Open Economy Macroeconomics

🧠 First Principles — Read This First

The balance of payments is a two-sided record of a country's dealings with the rest of the world. The current account records trade in goods and services, incomes and transfers; the capital account records the buying and selling of assets. A country that spends abroad more than it earns must sell assets or borrow, so a current account deficit is matched by a capital account surplus. When private flows do not close the gap, the central bank does, by selling foreign exchange from its reserves; that fall in reserves is what NCERT calls the overall balance of payments deficit.

The exchange rate is a price, set in the market for foreign currency. Indians demand dollars to buy foreign goods, send gifts and buy foreign assets; foreigners supply dollars to buy Indian goods and assets. Under a flexible rate the price moves until the two match; under a fixed rate the central bank buys or sells to hold it; under managed floating it lets the price move but intervenes to moderate the swings. Speculation, interest-rate differences and income growth move the rate in the short run; purchasing power parity predicts where it settles in the long run. India's rupee has been market-determined since the reforms of 1992-94, with the Reserve Bank buying and selling to keep the market orderly.

Trade changes the multiplier. In an open economy part of every extra rupee of income is spent on imports, which leak out of the circular flow of domestic income. With marginal propensity to consume c and marginal propensity to import m, the multiplier falls from 1 ÷ (1 − c) to 1 ÷ (1 − c + m): 5 against 2 in NCERT's Example 6.2. Exports become one more source of demand for domestic output, and a rise in domestic spending worsens the trade balance.

PART 1 — Quick Reference

The Chapter at a Glance

The 2026-27 reprint has no Summary, and Box 6.2 (international experience of exchange-rate management) and Box 6.3 (the Indian experience) are no longer printed, though Exercises 3, 5 and 19 still test them. This page carries them from Reprint 2021-22, the last edition that printed them.

India's Balance of Payments, Dated (record, not NCERT)

NCERT's Table 6.1 is a sample. The Reserve Bank's own tables give the real figures. The rows below follow NCERT's numbering; RBI's name is given where it differs. US$ billion; the current account deficit as per cent of GDP is in brackets.

Source: Reserve Bank of India, Developments in India's Balance of Payments during the Fourth Quarter (January-March) of 2025-26, 8 June 2026 (Press Release 2026-2027/412), and ... during the First Quarter (April-June) of 2026-27, 1 September 2026 (Press Release 2026-2027/1015), Table 1 in each. PR: partially revised; P: preliminary.

Three ways to read the table:

• By basis. 2025-26 and April-June 2026 are preliminary and will be revised; the October-December 2025 deficit has already been revised to US$15.5 bn (1.5 per cent of GDP). Quarters swing: January-March 2026 ran a current account surplus of US$7.1 bn (0.7 per cent of GDP). A quarter is not a year: the April-June 2026 deficit of US$4.2 bn compares with US$3.4 bn (0.4 per cent of GDP) in April-June 2025.
• By identity. In RBI's layout, current account + capital and financial account + errors and omissions = 0: for 2025-26, −25.2 + 25.4 − 0.1 = 0.1 (rounding); for 2024-25, −22.9 + 21.5 + 1.4 = 0. The rows add up the same way within rounding: 446.1 − 783.4 = −337.3, and −337.3 + 312.0 = −25.3 against RBI's printed −25.2. The "of which" lines under item B do not add up to B, because RBI lists only the main items.
• By reserves, NCERT's way. NCERT's capital account leaves the reserves out, so take them out of RBI's item B: 25.4 − 23.6 = 1.8 for 2025-26, 21.5 − 5.0 = 16.5 for 2024-25 and 2.6 − 8.1 = −5.5 for April-June 2026 (arithmetic, not published). NCERT's overall balance is then current account + capital account + errors and omissions: −25.2 + 1.8 − 0.1 = −23.5, which is the reserve depletion of 23.6 within rounding. NCERT: "The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus)." India ran an overall deficit of about US$23.6 bn in 2025-26, US$5.0 bn in 2024-25 and US$8.1 bn in April-June 2026; RBI's words for the quarter are "Foreign exchange reserves depleted by US$ 8.1 billion (on a BoP basis)".

The BoP records only transactions. The weekly reserves figure in the news is a stock, which also moves when gold prices and exchange rates change the value of what is held. Between end-March and 26 June 2026 the stock fell by US$24.2 bn, three times the BoP-basis depletion of US$8.1 bn in April-June. The Economic Survey 2025-26 makes the same point about gold, which rose from US$78.2 bn (end-March 2025) to US$117.5 bn (16 January 2026): "This increase reflects both valuation gains during a period of elevated global gold prices and a continued preference among central banks for diversifying into non-dollar reserve assets."

PART 2 — Concepts & Narrative

Opening: An Open Economy and Its Currency

An open economy interacts with other countries through three linkages:

1. Output market: it trades goods and services, so consumers and producers choose between domestic and foreign goods.
2. Financial market: it buys foreign financial assets, so investors choose between domestic and foreign assets.
3. Labour market: firms choose where to produce and workers where to work, though immigration laws restrict the movement of labour.

Movement of goods has traditionally been seen as a substitute for movement of labour. NCERT studies the first two linkages. Trade enters aggregate demand twice: spending on foreign goods "escapes as a leakage" from the circular flow of income, and exports enter "as an injection", raising demand for goods produced at home.

