1. Copyright © 2006 Pearson Education Canada The Exchange Rate 26 CHAPTER

2. Copyright © 2006 Pearson Education Canada Objectives After studying this chapter, you will able to  Describe the foreign exchange market and define the exchange rate  Explain how an exchange rate is determined  Explain why the exchange rate fluctuates and explain interest rate parity and purchasing power parity  Describe and assess the benefits and costs of a flexible exchange rate, fixed exchange rate, and monetary union

3. Copyright © 2006 Pearson Education Canada Many Monies! The Canadian dollar—or loonie—is just one of more than a hundred kinds of money that circulate in the global economy. The loonie is an important money, but it isn’t in the truly big league. The world’s four big monies are the U.S dollar, the Japanese yen, the U.K. pound, the European euro. Why do currency exchange rates fluctuate? Why does the Canadian dollar fluctuate against the U.S. dollar? Why isn’t there just one dollar?

4. Copyright © 2006 Pearson Education Canada Currencies and Exchange Rates To buy goods and services produced in another country we need money of that country. Foreign bank notes, coins, and bank deposits are called foreign currency. Figure 26.1 shows the currencies that Canada uses in its international trade.

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6. Currencies and Exchange Rates A fall in the value of one currency in terms of another currency is called currency depreciation. A rise in value of one currency in terms of another currency is called currency appreciation. Sometimes the Bank of Canada pegs the value of the exchange rate, as it did for most of the 1960s.

7. Copyright © 2006 Pearson Education Canada Currencies and Exchange Rates Figure 26.2 shows the average annual Canadian dollar in terms of the U.S. dollar from 1951 to 2005.

8. Copyright © 2006 Pearson Education Canada Currencies and Exchange Rates The Foreign Exchange Market We get foreign currency and foreigners get Canadian dollars in the foreign exchange market—the market in which the currency of one country is exchanged for the currency of another. Foreign Exchange Rates The price at which one currency exchanges for another is called a foreign exchange rate.

9. Copyright © 2006 Pearson Education Canada Currencies and Exchange Rates Cross Exchange Rates We can express the value of the Canadian dollar in terms of any other currency, called cross exchange rates. Figure 26.3 shows cross exchange rates on October 19, 2005.

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11. Currencies and Exchange Rates Figure 26.4 shows how the Canadian dollar has fluctuated against other currencies.

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13. The Foreign Exchange Market The Demand for One Money Is the Supply of Another Money When people who are holding one money want to exchange it for Canadian dollars, they demand Canadian dollars and they supply that other country’s money. So the factors that influence the demand for Canadian dollars also influence the supply of U.S. dollars, E.U. euros, U.K. pounds, and Japanese yen. And the factors that influence the demand for another country’s money also influence the supply of Canadian dollars.

14. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Demand in the Foreign Exchange Market The quantity of Canadian dollars that traders plan to buy in the foreign exchange market during a given period depends on 1. The exchange rate 2. World demand for Canadian exports 3. Interest rates in Canada and other countries 4. The expected future exchange rate

15. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market The Law of Demand for Foreign Exchange The demand for dollars is a derived demand. People buy Canadian dollars so that they can buy Canadian-made goods and services or Canadian assets. Other things remaining the same, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign exchange market.

16. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market There are two sources of the derived demand for Canadian dollars:  Exports effect  Expected profit effect Exports Effect The larger the value of Canadian exports, the greater is the quantity of Canadian dollars demanded on the foreign exchange market. And the lower the exchange rate, the greater is the value of Canadian exports, so the greater is the quantity of Canadian dollars demanded.

17. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Expected Profit Effect The larger the expected profit from holding Canadian dollars, the greater is the quantity of Canadian dollars demanded today. But expected profit depends on the exchange rate. The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying Canadian dollars and the greater is the quantity of Canadian dollars demanded today.

18. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market The Demand Curve for Canadian Dollars Figure 26.5 illustrates the demand curve for Canadian dollars on the foreign exchange market.

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20. The Foreign Exchange Market Supply in the Foreign Exchange Market The quantity of Canadian dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors but the main ones are 1. The exchange rate 2. Canadian demand for imports 3. Interest rates in Canada and other countries 4. The expected future exchange rate

21. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Imports Effect The larger the value of Canadian imports, the larger is the quantity of dollars supplied on the foreign exchange market. And the higher the exchange rate, the greater is the value of Canadian imports, so the greater is the quantity of Canadian dollars supplied.

22. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Expected Profit Effect For a given expected future Canadian dollar exchange rate, the lower the exchange rate, the greater is the expected profit from holding Canadian dollars, and the smaller is the quantity of Canadian dollars supplied on the foreign exchange market.

23. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Supply Curve for Canadian Dollars Figure 26.6 illustrates the supply curve of Canadian dollars in the foreign exchange market.

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25. The Foreign Exchange Market Market Equilibrium Figure 26.7 shows how demand and supply in the foreign exchange market determine the exchange rate.

26. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market If the exchange rate is too high, a surplus of dollars drives it down. If the exchange rate is too low, a shortage of dollars drives it up. The market is pulled (quickly) to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

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28. Exchange Rate Fluctuations Changes in the Demand for Dollars A change in any influence on the quantity of dollars that people plan to buy, other than the exchange rate, brings a change in the demand for dollars and a shift in the demand curve for dollars. These other influences are  World demand for Canadian exports  Interest rates in Canada and in other countries  The expected future interest rate

29. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations World Demand for Canadian Exports Increases At a given exchange rate, if world demand for Canadian exports increases, the demand for Canadian dollars increases and the demand curve for Canadian dollars shifts rightward. Interest rates in Canada and in other countries The Canadian interest rate minus the foreign interest rate is called the Canadian interest rate differential. If the Canadian interest differential rises, the demand for Canadian dollars increases and the demand curve for Canadian dollars shifts rightward.

30. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations The expected future interest rate At a given exchange rate, if the expected future exchange rate for Canadian dollars rises, the demand for Canadian dollars increases and the demand curve for dollars shifts rightward.

31. Copyright © 2006 Pearson Education Canada The Foreign Exchange Market Figure 26.8 shows how the demand curve for Canadian dollars shifts in response to changes in Canadian exports, the Canadian interest rate differential, and expectations of future exchange rates.

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33. Exchange Rate Fluctuations Changes in the Supply of Dollars A change in any influence on the quantity of Canadian dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars and a shift in the supply curve of dollars. These other influences are  Canadian demand for imports  Interest rates in Canada and in other countries  The expected future exchange rate

34. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Canadian Demand for Imports At a given exchange rate, if Canadian demand for imports increases, the supply of Canadian dollars on the foreign exchange market increases and the supply curve of Canadian dollars shifts rightward. Interest rates in Canada and in other countries If the Canadian interest differential rises, the supply for Canadian dollars decreases and the supply curve of Canadian dollars shifts leftward.

35. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations The expected future exchange rate At a given exchange rate, if the expected future exchange rate for Canadian dollars rises, the supply of Canadian dollars decreases and the demand curve for dollars shifts leftward.

36. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Figure 26.9 shows how the supply curve of Canadian dollars shifts in response to changes in Canadian demand for imports, the Canadian interest rate differential, and expectations of future exchange rates.

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38. Exchange Rate Fluctuations Changes in the Exchange Rate Changes in demand and supply in the foreign exchange market change the exchange rate (just like they change the price in any market).  If demand for Canadian dollars increases and supply does not change, the exchange rate rises.  If demand for Canadian dollars decreases and supply does not change, the exchange rate falls.  If supply of Canadian dollars increases and demand does not change, the exchange rate falls.  If supply of Canadian dollars decreases and demand does not change, the exchange rate rises.

39. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations A Depreciating Dollar: 1991  2002 During the 1990s, the North American Free Trade Agreement (NAFTA) came into effect and the volume of trade between Canada and the United States increased. The supply of Canadian dollars increased. The demand for Canadian dollars would have increased but traders expected the Canadian dollar to depreciate, which offset the factors leading to an increase in demand. Between 1991 and 2002, the Canadian dollar fell from 87 U.S. cents to 64 U.S. cents per dollar.

40. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Figure 26.10(a) illustrates the depreciation of the Canadian dollar. The increase in supply with no change in demand lowered the exchange rate and increased the quantity of dollars traded.

