1. Basics of International Finance
National income accounting
Records all the expenditures that contribute to a country’s income and output
Balance of payments accounting
Helps us keep track of both changes in a country’s indebtedness to foreigners and the fortunes of its export- and import-competing industries
Gross national product (GNP)
The value of all final goods and services produced by a country’s factors of production and sold on the market in a given time period. It is the basic measure of a country’s output.
4/15/2019
Econ 355, Nisha Malhotra

2. The National Income Identity for an Open Economy
It is the sum of domestic and foreign expenditure on the goods and services produced by domestic factors of production:
Y = C + I + G + EX – IM (12-1)
where:
Y is GNP
C: The amount consumed by private domestic residents
I : The amount put aside by private firms to build new plant and equipment for future production
G is government purchases
EX is exports
IM is imports
In a closed economy, EX = IM = 0.
4/15/2019
Econ 355, Nisha Malhotra

3. The Current Account and Foreign Indebtedness
Current account (CA) balance
The difference between exports of goods and services and imports of goods and services
(CA = EX – IM)
A country has a CA surplus when its CA > 0.
A country has a CA deficit when its CA < 0.
CA measures the size and direction of international borrowing.
A country’s current account balance equals the change in its net foreign wealth.
Example: Canada imports 20 bushels of wheat and exports only 10 bushels of wheat. The current account deficit of 10 bushels is the value of Canada’s borrowing from foreigners, which the country will have to repay in the future.
4/15/2019
Econ 355, Nisha Malhotra

4. The Balance of Payments Accounts (BOP)
Three types of international transactions are recorded in the balance of payments:
Exports or imports of goods or services
Purchases or sales of financial assets
Money, Stocks, government debt and purchase/sale of factories
Transfers of wealth between countries
They are recorded in the capital account.
Capital Account: -result from non-market activities, or represent the acquisition or disposal of nonproduced, nonfinancial assets.
Person moves to canada with her savings
Foreign aid/ forgiveness of debt
4/15/2019
Econ 355, Nisha Malhotra

5. The Fundamental BOP Identity
Any international transaction automatically gives rise to two
offsetting entries in the balance of payments resulting in a
fundamental identity:
Current account + financial account + capital account = 0
**************************************************************************
Capital Inflow and Outflow
Financial inflow also called -(capital inflow)
A loan from the foreigners with a promise that they will be repaid
Financial outflow also called - (capital outflow)
A transaction involving the purchase of an asset from foreigners
The loan enters financial account with a positive sign. The Canadian govt. is selling them an asset – a promise that this loan will be repaid in the future.
A financial inflow is sometimes also called a capital inflow.
4/15/2019
Econ 355, Nisha Malhotra

6. Official Reserve Transactions
Central bank-US/ (Bank of Canada)
The institution responsible for managing the supply of money
Official international reserves
Foreign assets held by central banks as a cushion against national economic misfortune
Official foreign exchange intervention
Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies.
4/15/2019
Econ 355, Nisha Malhotra

7. Goals of “Bank of Canada”
Low and Stable Inflation
A safe and secure currency
Financial Stability
The Efficient management of Govt. funds and Public Debt
4/15/2019
Econ 355, Nisha Malhotra

8. The Exchange Rate
THE EXCHANGE RATE refers to the value of the Canadian dollar against the currencies of other countries.
Depreciation: When the value (purchasing power) of the Canadian dollar falls.
(Moving from 1.3 per US dollar to 1.5 per US dollar)
(.77 per CA dollar to .67 per CA dollar)
imported goods become more expensive, and we tend to reduce the volume of our imports. At the same time, other countries will pay less for some of our products and that will tend to boost export sales.
A Depreciation lowers the relative price of export and increases the relative price of imports.
Appreciation: The opposite
4/15/2019
Econ 355, Nisha Malhotra