Trade needs money, and no single bank issues an international currency. Foreigners accept a national currency only if they trust that its purchasing power will stay stable. Governments have tried to earn that trust by promising to convert their currency freely, at a fixed price, into an asset they cannot control, usually gold or another national currency. Two things decide whether the promise is believed: whether conversion is free in unlimited amounts, and the price at which it happens. The international monetary system exists to handle these questions. Since what matters in trade is the currency in which it is paid, an Indian buying a ten-dollar American good needs to know the price of a dollar in rupees: "The price of one currency in terms of another currency is known as the foreign exchange rate".

6.1 The Balance of Payments

6.1.1 Current Account

The current account records trade in goods and services and transfer payments (NCERT Fig. 6.1):

• Trade in goods: exports and imports of goods.
• Trade in services: both factor income and non-factor income. Factor income is net international earnings on factors of production (labour, land and capital); non-factor income is the net sale of services such as shipping, banking, tourism and software services.
• Transfer payments: receipts the residents of a country get for "free", without providing goods or services in return: gifts, remittances and grants, from governments or from private citizens living abroad.

Imports are spending by our country that becomes another country's income, so they reduce demand for domestic output; exports bring income and add to it.

Balance on current account. The account is balanced when current receipts equal current payments. A surplus means the nation is a lender to other countries; a deficit means it is a borrower from them. NCERT's strip: current account surplus when receipts > payments, balanced when receipts = payments, deficit when receipts < payments. The balance has two parts:

• Balance of trade (BOT), or trade balance: exports of goods minus imports of goods. Exports are a credit and imports a debit. Exports greater than imports give a trade surplus; imports greater than exports a trade deficit.
• Net invisibles: exports minus imports of invisibles, which are services, transfers and income flows.

India shows why the two balances differ. Its goods trade ran a deficit of US$337.3 bn in 2025-26, but net invisibles of US$312.0 bn (services 216.6, of which software services exports alone were US$221.4 bn gross; transfers 143.6) cut the current account deficit to US$25.2 bn. Software exports are trade in a service product, a non-factor service; remittances are transfers, which RBI calls "Personal transfer receipts under secondary income account, mainly representing remittances by Indians employed overseas".

6.1.2 Capital Account

The capital account records all international transactions in assets: money, stocks, bonds, government debt and other forms in which wealth is held. Buying an asset abroad is a debit, because foreign exchange flows out: an Indian buying a UK car company is a debit on India's capital account. Selling an asset is a credit: an Indian company's shares sold to a Chinese buyer. NCERT's Fig. 6.2 lists the items: foreign direct investment (FDI), foreign institutional investment (FII), external borrowings and assistance.

Balance on capital account. The account is balanced when capital inflows (loans received from abroad, sale of assets or shares to foreigners) equal capital outflows (repayment of loans, purchase of assets or shares abroad). Inflows greater than outflows give a capital account surplus; smaller, a deficit.

6.1.3 Balance of Payments Surplus and Deficit

An individual who spends more than her income must sell assets or borrow. So must a country: a current account deficit must be financed by selling assets or borrowing abroad, that is, by a capital account surplus (a net capital inflow). NCERT writes this as

Current account + Capital account ≡ 0

When the deficit is financed entirely by international lending, with no movement in reserves, the country is in balance of payments equilibrium.

Alternatively, the country can use its reserves of foreign exchange to cover the deficit: the central bank sells foreign exchange, an official reserve sale. "The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus)." The premise is that the "monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus)". NCERT adds that "official reserve transactions are more relevant under a regime of fixed exchange rates than when exchange rates are floating".

Errors and omissions. International transactions cannot all be recorded accurately, so the BoP has a third element besides the two accounts, errors and omissions, which reflects this.

NCERT's second strip ties the overall balance to reserves: a BoP deficit has overall balance < 0 and reserve change > 0; a balanced BoP has both 0; a surplus has overall balance > 0 and reserve change < 0. The strip uses RBI's sign convention, in which a decrease in reserves is entered with a plus sign (it finances the deficit) and an increase with a minus sign. That is why RBI's table above shows the 2025-26 depletion as +23.6.

Table 6.1 and Box 6.1

NCERT's sample BoP for India, as printed (million US$):

Source: NCERT, Introductory Macroeconomics, ch. 6, Table 6.1, Reprint 2026-27, pp. 6-7.

NCERT reads it this way: there is a trade deficit and a current account deficit, but a capital account surplus, so the BoP is in balance. Most rows add up: 150 − 240 = −90; 30 − 10 + 32 = 52; −90 + 52 = −38; 0.15 + 2 + 10 + 15 + 19 − 5 = 41.15; 13 + 6 = 19. The last step does not: −38 + 41.15 + 3.15 = 6.30, not 0. For the overall balance to be 0, errors and omissions would have to be −3.15. Row 3's label "[2 – 1]" should also read [1 − 2], exports minus imports.

Box 6.1 explains BPM6: transactions are divided into a current account, a financial account and a capital account, and "almost all the transactions arising on account of trade in financial assets such as bonds and equity shares are now placed in the financial account". The box says that "RBI continues to publish the balance of payments accounts as per the old system also", and so does not give the new system's details. RBI's current releases use the BPM6 layout, so a reader of today's figures needs the map:

6.2 The Foreign Exchange Market

NCERT now turns from the accounts to a single transaction. An Indian resident on holiday in London (an import of tourist services) must pay in pounds and needs to know where to buy them and at what price. That price is the exchange rate; "The market in which national currencies are traded for one another is known as the foreign exchange market." Its main participants are commercial banks, foreign exchange brokers and other authorised dealers, and monetary authorities. Participants have their own trading centres, but the market itself is world-wide, in close and continuous contact.

