CHAPTER 35 (.4) – EXCHANGE RATE AND THE BALANCE OF PAYMENTS
THREE POLICY ISSUES
1. Is a current account deficit ‘bad’ and a surplus ‘good’?
2. Is there a ‘correct’ value for the Canadian dollar?
3. Should Canada fix its exchange rate with the US dollar?
Current Account Deficits and Surpluses
Current account: part of balance of payments accounts that records payments and receipts arising from
trade in goods and services and from interest and dividends that are earned by capital owned in one
country and invested in another
Trade account: records value of exports and imports of goods and services
Capital-service account: payments and receipts that represent income on assets such as interest and
Most years – significant trade surplus – exports more than it imports
But because it makes more investment payments (interest and dividends) to foreigners than it receives,
it has a deficit on the capital-service portion of the current account
60-95 – overall current account deficit of 2-3% of GDP.
But as trade surplus has increased by more than capital-service deficit, there has been a current account
surplus of 1-2% since 2000.
Balance of payments always balanced. So until 1995 current account deficits were matched by capital
account surpluses. Selling more assets to rest of world than it was buying.
Recent years – buying more assets from foreigners than selling to foreigners
Many argue that current account deficit is undesirable because it means that Canada is buying more
goods and services than it is selling. Exports are not ‘good’ and imports are not ‘bad.’
Current account surplus sometimes called a favourable balance. Deficit – unfavourable.
Believe gains from trade arise only from having a ‘favourable’ balance of trade. Misses point of
The gains from trade depend on the volume of trade (imports plus exports) rather than the balance of
trade. Nothing inherently bad about current account deficit.
Mercantilism – judge success of trade by size of trade balance.
Made sense to build up political/military power – surplus allowed nation to acquire assets.
Promote welfare and living standards – makes no sense. Average living standards maximized by having
individuals/countries specialize in what they have comparative advantage in and trade.
More specialization – more trade – more average living standards increase.
For country as a whole, gains from trade are to be judged by the volume of trade, not the balance.
If it has a current account deficit, it has a capital account surplus. Net seller of assets to rest of world.
In bonds or shares.
Increase indebtedness to foreigners by selling bonds – will eventually have to redeem and pay interest.
By selling income-earning equities to foreigners, Canadians give up a stream of income that they would
otherwise have. Both cases – lump sum of funds that can be used for consumption or investment.
A country that has a current account deficit is either borrowing from the rest of the world or selling its
ownership of some of its capital assets to the rest of the world. This is not necessarily undesirable.
Causes of Current Account Deficits
GNP = GDP + R = C + I + G + NX + R
R = net investment income received from abroad
Current account balance = NX + R = CA
GNP = C + I + G + CA
Income can be consumed, saved, or paid in taxes
GNP = C + S + T
C + I + G + CA = C + S + T
CA = S + (T-G) – I
Current account balance is equal to the excess of national saving, S + (T – G) over domestic investment, I
If they save more than needed to finance domestic investment – used to acquire foreign assets, CA > o
CA = (S-I) + (T-G)
Three reasons for increase in current account deficit:
1. Reduction in private saving
2. Rise in domestic investment
3. Rise in government’s budget deficit (twin deficits)
An increase in the level of investment, a decrease in the level of private saving, and an increase in the
government’s budget deficit are all possible causes of an increase in a country’s current account deficit.
Cannot discuss desirability without knowing cause.
Ex: investment causes increase in current account deficit but increases potential output in future.
A country’s current account deficit can increase for a number of reasons. Whether the rise in the current
account deficit is desirable depends on its underlying cause. A rise in the current account deficit may
reflect a positive economic development; a decline in the current account deficit may reflect a negative
Is There a “Correct” Value for the Canadian Dollar?
Low – ‘undervalued’, appreciation – ‘overvalued’
Exchange rate determined by competitive forces in the foreign exchange market. Many causes.
With a flexible exchange rate, the 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.
Does not mean ‘correct’ rate is constant. Constantly changing.
Some argue – various shocks may cause the exchange rate to rise or fall in the short run but there does
exist some fundamental level to which it returns.
Purchasing Power Parity
Purchasing power parity: the theory that over the long term, the exchange rate between two currencies
adjusts to reflect relative price levels Depends on the two currencies’ relative purchasing power
Currency will have same purchasing power in home country as when conv