9. Using the exchange rate to calculate the price for Canon
Canon Powershot SD Megapixel 2x Optical/3.2x Digital Zoom Digital Camera
PRICE: US $329.99
5% tax & free shipping=346.49
PRICE: CA $445.99
14.5% tax & free shipping=510.55
Buying the camera in the US-price in Canadian dollars
(US $) * (CA $/US $)
us$ * 1.32= ca $457.37
4/15/2019
Econ 355, Nisha Malhotra

10. The Foreign Exchange market
Exchange rates are determined by the interaction of buyers and sellers of foreign currencies in the foreign exchange market.
Commercial Banks, Corporations, Nonbank financial institutions and
Central banks.
Demand for deposit in a currency depends on the expected rate of return for this asset.
Choosing to hold Euro or Dollar deposit- Need to know-how the money value of the deposit will change and how the exchange rate will change
Money value depend on the currency’s interest rate
Change in exchange rate- rate of depreciation of the currency
4/15/2019
Econ 355, Nisha Malhotra

11. Demand for foreign currency asset
The expected rate of return difference between dollar and euro deposits is:
R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1)
where:
R$ = interest rate on one-year dollar deposits
R€ = today’s interest rate on one-year euro deposits
E$/€ = today’s dollar/euro exchange rate (number of dollars per euro)
Ee$/€ = dollar/euro exchange rate (number of dollars per euro) expected to prevail a year from today
4/15/2019
Econ 355, Nisha Malhotra

12. Determination of the Equilibrium Dollar/Euro Exchange Rate
Interest Parity: The Basic Equilibrium Condition
The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.
R$= R€ + (Ee$/€ -E$/€ )/E$/€
4/15/2019
Econ 355, Nisha Malhotra

13. Equilibrium in the Foreign Exchange Market
Determination of the Equilibrium Dollar/Euro Exchange Rate
Rates of return
(in dollar terms)
Exchange rate, E$/€ R$
Return on
dollar deposits
Expected return
on euro deposits
E2$/€ 2 1
E1$/€
E3$/€ 3
4/15/2019
Econ 355, Nisha Malhotra

14. Relationships Interest rates & Current Exchange Rate
An increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies
Rates of return
(in dollar terms)
Exchange rate, E$/€
Dollar return
R2$
Expected
euro return
R1$ 1
E1$/€ 1' 2
E2$/€
4/15/2019
Econ 355, Nisha Malhotra

15. Relationships Expectations about the future exchange rate & Current Exchange Rate
A rise in the expected future exchange rate causes a rise in the current exchange rate.
Rates of return
(in dollar terms)
Exchange rate, E$/€
Dollar return R$
Expected
euro return
Rise in the future
Exchange rate 2
E2$/€ 1
E1$/€
4/15/2019
Econ 355, Nisha Malhotra

16. Relationships Money supply and the exchange rate in the short run
Money supply & interest rate--Increase in the level of the nominal money supply lowers the interest rate
Since people are holding more money than they desire, they bid for assets that pay interest. The economy as a whole cannot reduce its money holdings, so interest rates are driven down as unwilling money holders compete to lend their excess cash balance.
Interest rate & exchange rate (interest parity condition)-- decrease in dollar interest rate depreciates the currency
Thus, an in crease in a country’s money supply causes its currency to depreciate in the foreign exchange market.
Long Run-Price level increases and no change in the interest rate and output. It does lead to a permanent depreciation in the currency.
Price level and the future expectations are given
4/15/2019
Econ 355, Nisha Malhotra

17. (Dollar interest rate) (Dollar/Euro exchange rate)
Relationships Money supply and the exchange rate
Money-Market/Exchange Rate Linkages
Canada
Bank of Canada
Europe
European System
of Central Banks
(Canada
money supply)
MSCA
MSE
(European
money supply)
Canada
money market
European
money market
Foreign
exchange
market R$
(Dollar interest rate) R€
(Euro interest rate)
E$/€
(Dollar/Euro exchange rate)
4/15/2019
Econ 355, Nisha Malhotra