THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
Balance of Payments
The balance of payments shows the record of all transactions of residents of Canada with the
rest of the world. There are 3 main accounts in the balance of payments:
1) Current account
Merchandise account, service account, investment income, transfers
2) Capital account
Borrowing and lending, capital investment
3) Official financing account
Elimination of deficits or surpluses
Foreign Exchange Rate
The foreign exchange rate is the value of 1 unit of foreign currency in terms of Canadian dollars
(e). The value of the Canadian dollar in terms of a foreign currency is equal to the inverse of the
exchange rate (1/e).
Example: the exchange rate for the US dollar is approximately 0.98. that is, one US dollar is
exchanged for $0.98 Canadian dollars.
Therefore, the value of the Canadian dollar in terms of the US dollar is 1/0.98 = 1.02
Supply of Foreign Currency
Since foreign currency is exchanged for Canadian dollars, a supply of foreign currency in the
exchange market implies a demand for Canadian dollars.
The supply of foreign currency in the exchange market originates from:
- Canadian exports of goods and services
- Capital inflows (e.g. foreign investment)
- Foreign visitors to Canada
The quantity supplied for foreign currency increases as the exchange rate increases.
Demand for Foreign Currency
Since foreign currency is exchanged for Canadian dollars, a demand for foreign currency in the
exchange market implies a supply of Canadian dollars.
The demand for foreign currency in the exchange market originates from:
- Canadian imports of goods and services
- Capital outflows (e.g. Canadian investment abroad)
- Canadian visitors to other countries
The quantity demanded of foreign currency decreases as the exchange rate increases.
Flexible Exchange Rate System
The value of the exchange rate is determined by market forces (i.e., by the demand and supply
of foreign exchange)
Therefore, the exchange market is always in equilibrium, there is neither a surplus nor a deficit.
In other words, the balance of payment shows neither a surplus nor a deficit. At e = e1, there an excess supply of foreign exchange
and the value of e will fall.
At e = e2, there an excess demand of foreign exchange
and the value of e will rise.
At e = e0, D = S and the exchange market for euros is
An increase in demand for foreign exchange or a decrease in the supply will cause the
Canadian dollar to depreciate (the exchange rate to rise). A decrease in the demand for an
increase in supply will cause the Canadian dollar to appreciate (the exchange rate to fall).
Fixed Exchange Rate System
The value of the exchange rate is set by the Bank of Canada. Therefore, the foreign exchange
market needs not be in equilibrium (there could be a surplus or deficit).
Devaluation: value of e falls (Canadian dollar value increases, revaluation of Canadian dollar)
Revaluation value of e rises (Canadian dollar value decreases, devaluation of Canadian dollar)
Changes in the Value of the Fixed Exchan