1. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Understanding Economics 5th edition by Mark Lovewell

2. Chapter 14 The Foreign Sector Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 5 th edition by Mark Lovewell

3. Learning Objectives After this chapter you will be able to: 1. explain the balance-of-payments accounts, which include the current account and the capital and financial accounts 2. understand exchange rates and how they are determined 3. summarize exchange rate systems and their evolution Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

4. The Balance of Payments Accounts The balance of payments accounts provide a summary of all transactions between Canadian residents and foreigners that involve exchanging Canadian dollars for some other currency. Receipts (shown by a + sign) represent monetary inflows to the Canadian economy. Payments (shown by a - sign) represent monetary outflows from the Canadian economy. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

5. The Current Account (a) The current account (which summarizes all foreign transactions associated with current economic activity in Canada and involving Canadian dollars) includes four types of transactions: trade in merchandise trade in services flows of investment income transfers Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

6. The Current Account (b) A current account surplus occurs when this account’s receipts outweigh payments while a current account deficit occurs when payments outweigh receipts. The merchandise balance of trade equals merchandise export receipts minus merchandise import payments. The balance of trade represents export receipts minus import payments for both goods and services. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

7. Canada’s Current Account (2007) Figure 14.1, Page 380 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Merchandise trade463.1-415.0=+48.0 Trade in services67.3-86.5=-19.2 Balance of trade (net exports)+28.9 Investment Income71.4-85.6=-14.2 Transfers9.5-10.6=-1.1 Current account surplus=+13.6 (+) or deficit (-) Receipts (+) (Canadian $ inflows) (Canadian $ billions) Payments (-) (Canadian $ outflows) Balance (net) (Canadian $ inflows – Outflows)

8. The Capital and Financial Accounts (a) The capital account summarizes transfer of ownership of savings and intangible assets. The financial account, which summarizes all foreign transactions of financial assets involving Canadian dollars, includes three types of transactions: Portfolio investment does not give the buyer controlling interest. Direct investment is financial investment that gives the buyer controlling interest. Other financial investments are linked to day-to-day fluctuations in bank deposits. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

9. The Capital and Financial Accounts (b) A capital and financial accounts surplus occurs when this accounts’ receipts outweigh payments so that Canadians make less foreign investments than foreigners make in Canada. A capital and financial accounts deficit occurs when this account’s payments outweigh receipts so that Canadians make more foreign investments than foreigners make in Canada. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

10. Canada’s Capital and Financial Accounts (2007) Figure 14.2, Page 382 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Capital Account5.0-0.8=+5.9 Financial Account Direct investment116.7-57.8=+58.9 Portfolio investment-80.0 Other financial investment+3.8 Total capital and financial 9-13.1 account surplus (+) or deficit (-) (excl. official reserves) Receipts (+) (Canadian $ inflows) (Canadian $ billions) Payments (-) (Canadian $ outflows) Balance (net) (Canadian $ inflows – outflows)

11. Balance-of-Payments Surpluses and Deficits A balance-of-payments surplus is a positive net balance showing that receipts outweigh payments on the current account and capital and financial accounts combined. A balance-of-payments deficit is a negative balance showing that payments outweigh receipts on the current account and capital and financial accounts combined. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

12. Canada’s Balance of Payments (2007) Figure 14.3, Page 384 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 1.Current account+13.6 2.Capital and financial accounts-13.1 3.Statistical discrepancy+4.1 Balance-of-payments surplus (+) or deficit (-)+4.6 4.Changes in official reserves-4.6 (Canadian $ billions) Balance (net)

13. Changes in Official Reserves (a) The change in official reserves: shows the effect of the Bank of Canada’s buying and selling of foreign currency on the flow of Canadian dollars is equal in value (and opposite in sign) to the surplus or deficit noted in the balance of payments Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

14. Changes in Official Reserves (b) A negative change in official reserves indicates that the Bank of Canada sold Canadian dollars (creating an outflow) by buying foreign currency. A positive change in official reserves indicates that the Bank of Canada bought Canadian dollars (creating an inflow) by selling foreign currency. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