6.2.1 Foreign Exchange Rate

The foreign exchange (forex) rate is the price of one currency in terms of another; it links currencies and allows international costs and prices to be compared. If ₹50 buys $1, the rate is ₹50 per dollar. NCERT assumes only two countries, India and the USA, so there is one rate to determine.

• Demand for foreign exchange comes from buying foreign goods and services, sending gifts abroad, and buying foreign financial assets. A rise in the price of foreign exchange makes foreign goods dearer in rupees, so imports and the demand for foreign exchange fall: the demand curve slopes down.
• Supply of foreign exchange comes from exports (foreigners buying domestic goods and services), gifts and transfers from foreigners, and foreigners buying domestic assets. A rise in the price of foreign exchange makes Indian goods cheaper for foreigners, so exports, and hence the supply of foreign exchange, may rise. Whether they actually rise depends on several factors, particularly the elasticity of demand for exports and imports.

Nominal and Real Exchange Rates

The 2026-27 text uses the real exchange rate in its Appendix and tests both rates in Exercises 3 and 4, but no longer defines them in the chapter. NCERT's Reprint 2021-22 summary does:

• "The nominal exchange rate is the price of one unit of foreign currency in terms of domestic currency": e, rupees per dollar.
• "The real exchange rate is the relative price of foreign goods in terms of domestic goods. It is equal to the nominal exchange rate times the foreign price level divided by the domestic price level." So R = e × P_f ÷ P. It measures a country's competitiveness in international trade; "When the real exchange rate is equal to one, the two countries are said to be in purchasing power parity."

A higher R makes foreign goods relatively dearer: imports fall and exports rise (Appendix 6.1). A buyer comparing domestic and foreign goods needs the real rate, because a rise in e that is matched by a rise in domestic prices leaves competitiveness unchanged.

6.2.2 Determination of the Exchange Rate

A country's exchange rate can be flexible, fixed or managed floating.

Flexible (floating) exchange rate. Demand and supply set the rate where the curves cross: the rate e on the vertical axis and the quantity of dollars q on the horizontal axis. In a completely flexible system central banks do not intervene. If Indians travel abroad more, demand for foreign goods and services rises and the demand curve for dollars shifts right. NCERT's numbers: the rate rises from e0 = 50 to e1 = 70, so a dollar now costs ₹70 instead of ₹50. A rise in the price of foreign currency in domestic currency is a depreciation of the rupee; a fall, so that fewer rupees buy a dollar, is an appreciation.

Speculation. Money is an asset. If investors believe the pound will appreciate against the rupee, they want to hold pounds. NCERT's example: the rate is ₹80 per pound and investors expect ₹85 by the month's end. Buying 1,000 pounds for ₹80,000 and selling them later for ₹85,000 would earn ₹5,000. The extra demand for pounds raises the rupee-pound rate now, "making the beliefs self-fulfilling".

Interest rates. In the short run the interest rate differential matters: large funds owned by banks, multinational companies and wealthy individuals move across the world in search of the highest return. If equally safe government bonds pay 8 per cent in country A and 10 per cent in country B, the differential is 2 per cent. A's investors buy B's currency to buy B's bonds, and B's investors demand less of A's currency, so the demand curve for A's currency shifts left and the supply curve right: A's currency depreciates and B's appreciates. Hence "a rise in the interest rates at home often leads to an appreciation of the domestic currency". The implicit assumption is that nothing restricts the purchase of foreign government bonds.

Income. Higher income raises spending, including on imports, so demand for foreign exchange shifts right and the domestic currency depreciates. If income abroad rises too, exports rise and the supply of foreign exchange shifts out, and the net effect depends on whether exports grow faster than imports. Other things equal, a country whose aggregate demand grows faster than the rest of the world's normally finds its currency depreciating.

The long run: purchasing power parity (PPP). As long as there are no barriers to trade such as tariffs and quotas, exchange rates should adjust so that the same product costs the same in every currency, apart from transport costs. Over the long run, then, the rate between two currencies reflects the difference in their price levels.

Example 6.1. A shirt costs $8 in the US and ₹400 in India, so the rate should be ₹400 ÷ $8 = ₹50 per dollar. At ₹60 an American shirt would cost ₹480 against ₹400 for an Indian one, and every buyer would go to India; below ₹50 all the business would go to the US. Now prices rise by 20 per cent in India and 50 per cent in the US: the Indian shirt costs ₹480 and the American $12. For the two to be equal, $12 must be worth ₹480, so $1 = ₹40. The dollar has depreciated, from ₹50 to ₹40.

Fixed exchange rate. The government fixes the rate. In NCERT's Fig. 6.3 the market rate is e = ₹50 per dollar. To encourage exports, the government makes the rupee cheaper for foreigners by fixing a higher rate, e1 = ₹70. At e1 the supply of dollars exceeds the demand (the gap AB in the figure), and the RBI buys the excess dollars with rupees. Intervention can hold any rate, but the government keeps piling up foreign exchange as long as it continues. At a rate such as e2, below e, there is excess demand for dollars, which the government must meet from its past holdings of dollars; if it cannot, a black market for dollars may come up.

Under a fixed rate, a government action that raises the exchange rate (making the domestic currency cheaper) is a devaluation; one that lowers it (making the domestic currency dearer) is a revaluation.

