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Lecture

ECO100Y5 Lecture Notes - Foreign Exchange Market, Reserve Currency, Capital Account


Department
Economics
Course Code
ECO100Y5
Professor
Edward Ho

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Chapter 35: Exchange Rates and the balance of Payments
35.1 The balance of payments
Balance of payments accounts: a summery records of a country’s transactions with the rest of the world, including
the buying and selling of goods services and assets.
There are two main categories to the balance of payments: the current account and the capital account
The current account
Current Account: the part of the 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 more
country and invested in another.
The current accounts is divided into two main sections:
Trade account: in the balance of payments, this account records the value of exports and imports of goods and
services.
Canadian imports of goods and services require a payment to foreigners and thus are entered as debit items on
the trade account; Canadian exports of goods and services generate a receipt to Canada and thus are recorded
as credit items.
Capital-service account: in the balance of payments this account records they payments and receipts that
represent income on assets (such as interest and dividends)
The capital account
Capital account: the part of the balance of payments accounts that records payments and receipts arising from
the purchase and sale of assets.
The purchase of foreign assets by a Canadians is treated just like the purchase of foreign goods. Since producing
if foreign asset requires a payment from Canadians to foreigners, it is entered as a debit item in the Canadian
Capital account. Note to that when Canadians purchase foreign assets, Financial Capital is leaving Canada and
going abroad, and sell this is called a capital outflow.
The sale of Canadian assets to foreigners and generates a receipt for Canada, and thus is entered as a credit item
in the Canadian Capital account. When Canadian sell assets to foreigners, Financial Capital is entering Canada
from abroad, and so this is called a capital inflow.
The capital account distinguishes between indirect investment and portfolio investment.
The former involves the purchase or sale of assets that alter the legal control of those assets such as when a
controlling interest of a company is purchased. The latter involves transactions in assets that do not alter that
legal control of the assets, such as when minority of a company’s shares is purchased.
One part of the capital account shows the government’s transaction in its official foreign exchange reserves.
This official financing account is included as part of the capital account because official reserves are assets rather
than goods and services. If the government it increases its reserves, it does so by purchasing foreign currency
assets, and this transaction would be recorded as accredited and am in the official financing account.
The balance of payments must be balance
The current account balance and presents the difference between the payments and receipts from international
transactions of goods and services
The capital account balance is the difference between debt payments and receipts from international
transactions in assets.
The balance of payments is the sum of current account and capital account balances.
In a given period of time , usually a year, the current account plus the capital account must equal zero. In other
words, the balance of payments is all is equal to zero. In algebraic term, we can write:
Balance of payments = CA + KA = 0
Where CA is the current account balance and KA is the capital account balance. Note to that this is an identity
the Accounting System and used for the balance of payments defines transaction in such a way that CA + KA = 0.
But it is the Accounting System is based on some economic logic.
Consider a CA surplus:
exports exceed imports
the “extra” earnings must be used to acquire foreign assets
KA deficit (capital outflow)