15. Exchange Rates The exchange rate is the value of one nation’s currency in terms of another currency. Two exchange rates can be used to compare any two currencies (e.g. the Canadian and U.S. dollars). For example, Canadian dollars to buy US$1 = (1/U.S. dollars to buy CDN$1). Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

16. Exchange Rates and Prices The impact of exchange rates on prices can be illustrated using Canadian and U.S. dollars. A product’s U.S. dollar price = the Canadian dollar price x U.S. dollars to buy CDN$1.00. A product’s Canadian dollar price = the U.S. dollar price x Canadian dollars to buy US$1.00. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

17. The Demand for Canadian Dollars The demand for Canadian dollars is the relationship between the price of a Canadian dollar and the quantity demanded in exchange for another currency (e.g. the U.S. dollar). The demand curve’s negative slope is determined by foreign export buyers, since the higher Canadian $ means that Americans find Canadian products more expensive and so they buy fewer of them. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

18. The Supply of Canadian Dollars The supply of Canadian dollars is the relationship between the price of a Canadian dollar and the quantity supplied in exchange for another currency (e.g. the U.S. dollar). The supply curve’s positive slope is determined by Canadian import buyers, since a higher Canadian $ means that Canadians find American products cheaper and so they buy more of them. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

19. A Foreign Exchange Market Figure 14.4, Page 387 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Canadian Dollar Demand and Supply Curves Quantity of Canadian Dollars (billions) Price of Canadian Dollar (in $US) 0 4045505560 0.75 0.76 0.77 0.78 D S a a c c b Shortage Surplus US$0.78 US$0.76 US$0.75 60 – 40 = +20 50 – 50 = 0 45 – 55 = -10 Canadian Dollar Demand and Supply Schedules Price of Cdn. Dollar (in $US) Quantity of Cdn. Dollars Supplied Quantity of Cdn. Dollars Supplied ($ billions) (surplus (+) or shortage (-)) -

20. Appreciation and Depreciation When an exchange rate is allowed to vary, foreign exchange markets will reach equilibrium where demand and supply are equal. A currency appreciates when its price rises relative to the price of another currency. A currency depreciates when its price falls relative to the price of another currency. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

21. Changes in Exchange Rates (a) Four factors change exchange rates: price differences A rise in A’s prices relative to B’s decreases demand and increases supply of A’s currency and lowers its price in terms of B’s currency (and vice versa). product demand A rise in demand for A’s products increases demand and decreases supply of A’s currency and raises its price in terms of other currencies (and vice versa). Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

22. Changes in Exchange Rates (b) interest rates A rise in A’s interest rate relative to B’s increases demand and decreases supply of A’s currency, raising its price in terms of B’s currency (and vice versa). speculation Signs that A’s currency will increase relative to B’s currency mean an immediate increase in demand and decrease in supply of A’s currency and raise its price in terms of B’s currency (and vice versa). Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

23. Exchange Rate Changes Figure 14.5, Page 389 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Quantity of Canadian Dollars (billions) Price of Canadian Dollar (in $US) 0 5060 0.75 0.80 0.85 Quantity of Canadian Dollars (billions) Price of Canadian Dollar (in $US) 0 6070 0.75 0.80 0.85 D2D2 D3D3 S2S2 S3S3 d c D1D1 D0D0 S1S1 S0S0 a b

24. Exchange Rate Systems (a) Flexible exchange rates are allowed to move freely to their equilibrium levels. Fixed exchange rates are set or “pegged” to a certain value by each country’s government. A target exchange rate below equilibrium creates an excess demand for the currency and a balance-of- payments surplus. A target exchange rate above equilibrium creates an excess supply for the currency and a balance-of- payments deficit. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

25. Exchange Rate Systems (b) A low fixed exchange rate stimulates exports, but brings the danger of inflation. A high fixed exchange rate puts downward pressure on inflation as well as on real output and employment. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