6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems

Fixed rates depend on credibility: people must believe the government can hold the rate. When the BoP is in deficit, the government covers the gap from its official reserves. If people think the reserves are too small, they expect a devaluation; when that belief turns into aggressive buying of the other currency that forces a devaluation, it is a speculative attack. Fixed rates are prone to such attacks, as before the collapse of the Bretton Woods system.

Flexible rates give the government more room and do not need large reserves. Their main advantage is that movements in the rate take care of BoP surpluses and deficits automatically. Countries also "gain independence in conducting their monetary policies, since they do not have to intervene to maintain exchange rate". Read with the interest-rate passage above, the point is this: when funds move freely in search of higher interest, a country that fixes its exchange rate must set its interest rate and use its reserves to defend that rate, while a floating country can set its interest rate for domestic aims and let the exchange rate move.

6.2.4 Managed Floating

Without any formal international agreement the world has moved to managed floating, a mix of the flexible system (the float) and the fixed system (the management), "also called dirty floating". Central banks buy and sell foreign currencies to moderate exchange-rate movements when they judge it appropriate, so "Official reserve transactions are, therefore, not equal to zero."

India fits the description. The rupee is market-determined, "with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases" (NCERT Box 6.3, Reprint 2021-22). Both adjustments show in the 2025-26 record: the rupee depreciated by about 5.4 per cent against the dollar between April 2025 and mid-January 2026 (Economic Survey), and reserves fell by US$23.6 bn on a BoP basis over the year.

Exchange Rate Arrangements in History (NCERT Reprint 2021-22, Boxes 6.2 and 6.3)

These boxes are not in the 2026-27 reprint, but Exercises 5 and 19 still ask about them.

The gold standard (about 1870 to 1914). It was "the epitome of the fixed exchange rate system". Every currency was defined in gold, and each country guaranteed free conversion of its currency into gold at a fixed price. If one unit of currency A was worth one gram of gold and one unit of B two grams, B was worth twice A. Rates moved only within limits set by the cost of melting, shipping and recoining gold; beyond them arbitrage paid. Each country needed enough gold reserves to keep its parity.

Would a country that imported too much lose all its gold? Mercantilists thought so and wanted tariffs, quotas and export subsidies. David Hume, writing in 1752, showed why not. A country losing gold sees its prices and costs fall; its cheaper goods raise exports and cut imports, while the gold-gaining country's prices rise. This price-specie-flow mechanism (precious metals were called "specie") improves the deficit country's BoP until trade balances and gold stops flowing: an automatic, self-correcting equilibrium with no tariffs or state action. That is the answer to Exercise 5.

The standard had weaknesses. It broke down periodically in crises, and world price levels were at the mercy of gold discoveries: with M = kPY, if output grew 4 per cent a year, the gold supply had to grow 4 per cent a year to keep prices stable. Mines did not keep up, and prices fell across the world in the late nineteenth century. Silver (bimetallism), fractional reserve banking (typically one-fourth gold against paper currency), the gold exchange standard (holding a gold-standard currency such as the dollar or the pound instead of gold) and gold finds in the Klondike and South Africa held deflation off till 1929. Between 1914 and 1945 there was no lasting system: a brief return to gold and a period of flexible rates.

Bretton Woods (1944). The conference set up the IMF and the World Bank and restored fixed rates with a two-tier system: the US guaranteed to convert dollars into gold at $35 an ounce, and every participating IMF member promised to convert its currency into dollars at a fixed price, the official exchange rate. At 5 francs a dollar, the franc was fixed at 175 francs an ounce of gold. Rates could change only in "fundamental disequilibrium", which came to mean a chronic, sizeable BoP deficit. The two tiers saved gold, of which the US held almost 70 per cent of official world reserves. The flaw was the Triffin Dilemma: the rest of the world's reserves grew through continued US BoP deficits, and as the US's short-term dollar liabilities rose against its gold, belief in the $35 promise would erode. Robert Triffin proposed a new reserve asset under the IMF. In 1967 the IMF created Special Drawing Rights (SDRs), "paper gold", first defined as 35 SDRs to an ounce of gold and redefined several times since 1974; the original instalments were distributed according to members' IMF quotas.

Breakdown. The pound was devalued in 1967; a flight from dollars into gold in 1968 created a two-tier gold market (official $35, private market rate); in August 1971 the US stopped converting dollars into gold at $35 an ounce. The Smithsonian Agreement (1971) widened the permitted band to 2.5 per cent either side of new central rates and lasted only 14 months. The United Kingdom, Switzerland and then Japan began to float in the early 1970s, and the 1976 revision of the IMF's Articles let countries choose to float or to peg (to one currency, a basket or the SDR).

Arrangements since then (the answer to Exercise 19): monetary union (the euro, with exchange rates between members permanently fixed from January 1999 and notes and coins from January 2002); pegs to a single currency (several former French colonies in Africa pegged to the French franc) or to a basket weighted by trade; a currency board (Argentina from 1991, with the peso-dollar rate fixed by law and every unit of domestic money backed by foreign currency, so the central bank could neither expand money at will nor act as lender of last resort; abandoned for a float in January 2002 after a crisis); dollarisation (Ecuador in 2000, which gave control of its money supply to the US Federal Reserve); and managed floating. Most rates now move a little every day, and gold has lost its monetary role.