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42. Exchange Rate Fluctuations An Appreciating Dollar: 2002  2005 During 2004 and 2005, the world demand for resources increased, driven mainly by rapid economic growth in China and India. The result was a large increase in the world demand for Canadian exports and an increase in the demand for the Canadian dollar. This increase in demand and rise in the Canadian dollar was expected and, as a result, the supply of dollars decreased. The increase in demand and decrease in supply raised the exchange rate from 64 U.S. cents to 81 U.S. cents

43. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Figure 26.10(b) illustrates the depreciation of the Canadian dollar. The increase in the demand for Canadian dollars and the decrease in the supply of Canadian dollars raised the Canadian dollar exchange rate.

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45. Exchange Rate Fluctuations Exchange Rate Expectations The exchange rate changes when it is expected to change. But expectations about the exchange rate are driven by deeper forces. Two such forces are  Purchasing power parity  Interest rate parity

46. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Purchasing Power Parity A currency is worth the value of goods and services that it will buy. The quantity of goods and services that one unit of a particular currency will buy will differ from the quantity of goods and services that one unit of another currency will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity, which means equal value of money.

47. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations If one Canadian dollar exchanges for 85 U.S. cents, then purchasing power parity is attained when one Canadian dollar buys the same quantity goods and services in the Canada as 85 cents buys in the United States. If one Canadian dollar buys more goods and services in Canada than 85 U.S. cents buys in the United States, people will expect that the Canadian dollar will eventually appreciate. If one Canadian dollar buys less goods and services in the Canada than 85 U.S. cents buys in the United States, people will expect that the Canadian dollar will eventually depreciate.

48. Copyright © 2006 Pearson Education Canada Exchange Rate Fluctuations Interest rate parity A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the returns on two currencies are equal, interest rate parity prevails. Interest rate parity means equal interest rates when exchange rate changes are taken into account. Market forces achieve interest rate parity very quickly.

49. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Four distinct exchange rate policies are  Flexible exchange rate  Fixed exchange rate  Crawling peg  Currency union Flexible Exchange Rate A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. The Bank of Canada operates a flexible exchange rate.

50. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Fixed Exchange Rate A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market. The Bank of Canada operated a fixed exchange rate during the 1960s when the dollar was pegged at 92.5 U.S. cents.

51. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Figure 26.11 shows how the Bank of Canada can intervene in the foreign exchange market to keep the exchange rate close to a target rate (90 U.S. cents per dollar in this example). If demand increases, the Bank sells dollars to increase supply.

52. Copyright © 2006 Pearson Education Canada Exchange Rate Policy If demand decreases, the Bank buys dollars to decrease supply. Persistent intervention on one side of the foreign exchange market cannot be sustained.

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54. Exchange Rate Policy Crawling Peg A crawling peg exchange rate policy is one that selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. The Bank of Canada has never operated a crawling peg. But China is a country that does so. A crawling peg works like a fixed exchange rate except that the target value changes. The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

55. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Currency Union A currency union is a merger of the currencies of a number of countries to form a single money and avoid foreign exchange transactions. How likely is a currency union between Canada and the United States? The benefits of a currency union are  Transparency and competition improve  Transactions costs fall  Foreign exchange risk is eliminated  The real interest rate fall

56. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Transparency and Competition Improve A single currency provides a single unit of account, so prices are easily compared across all the members of the currency union. Transactions Costs Fall A single currency eliminates foreign exchange transactions costs—the costs of converting Canadian dollars to U.S. dollars or the reverse conversion.

57. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Foreign Exchange Risk Eliminated With a single currency, exporters and importers no longer face foreign exchange risk. So elimination of exchange risk greatly simplifies the life of thousands of firms. Real Interest Rates Fall The real interest rate is the cost of capital and the return to saving. It includes a premium for risk. One type of risk arises from currency fluctuations and inflation fluctuations. If a single currency can eliminate or lower this type of risk it can lower the real interest rate and stimulate saving and investment.

58. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Two major costs of a currency union are  Shocks that need national monetary policy  Loss of sovereignty Shocks that Need National Monetary Policy A single currency means a single monetary policy—in the North American context, one monetary policy for the United States and Canada. But many economic shocks call for a monetary policy response that is specific to the economy receiving the shock.

59. Copyright © 2006 Pearson Education Canada Exchange Rate Policy Loss of Sovereignty If a country joins with another country to form a currency union, each country surrenders some sovereignty—the ability to set its own monetary policy. In principle, national fiscal policy might be used to pursue national economic policy goals where monetary policy is not available. But usually, before a currency union can be agreed upon, some limits must also be agreed for the use of fiscal policy. Is it likely Canada and the United States would adopt a North American dollar?

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