© 2005 mcgraw-hill ryerson ltd. macroeconomics, chapter 17 1 exchange rates and the balance of...

© 2005 McGraw-Hill Ryerson Ltd.© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17Macroeconomics, Chapter 17 11

EXCHANGE RATESEXCHANGE RATESAND THE AND THE

BALANCE OF PAYMENTSBALANCE OF PAYMENTS

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGESLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE


In this chapter you will learnIn this chapter you will learn

17.117.1 How international trade is financed How international trade is financed

17.2 17.2 About a nation’s balance of paymentsAbout a nation’s balance of payments

17.317.3 What a flexible exchange-rate system is What a flexible exchange-rate system is and its effects on the domestic economyand its effects on the domestic economy

17.417.4 What a fixed exchange-rate system is and What a fixed exchange-rate system is and its effects on the domestic economyits effects on the domestic economy

17.517.5 About the history of the world’s exchange- About the history of the world’s exchange-rate regimesrate regimes


Chapter 17 TopicsChapter 17 Topics

17.117.1 Financing International Trade Financing International Trade

17.217.2 The Balance of Payments The Balance of Payments

17.317.3 Foreign Exchange Markets: Flexible Foreign Exchange Markets: Flexible Exchange RatesExchange Rates

17.417.4 Fixed Exchange Rates Fixed Exchange Rates

17.517.5 International Exchange-Rate International Exchange-Rate SystemsSystems


Financing International TradeFinancing International Trade

differing national currencies complicate differing national currencies complicate international tradeinternational trade

currencies are exchanged in foreign currencies are exchanged in foreign exchange marketsexchange markets


Canadian Export TransactionCanadian Export Transaction

Assume $2 = £1Assume $2 = £1

1.1. $300,000 in Canadian telecommunications $300,000 in Canadian telecommunications equipment purchased by a British buyer for equipment purchased by a British buyer for £150,000£150,000

2.2. £150,000 cheque drawn on British bank to £150,000 cheque drawn on British bank to pay for equipmentpay for equipment

3.3. £150,000 cheque is exchanged for $300,000 £150,000 cheque is exchanged for $300,000 at a Canadian bankat a Canadian bank

4.4. Canadian bank sends £150,000 cheque to Canadian bank sends £150,000 cheque to London bank for future transactionsLondon bank for future transactions


Points to RememberPoints to Remember

Canadian exports create:Canadian exports create: a foreign demand for Canadian $ a foreign demand for Canadian $ an increase in the supply of foreign an increase in the supply of foreign

currency owned by Canadian bankscurrency owned by Canadian banks



Canadian imports:Canadian imports: create a domestic demand for foreign create a domestic demand for foreign

currenciescurrencies reduce the supplies of foreign reduce the supplies of foreign

currencies held by Canadian bankscurrencies held by Canadian banks



Canadian exports supply the foreign Canadian exports supply the foreign currencies needed to “pay for” importscurrencies needed to “pay for” imports

Demand for & supplies of foreign Demand for & supplies of foreign currencies also arise from transactions currencies also arise from transactions involving services & payment of interest involving services & payment of interest & dividends on foreign investments& dividends on foreign investments


The Canadian The Canadian balance of paymentsbalance of payments shows the balance between shows the balance between – all the payments that Canada receives all the payments that Canada receives

from foreign countries &from foreign countries &– all the payments which we make to themall the payments which we make to them

The Balance of PaymentsThe Balance of Payments


Current AccountCurrent Account

shows the flows resulting from imports & shows the flows resulting from imports & exports of goods & servicesexports of goods & services– the the balance on goodsbalance on goods is the net amount of is the net amount of

imports & exports of goods onlyimports & exports of goods only– the the balance on goods & servicesbalance on goods & services includes goods includes goods

& services& services– trade in services, investment income & transfers trade in services, investment income & transfers

are included to get the are included to get the current account balancecurrent account balance– in 2002, Canada had a current account surplus of in 2002, Canada had a current account surplus of

$17.3 billion$17.3 billion


The Canadian Balance of PaymentsThe Canadian Balance of Paymentsin 2002 (billions of dollars)in 2002 (billions of dollars)

