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

Chapter at a glance

Concept	Key point
Balance of payments	Current account (trade in goods – balance of trade; services, income, transfers) and capital account (investment, loans, banking capital)
Official reserve transactions	Sale/purchase of foreign exchange reserves by the central bank to cover BoP deficit/surplus
Exchange rates	Nominal rate (domestic currency per unit of foreign currency); real exchange rate
PPP	in the long run
Regimes	Fixed (gold standard, Bretton Woods), flexible (market determined), managed floating
Devaluation vs depreciation	Devaluation – reduction by government under fixed rate; depreciation – fall due to market forces under flexible rate
Open economy income	;
Open economy multiplier	(lump-sum tax); (proportional tax)

Exercises

Answer

E.g. India often has a large trade deficit (goods), partly offset by a surplus on services and remittances, giving a smaller current account deficit.

Balance of trade covers only exports and imports of goods; the current account balance adds net services, income and transfers to it.

Answer

Official reserve transactions are transactions by the central bank (RBI) involving its foreign exchange reserves – selling foreign exchange (drawing down reserves) when there is a BoP deficit, or buying it (adding to reserves) when there is a surplus.

Importance

1. They finance the overall BoP deficit (or absorb the surplus), so the BoP always balances.
2. A decrease in reserves (shown as a credit in BoP) indicates an overall deficit; an increase (debit) indicates a surplus.
3. They help stabilise the exchange rate in fixed and managed floating systems.
4. Adequate reserves give confidence to foreign investors and provide a cushion against external shocks.

They are the central bank’s sales or purchases of foreign exchange reserves; they settle the overall BoP deficit or surplus, show the BoP position, and help stabilise the exchange rate.

Answer

• Nominal exchange rate (e) – the price of one unit of foreign currency in terms of domestic currency (e.g. ₹ 85 = $ 1). It ignores price levels.
• Real exchange rate – the relative price of foreign goods in terms of domestic goods:

where is the foreign price level and the domestic price level.

Relevance: to decide whether to buy domestic or foreign goods, the real exchange rate is more relevant, because it compares the actual prices of goods in the two countries after converting currencies. It measures international competitiveness. If the real exchange rate rises (foreign goods relatively dearer), buying domestic goods is better.

The nominal rate is the price of foreign currency in domestic currency; the real rate (eP_f/P) is the relative price of foreign goods in terms of domestic goods – the real rate is relevant for choosing between domestic and foreign goods, as it compares actual prices.

Answer

Nominal exchange rate (price of 1 yen in rupees): rupee per yen.

So one unit of Japanese goods costs as much as 2 units of Indian goods.

Real exchange rate = (0.8 × 3)/1.2 = 2.

Answer

Under the gold standard (about 1870–1914), each currency was defined in terms of gold and was freely convertible into gold, so exchange rates were fixed. BoP equilibrium was achieved automatically through the price–specie–flow mechanism (David Hume):

1. A country with a BoP deficit (imports > exports) paid for it in gold, so gold flowed out.
2. The outflow of gold reduced its money supply, causing prices to fall.
3. Lower prices made its exports cheaper and imports dearer, so exports rose and imports fell.
4. The deficit was corrected.
5. The surplus country received gold, its money supply and prices rose, its exports fell and imports rose, eliminating its surplus.

Thus, deficits and surpluses were corrected automatically without government intervention.

Deficit countries lost gold, which reduced their money supply and prices; this made their exports cheaper and imports dearer, correcting the deficit (the reverse happened in surplus countries) – the price–specie–flow mechanism.

Answer

Under a flexible (floating) exchange rate, the exchange rate is determined by the market forces of demand for and supply of foreign exchange, without central bank intervention:

• Demand for foreign exchange (e.g. dollars) comes from imports, travel abroad, investment abroad, repaying foreign loans. It is downward sloping – a higher rupee price of the dollar makes imports dearer, reducing demand.
• Supply of foreign exchange comes from exports, foreign tourists, foreign investment in India, remittances. It is upward sloping – a higher rupee price of the dollar makes Indian goods cheaper, raising exports.

The equilibrium exchange rate is where demand equals supply. If demand rises (e.g. more imports), the rupee depreciates (dollar becomes costlier); if supply rises (more exports, FDI), the rupee appreciates.

Under a flexible regime, the exchange rate is set where the market demand for foreign exchange (from imports, investment abroad) equals its supply (from exports, inflows); changes in demand or supply cause depreciation or appreciation.

Answer

Both make the domestic currency cheaper and exports more competitive.

Devaluation is a deliberate cut in the currency’s value by the government under a fixed rate; depreciation is a fall in its value due to market forces under a flexible rate.

Answer

Yes. In a managed floating (dirty floating) system, the exchange rate is mainly determined by market forces, but the central bank intervenes to prevent excessive fluctuations:

• If the domestic currency is depreciating too fast, the central bank sells foreign exchange (from its reserves) to increase supply and support the currency.
• If it is appreciating too fast, it buys foreign exchange, increasing demand and preventing excessive appreciation.

Intervention is needed to reduce volatility, maintain stability and confidence, avoid speculative attacks, and protect the competitiveness of exports and the cost of imports. India follows this system.