The Indian experience (Box 6.3, with RBI's records):

Sources: NCERT Box 6.3 (Reprint 2021-22); RBI chronology 1991-2000; RBI FAQ on exchange rates (annual averages, 1945-1971).

Appendix 6.1: Determination of Equilibrium Income in an Open Economy

Once people can buy goods made at home or abroad, two ideas must be kept apart: domestic demand for goods (C + I + G, spending by residents on goods from anywhere) and demand for domestic goods (spending by anyone on goods made at home).

The national income identity. In a closed economy,

Y = C + I + G (6.1)

In an open economy exports (X) are an extra source of demand for domestic goods, and imports (M) are the part of domestic demand that falls on foreign goods:

Y + M = C + I + G + X (6.2) Y = C + I + G + X − M (6.3) Y = C + I + G + NX (6.4)

NX, net exports (X − M), is positive with a trade surplus and negative with a trade deficit.

What drives imports and exports. Imports rise with domestic income Y and fall with the real exchange rate R (a higher R makes foreign goods dearer). Exports are other countries' imports: they rise with foreign income Y_f and with R (a higher R makes domestic goods cheaper). NCERT holds price levels and the nominal rate constant, so R is fixed, and treats exports as exogenous (X = X̄). Imports have an autonomous part and a part that rises with income:

M = M̄ + mY, with M̄ > 0 and 0 < m < 1 (6.5)

m is the marginal propensity to import, the fraction of an extra rupee of income spent on imports, analogous to the marginal propensity to consume.

Equilibrium income. With C = C̄ + c(Y − T):

Y = C̄ + c(Y − T) + Ī + Ḡ + X̄ − M̄ − mY (6.6)

Collecting all autonomous terms as Ā = C̄ − cT + Ī + Ḡ + X̄ − M̄:

Y = Ā + cY − mY (6.7) (1 − c + m)Y = Ā (6.8) Y* = Ā ÷ (1 − c + m) (6.9)

The open economy multiplier. Since m > 0, the multiplier is smaller than in a closed economy:

ΔY ÷ ΔĀ = 1 ÷ (1 − c + m) (6.10)

Example 6.2. With c = 0.8 and m = 0.3, the closed economy multiplier is 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5 (6.11) and the open economy multiplier 1 ÷ (1 − 0.8 + 0.3) = 1 ÷ 0.5 = 2 (6.12). A rise of 100 in domestic autonomous demand raises output by 500 in a closed economy but only 200 in an open one.

Why it is smaller. A rise in autonomous spending, say government purchases, raises income directly and then consumption, which raises income again (Chapter 4). In an open economy part of each round of extra consumption is spent on foreign goods, so the induced rise in demand for domestic goods is smaller. "The increase in imports per unit of income constitutes an additional leakage from the circular flow of domestic income at each round of the multiplier process" (see Income Determination for the closed economy multiplier).

Exports and imports as shocks. Autonomous expenditure in an open economy also contains exports and autonomous imports, so changes in them move income:

ΔY* ÷ ΔX̄ = 1 ÷ (1 − c + m) (6.13) ΔY* ÷ ΔM̄ = −1 ÷ (1 − c + m) (6.14)

A rise in demand for exports raises demand for domestic output just as more government spending or investment would; an autonomous rise in imports lowers it.

What happens to the trade balance (NCERT's Reprint 2021-22 summary, points 10 and 11). Net exports are NX = X̄ − M̄ − mY. On Example 6.2's numbers:

• A rise of 100 in domestic autonomous demand raises income by 200 and imports by 0.3 × 200 = 60, so the trade balance worsens by 60: "It also results in a deterioration of the trade balance."
• A rise of 100 in exports also raises income by 200 and imports by 60, but exports have risen by 100, so the trade balance improves by 40: "An increase in foreign income leads to increased exports and increases domestic output. It also improves the trade balance."

With a proportional income tax (Exercise 12), T = tY makes disposable income (1 − t)Y, so the multiplier becomes 1 ÷ [1 − c(1 − t) + m], and Ā no longer contains −cT. Taxes and imports are both leakages, and each makes the multiplier smaller (compare the proportional-tax multiplier in Government Budget and the Economy).

PART 3 — UPSC Integration

Three Frameworks

1. Two accounts and one balancing item. Every autonomous transaction goes to the current account (earning and spending) or the capital account (assets and borrowing); errors and omissions catch what was missed; whatever is left is the overall balance, which the reserves absorb. Current account + capital account + errors and omissions = overall balance = fall in reserves. India 2025-26: −25.2 + 1.8 − 0.1 ≈ −23.6, met from reserves. A Prelims question on the BoP is usually a question about which account an item belongs to, or about this identity.

2. Who absorbs a shock: the rate or the reserves. A rise in demand for dollars (more imports, capital leaving, higher interest abroad, expected depreciation) must be absorbed somewhere. Under a flexible rate the rupee depreciates; under a fixed rate the central bank sells reserves, and a black market appears if they run short; under managed floating it is some of each. India's 2025-26 record shows both: the rupee fell about 5.4 per cent against the dollar between April 2025 and mid-January 2026, and reserves fell by US$23.6 bn on a BoP basis. A Mains answer on the rupee uses this frame, then asks whether the reserves are adequate (about 11 months of imports) and the debt manageable (20.8 per cent of GDP, debt service 5.6 per cent of current receipts).