ExportsExports ImportsImports BalanceBalance

Current AccountCurrent Account

Merchandise 410.3 - 356.1 +54.2Services 58.2 - 66.1 - 7.9

Balance on Goods and Services Balance on Goods and Services +46.3+46.3

7. Net Investment Income - 30.48. Net Transfers + 1.4

9. Current Account Balance9. Current Account Balance +17.3+17.3

Table 17-1Table 17-1


Capital AccountCapital Account

shows capital inflows & outflowsshows capital inflows & outflows– purchase or sale of real or financial assetspurchase or sale of real or financial assets– official settlements accountofficial settlements account

TIPTIP: : – a + sign indicates a “source” of foreign a + sign indicates a “source” of foreign

exchange, exchange, – a - sign indicates a “use” of foreign a - sign indicates a “use” of foreign

exchangeexchange


The Canadian Balance of PaymentsThe Canadian Balance of Paymentsin 2002 (billions of dollars)in 2002 (billions of dollars)

BalanceBalance

Capital AccountCapital Account

10. Capital inflows + 69.1 11. Capital outflows - 75.7 12. Capital12. Capital account balance account balance - 6.6- 6.6

Official settlements accountOfficial settlements account13. Official international reserves13. Official international reserves - 10.7 - 10.7

Balance of paymentsBalance of payments $ 0

Table 17-1Table 17-1


Payments Deficits & SurplusesPayments Deficits & Surpluses

A drawing down of official international A drawing down of official international reserves (a + official reserves entry) reserves (a + official reserves entry) measures a nation’s balance of payments measures a nation’s balance of payments deficitdeficit

A building up of official reserves (a – official A building up of official reserves (a – official reserves entry) measures a balance of reserves entry) measures a balance of payments surpluspayments surplus

Deficits not necessarily bad, but cannot be Deficits not necessarily bad, but cannot be maintained indefinitely, because international maintained indefinitely, because international reserves are limitedreserves are limited

GLOBAL PERSPECTIVE 17.1GLOBAL PERSPECTIVE 17.1

Canada's Trade Balance with Selected Nations, 2002

-20 -10 0 10 20 30 40 50 60 70 80 90 100

Other Countries

European Union

Japan

U.S.

$ billions


The Balance of Payments, 1975-2002The Balance of Payments, 1975-2002


Foreign Exchange MarketsForeign Exchange Markets

competitive marketscompetitive markets linkages to all domestic & foreign priceslinkages to all domestic & foreign prices


Flexible Exchange RatesFlexible Exchange Rates

Rates by which national currencies are Rates by which national currencies are exchanged are determined by demand exchanged are determined by demand & supply& supply

P

Q

D

The Market for Foreign Currency (Pounds)The Market for Foreign Currency (Pounds)D

olla

r p

ric

e o

f 1

po

un

d

Quantity of pounds

Figure 17-2Figure 17-2

who are the who are the demanders of demanders of pounds in fx pounds in fx

markets?markets?

P

Q

D

S

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds

The Market for Foreign Currency (Pounds)The Market for Foreign Currency (Pounds)

who are the who are the suppliers of suppliers of pounds to fx pounds to fx

markets?markets?


P

Q

D

S

dollar price of dollar price of pounds is pounds is

determined by determined by demand & supplydemand & supply

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds

The Market for Foreign Currency (Pounds)The Market for Foreign Currency (Pounds)Figure 17-2Figure 17-2

P

Q

D

S

2

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of poundsQ1

The Market for Foreign Currency (Pounds)The Market for Foreign Currency (Pounds)Figure 17-2Figure 17-2

P

Q

D

S

Poundappreciates

D

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds


2

Q1


P

Q

D

S

D

Pounddepreciates

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds


2

Q1



Determinants of Determinants of ExchangeExchange Rate Rate ChangesChanges

Changes in TastesChanges in Tastes Relative Income ChangesRelative Income Changes Relative Price-Level ChangesRelative Price-Level Changes

– Purchasing Power Parity TheoryPurchasing Power Parity Theory Relative Interest RatesRelative Interest Rates SpeculationSpeculation


Advantages of Flexible RatesAdvantages of Flexible Rates

automatic adjustment to eventually automatic adjustment to eventually eliminate balance of payments deficits eliminate balance of payments deficits or surplusesor surpluses

