Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Exchange Rates and the Balance of Payments CHAPTER TEN

© 2004 McGraw–Hill Ryerson Limited Calculate the value of the Canadian dollar in terms of other currencies Identify who wants to buy and sell Canadian dollars and why Explain why the value of the Canadian dollar fluctuates Compare flexible and fixed exchange rate systems Construct a balance sheet of international payments Understand what a balance of payments surplus and deficit means This Chapter Will Enable You to:

© 2004 McGraw–Hill Ryerson Limited Exchange Rates An exchange rate is the rate at which one currency is exchanged for another To convert one currency into another, we use the following formula: 1 Canadian dollar = 1 / (1 unit of foreign currency) Or, 1 unit of foreign currency = 1 / ( 1 Canadian dollar)

© 2004 McGraw–Hill Ryerson Limited Currency Appreciation and Depreciation Currency appreciation –The rise in the exchange rate of one currency for another Currency depreciation –The fall in the exchange rate of one currency for another

© 2004 McGraw–Hill Ryerson Limited Exchange Rate Regimes Flexible exchange rates –A currency exchange rate determined by the market forces of supply and demand and not interfered with by government action Fixed exchange rates –A currency exchange rate pegged by the government and therefore prevented from rising and falling

© 2004 McGraw–Hill Ryerson Limited Determinant of long-term exchange rate values Purchasing power parity theory –A theory suggesting that exchange rates will change so as to equate the purchasing power of each currency

© 2004 McGraw–Hill Ryerson Limited Differences in Purchasing Power Between Countries These five factors explain the differences in purchasing power between countries: –The fact that many services, such as haircuts, are not traded internationally –The existence of transportation and insurance costs –The existence of tariffs and other trade restrictions –The expression of particular preferences by consumers –The effect on the value of currencies of trade in financial assets

© 2004 McGraw–Hill Ryerson Limited Flexible Exchange Rates and the Demand for the Canadian Dollar (I) Demand depends on: Foreigners who want to buy Canadian exports or who want to travel to Canada Foreigners who want to purchase Canadian investments –Direct investment: The purchase of real assets –Portfolio investment: The purchase of shares or bonds representing less than fifty percent ownership

© 2004 McGraw–Hill Ryerson Limited Demand for the Canadian Dollar (II) Demand also depends on: Canadians who receive income from abroad Currency speculators –Buying a currency in the expectation that its value will rise Arbitrage: The process of buying a commodity in one market, where the price is low, and immediately selling it in a second market where the price is higher

© 2004 McGraw–Hill Ryerson Limited The Demand Curve For The Canadian Dollar P of Can. $ Q of Can $ D P1P1 Q1Q1 The demand curve for the Canadian dollar is a conventional demand curve Figure 10.1

© 2004 McGraw–Hill Ryerson Limited The Supply Of Canadian Dollars S P of Can. $ Q of Can. $ P1P1 Q1Q1 The supply curve for the Canadian dollar is a conventional supply curve Figure 10.2

© 2004 McGraw–Hill Ryerson Limited Equilibrium in Foreign-Exchange Markets Q of Can. $ D S P of Can. $ ER 1 Q1 An equilibrium exchange rate Figure 10.3

© 2004 McGraw–Hill Ryerson Limited Effect of Depreciation/Appreciation on Exports When the Canadian dollar depreciates, the effective price of Canadian exports decreases and total exports are likely to rise When the Canadian dollar appreciates, the effective price of Canadian exports increases, and total exports are likely to fall

© 2004 McGraw–Hill Ryerson Limited The Supply and Demand of Currencies Quantity demanded of foreign currencies is equal to quantity supplied of Canadian dollars Quantity demanded of Canadian dollars is equal to quantity supplied of foreign currencies

© 2004 McGraw–Hill Ryerson Limited Effect of Appreciation/Depreciation on Imports When the Canadian dollar appreciates, the effective price of Canadian imports decreases and total imports are likely to rise When the Canadian dollar depreciates, the effective price of Canadian imports increases and total imports are likely to fall

© 2004 McGraw–Hill Ryerson Limited Changes in Demand and Supply P of Can. $ Q1Q1 ER 1 Q2Q2 D1D1 D2D2 ER 2 S Q of Can. $ An increase in demand for a currency… the equilibrium exchange will rise from ER1 to E2 the equilibrium quantity will rise from Q1to Q2 An increase in demand for a currency… the equilibrium exchange will rise from ER1 to E2 the equilibrium quantity will rise from Q1to Q2 Figure 10.4