26. Fixed Exchange Rates Figure 14.6, Page 393 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Canadian Dollar Demand and Supply Curves Quantity of Canadian Dollars (billions) Price of Canadian Dollar (in $US) 06065707580 0.82 0.83 0.84 0.85 Balance-of- Payments Surplus Balance-of- Payments Deficit S D a a b cc US$0.85 US$0.84 US$0.82 75 – 65 = +10 70 – 70 = 0 60 – 80 = -20 Canadian Dollar Demand and Supply Schedules Price of Canadian Dollar (in $US) Quantity Supplied Quantity Supplied ($ billions) (surplus (+) or shortage (-)) -

27. The Evolution of Exchange Rate Systems (a) There have been three major exchange rate systems used by industrialized countries during the past century: the gold standard (1879-1934), which meant that each country set the value of its currency in terms of an amount of gold the Bretton Woods System (1945-1971), which was based on adjustable fixed exchange rates Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

28. The Evolution of Exchange Rate Systems (b) the managed float (1971-the present), which is a flexible exchange rate system that sometimes involves short- term government intervention Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

29. Canadian Exchange Rates Figure 14.7, Page 396 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

30. Cities, Creativity and Diversity (a) According to economic thinker Jane Jacobs, “[P]overty has no causes… Only prosperity has causes.” In her view, small-scale creativity and productive efficiency are the main drivers of growth. these factors are inextricably tied to cities which find ways to produce previously imported items this theory also means that the main way a country gains long-term wealth is by fostering vigorous import- replacing cities within its borders, as in the case of Japan, South Korea, and more recently China Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

31. Cities, Creativity and Diversity (b) In mid-career, Jacobs extended her thinking to devise a model of social and economic ethics, in which the concept of diversity is again key. Societies thrive, she said, only if the rules that underlie commerce and politics remain distinct. Businesspeople need to tout honesty, initiative and inventiveness, recognize the benefits of efficiency, voluntary contracts, know when to collaborate and compete, and understand the costs of ostentatious consumption and pessimism about the future. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

32. Cities, Creativity and Diversity (c) Rulers, in contrast, must honour loyalty, discipline and respect for hierarchy. If businesspeople start acting like rulers or rulers like businesspeople, so-called monstrous hybrids are created. Examples include the recent mania for corporate mergers and acquisitions which many commentators – doubtless including Jacobs if she were still alive – see as one of the main causes of the financial crisis of 2008. Jacobs’ analysis of systemic moral lapses is therefore highly pertinent today. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

33. International Finance in Canada (a) (Online Learning Centre) At one time, a capital account surplus and current account deficit were typical for Canada. This reflected the fact that Canadians’ foreign liabilities have traditionally exceeded Canadians’ foreign assets. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

34. International Finance in Canada (b) (Online Learning Centre) Canada’s net foreign assets are its foreign assets minus its foreign liabilities. For 2007, net foreign assets were -$125 billion, which means that Canadians are net foreign borrowers by this amount. Canada’s net foreign borrowing as a percentage of GDP is high by international standards. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

35. Foreign Control in Canada (a) (Online Learning Centre) Much of the controversy over Canada’s net foreign liabilities relates to foreign direct investment, which involves controlling interest in Canadian companies. After falling the 1970s and early 1980s, the share of foreign control of capital employed in nonfinancial industries in Canada has been rising. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

36. Foreign Control in Economy (b) (Online Learning Centre) Foreign control in the Canadian economy is most prevalent in oil and gas extraction and coal mining as well as in manufacturing. Foreign control is least prevalent in construction. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

37. Foreign Control in Canada (c) (Online Learning Centre) The debate over foreign direct investment is closely tied to the role of transnational corporations, which play a major role in the Canadian economy. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

38. Foreign Control in Canada (d) (Online Learning Centre) There are two main benefits of foreign ownership: It increases the overall stock of capital assets, raising productivity and living standards. To the extent that transnational corporations concentrate production in those countries where it can be carried out most efficiently, these corporations help cut production costs and prices. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

39. Foreign Control in Canada (e) (Online Learning Centre) There are three main drawbacks of foreign ownership: It increases Canada’s overall foreign liabilities. It reduces Canadian economic sovereignty. It tends to reduce research and development expenditures in Canada, since these expenditures are often concentrated in the head-offices of transnational corporations. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

40. Chapter 14 The End Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 5 th edition by Mark Lovewell