P

Q

D

S

suppose suppose tastestastes

change change & Canadians& Canadianswant to buywant to buymore British more British automobilesautomobilesD

olla

r p

ric

e o

f 1

po

un

d

Quantity of pounds

2

Adjustments Under Flexible Exchange RatesAdjustments Under Flexible Exchange RatesFigure 17-3Figure 17-3

P

Q

D

S

demand for demand for poundspounds

increasesincreases

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds

D

2

Adjustments Under Flexible Exchange RatesAdjustments Under Flexible Exchange RatesFigure 17-3Figure 17-3

P

Q

D

S

Canadian Canadian balance of balance of payments payments

deficitdeficit

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds

D

2

Adjustments Under Flexible Exchange RatesAdjustments Under Flexible Exchange Rates

a b


P

Q

D

S

Do

llar

pri

ce

of

1 p

ou

nd

Quantity of pounds

D

2

change in change in the the

exchange exchange rate to rate to $3=$3=£1£1would would

correct the correct the deficitdeficit

Adjustments Under Flexible Exchange RatesAdjustments Under Flexible Exchange Rates

3 c

ba



Flexible Exchange RatesFlexible Exchange Rates

with a lower $, Canadians will want to with a lower $, Canadians will want to import less, & the British will want to import less, & the British will want to buy more Canadian goods & servicesbuy more Canadian goods & services


Disadvantages of Flexible RatesDisadvantages of Flexible Rates

reduced trade because of risks reduced trade because of risks associated with constantly changing associated with constantly changing exchange ratesexchange rates

worsening terms of trade if there is a worsening terms of trade if there is a sizeable depreciationsizeable depreciation

challenges in designing domestic challenges in designing domestic macroeconomic policies in nations macroeconomic policies in nations heavily dependent on tradeheavily dependent on trade


Fixed Exchange RatesFixed Exchange Rates

Use of ReservesUse of Reserves– currency interventionscurrency interventions

Trade PoliciesTrade Policies Exchange Controls & RationingExchange Controls & Rationing

restricted choicerestricted choice black marketsblack markets

distorted tradedistorted trade favouritismfavouritism


Fixed Exchange RatesFixed Exchange Rates

Use of ReservesUse of Reserves– currency interventionscurrency interventions

Trade PoliciesTrade Policies Exchange Controls & RationingExchange Controls & Rationing Domestic Macroeconomic AdjustmentsDomestic Macroeconomic Adjustments


Exchange Rate SystemsExchange Rate Systems

The Gold Standard: Fixed Exchange The Gold Standard: Fixed Exchange RatesRates 1879 - 1934 1879 - 1934 – currency defined in goldcurrency defined in gold– fixed relationship between gold stock & fixed relationship between gold stock &

money supply maintainedmoney supply maintained– gold freely exported & importedgold freely exported & imported



Gold flows resulted in fixed exchange Gold flows resulted in fixed exchange ratesrates

Domestic macroeconomic adjustments Domestic macroeconomic adjustments sometimes distastefulsometimes distasteful

Gold standard collapsed in the Gold standard collapsed in the worldwide depression of the 1930sworldwide depression of the 1930s– series of devaluationsseries of devaluations



The Bretton Woods System The Bretton Woods System 1944-19711944-1971– adjustable-peg systemadjustable-peg system– International Monetary FundInternational Monetary Fund (IMF) (IMF)

Maintaining pegged ratesMaintaining pegged rates– Official international reservesOfficial international reserves– Gold salesGold sales– IMF borrowingIMF borrowing



Fundamental Imbalances: Adjusting the Fundamental Imbalances: Adjusting the PegPeg

Demise of the Bretton Woods SystemDemise of the Bretton Woods System– 1971: the US floated the dollar1971: the US floated the dollar



The Current System: The Managed The Current System: The Managed FloatFloat– G-7 G-7 Intervention in 1987 Intervention in 1987

““almost” flexiblealmost” flexible proponents & criticsproponents & critics

– has functioned better than anticipatedhas functioned better than anticipated– a “nonsystem”a “nonsystem”

© 2005 mcgraw-hill ryerson ltd. macroeconomics, chapter 17 1 exchange rates and the balance of...

Documents

mcgrawhill ryerson

canadian balance of

foreign exchange markets

foreign currencies n

n canadian exports

canadian banks slide

canadian imports

flexible exchange rates