Key Concepts

An economy that interacts with the rest of the world — it trades goods and services, and it borrows, lends and holds financial assets across its borders. Its aggregate demand therefore includes exports, and p …

A systematic record of all economic transactions between the residents of a country and the rest of the world over a given period. It is organised into a current account (goods, services and transfers) and a cap …

The situation in which a country's payments on the current account exceed its receipts — that is, it spends more on imports of goods, services and net transfers abroad than it earns. Such a deficit must be financed by a net inflow on the capital account …

Purchases and sales of foreign exchange made by the monetary authority (the central bank) out of, or into, its official reserves in order to settle an overall balance of payments surplus or deficit. A fall in reserves finances an overall deficit; a rise absorbs an overall surplus. They ma …

Autonomous ('above the line') transactions are undertaken for their own sake — for profit, trade or investment — independently of the balance of payments position; the BoP is in surplus or deficit according to whether autonomous receipts exceed or fall short of autonomous payments. Accommodating ('below the line') transactions, chiefly official r …

The nominal exchange rate is the price of one currency in terms of another (for example, rupees per dollar). The real exchange rate adjusts this for price levels — it is the relative price of foreign goods in terms of domestic goods — and so measures a country's comp …

The long-run theory that, in the absence of trade barriers and transport costs, exchange rates adjust so that an identical good costs the same in different countries when expressed in a common currency. It implies that the currency of the country with the h …

An exchange rate (also called a floating rate) determined purely by the market forces of demand for and supply of foreign exchange, with no central bank intervention. It moves freely to clear the foreign exchange market and automatically adjusts to surp …

A market-driven fall in the value of the domestic currency relative to a foreign currency under a flexible exchange rate — it takes more units of domestic currency to buy one unit of foreign currency. (The government-decided counterpart …

The difference between interest rates available in two countries. In the short run it drives large movements of financial capital toward the higher-yielding currency, raising the demand for that currency and typically causing it t …

An exchange rate system in which the government or central bank pegs the currency at a chosen level and stands ready to buy or sell foreign exchange from its reserves to defend that level. Maintaining it requi …

A deliberate government decision, under a fixed exchange rate system, to raise the exchange rate (more domestic currency per unit of foreign currency), thereby making the domestic currency cheaper for foreigners. Its opposite, lowering the rate to make the …

A hybrid system (also called 'dirty floating') in which the exchange rate is largely market-determined, but central banks intervene from time to time to moderate excessive movements. Because such intervention occurs, official reserve transactions are not equal to zero. It is the syste …

The total demand for goods produced within the country. It differs from domestic demand for goods (what residents spend): it adds exports, which are foreign demand for home output, and subtracts imports, which are home spending that falls on foreign output — so demand for domes …

The fraction of an extra rupee of income that is spent on imports, $m = \dfrac{\Delta M}{\Delta Y}$, with $0 < m < 1$. It is analogous to the marginal propensity to consume and, because imports are a leakage from the circular flow, it makes the open-economy m …

Exports minus imports, $NX = X - M$. A positive value (exports exceeding imports) is a trade surplus; a negative value is a trade deficit. Net exports are the additional term that the open economy adds to ag …

The factor by which a change in autonomous expenditure changes equilibrium income once foreign trade is allowed for, equal to $\dfrac{1}{1 - c + m}$, where $c$ is the marginal propensity to consume and $m$ the marginal propensity to import. Since $m > 0$, it is smaller than the closed-economy multiplier $\dfrac{1}{1 - c}$, because imports …