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CHAPTER 19: EXCHANGE RATES AND THE
BALANCE OF PAYMENTS
19.1 Balance of payments
- The Balance of payments account is a summary record of a country’s transactions with the rest of the world, including buying and selling goods, services, and assets. + Receipt: sale of a product or asset to foreigners = credit item + Payment for Canada: purchase of a product/ asset from foreigners – debit item
- The overall balance of payments always balances, but the individual components do not have to. 1. The Current Account + Records transactions arising from trade in goods and services, net investment income earned from foreign asset holdings.
- Foreign asset holdings: e.g dividends from holding shares, mutual funds in other countries.
- The current account is divided into 2 main sections
- Trade account: records payments and receipts arising from the import and export of goods. (cars, services, etc.)
- Capital-service account: records the payments and receipts that represent income earned from asset holdings. 2. The Capital Account
Records international transactions in assets, including bonds, shares of companies, real estate and factories.
- Capital outflow: Ca purchases foreign assets
- Gov’s transactions in its official foreign-exchange reserves – official financing account
- Increase reserves by purchasing foreign-currency assets- debit item
- Reduce reserve by selling foreign-currency assets – credit item 3. The balance of payments must balance
- Current account balance: the difference between the payments and receipts from international transactions in goods and services.
- Capital account balance: the difference between payments and receipts from international transactions in assets. => Balance of payments = current account balance + capital account balance = CA + KA = 0 => This is an identity e.g: Canada has current account surplus of 50 billion, CA = 50 billion -> foreign owe Canadians 50 billion => 2 possibilities:
- Purchase 50b more of goods and services from the rest of the world => CA = 0 +Purchase 50b of assets from foreigners (capital outflow) => KA =
- Do a combination of two above
- With CA surplus, Canadians are holding new ‘IOU’ from foreigners of 50 billions.
- The exchange rate is the rate at which one currency exchanges for another. e.g The price of 1 U.S dollar was 1.25 Canadian dollars => The Can-US exchange rate was 1.25. => Canadian dollar worth 1/1.25=0.8 dollars
- This book defines the exchange rate as the Canadian-dollar price of one unit of foreign currency.
- Appreciation of CA = Canadian dollar has become more valuable -> fewer Canadian dollars to purchase one unit of foreign currency. Fall in exchange rate.
- Because CAD are traded for euros in the foreign-exchange market, a demand for euros implies a supply of CAD, and vice versa
- System:
- Foreign-exchange market
- Product: euros
- price: exchange rate
- Transactions that generate a receipt for Canada in its balance of payments represent a supply of foreign exchange by foreigners
< payments -> demand for foreign exchange by Canadians Let us assume that BOC makes no transactions in the foreign- exchange market. II. The supply of foreign exchange Foreigners purchase Canadian -> supply foreign currency to get CAD. 1. Canadian Exports
Sources of supply of foreign exchange = international trade.
- Canadian Asset Sales: Capital Inflows Capital inflows: corporate bonds, real estate or shares in Canadian firm
- Reserve Currency
- Firms, banks and govs accumulate and hold foreign-exchange reserves (like saving accounts)
- Maybe in several different currencies.
- Increase its reserve holdings of CAD, reduce reserve holding of euros. B e supplier of euros and a demander of CAD in foreign-exchange markets. Small factor for Ca as most foreign entities do not hold many CAD in their reserve accounts. >< The holding of US dollars as a reserve currency is far more important.
- The total supply of foreign exchange.
- The supply of foreign exchange (or the demand for CAD in the market) = sum of the supplies for all the purchases of Canadian goods and services, assets and the purchase of CAD to add to currency reserves.
- The demand for any one currency will be the aggregate demand of individuals, firms, and governments in a number of different countries. Total supply of foreign exchange may include Germans who are offering euros, Japanese who are offering yen, and so on.
- The supply curve for foreign exchange
III. The demand for foreign exchange
- Arises from all international transactions that represent a payment for Canada in our balance of payments.