3. The open economy multiplier and the trade balance. Imports leak from every round of spending, so the multiplier is 1 ÷ (1 − c + m), and 1 ÷ [1 − c(1 − t) + m] with a proportional tax. A domestic stimulus raises output and worsens the trade balance by m times the rise in income; a rise in exports raises output and improves the trade balance. Every numerical in the chapter is this framework with numbers.

Confused Pairs

Exam Strategy

• Prelims: classification first (which account; factor or non-factor; transfer or capital; autonomous or accommodating), then signs (a fall in reserves is + in RBI's tables; a rise in ₹ per dollar is a weaker rupee). Learn NCERT's numbers: 50 to 70 depreciation, ₹80,000 for £1,000, 8 against 10 per cent, the shirt at ₹50 and then ₹40, multipliers 5 and 2. History in order: gold standard to 1914, Hume 1752, Bretton Woods 1944 and $35 an ounce, SDRs 1967, August 1971, Smithsonian 1971 (±2.5 per cent), IMF Articles 1976, euro 1999 and 2002; India 1966 (36.5 per cent), September 1975, July 1991, March 1992, March 1993, August 1994. For current affairs know the record with its dates: current account deficit 0.6 per cent of GDP (2025-26), reserves US$747.6 bn (25 September 2026), rupee ₹95.99 (1 October 2026), external debt 20.8 per cent of GDP (end-June 2026), remittances US$135.4 bn (FY25), WTO rank 8th (6th excluding intra-EU).
• Mains (GS3): for the current account deficit, the rupee or capital flows, start with the BoP identity, then the dated record (a large goods deficit offset by services and remittances; FDI net small because of repatriation; FPI outflows in 2025-26 and April-June 2026; reserves drawn down), then judge sustainability with NCERT's test: "Trade deficits need not be alarming if the country invests the borrowed funds yielding a rate of growth higher than the interest rate" (Reprint 2021-22). Add reserve cover and external debt ratios, and the trade-off between defending the rupee with reserves and letting it move.
• Numericals: build Ā first (C̄ − cT + Ī + Ḡ + X̄ − M̄), divide by 1 − c + m (or 1 − c(1 − t) + m), then compute M and NX at the new income. Check: Y = C + I + G + X − M. For PPP, the rate moves in proportion to the ratio of price levels.

Practice Questions

Prelims (UPSC-pattern, not past papers)

1. Which one of the following is recorded in India's current account? (a) An Indian company buys a car company in the United Kingdom (b) A Chinese investor buys shares of an Indian company (c) A nurse working in Kuwait sends money home to Kerala (d) An Indian firm takes an external commercial borrowing Answer: (c). Remittances are transfers, a current account item (RBI: secondary income). The other three are transactions in assets or borrowing: capital account (NCERT 6.1.1-6.1.2).

2. Consider the following statements:

   1. Official reserve transactions are accommodating transactions, determined by the gap in the balance of payments.
   2. A decrease in official reserves is called an overall balance of payments surplus.
   3. Official reserve transactions are more relevant under fixed exchange rates than under floating rates.

   Which of the statements given above are correct? (a) 1 and 2 only (b) 1 and 3 only (c) 2 and 3 only (d) 1, 2 and 3 Answer: (b). A decrease in reserves is an overall BoP deficit (NCERT 6.1.3).

3. A country's current account balance is −38 and its capital account balance (excluding reserves) is +41.15. If its official reserves are unchanged, its errors and omissions must be: (a) +3.15 (b) −3.15 (c) +79.15 (d) zero Answer: (b). Current account + capital account + errors and omissions = overall balance = 0 when reserves do not change, so −38 + 41.15 + E = 0. NCERT's Table 6.1 prints +3.15, which does not balance.

4. Consider the following statements:

   1. Devaluation is a fall in the external value of a currency brought about by government action under a fixed exchange rate.
   2. A rise in the exchange rate from ₹50 to ₹70 per US dollar is a depreciation of the rupee.
   3. Under a completely flexible exchange rate the central bank intervenes to keep the rate within a band.

   Which of the statements given above are correct? (a) 1 and 2 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3 Answer: (a). Under a completely flexible system central banks do not intervene; intervention to moderate the rate is managed floating.

5. A shirt costs ₹400 in India and $8 in the United States. Prices in India then rise by 10 per cent and prices in the US do not change. By purchasing power parity the exchange rate moves: (a) from ₹50 to ₹55 per dollar (b) from ₹50 to ₹45 per dollar (c) from ₹45 to ₹50 per dollar (d) nowhere, since US prices are unchanged Answer: (a). ₹400 ÷ 8 = 50; after the rise ₹440 ÷ 8 = 55. The rupee depreciates in line with India's higher inflation (Example 6.1's method).

6. Under a flexible exchange rate, other things remaining the same, which one of the following would make the rupee appreciate against the dollar? (a) More Indians travelling abroad (b) A rise in interest rates in India relative to the United States (c) Indian aggregate demand growing faster than that of the rest of the world (d) A widespread expectation that the dollar will appreciate Answer: (b). Higher Indian interest rates draw funds into rupee assets. The other three raise demand for dollars and make the rupee depreciate (NCERT 6.2.2).

7. In an economy the marginal propensity to consume is 0.75 and the marginal propensity to import is 0.25. If exports rise by 100, equilibrium income rises by: (a) 400 (b) 250 (c) 200 (d) 100 Answer: (c). Open economy multiplier = 1 ÷ (1 − 0.75 + 0.25) = 1 ÷ 0.5 = 2 (eq. 6.13). Imports rise by 0.25 × 200 = 50, so net exports improve by 50.

8. Consider the following statements:

   1. India's current account deficit in 2025-26 was about 0.6 per cent of GDP.
   2. India's foreign exchange reserves fell on a balance of payments basis in 2025-26.
   3. In the WTO's statistics for 2025, India is the world's fifth largest exporter of commercial services.

   Which of the statements given above are correct? (a) 1 and 2 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3 Answer: (a). RBI (8 June 2026): deficit US$25.2 bn, 0.6 per cent of GDP; reserves depleted by US$23.6 bn on a BoP basis. The WTO (March 2026) ranks India 8th, or 6th excluding intra-EU trade.

NCERT Exercises 1-19 (worked answers)

1. Balance of trade and current account balance. The balance of trade is exports minus imports of goods only. The current account balance adds net invisibles: services, income and transfers. India in 2025-26: trade balance −US$337.3 bn, net invisibles +312.0, current account balance −25.2 (RBI).
2. Official reserve transactions. Purchases and sales of foreign exchange by the central bank. They are the accommodating item that covers whatever gap the autonomous transactions leave: a fall in reserves is an overall BoP deficit, a rise a surplus, and the monetary authorities are the ultimate financiers of any deficit. They matter most under fixed rates, where the central bank must buy or sell to hold the rate; under managed floating they are not zero. India drew down US$23.6 bn of reserves (BoP basis) in 2025-26.
3. Nominal and real exchange rate. The nominal rate e is the price of a unit of foreign currency in domestic currency. The real rate R = eP_f ÷ P is the price of foreign goods in terms of domestic goods. To choose between domestic and foreign goods, the real rate is the relevant one: it compares what the goods actually cost, while a change in e that is offset by a change in prices changes nothing.
4. 1.25 yen buy a rupee; P_Japan = 3, P_India = 1.2. The nominal rate as the rupee price of a yen is e = 1 ÷ 1.25 = ₹0.8 per yen. Real rate R = eP_f ÷ P = 0.8 × 3 ÷ 1.2 = 2: one unit of Japanese goods costs two units of Indian goods.
5. The gold standard's automatic mechanism. Currencies were convertible into gold at fixed prices, so exchange rates were fixed. A country with a BoP deficit paid in gold, its money stock fell, and its prices and costs fell; the surplus country's rose. The deficit country's exports rose and imports fell until trade balanced and gold stopped flowing: Hume's price-specie-flow mechanism (1752), self-correcting without tariffs or state action.
6. The rate under a flexible regime. Demand for foreign exchange (imports, gifts abroad, buying foreign assets) slopes down; supply (exports, transfers received, foreigners buying domestic assets) slopes up. The rate settles where they meet, with no central bank intervention, and moves when either curve shifts: more travel abroad raises demand and depreciates the rupee (₹50 to ₹70 in NCERT's example). Speculation, interest-rate differentials and income growth shift the curves in the short run; PPP fixes the long-run level.
7. Devaluation and depreciation. Both raise the domestic price of foreign currency. Depreciation happens through the market under a flexible rate; devaluation is a government decision under a fixed rate. India's devaluations of June 1966 (36.5 per cent) and July 1991 (about 18 per cent in two steps) were devaluations; the rupee's fall of about 5.4 per cent against the dollar between April 2025 and January 2026 was a depreciation.
8. Intervention under managed floating. Yes. Managed floating mixes a market-determined rate with central bank purchases and sales to moderate movements when the authority thinks it appropriate, so official reserve transactions are not zero. India's RBI buys and sells to keep conditions orderly.
9. Demand for domestic goods and domestic demand for goods. Not the same. Domestic demand for goods is C + I + G, spending by residents on goods made anywhere. Demand for domestic goods is C + I + G + X − M: residents' spending minus the part that falls on imports, plus foreigners' spending on our exports.
10. M = 60 + 0.06Y. The marginal propensity to import is m = 0.06. Aggregate demand for domestic goods is AD = Ā + (c − m)Y, where Ā includes −60: imports lower the intercept, and m flattens the AD line, so the multiplier is 1 ÷ (1 − c + m). The higher m, the flatter the AD line and the smaller the multiplier.
11. Why the open economy multiplier is smaller. At every round of the multiplier process part of the extra income is spent on imports, which raise foreign rather than domestic income. Imports are an extra leakage, so the induced rise in demand for domestic goods is smaller: 1 ÷ (1 − c + m) < 1 ÷ (1 − c). At c = 0.8 and m = 0.3, 2 against 5.
12. The multiplier with proportional taxes. With T = tY, Y = C̄ + c(1 − t)Y + Ī + Ḡ + X̄ − M̄ − mY, so Y* = Ā ÷ [1 − c(1 − t) + m], with Ā = C̄ + Ī + Ḡ + X̄ − M̄, and the multiplier is 1 ÷ [1 − c(1 − t) + m]. With the numbers of Exercise 18 (c = 0.75, t = 0.2, m = 0.2) it is 1 ÷ 0.6 = 1.67.
13. C = 40 + 0.8Y_D, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y. (a) Ā = 40 − 0.8 × 50 + 60 + 40 + 90 − 50 = 140; multiplier = 1 ÷ (1 − 0.8 + 0.05) = 1 ÷ 0.25 = 4; Y* = 560. Check: C = 40 + 0.8 × 510 = 448, M = 50 + 28 = 78, and 448 + 60 + 40 + 90 − 78 = 560. (b) NX = 90 − 78 = 12, a trade surplus. (c) G from 40 to 50: Ā = 150, Y = 600; M = 80, NX = 10. Income rises by 4 × 10 = 40 and net exports fall by m × 40 = 2.
14. The same economy with X = 100 (G = 40). Ā = 150, Y = 600, a rise of 40; M = 50 + 30 = 80, NX = 100 − 80 = 20, a rise of 8 (ΔX − mΔY = 10 − 2). Unlike the rise in G, a rise in exports improves the trade balance.
15. ₹30 = $1 in 2010; Indian prices double over 20 years, US prices unchanged. By PPP the rate rises in proportion to India's price level: ₹60 per dollar in 2030.
16. Higher inflation in A than in B under a fixed rate. With e fixed, A's goods become dearer relative to B's: the real exchange rate R = eP_B ÷ P_A falls (a real appreciation for A). A's exports to B fall and its imports from B rise, so A's trade balance with B worsens. A must finance the gap from reserves; if they run short, it faces pressure to devalue.
17. Should a current account deficit be a cause for alarm? Not necessarily. A deficit means the country borrows from or sells assets to the rest of the world; it is safe if the borrowing finances investment that earns more than the interest rate ("Trade deficits need not be alarming if the country invests the borrowed funds yielding a rate of growth higher than the interest rate", Reprint 2021-22). It is a worry if it finances consumption, depends on volatile short-term flows, or outruns the reserves. India's record: a deficit of 0.6 per cent of GDP in 2025-26, an overall deficit of US$23.6 bn met from reserves, external debt of 20.8 per cent of GDP and debt service of 5.6 per cent of current receipts (end-June 2026), and reserves of about 11 months of goods imports.
18. C = 100 + 0.75Y_D, I = 500, G = 750, t = 0.2, X = 150, M = 100 + 0.2Y. Y = 100 + 0.75 × 0.8Y + 500 + 750 + 150 − 100 − 0.2Y = 1,400 + 0.4Y, so Y* = 1,400 ÷ 0.6 = 2,333.33 (multiplier 1.67). Tax revenue = 0.2 × 2,333.33 = 466.67, so the budget deficit is 750 − 466.67 = 283.33. Imports = 100 + 466.67 = 566.67, so the trade deficit is 566.67 − 150 = 416.67. Check: C = 100 + 0.75 × 1,866.67 = 1,500, and 1,500 + 500 + 750 + 150 − 566.67 = 2,333.33; saving minus investment (366.67 − 500 = −133.33) plus the budget balance (−283.33) equals net exports (−416.67).
19. Exchange rate arrangements. The gold standard (about 1870-1914); Bretton Woods (1944-71), with the dollar convertible into gold at $35 an ounce and other currencies pegged to the dollar; the Smithsonian Agreement (1971, ±2.5 per cent bands); managed floating since the 1970s, with the 1976 IMF Articles letting countries float or peg; pegs to a single currency (the French franc for several former French colonies in Africa) or a trade-weighted basket (India 1975-92; NCERT gives a ±5 per cent band); currency boards (Argentina 1991-2002); dollarisation (Ecuador 2000); and monetary union (the euro, rates fixed from January 1999, notes and coins from January 2002).

