing a BoP deficit. Without sufficient reserves, the central bank will have to allow the exchange rate to reach its equilibrium level. This might amount to an even larger devaluation than would have been required before the speculative ‘attack’ on the domestic currency began. International experience shows that it is precisely this that has led many countries to abandon the system of fixed exchange rates. Fear of such an attack induced the US to let its currency float in 1971, one of the major events which precipitated the breakdown of the Bretton Woods system.

Managed Floating

Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part). Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. Official reserve transactions are, therefore, not equal to zero.

Exchange Rate Management: The International Experience

The Gold Standard:
From around 1870 to the outbreak of the First World War in 1914, the prevailing system was the gold standard which was the epitome of the fixed exchange rate system. All currencies were defined in terms of gold; indeed some were actually made of gold. Each participant country committed to guarantee the free convertibility of its currency into gold at a fixed price. This meant that residents had, at their disposal, a domestic currency which was freely convertible at a fixed price into another asset (gold) acceptable in international payments. This also made it possible for each currency to be convertible into all others at a fixed price. Exchange rates were determined by its worth in terms of gold (where the currency was made of gold, its actual gold content). For example, if one unit of say currency A was worth one gram of gold, one unit of currency B was worth two grams of gold, currency B would be worth twice as much as currency A. Economic agents could directly convert one unit of currency B into two units of currency A, without having to first buy gold and then sell it. The rates would fluctuate between an upper and a lower limit, these limits being set by the costs of melting, shipping and recoining between the two Currencies 3. To maintain the official parity each country needed an adequate stock of gold reserves. All countries on the gold standard had stable exchange rates.

The question arose – would not a country lose all its stock of gold if it imported too much (and had a BoP deficit)? The mercantilist4 explanation was that unless the state intervened, through tariffs or quotas or subsidies, on exports, a country would lose its gold and that was considered one of the worst tragedies. David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if the stock of gold went down, all prices and costs would fall commensurately and no one in the country would be worse off. Also, with cheaper goods at home, imports would fall and exports rise (it is the real exchange rate which will determine competitiveness). The country from which we were importing and making payments in gold would face an increase in prices and costs, so their now expensive exports would fall and their imports of the first country’s now cheap goods would go up. The result of this pricespecie- flow (precious metals were referred to as ‘specie’ in the eighteenth century) mechanism is normally to improve the BoP of the country losing gold, and worsen that of the country with the favourable trade balance, until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow. The equilibrium is stable and self-correcting, requiring no tariffs and state action. Thus, fixed exchange rates were maintained by an automatic equilibrating mechanism. Several crises caused the gold standard to break down periodically.

Moreover, world price levels were at the mercy of gold discoveries. This can be explained by looking at the crude Quantity Theory of Money, M = kPY, according to which, if output (GNP) increased at the rate of 4 per cent per year, the gold supply would have to increase by 4 per cent per year to keep prices stable. With mines not producing this much gold, price levels were falling all over the world in the late nineteenth century, giving rise to social unrest. For a period, silver supplemented gold introducing ‘bimetallism’. Also, fractional reserve banking helped to economise on gold. Paper currency was not entirely backed by gold; typically countries held one-fourth gold against its paper currency. Another way of economising on gold was the gold exchange standard which was adopted by many countries which kept their money exchangeable at fixed prices with respect to gold but held little or no gold. Instead of gold, they held the currency of some large country (the United States or the United Kingdom) which was on the gold standard. All these and the discovery of gold in Klondike and South Africa helped keep deflation at bay till 1929. Some economic historians attribute the Great Depression to this shortage of liquidity. During 1914-45, there was no maintained universal system but this period saw both a brief return to the gold standard and a period of flexible exchange rates.

