The external sector On the Road to Capital Account Convertibility?

Abstract

Abstract We saw in the last chapter that the government budget is intimately linked to the external sector. For example, the government partially finances its expenditures by borrowing abroad. This fact directly links the government budget to the external sector. In turn, the external debt the government accumulates has important bearing on the conduct of its fiscal policy. The government’s spending also impacts the current account in an essential way, which further links the budget and the external account. In this chapter, we frontally focus on the external account. Specifically, we consider the current account and capital account transactions and their effects on the broad aggregates of the economy such as prices, exchange rate, and monetary policy. We begin by returning to the investment-savings and balance of payments identities introduced in the last chapter. To recapitulate, we saw in the last chapter that foreign savings must fill the gap between private domestic investment and private plus public domestic savings. Foreign savings themselves equal the current account deficit. In turn, the balance of payments identity dictates that the current account deficit be equal to the net external capital inflows minus the change in the volume of foreign exchange reserves held by the RBI.