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Lecture notes Prepared by Anton Ljutic CHAPTER TEN Exchange Rates and the Balance of Payments © 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: • 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 © 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 The demand curve for the Canadian dollar is a conventional demand curve P of Can. $ P1 Figure 10.1 D Q1 © 2004 McGraw–Hill Ryerson Limited Q of Can $ The Supply Of Canadian Dollars S P of Can. $ The supply curve for the Canadian dollar is a conventional supply curve P1 Figure 10.2 Q1 Q of Can. $ © 2004 McGraw–Hill Ryerson Limited Equilibrium in Foreign-Exchange Markets S P of Can. $ An equilibrium exchange rate ER1 Figure 10.3 D Q1 Q of Can. $ © 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. $ •An increase in demand for a currency… •the equilibrium exchange will rise from ER1 to E2 •the equilibrium quantity will rise from Q1to Q2 S ER2 ER1 D2 D1 Q1 Q2 Q of Can. $ © 2004 McGraw–Hill Ryerson Limited Figure 10.4 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 P of Can. $ AS P2 P1 An increase in Canadian exports increases AD from AD1 to AD2. This results in a rise in P and GDP AD2 AD1 Y1 Y2 © 2004 McGraw–Hill Ryerson Limited Q Figure 10.5 An Increase in the Supply of Canadian Dollars P of Can. $ S1 S 2 Following an increase in the supply of Canadian dollars, the dollar depreciates and the quantity of dollars traded increases. ER1 ER2 D Q1 Q2 © 2004 McGraw–Hill Ryerson Limited Q 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 Fixed Exchange Rates (II) An Increase in Currency Demand Under Fixed Exchange Rates P of Can. $ S ER2 ER1 fixed shortage D2 D1 Qs Qd © 2004 McGraw–Hill Ryerson Limited Q of Can. $ Figure 10.7 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 Fixed Exchange Rates (III) A Decrease in Currency Demand Under Fixed Exchange Rates S P of Can. $ ER1 surplus fixed ER2 Figure 10.8 D1 D2 Qd Qs © 2004 McGraw–Hill Ryerson Limited Q of Can. $ 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 Balance of Current Account and Capital Account - 26 + 3 Official Settlements Account Change in Canadian dollars (change in foreign reserves Total Balance (sum of three accounts) © 2004 McGraw–Hill Ryerson Limited - 3 0 Chapter Summary: What to Study and Remember • 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 © 2004 McGraw–Hill Ryerson Limited