Yes – in managed floating, the central bank buys or sells foreign exchange to smooth excessive fluctuations, ensuring stability, confidence and protection against speculation.

Answer

No.

• Domestic demand for goods = demand by residents of the country for all goods (domestic and foreign) = .

  

• Demand for domestic goods = demand for goods produced in the country, by residents and foreigners = .

  

The difference is net exports (X – M): imports are part of domestic demand but not of demand for domestic goods; exports are part of demand for domestic goods but not of domestic demand.

No – domestic demand for goods is C + I + G (residents’ demand for all goods), while demand for domestic goods is C + I + G + X – M (all demand for goods produced at home).

Answer

Marginal propensity to import .

Relationship with AD: in an open economy

so the slope of the AD function is . A higher marginal propensity to import makes the AD function flatter: part of each increase in income leaks abroad as imports and does not raise demand for domestic goods. This also reduces the multiplier to .

m = 0.06; the slope of the open-economy AD function is (c – m), so a higher marginal propensity to import makes AD flatter and lowers the multiplier.

Answer

In a closed economy, the multiplier is . In an open economy, part of every increase in income is spent on imports (marginal propensity to import ), which is a leakage from the domestic income stream – it raises income abroad, not at home. So in each round, less is spent on domestic goods:

E.g. with , : closed = 5, open = 1/0.4 = 2.5.

Because part of each increase in income leaks out as imports (m), less is spent on domestic goods in each round; so the multiplier 1/(1 – c + m) is smaller than 1/(1 – c).

Answer

, , with autonomous:

Open economy multiplier with proportional taxes = 1 / [1 – c(1 – t) + m].

Answer

(a) .

(b) ; (surplus).

(c) Multiplier ; → , so . ; – net exports fall by 2.

1. Y* = 560; (b) NX = 12; (c) income rises to 600 and net exports fall to 10.

Answer

(Starting from G = 40.) , multiplier = 4 → , so . ; – net exports rise by 8 (from 12 to 20).

Equilibrium income rises by 40 (to 600) and net exports rise from 12 to 20.

Answer

According to PPP, . Indian prices double while US prices are constant, so the exchange rate doubles:

₹ 60 = $ 1 in 2030.

Answer

With a fixed nominal exchange rate, higher inflation in A makes A’s goods relatively more expensive and B’s goods relatively cheaper (A’s real exchange rate appreciates). So A’s exports to B fall and A’s imports from B rise. A’s trade balance worsens (moves towards deficit), while B’s trade balance improves (moves towards surplus).

A’s goods become relatively dearer, so A’s exports fall and imports rise – A’s trade balance deteriorates (deficit) and B’s improves.

Answer

Not necessarily. It depends on the cause and how it is financed:

• Not alarming if the deficit arises from imports of capital goods and investment that will raise future productive capacity and exports, and is financed by stable capital inflows (FDI). Many growing economies run current account deficits.
• Alarming if it arises from excess consumption (or large government deficits), is large and persistent, and is financed by short-term or volatile capital (hot money) or by depleting reserves. It raises external debt, may lead to sudden capital outflows, currency depreciation and a BoP crisis (as in India in 1991).

So a moderate, investment-driven and well-financed current account deficit is not a cause for alarm; a large, consumption-driven deficit financed by volatile flows is.

Not necessarily – a deficit financing productive investment and covered by stable inflows like FDI is sustainable; a large, persistent, consumption-driven deficit financed by volatile capital or reserves is a cause for alarm.

Answer

.

.

• Tax revenue ; budget deficit .

  

  

• Imports ; trade deficit .

  

  

Equilibrium income ≈ 2,333.33; budget deficit ≈ 283.33; trade deficit ≈ 416.67.

Answer

1. Gold standard (1870–1914) – currencies fixed in terms of gold; automatic adjustment through gold flows.
2. Bretton Woods system (1944–1971) – fixed but adjustable exchange rates; currencies pegged to the US dollar, which was convertible into gold at $ 35 per ounce; IMF and World Bank set up; devaluation allowed in case of fundamental disequilibrium.
3. Flexible (floating) exchange rates – after the collapse of Bretton Woods (1971–73), many major currencies float freely.
4. Managed floating – market-determined rates with central bank intervention to limit volatility (India since 1993).
5. Currency boards and hard pegs – currency fixed to another (e.g. Hong Kong dollar to US dollar).
6. Currency unions – a common currency for several countries (e.g. the euro in the Eurozone).
7. Crawling pegs and target bands – gradual adjustment of the peg or keeping the rate within a band.

These arrangements aim at stability, confidence in trade and investment, and the correction of BoP imbalances.

Arrangements include the gold standard, the Bretton Woods dollar–gold system of adjustable pegs, free floating, managed floating (as in India), currency boards and hard pegs, currency unions like the euro, and crawling pegs/target bands.

Topic checklist

• ☒ Balance of payments and official reserve transactions (Q 1, 2, 17)
• ☒ Exchange rates – nominal, real, PPP, regimes (Q 3–8, 15, 16, 19)
• ☒ Open economy income determination and multipliers (Q 9–14, 18)

Total questions answered: 19 of 19