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Any surplus on the current account must be matched by any equal deficit on the capital account. A current
account surplus thus implies a capital outflow. The balance of payments is always zero.
Any deficit in the current account must be matched by an equal surplus in the capital account. A current
account deficit thus implies a capital inflow. The balance of payments is always a zero
A balance of payments deficit?
A “ Balance of payments deficit” probably serves to a situation in which the government is selling official
foreign-currency reserves. A “balance of payments surplus” refers to a situation in which the government is
buying official foreign-currency reserves. In both cases, as always, in balance of payments is actually in
balance.
Summary
1. The current account shows all transactions in goods and services between Canada and the rest of the world
(including investment income and transfers).
2. The capital account shows all transactions in assets between Canada and the rest of the world. Part of the
capital account shows the change in the government’s holding of foreign-currency reserves.
3. All transactions involving a payment from Canada appear as debit items. All transactions involving a receipt to
Canada appear as credit items.
4. The balance of paymentsthe sum of the current account and the capital accountmust by definition all of us
be zero.
35.2 the foreign-exchange market
The currency of a country is acceptable within the border of that country, but usually it will not be accepted by
firms and households in another country.
Trade between countries are normally requires the exchange of the currency of one country for that of
another.
The exchange of one currency for another is calls a foreign-exchange transaction.
Exchange rate: the number of units of domestic currency required to purchase one unit of foreign currency
Appreciation: a fall in the exchange ratethe domestic currency has become more valuable so that it takes
fewer units of domestic currency to purchase one unit of foreign currency
Depreciation: a rise in the exchange ratethe domestic currency has become less valuable so that it takes more
units of domestic currency to purchase one unit of foreign currency.
An appreciation of the Canadian dollar is a fall in the exchange rate; and depreciation of the Canadian dollar is
a rise in the exchange rate.
Because Canadian dollars are traded for a euros in the foreign-exchange market, it follows that the demand
for euros implies the supply of Canadian dollars and a supply of euros implies the demand for Canadian
dollars
For this reason, in theory of the exchange rate between dollars and euros can deal either with the demand and
supply of dollars or with a demand and supply of euros. We will concentrate on the demand, supply, and price
of the Euros. Thus to the market and we will be considering in general terms is therefore an exchange market
when the product is the foreign-exchange (euros) and the price is that exchange rate (the Canadian dollar price
of the Euros)
A demand for foreign currency implies a supply of Canadian dollars to the FX market.
Conversely, a supply of foreign currency implies a demand for Canadian dollars in the FX market.
The supply of foreign exchange
When other foreigners purchase Canadian goods, services, or assets, the supply of foreign currency to their
foreign exchange market and demand, in return, Canadian dollars with which to pay for their purchases. Thus,
the supply of foreign-exchange and the associated in demand for Canadian dollars arises from Canada sale of
goods, services, and assets to the rest of the world.
Canadian exports:
One important source of supply of foreign-exchange is foreigners who wish to buy Canadian made goods and
services. Therefore Canadian exports are sources of supply of foreign exchange, arising out of international
trade. Each potential buyer wants to sell its own currency in exchange for Canadian dollar that it can then be
used to purchase Canadian goods and services.
Assets sales: capital inflows:
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A second source of supply of foreign-exchange comes from foreigners who wants to purchase canyon assets
such as a government or corporate bonds, real estate, or shares in a Canadian firm. To buy Canadian assets,
holders of foreign currencies must first sale their foreign currency and by Canadian dollars. In these are called to
the capital inflows to Canada
Reserve currency:
Firms, banks, and governments often accumulate and hold foreign exchange reserves. These reserves may be in
several different currencies. For example if the the government of Poland may decides to increase its reserves
holding of Canadian dollars and reduce its reserves holding of euros, as it does so, it will be a supplier of euros
and in demander of Canadian dollars in foreign exchange markets.
The total supply of foreign-exchange:
The supply of foreign-exchange or the demand for Canadian dollars by holders of foreign currencies is the sum
of the suppliers for other purposesfor purchases of Canadian exports, for capital inflow to Canada, and for the
purchase of Canadian dollars two and two currency reserves.
Because people, firms and governments in all countries purchase goods in access from many other countries,
the demand for any one currency will be aggregate demand of individuals, firms, and governments in a number
of different countries. Thus the total supply of foreign-exchange or the demand of Canadian dollars may include
different offerings of currencies from different countries.
The supply curve for foreign-exchange:
The supply of foreign exchange on the foreign exchange market is represented by a positively sloped curve
shown in the graph below
The supply curve for foreign-exchange is positively sloped when it is product against the exchange rate; a
depreciation of the Canadian dollar (a rise in the exchange rate) increase as the quantity of foreign-exchange
supplied.
The demand for foreign exchange
The demand for foreign-exchange arises from all international transactions that represent the payment in
Canada’s balance of payments.
Canadian seeking to purchase foreign products will be supplying Canadian dollars and demanding foreign-
exchange for its purposes. Canadians may also seek to purchase foreign assets. If they do, they will supply
Canadian dollars and demand for exchange. Similarly a country with the reserves of Canadian dollars may
decide to sell them in order to demander some other currency.
The demand curve for foreign-exchange:
When the Canadian dollar to appreciate against the euro, the Canadian dollar price of European goods arises.
Because it takes more dollars to buy the same European good at an unchanged Euro price, Canadians will buy
fewer of the now more expensive European goods.
The demand curve for foreign-exchange is negatively sloped when is plotted against the exchange rate; and
appreciation of the Canadian dollar (a fall in the exchange rate) increases the quantity of foreign-exchange
demanded.
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