- The demand curve
- Negatively sloped when it is plotted against the exchange rate
- An appreciation of the CAD (a fall in the exchange rate) increases the quantity of foreign exchange demanded. 19.3 The Determination of Exchange Rates
- The demand and supply curves don’t include transactions in the foreign-exchange market made by the central bank to alter the value of exchange rate.the >< include in a subset of the official financing account. Three possibilities for central bank behavior: o When the BOC makes no transactions in the f-e market, there is said to be a purely floating or flexible exchange rate. o When the BOC intervenes in the f-e market to ‘fix’ or ‘peg’ the exchange rate at a particular value, there is said to be a fixed exchange rate or pegged exchange rate. o Between these 2 ‘pure’ systems are a variety of possible intermediate cases. + Adjustable peg: BOC fix specific values for their exchange rates >< explicitly recognize that circumstances may arise in which they will change that value.
- Managed float: BOC stabilizes influence on the exchange rate but does not try to fix it at some publicly announced value. Most industrialized countries today operate a mostly flexible exchange rate. Mostly market determined but the central bank sometimes intervenes to offset significant short-run fluctuations. o Canada alternated between a system of fixed exchange rates and flexible exchange rates between WWII and 1970 o Flexible exchange rate since 1970 I. Flexible Exchange Rates Exchange rate is set in a freely competitive market, with no intervention by the central bank. e.g: Exchange rate is so high (e1) => quantity of foreign exchange supplied exceeds the quantity demanded. Excess supply of foreign exchange Exchange rate fall => CAD appreciate Reduction in the quantity of foreign exchange supplied + Increase in the quantity of foreign exchange demanded. Reduce the amount of excess supply => quantity demanded = quantity supplied Exchange rate is at its equilibrium or market-clearing value
History of exchange-rate system
- Gold standard: Fixed exchange-rate system
- Bretton Woods system (1944-1970): adjustable peg Fixed exchange rates and f-e reserves a. A hypothetical Can-US example
- BOC pegs the Can-US exchange rate
- Fixed exchange rate between CAD 1.10-1.20 to the US dollar
- BOC stabilizes the exchange rate in the face of seasonal, cyclical and fluctuations in demand and supply
- Buy US dollars, f-e reserve rise
- Sell US dollars, f-e reserve fall
- Bank’s interventions’ effects
- If the demand curve cuts the supply curve in the range 1.10-1.20, the Bank need not intervene
- If the demand curve shifts to D Excess demand for US dollars that the Bank must satisfy. Bank sells US dollars from its reserves to the extent of Q4Q1 per month => prevent the exchange rate from rising above 1.
- If the demand curve shifts down to D2, there is an excess supply of US dollars that the Bank must satisfy -> buys US dollars to the extend of Q2Q3 per month in order to prevent the exchange rate from falling below 1.
- Suppose the average level of demand becomes D1, with fluctuations in either side of this level. >< Bank has only a limited amount of f-e reserves + Change the fixed exchange rate, or +gov policy can try to shift the curves: restrict demand for foreign exchange: impose import quotas and foreign-travel restrictions, or increase the supply of US dollars by encouraging Canadian exports b. The actual Chinese – US exchange rate
- Between 1995 and 2005, China: a form of fixed exchange rate rigidly fixed at 8.3 uan per US dollar
- Since 2005, adjustable peg system: yuan was permitted to gradually appreciate against the U.S dollar. III. Changes in flexible exchange rates Anything that shifts the demand curve for foreign exchange to the right or the supply curve for foreign exchange to the left -> a rise in exchange rate/depreciation of the CAD.
Demand curve to the left. => CAD appreciate
- If the demand for foreign cars was relatively insensitive to the price, the rise in foreign prices would lead to an increase in in the demand for foreign exchange Depends on price responsiveness. c. Changes in Overall Price Levels Change in all prices because of general inflation Equal inflation in both countries: Equal inflation => relative prices will be unchanged and so demands wont shift between countries. Inflation in only 1 country e.g : Inflation in Canada => dollar price of CA goods will rise => more expensive in Euro => quantity of Ca exports decrease => supply of f-e by EU importers decreases => supply curve to the left
< The Canadian-dollar price of EU goods in Canada will not change => cheaper than Ca goods => demand for f-e to purchase imports will rise. => demand curve to the right Inflation in Canada and no inflation in Europe, equilibrium exchange rate must rise => CAD depreciate. Inflation at unequal rates
- If country A’s inflation rate is higher than country B’s, country A’s exports are becoming relatively expensive in B’s markets
< imports from B are becoming cheap in A’s markets => A to depreciate relative to B
d. Movements of financial capital. e.g: Increased desire to purchase EU assets = capital outflow from CA Demand curve for f-e to the right CAD depreciate Short-term capital movements
- Motive for short term capital flows is a change in interest rates + Carry trade: the holders of balances will tend to lend them in markets in which interest rates are highest. If one country’s short term interest rate rises above the rates in other countries => large inflow of short-term capital into that country (to take ad of high ir) Increase demand for the domestic currency => appreciate - Second motive: speculation about the future value of a country’s exchange rate + Foreigners expect CAD to appreciate in the near future Induced to buy CAD stocks or bonds now Long-term Capital movements
- Largely influenced by long-term expectations regarding the business environment in a country. e.g:
- Cad will be an attractive destination for long-term investment if it is seen by foreigners ad a country in which there are attractive profit opportunies, stable and business friendly, educated workforce, good public infrastructure
- Changes in tax and regulatory policy are ofthen the causes of significant swings in long term investment.
