1. Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

2. 18-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO18.1Explain how currencies of different nations are exchanged when international transactions take place. LO18.2Analyze the balance sheet Canada uses to account for international payments it makes and receives. LO18.3Discuss how exchange rates are determined in a currency market that has flexible exchange rates. LO18.4Describe the difference between flexible exchange rates and fixed exchange rates. LO18.5Explain the current system of managed floating exchange rates. 18 Exchange Rates and the Balance of Payments

3. Vast majority of international financial transactions fall into two categories: International trade International asset transactions Differing national currencies complicate international trade Currency for these transactions is purchased in foreign exchange markets LO1 © 2016 McGraw ‐ Hill Education Limited 18.1 Financing International Trade 18-3

4. The Canadian balance of payments shows the balance between All the payments that Canada receives from foreign countries All the payments which we make to them LO2 © 2016 McGraw ‐ Hill Education Limited 18.2 18-4 The Balances of International Payments

5. Current Account Shows the flows resulting from imports and exports of goods and services The balance on goods is the net amount of imports and exports of goods only The exports and imports of services includes sales or purchases to/from residents of foreign nations on things such as insurance, consulting, travel and brokerage services, etc. The balance on goods and services includes goods and services trade in services, investment income and transfers are included to get the current account balance In 2014, Canada had a current account deficit of $40 billion LO2 © 2016 McGraw ‐ Hill Education Limited 18.2 18-5 The Balances of International Payments

6. Capital and Financial Account Shows capital inflows and outflows Purchase or sale of real or financial assets Official settlements account TIP A “+” sign indicates a “source” of foreign exchange A “-” sign indicates a “use” of foreign exchange LO2 © 2016 McGraw ‐ Hill Education Limited 18.2 18-6 The Balances of International Payments

7. © 2016 McGraw ‐ Hill Education Limited LO2 18-7 TABLE 18-1 Canada’s Balance of Payments, 2014 (billions of dollars) Current Account (1)Merchandise exports+529 (2)Merchandise imports–524 (3)Balance of trade +5 (4)Exports of services+95 (5)Imports of services–118 (6)Balance on goods and services -18 (7)Net investment income–20 (8)Net transfers–2 (9)Current account balance-40 Capital and financial account: (10) Foreign purchases of assets in Canada (capital inflow)+178 (11) Canadian purchases of assets abroad (capital outflow)–141 (12) Statistical discrepancy+4 (13) Capital account balance+41 Official settlement account: (14) Official international reserves Balance of payments0 Source: Statistics Canada, http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/econ01a-eng.htm. Accessed March 11, 2012.

8. 18.1 GLOBAL PERSPECTIVE Canada’s Trade Balance with Selected Nations, 2014 © 2016 McGraw ‐ Hill Education Limited LO2 18-8

9. Why the Balance? The balance on the current account and the balance on the capital and financial account must always sum to zero Any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account If trading partners have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to the other LO2 © 2016 McGraw ‐ Hill Education Limited 18.2 18-9 The Balances of International Payments

10. Payments Deficits and Surpluses A drawing down of official international reserves (a + official reserves entry) measures a nation’s balance of payments deficit A building up of official reserves (a – official reserves entry) measures a balance of payments surplus Deficits not necessarily bad, but cannot be maintained indefinitely, because international reserves are limited LO2 © 2016 McGraw ‐ Hill Education Limited 18.2 18-10 The Balances of International Payments

11. Competitive markets Linkages to all domestic & foreign prices LO3 © 2016 McGraw ‐ Hill Education Limited 18.3 Foreign Exchange Markets: Flexible Exchange Rate 18-11

12. 18.2 GLOBAL PERSPECTIVE © 2016 McGraw ‐ Hill Education Limited LO3 18-12 Exchange Rates: Foreign Currency per Canadian Dollar

13. Exchange-Rate Systems: Flexible (floating) exchange-rate system Fixed exchange-rate system Depreciation and Appreciation Determinants of Exchange Rate Changes Demand and supply analysis LO3 © 2016 McGraw ‐ Hill Education Limited 18.3 Foreign Exchange Markets: Flexible Exchange Rate 18-13

14. © 2016 McGraw ‐ Hill Education Limited LO3 18-14 FIGURE 18-1 KEY GRAPH - The Market for Foreign Currency (Pounds) Q 0 Dollar Price of 1 Pound Quantity of Pounds P D1D1 S1S1 Dollar Appreciates (Pound Depreciates) Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1

15. Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative inflation rate changes ▪ Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation LO3 © 2016 McGraw ‐ Hill Education Limited 18.3 Foreign Exchange Markets: Flexible Exchange Rate 18-15

16. © 2016 McGraw ‐ Hill Education Limited LO3 18-16 TABLE 18-2 Determinants of Exchange-Rate Changes: Factors That Change the Demand or the Supply of a Particular Currency and Thus After the Exchange Rate DeterminantExamples Changes in tastesJapanese electronic equipment declines in popularity in Canada (Japanese yen depreciates, Canadian dollar appreciates) European tourists reduce visits to Canada (Canadian dollar depreciates; European euro appreciates). Changes in relative incomesEngland encounters a recession, reducing its imports, while Canadian real output and real income surge, increasing Canadian imports (British pound appreciates, Canadian dollar depreciates). Changes in relative inflation rates Switzerland experiences a 3 percent inflation rate compared to Canada’s 10 percent rate (Swiss franc appreciates; Canadian dollar depreciates). Changes in relative real interest rates The Bank of Canada drives up interest rates in Canada while the Bank of England takes no such action (Canadian dollar appreciates; British pound depreciates). Changes in relative expected returns on stocks, real estate, or production facilities Corporate tax cuts in Canada raise expected after-tax investment returns in the Canada rise relative to those in Europe (Canadian dollar appreciates; the euro depreciates) SpeculationCurrency traders believe South Korea will have much greater inflation than Taiwan (South Korean won depreciates; Taiwanese dollar appreciates) Currency traders think Finland’s interest rates will plummet relative to Denmark’s rates (Finland’s markka depreciates; Denmark’s krone appreciates)

17. © 2016 McGraw ‐ Hill Education Limited LO3 18-17 FIGURE 18-2 Adjustments Under Flexible Exchange Rates Q 0 Dollar Price of 1 Pound Quantity of Pounds P D1D1 S1S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 D2D2 Exchange Rate: $3 = £1 Balance Of Payments Deficit Q2Q2 x a b c

18. © 2016 McGraw ‐ Hill Education Limited LO3 18-18 FIGURE 18-3 Adjustments Under Fixed Exchange Rates Q 0 Dollar Price of 1 Pound Quantity of Pounds P D1D1 S1S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 D2D2 Balance Of Payments Deficit Q2Q2 x a b c S2S2

19. Disadvantages of flexible exchange rates Uncertainty and diminished trade Terms-of-trade changes The challenges to managing and designing domestic macroeconomic policies LO3 © 2016 McGraw ‐ Hill Education Limited 18.3 Foreign Exchange Markets: Flexible Exchange Rate 18-19

20. Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO4 © 2016 McGraw ‐ Hill Education Limited 18-20 18.4 Fixed Exchange Rates

21. Gold standard 1879-1934 Fixed exchange rate system Bretton Woods 1944-1971 Fixed exchange rate system indirectly tied to gold Managed float 1971-present LO5 © 2016 McGraw ‐ Hill Education Limited 18-21 18.5 The Current Exchange-Rate System: The Managed Float

22. Current system (1971 to present) “Almost” flexible system Considerably more volatile than under Bretton Woods G8 collectively intervene to stabilise currencies Proponents and critics Has functioned better than anticipated A “nonsystem” Most economists favour its continuation LO5 © 2016 McGraw ‐ Hill Education Limited 18-22 18.5 The Current Exchange-Rate System: The Managed Float

23. The LAST WORDSpeculations in Currency Markets © 2016 McGraw ‐ Hill Education Limited 18-23 Contrary to popular belief, speculators often play a positive role in currency markets. Positive or negative influence? Contributes to currency market fluctuations Self-fulfilling expectations Smoothing short-term fluctuations Absorbing risk Futures market at work Positive role played overall

24. LO18.1 Explain how currencies of different nations are exchanged when international transactions take place. LO18.2 Analyze the balance sheet Canada uses to account for international payments it makes and receives. LO18.3 Discuss how exchange rates are determined in a currency market that has flexible exchange-rates. LO18.4 Describe the difference between flexible exchange rates and fixed exchange rates. LO18.5 Explain the current system of managed floating exchange rates. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 18-24