The Bretton Woods System:
The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and reestablished a system of fixed exchange rates. This was different from the international gold standard in the choice of the asset in which national currencies would be convertible. A two-tier system of convertibility was established at the centre of which was the dollar. The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $35 per ounce of gold. The second-tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price. The latter was called the official exchange rate. For instance, if French francs could be exchanged for dollars at roughly 5 francs per dollar, the dollars could then be exchanged for gold at $35 per ounce, which fixed the value of the franc at 175 francs per ounce of gold (5 francs per dollar times 35 dollars per ounce).
A change in exchange rates was to be permitted only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a chronic deficit in the BoP of sizeable proportions. Such an elaborate system of convertibility was necessary because the distribution of gold reserves across countries was uneven with the US having almost 70 per cent of the official world gold reserves. Thus, a credible gold convertibility of the other currencies would have required a massive redistribution of the gold stock. Further, it was believed that the existing gold stock would be insufficient to sustain the growing demand for international liquidity. One way to save on gold, then, was a two-tier convertible system, where the key currency would be convertible into gold and the other currencies into the key currency.

In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit (other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar).

The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves.

Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974. At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, pound sterling) of the five countries (France, Germany, Japan, the UK and the US). It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. The original installments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade). The breakdown of the Bretton Woods system was preceded by many events, such as the devaluation of the pound in 1967, flight from dollars to gold in 1968 leading to the creation of a two-tiered gold market (with the official rate at $35 per ounce and the private rate market determined), and finally in August 1971, the British demand that US guarantee the gold value of its dollar holdings. This led to the US decision to give up the link between the dollar and gold.

The ‘Smithsonian Agreement’ in 1971, which widened the permissible band of movements of the exchange rates to 2.5 per cent above or below the new ‘central rates’ with the hope of reducing pressure on deficit countries, lasted only 14 months. The developed market economies, led by the United Kingdom and soon followed by Switzerland and then Japan, began to adopt floating exchange rates in the early 1970s. In 1976, revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them (to a single currency, a basket of currencies, or to the SDR). There are no rules governing pegged rates and no de facto supervision of floating exchange rates.

The Current Scenario:
Many countries currently have fixed exchange rates. Some countries peg their currency to the dollar. The creation of the European Monetary Union in January, 1999, involved permanently fixing the exchange rates between the currencies of the members of the Union and the introduction of a new common currency, the Euro, under the management of the European Central Bank. From January, 2002, actual notes and coins were introduced. So far, 12 of the 25 members of the European Union have adopted the euro. Some countries pegged their currency to the French franc; most of these are former French colonies in Africa. Others peg to a basket of currencies, with the weights reflecting the composition of their trade. Often smaller countries also decide to fix their exchange rates relative to an important trading partner. Argentina, for example, adopted the currency board system in 1991. Under this, the exchange rate between the local currency (the peso) and the dollar was fixed by law. The central bank held enough foreign currency to back all the domestic currency and reserves it had issued. In such an arrangement, the country cannot expand the money supply at will. Also, if there is a domestic banking crisis (when banks need to borrow domestic currency) the central bank can no longer act as a lender of last resort. However, following a crisis, Argentina abandoned the currency board and let its currency float in January 2002.

Another arrangement adopted by Equador in 2000 was dollarisation when it abandoned the domestic currency and adopted the US dollar. All prices are quoted in dollar terms and the local currency is no longer used in transactions. Although uncertainty and risk can be avoided, Equador has given the control over its money supply to the Central Bank of the US – the Federal Reserve – which will now be based on economic conditions in the US. On the whole, the international system is now characterised by a multiple of regimes. Most exchange rates change slightly on a day-to-day basis, and market forces generally determine the basic trends. Even those advocating greater fixity in exchange rates generally propose certain ranges within which governments should keep rates, rather than literally fix them. Also, there has been a virtual elimination of the role for gold. Instead, there is a free market in gold in which the price of gold is determined by its demand and supply coming mainly from jewellers, industrial users, dentists, speculators and ordinary citizens who view gold as a good store of value.


The balance of payments (BoP) record the transactions in goods, services and assets between residents of a country with the rest of the world. There are two main accounts in the BoP – the current account and the capital account. The current account records exports and imports in goods and services and transfer payments. Trade in services denoted as invisible trade (because they are not seen to cross national borders) includes both factor income (payment for inputs-investment income, that is, the interest, profits and dividends on our assets abroad minus the income foreigners earn on assets they own in India) and non-factor income (shipping, banking, insurance, tourism, software services, etc.). Transfer payments are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. They consist of remittances, gifts and grants. They could be official or private. The balance of exports and imports of goods is referred to as the trade balance. Adding trade in services and net transfers to the trade balance, we get the current account balance. The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc. We note that any transaction resulting in a payment to foreigners is entered as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive sign.