© 2004 McGraw–Hill Ryerson Limited The Demand for the Canadian Dollar …is determined by: –The level of foreign incomes –The price of Canadian products relative to the price of foreign products –Foreigners’ tastes –Comparative interest rates

© 2004 McGraw–Hill Ryerson Limited The Effect of an Increase in Exports on AD Q1Q1 An increase in Canadian exports increases AD from AD1 to AD2. This results in a rise in P and GDP An increase in Canadian exports increases AD from AD1 to AD2. This results in a rise in P and GDP AS AD 2 AD 1 P2P2 P1P1 Y1Y1 Y2Y2 P of Can. $ Figure 10.5

© 2004 McGraw–Hill Ryerson Limited An Increase in the Supply of Canadian Dollars Q1Q1 Q1Q1 Following an increase in the supply of Canadian dollars, the dollar depreciates and the quantity of dollars traded increases. Q2Q2 S1S1 D P of Can. $ ER 1 S2S2 ER 2

© 2004 McGraw–Hill Ryerson Limited Fixed Exchange Rates (I) They add a degree of certainty to international trade They prevent instability in the export and import industries They discourage currency speculation They appeal to people who tend to equate the exchange rate with national prestige

© 2004 McGraw–Hill Ryerson Limited P of Can. $ Fixed Exchange Rates (II) An Increase in Currency Demand Under Fixed Exchange Rates fixed D1D1 S QsQd D2D2 ER 1 ER 2 Q of Can. $ Figure 10.7 shortage

© 2004 McGraw–Hill Ryerson Limited The Effect of Currency Overvaluation Given fixed exchange rate, an increase in demand for the Canadian dollar results in the dollar being undervalued (compared with free-market value) and a dollar shortage To support the fixed rate, the Bank of Canada must supply the additional dollars demanded by the market The supply of additional dollars and the strong demand for Canadian exports will exert inflationary pressure on Canada’s economy (until an equilibrium is re-established)

© 2004 McGraw–Hill Ryerson Limited surplus Fixed Exchange Rates (III) A Decrease in Currency Demand Under Fixed Exchange Rates P of Can. $ D2D2 S Qd D1D1 ER 1 fixed Qs ER 2 Q of Can. $ Figure 10.8

© 2004 McGraw–Hill Ryerson Limited Overvalued Exchange Rates A government can defend its currency in four ways: –Introducing quotas or tariffs to reduce imports or subsidies to boost exports Subsidy –A payment by government for the purpose of increasing some particular activity or increasing the output of a particular good –Introducing foreign-exchange controls –Negotiating voluntary export restrictions –Creating a recession at home

© 2004 McGraw–Hill Ryerson Limited Devaluation And Dirty Float Devaluation –The re-fixing by the government of an exchange rate at a lower level Dirty float –An exchange rate that is not officially fixed by the government but is managed by the central bank’s ongoing intervention in the market

© 2004 McGraw–Hill Ryerson Limited The Balance Of Payments (I) It is an accounting of a country’s international transactions that involves the payment and receipts of foreign currencies –Current account A subcategory of the balance of payments that shows the income or expenditures related to exports and imports –Capital account A subcategory of the balance of payments that reflects changes in ownership of assets associated with foreign investment

© 2004 McGraw–Hill Ryerson Limited Balance Of Payments (II) –Official settlement’s account A subcategory of the balance of payments that shows the change in a country’s official foreign exchange reserves –Balance of trade The value of a country’s exports of goods and services less the value of its imports

© 2004 McGraw–Hill Ryerson Limited Canada’s Balance of Payments 2001 ($ bil.) Current Account Export of goods and services+ 468 Import of goods and services- 413 = Balance of trade+ 55 Investment income from abroad+ 37 Investment income paid abroad- 65 Net investment income- 28 Transfers (net)+ 2 = Current Account balance+ 29 Capital Account Foreign investment in Canada+ 81 Less Canadian investment abroad-107 = Capital Account balance- 26 Balance of Current Account and Capital Account+ 3 Official Settlements Account Change in Canadian dollars (change in foreign reserves- 3 Total Balance (sum of three accounts) 0

© 2004 McGraw–Hill Ryerson Limited Determining the value of the Canadian dollar in terms of other currencies Identifying who wants to buy and sell Canadian dollars and why Explaining why the value of the Canadian dollar fluctuates Comparing flexible and fixed exchange rate systems Constructing a balance sheet of international payments Understanding what a balance of payments surplus and deficit means Chapter Summary: What to Study and Remember