The open economy

An open economy trades with other countries. Most modern economies are open, linked to the world through three markets:

• the output market: buying and selling goods and services;
• the financial market: buying and selling financial assets (shares, bonds);
• the labour market: people moving to work abroad. (The chapter focuses on the first two.)

For the circular flow of income, imports are a leakage: money spent on them goes out of the country. Exports are an injection: foreigners' spending comes in.

There is no single world currency. A country's currency is used in trade abroad only if people trust that its purchasing power will stay stable. In the past, governments promised to exchange their currency freely for gold, or for other currencies, at a fixed price.

To buy a foreign good, an Indian needs foreign currency, so she must know its price in rupees. The exchange rate is the price of one currency in terms of another: for example, ₹83 per US dollar.