NCERT Book Class 12 Economics (Macroeconomics) Chapter 6 Open Economy Macroeconomics

Open Economy
Macroeconomics

An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
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 goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign