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Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 0 CHAPTER 5 International Trade and Exchange Rates Learning objectives Understand that the balance of payments is composed of the current account and the capital account. Understand that the current account balance and the capital account balance must sum to zero. Understand that a small open economy takes the foreign real interest rate. Understand that given the foreign real rate of interest, domestic savings does not have to equal domestic investment in equilibrium. Understand that if domestic savings is greater than domestic investment, then there is a balance of trade surplus and net foreign lending is positive. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd. CHAPTER 5 International Trade and Exchange Rates Learning objectives (cont’d) Understand that Canada has operated under both a floating and a flexible rate system. Understand that purchasing power parity predicts that the exchange rate will move to equate purchasing power internationally. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd. International Trade Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o Open economy: An economy that trades goods, services, and assets with other countries. o Closed economy: An economy that does not engage in any international trade. Slide 3 The Balance of Payments Accounts Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o The Balance of payments: A record of the transactions of a country with the rest of the world. o Rule A: Any transaction that gives rise to a payment by Canadian residents to a foreign country is an outflow and is recorded as a debit item (minus signs in Table 5-1). o Rule B: Any transaction that gives rise to a payment by foreigners to a Canadian resident is an inflow and is recorded as a credit item. (plus signs in Table 5-1). Slide 4 Table 5-1: Canada’s International Balance of Payments, 2002 (Billion of dollars) Current Account Net Exports Exports Imports Net Income and Assets Receipts on Investments Payments on Investments Net Transfers Transfer Receipts Transfer Payments Current Account Balance Copyright 2005 © McGraw-Hill Ryerson Ltd. 49.5 472.6 423.1 -27.5 31.6 -59.1 1.4 7.0 -5.6 23.4 Slide 5 Table 5-1: Canada’s International Balance of Payments, 2002 (Billion of dollars) Capital and Financial Account Capital Account Net Flow Inflow Outflow Financial Account Net Flow Canadian Liabilities Net Inflow Canadian Assets Net Outflow Official Reserves Other Assets Current Account Balance Statistical Discrepancy Copyright 2005 © McGraw-Hill Ryerson Ltd. 4.8 5.6 -0.8 -18.0 62.9 -80.8 0.3 -80.1 -13.2 -10.2 Slide 6 The Balance of Payments Accounts o Net exports: The difference between exports and imports. o Merchandise trade balance: The difference between export goods and import goods. o Capital and Financial Account: Financial account records direct investment and portfolio investment, while capital account includes items such as inheritances and trade in intellectual property. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o Current Account: Net exports, net income from assets, and net transfers. Slide 7 The Balance of Payments Accounts o If a country runs a deficit in current account, spending more abroad than it receives from sales to the rest of the world, the deficit needs to be financed selling assets thereby borrowing abroad. 1) Current account + Capital account = 0 Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o Official Reserves: Assets held by central banks that can be used to make international payments. o The overall balance of payments must be zero. Slide 8 Savings and Investment in a Small Open Economy • NX: Net exports • YNR: Net investment income from non residents Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o In a closed economy (Chapter 3): Y=C+I+G o In an open economy: Y = C + I + G +NX (2) o From Chapter 2: S = I + (NX + YNR) (3) Slide 9 Savings and Investment in a Small Open Economy Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates S = I + CA (4) S - I = CA (5) o Equation 5) in terms of trade in goods and services: S - I = NX (6) o If S > I, then excess domestic savings is loaned to foreigners. o Net Foreign Investment: The amount that domestic residents are lending foreigners. Slide 10 Savings and Investment in a Small Open Economy o Foreign (or World) Real Rate of Interest: The real interest rate that prevails in international capital markets; individuals, businesses, and governments are assumed to be able to borrow and lend at this rate. o In Canada, the foreign real rate of interest is exogenous. o Twin deficit: In a small open economy, a government budget deficit leads to a balance of trade deficit. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates The Role of the World Real Rate of Interest Slide 11 Savings and Investment in a Small Open Economy S Real Rate of Interest r rf r NX > 0 Savings, Investment Copyright 2005 © McGraw-Hill Ryerson Ltd. I S, I If the foreign real rate of interest, rf, is greater than the domestic real rate of interest, r, then net exports are greater than zero. In this situation, net foreign investment (lending) must also be positive. Chapter 5: International Trade and Exchange Rates Figure 5-1: Savings and investment in a Small Open Economy Slide 12 Savings and Investment in a Small Open Economy S Real Rate of Interest r r rf NX < 0 Savings, Investment Copyright 2005 © McGraw-Hill Ryerson Ltd. I S, I If the foreign real rate of interest, rf, is less than the domestic real rate of interest, r, then net exports are negative (trade deficit). In this situation, net foreign investment (lending) must also be negative. Chapter 5: International Trade and Exchange Rates Figure 5-2: Savings and investment in a Small Open Economy Slide 13 Savings and Investment in a Small Open Economy Figure 5-3: A Government Budget Deficit and a Balance of Trade Deficit Real Rate of Interest S’ S r1 At the foreign real rate of interest, savings is less than investment, and there is a balance of trade deficit equal to S’ - I. r0 = r f I S’ I Savings, Investment Copyright 2005 © McGraw-Hill Ryerson Ltd. S, I Chapter 5: International Trade and Exchange Rates r A government budget deficit shifts the savings curve left to S’. Slide 14 Savings and Investment in a Small Open Economy Figure 5-4: The Twin Deficits, 1961-2002 Chapter 5: International Trade and Exchange Rates Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 15 Exchange Rates o Nominal Exchange Rate: The number of Canadian dollars that must be given up in order to purchase a unit of foreign currency. o $Can1.17 = 100 Yen or $Can1.40 = $US1.00. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Exchange Rate Determination Slide 16 Exchange Rates o Flexible (or floating) Exchange Rate: The central bank allows the exchange rate to be determined by the foreign exchange market. o Currency Appreciation or Depreciation: A change in the price of foreign exchange under flexible exchange rate. o Appreciation: From $C1.40 = $US1.00 to $C1.35 = $US1.00 o Depreciation: From $C1.40 = $US1.00 to $C1.45 = $US1.00 Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Exchange Rate Determination Slide 17 Exchange Rates o Fixed Rate System: Central banks buy and sell currency at a fixed rate in terms of foreign exchange. (Figure 5-5) o A devaluation (revaluation) takes place when the value of the currency in terms of foreign exchange is reduced (increased) by official sanction. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Exchange Rate Determination Slide 18 Exchange Rates S Domestic Currency Price of Foreign Exchange e To fix the exchange rate at e2 below the equilibrium rate e1, the central bank has to meet the excess demand by selling foreign currency. E e1 e2 D Foreign Exchange Copyright 2005 © McGraw-Hill Ryerson Ltd. S, I Chapter 5: International Trade and Exchange Rates Figure 5-5: The Foreign Exchange Market Slide 19 Exchange Rates o Intervention: Occurs when the central bank has to buy or sell currency to make up for any excess supply or demand arising from private transactions. o Managed (or Dirty) Floating: Central banks intervene by buying or selling foreign currency and attempt to influence exchange rates. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Exchange Market Intervention Slide 20 Exchange Rates Figure 5-6: The Canadian Dollar, 1913-2003 Chapter 5: International Trade and Exchange Rates Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 21 Exchange Rates o Bilateral exchange rate: The value of one exchange rate against another. o Multilateral exchange rate: The value of one currency against a basket of other currencies. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Alternative Measures of the Exchange Rate Slide 22 Exchange Rates Table 5-2: Alternative Measure of Exchange Rate, 1990-2003 (Canadian Dollars) Chapter 5: International Trade and Exchange Rates Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 23 BOX The Euro 5-1 Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 24 Purchasing Power Parity www.economist.com/markets/bigmac Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o Purchasing Power Parity (PPP): Theory of the exchange rate that states that in the long run, the nominal exchange rate moves primarily as a result of difference in price level behaviour between two countries. o Example: Slide 25 Purchasing Power Parity C P P US C US PUS e US (7) $2.511.47 $3.69Cdn. e : nominal exchange rate, measured as the Canadian dollar price of one US dollar. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o April 2000: Big Mac cost $2.51 US in the United States and $2.85 Cdn. In Canada. o Convert US price in Canadian dollars: Slide 26 Purchasing Power Parity e P P US Relative BM price US C (8) C $3.69 Cdn. $2.85 US 1.29 The US Big Mac costs 29 percent more than the Canadian Big Mac. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o The relative price of a Big Mac in two currencies: Slide 27 Purchasing Power Parity e ppp P P C US (9) US $2.85 Cdn. $2.51 US 1.14 If e = 1.14 in equation 8), then eppp = 1. The Canadian dollar is undervalued by 29 percent. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates o The PPP level of nominal exchange rate is the level that would make this relative price equal to 1: C Slide 28 Purchasing Power Parity eP R P f P : Domestic price level Pf: Foreign price level e : Nominal exchange rate Copyright 2005 © McGraw-Hill Ryerson Ltd. (10) Chapter 5: International Trade and Exchange Rates o Real Exchange Rate: The ratio of foreign prices to domestic prices, measured in a common currency. Slide 29 Exchange Rates Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates Figure 5-7: The Real Exchange Rate, 1914-2002 Slide 30 BOX Burgernomics 5-2 www.economist.com/markets/bigmac Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 31 Chapter Summary Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 5: International Trade and Exchange Rates • The balance of payments is a record of transactions of Canadians with foreigners. • Canada is a small open economy, which takes the foreign (world) real interest rate as exogenous. • If domestic savings is greater than domestic investment, then there is a balance of trade surplus and net foreign lending is positive. • The foreign exchange rate can be measured as a nominal exchange rate or as a real exchange rate. • Purchasing power parity predicts that the exchange rate will move to equate purchasing power internationally. Slide 32 The End Chapter 5: International Trade and Exchange Rates Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 33