Open economy

In an open economy, we have to consider the impact of such policies on the country’s balance of payments. The current account , income and the real exchange rate. It is positively related to foreign income and the real exchange rate and negatively related to domestic income.

The capital account on the other hand, which records capital flows incurred in the purchase and sales of real and financial assets, is affected by differences between the domestic and the foreign interest rate. A wider spread between domestic and foreign interest rate results in a net capital inflow into the country. Net capital outflow results when there is a narrowing of the spread between domestic and foreign interest rate. Net capital inflows therefore depends positively on the difference between domestic interest rate minus the foreign interest rate.