# MGEA06H3 Lecture Notes - Demand Curve, Capital Outflow, David Buss

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30 Nov 2010
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OPEN ECONOMY (PART 1)
Outline
x What is the foreign exchange market?
x Discuss factors that affect demand for and supply of a country’s currency.
x Use of the demand and supply curves of C\$ in the foreign exchange market to determine the value of C\$.
x Discuss different exchange rate regimes.
x Go through a numerical example to show how a change in exchange rate affects the economy.
The Foreign Exchange Market
x The foreign exchange market is the market where we exchange one currency for another, and the price in the market is the exchange
rate, E.
x There are two ways to quote exchange rate:
1) The value of foreign currency, say US\$, in C\$ (i.e., # of C\$ needed to exchange 1 US\$), EC\$ per US\$.
2) The value of C\$ in US\$ (i.e., # of US\$ needed to exchange 1 C\$), EUS\$ per C\$.
o In our class, exchange rate is quoted as the # of US\$ needed to exchange 1 C\$, EUS\$ per C\$.
o The relationship between these two quotations is:
EC\$ per US\$ = 1 / EUS\$ per C\$
x Similar to other markets, the exchange rate is determined by the forces of demand for and supply of C\$ internationally.
x There is a big difference between the exchange rate and interest rate, do don’t get yourself confused!
Foreign Exchange Market vs. (Domestic) Money Market
Foreign Exchange Market Demand for C\$ vs. (Domestic) Demand for Money
x Demand for C\$ in the foreign exchange market comes from people who want to use foreign currency to buy C\$ (i.e., mostly people
who are outside Canada).
o They need C\$ because they want to buy Canadian goods and/or Canadian assets.
x (Domestic) Demand for money, L (r, Y), is the demand for liquidity (i.e., Canadians who live in Canada).
o Demand for money means Canadians want to hold a portion of our wealth in the form of liquid assets such as cash, and we
need to have cash in our pockets to facilitate our daily transactions.
Foreign Exchange Market Supply of C\$ vs. (Domestic) Supply of Money
x Supply of C\$ in the foreign exchange market comes from people who want to use C\$ to buy foreigners (i.e., usually Canadians).
o They need to sell C\$ because they want to buy foreign goods and/or foreign assets.
x (Domestic) Supply of money, MS, is determined by the Bank of Canada and the commercial banks (from the loan creation process).
MS = Currency in circulation + Demand deposits
Source of (International) Demand for C\$ & Supply of C\$
x Remember a countrys BOP accounts summarize its international transactions with the rest of the world.
x By looking at these accounts, we will have idea where the sources of the demand for and supply of a country’s currency come from.
x We know that whenever foreigners buy stuff from us, there will be a demand for C\$; and whenever we buy stuff from them, there
will be a supply of C\$.
x Implications:
o The demand for C\$ arises from the export of goods, services, and assets.
o The supply of C\$ comes from the imports of goods, services, and assets.
x What this means is if we know the factors that affect our exports and imports of goods, services, and assets, then we know the factors
that affect the demand for and supply of C\$.
Factors that Affects the Demand for C\$
1. Exchange rate, EUS\$ per C\$
x Holding all else constant, Canadian goods & services become more expensive when C\$ appreciates (E increases).
o The exports of goods and services decreases Æ trade balance decreases & CA decreases Æ demand for C\$ decreases
2. Interest rate in Canada, rC
x Holding all else constant, when rC increases, (rC – rUS) increases Æ Canadian assets become more attractive.
x Investors want to purchase more Canadian assets such as bonds.
o The exports of assets increases Æ Canada experiences capital inflow (KA increases) Æ demand for C\$ increases
3. Foreign GDP
x Holding all else constant, an increase in foreign GDP increases foreign demand for Canadian goods & services.
o The exports of goods and services increases Æ trade balance increases & CA increases Æ demand for C\$ increases
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Factors that Affects the Supply of C\$
1. Exchange rate, EUS\$ per C\$
x Holding all else constant, Canadian goods & services become more expensive when C\$ appreciates (E increases).
o The imports of goods and services increases Æ trade balance decreases & CA decreases Æ supply of C\$ increases
2. Foreign interest rate, say rUS
x Holding all else constant, when rUS increases, (rCrUS) decreases Æ American assets become more attractive.
x Investors, including Canadian investors, want to purchase more American assets.
o The imports of assets increases Æ Canada experiences capital outflows (KA decreases) Æ supply of C\$ increases
x Holding all else constant, an increase in Canada’s GDP increases Canadian demand for foreign goods & services.
o The imports of goods and services increases Æ trade balance decreases & CA decreases Æ supply of C\$ increases
Summary
x Factors that affect the demand for and supply of C\$ include exchange rate, Canada’s interest rate, foreign interest rate, foreign GDP,
Determination of the Exchange Rate
x We discuss how a change in the factors discussed above affects the exchange rate.
Case 1—An Increase in Canadian Interest Rate
Suppose rC increases:
x Canadian assets become more attractive to both Canadians and foreigners Æ exports of assets increases (capital inflow)
x demand for C\$ increases to D1C\$ (demand curve shifts to the right)
x at E0, excess demand for C\$
x C\$ appreciates to E1 (E increases, pt C is the new equilibrium)
Case 2—An Increase in Foreign Interest Rate, say rUS
Suppose rUS increases:
x American assets become more attractive Æ import of assets increases (capital outflow)
x supply of C\$ increases to S1C\$ (supply curve shifts to the right)
x at E0, excess supply of C\$
x C\$ depreciates to E1 (E decreases, pt B is the new equilibrium)
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