- Mercantilism: a current account surplus is sometimes called ‘favorable balance, current account deficit is sometimes called an ‘unfavorable balance’.
- This belief misses the central point: countries gain from trade because trade allows each country to specialize in the production of those products in which its opportunity costs are low. => The gains from trade have nothing to do with whether there is a trade deficit or surplus
- Exploitation doctrine of international trade : one country’s surplus is another country’s deficit
- Mercantilists, preceded Adam Smith, judged the success of trade by the size of the trade balance.
- Make sense in terms of objectives: good for political and military power >< not living standards of its citizen.
- Opponents
- To maximize living standards by specialization
- With specialization, there will be trade deficit for a specific product or with a specific country
- Gains from trade are to be judged by the volume of trade rather than by the balance of trade.
- A change in policy that results in an equal increase in both exports and imports will generate gains because it allows for specialization according to comparative advantage, even though it causes no change in either country’s trade balance.
2. International Borrowing If Ca has a current account deficit => has a capital account surplus It is a net seller of assets to the rest of the world. (bonds and equities) - Sell bonds => increase indebtedness to foreigners and will have to redeem the bonds and pay interests - Sell income-earning equities to foreigners, Canadians give up a stream of income that they would otherwise have. - Both cases, they get a lump sum of funds that can be used for any type of consumption or investment. This is not necessarily undesirable. It depends on why Canadian are borrowing, aka having a current account deficit. 3. Causes of current account deficits CA = S + (T – G) – I = (S – I) + (T – G) Where: CA: Current account surplus(or deficit) S: private saving I: Private-sector investment T - G: budget surplus (or deficit) of the total government sector - This equation can be derived from the national income accounting identities. - This equation says that the current account balance in any year is exactly equal to the excess of national saving, S + (T – G), over domestic investment, I.
- S and I unchaged >< Gov increases its budget deficit. T – G falls => current account deficit increases (or current account surplus falls) Whether the larger budget deficit is itself undesirable depends on many issues, much depending on the details of the policy actions and the economic context. II. Value for the Canadian Dollar
- With a flexible exchange rate, the f-e market determines the value of the exchange rate.
- With respect to the forces of demand and supply, the equilibrium exchange rate is the ‘correct’ exchange rate.
< frequent changes in demand-supply -> correct exchange rate is frequently changing.
- Some economist argue that there exists a ‘fundamental’ value of the exchange rate that will hold in the long run, determined by **purchasing power parity
- Purchasing power parity (PPP)**
- Over the long term, the value of the exchange rate between two currencies depends on the two currencies’ relative purchasing power for goods and services.
- A currency will tend to have the same purchasing power when it is spent in its home country as it would have if it were converted to foreign exchange and spent in the foreign country. The price of identical baskets of goods should be the same in the two countries when the price is expressed in the same currency
PC and PE are the price levels in Canada and Eu e: Canadian-dollar price of euros (the exchange rate) = nominal exchange rate + PC > e x PE => People would increase their purchases of the cheaper EU goods => depreciation of CAD rise in e => continue until the equality was re-established
- PPP exchange rate: value of the exchange rate that makes this equation + PPP exchange rate is not constant. + If inflation is higher in Canada than in EU => PC will be rising faster than PE PPP exchange rate will be rising 2. Theory Confronts Reality
- Theory of PPP predicts that if the actual exchange rate e does not = PPP exchange rate e is either overvalued or undervalued Demands and supplies of Canadian and EU goods will change until the equality holds.
- In reality, the actual exchange rate deviates from the PPP exchange rate for extended periods.