BoP Surplus and Deficit

The essence of international payments is that just like an individual who spends more than her income must finance the difference by selling assets or by borrowing, a country that has a deficit in its current account (spending more abroad than it receives from sales to the rest of the world) must finance it by selling assets or by borrowing abroad. Thus, any current account deficit is of necessity financed by a net capital inflow. There has been a trade deficit throughout the period and a surplus in invisibles except for 1990-91. The current account deficit (which has been observed for 24 years from 1977-78) had started shrinking and turned into surplus from 2001-02. The surplus continued till 2003-04, but turned into a deficit in 2004-05. The large trade deficit could not be bridged by the invisibles surplus. In April-September 2005-06, the current account deficit of US$13 billion was financed by a capital inflow of US$19.5 billion, the extra capital inflow of US$ 6.5 billion being added to our stock of foreign exchange.

Alternatively, the country could engage in official reserve transactions, running down its reserves of foreign exchange, in the case of a deficit by selling foreign currency in the foreign exchange market. The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus). The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus). A country is said to be in balance of payments equilibrium when the sum of its current account and its non-reserve capital account equals zero, so that the current account balance is financed entirely by international lending without reserve movements. We note that the official reserve transactions are more relevant under a regime of pegged exchange rates than when exchange rates are floating. Autonomous and Accommodating Transactions: International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance due to profit motive). These items are called ‘above the line’ items in the BoP. The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments. Accommodating transactions (termed ‘below the line’ items), on the other hand, are determined by the net consequences of the autonomous items, that is, whether the BoP is in surplus or deficit. The official reserve transactions are seen as the accommodating item in the BoP (all others being autonomous). Errors and Omissions constitute the third element in the BoP (apart from the current and capital accounts) which is the ‘balancing item’ reflecting our inability to record all international transactions accurately.

Open Economy Macroeconomics

So far, we have simplified the analysis of income determination by assuming a closed economy. In reality, most modern economies are open. Interaction with other economies of the world widens choice in three broad ways

  1. Consumers and firms have the opportunity to choose between domestic and foreign goods. This is the product market linkage which occurs through international trade.
  2. Investors have the opportunity to choose between domestic and foreign assets. This constitutes the financial market linkage.
  3. Firms can choose where to locate production and workers to choose where to work. This is the factor market linkage. Labour market linkages have been relatively less due to various restrictions on the movement of people through immigration laws. Movement of goods has traditionally been seen as a substitute for the movement of labour.

We focus here on the first two linkages.

An open economy is one that trades with other nations in goods and services and, most often, also in financial assets. Indians, for instance, enjoy using products produced around the world and some of our production is exported to foreign countries. Foreign trade, therefore, influences Indian aggregate demand in two ways. First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing aggregate demand. Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for domestically produced goods. Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy. In 2004-2005, this was 38.9 per cent for the Indian economy (imports constituted 17.1 per cent and exports 11.8 per cent of GDP). This is substantially higher than a total of 16 per cent that prevailed in 1985-86. However, in comparison to other countries, India is relatively less open. There are several countries whose foreign trade proportions are above 50 per cent of GDP.

Now, when goods move across national borders, money must move in the opposite direction. At the international level, there is no single currency that is issued by a central authority. Foreign economic agents will accept a national currency only if they are convinced that the currency will maintain a stable purchasing power. Without this confidence, a currency will not be used as an international medium of exchange and unit of account since there is no international authority with the power to force the use of a particular currency in international transactions. Governments have tried to gain confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing authority has no control. This other asset most often has been gold, or other national currencies. There are two aspects of this commitment that has affected its credibility – the ability to convert freely in unlimited amounts and the price at which conversion takes place. The international monetary system has been set up to handle these issues and ensure stability in international transactions. A nation’s commitment regarding the above two issues will affect its trade and financial interactions with the rest of the world.

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