📦 Revision Capsule

Sources

• NCERT, Introductory Macroeconomics (Class XII), ch. 6 "Open Economy Macroeconomics", Reprint 2026-27: ncert.nic.in PDF. Boxes 6.2 and 6.3 and the chapter Summary as printed in Reprint 2021-22 (pp. 11-16).
• Reserve Bank of India, Developments in India's Balance of Payments during the Fourth Quarter (January-March) of 2025-26, 8 June 2026 (Table 1): rbi.org.in; during the First Quarter (April-June) of 2026-27, 1 September 2026 (Table 1): rbi.org.in.
• Reserve Bank of India, Weekly Statistical Supplement extracts (foreign exchange reserves), 2 October 2026: rbi.org.in; 11 September 2026: rbi.org.in.
• Reserve Bank of India, homepage reference rate (FBIL), 1 October 2026: rbi.org.in.
• Ministry of Finance, Economic Survey 2025-26, ch. 4 "External Sector", paras 4.86-4.89 and remittances: indiabudget.gov.in PDF.
• Reserve Bank of India, India's External Debt as at the end of June 2026, 30 September 2026: rbi.org.in.
• Reserve Bank of India, Survey on Computer Software and Information Technology Enabled Services Exports: 2025-26, 18 September 2026: rbi.org.in.
• Reserve Bank of India, Bulletin, March 2025, "Changing Dynamics of India's Remittances – Insights from the Sixth Round of India's Remittances Survey": rbi.org.in.
• World Trade Organization, Global Trade Outlook and Statistics, March 2026, Appendix Tables 3 and 4: wto.org PDF.
• DPIIT, Quarterly Fact Sheet on FDI, April 2000 to December 2025 (February 2026): dpiit.gov.in PDF; FDI equity inflow, April 2025 to March 2026: dpiit.gov.in PDF.
• Reserve Bank of India, General Allocation of Special Drawing Rights by the IMF, 1 September 2021: rbi.org.in.
• Reserve Bank of India, History: chronology 1991-2000 (devaluation, LERMS, unified rate, Article VIII): rbi.org.in; FAQ "Exchange Rate" (annual averages 1945-1971): rbi.org.in.