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Chapter 35

Economics 102: Chapter 35

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Department
Economics
Course
ECON 102
Professor
Robert Gateman
Semester
Winter

Description
Economics 102: Principles of Macroeconomics Chapter 35 35.1 The Balance of Payments  Balance of payments accounts: summary record of a country's transactions with the rest of the world o Includes the buying and selling of goods, services, and assets o The sum of the current account and capital account balance o Categorized by whether a transaction generates a payment or a receipt for Canada  Credit: transactions that represent a receipt, the sale of a product or asset  Debit: transaction that represents a payment, the purchase of a product or asset The Current Account:  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 the value of exports and imports of goods and services  Capital-service account: records the payment and receipts that represent income on assets The Capital Account:  Records payments and receipts arising from the purchase and sale of assets o Includes bonds, shares, real estate, and factories  Direct investment: the purchase or sale of assets that alter the legal control of those assets  Portfolio investment: transactions in assets that do not alter the legal control of the assets  Official financing account: the government transactions in its official foreign-exchange reserves The Balance of Payments Must Balance:  o CA: capital account; KA: capital account  Any surplus on the current account must be matched by an equal deficit on the capital account o A CA 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 o A CA deficit thus implies a capital inflow; the balance of payments is always zero A Balance of Payments Deficit?  Balance of payments deficit usually refers to a situation in which the government is selling, official foreign-currency reserves  Balance of payments surplus usually refers to a situation in which the government is buying official foreign currency reserves o In both cases, the balance of payments is actually in balance 35.2 The Foreign-Exchange Market  Exchange rate: the number of units of domestic currency required to purchase one unit of foreign currency o Appreciation: fall in the exchange rate Economics 102: Principles of Macroeconomics o Depreciation: rise in the exchange fall The Supply of Foreign Exchange:  Supply of foreign exchange arises from Canada's sale of goods, services, and assets to the rest of the world Canadian Exports:  Foreign exchange arising out of international trade  Each potential buyer wants to sell its own currency in exchange for CND that it can use to purchase Canadian goods or services Asset Class: Capital Inflows  Purchase of Canadian assets (government/corporate bonds, real estate, or shares)  Sell foreign currency for CND in order to buy Canadian assets Reserve Currency:  Firms, banks and governments often accumulate and hold foreign exchange reserves o Countries may hold several different currencies at the same time The Total Supply of Foreign Exchange:  The supply of foreign exchange or the demand for CND by holders of foreign currencies  People, firms, and governments in all countries purchase goods/assets from many other countries, the demand for any one currency will be the AD of individuals, firms, and governments in a number of different countries The Supply Curve for Foreign Exchange:  Vertical axis is the exchange rate, the horizontal axis is the quantity of currency  Depreciation of the CND increases the quantity of foreign exchange supplied The Demand for Foreign Exchange:  Arises from all international transactions that represent a payment in Canada's balance of payments The Demand Curve for Foreign Exchange:  An appreciation of the CND increases the quantity of foreign exchange demanded 35.3 The Determination of Exchange Rates  Flexible exchange rates: when the central bank makes no transactions in the forex market o The forces of supply and demand determine the exchange rate  Fixed exchange rate: exchange rate is maintained within a small range around its publicly stated par value by the intervention in the foreign exchange market by a country's central bank  Adjustable peg system: rates are fixed in the short-term but are occasionally changed in response to changes in economic events  Managed float: central bank seeks to have some stabilizing influence on the exchange rate but does not try to fix it at some publicly announced value Economics 102: Principles of Macroeconomics Flexible Exchange Rates:  Excess supply of foreign exchange leads to a fall in the exchange rate, which reduces the amount of excess supply o The exchange rate will return to the equilibrium value  Excess demand of foreign exchange leads to a rise in the exchange rate, which reduces the amount of excess demand Fixed Exchange Rates:  Official financing transactions must offset any excess demand or supply of foreign exchange  Bretton Woods system: a fixed exchange-rate system that provided for circumstances under which exchange rates could be adjusted Changes in Flexible Exchange Rates:  The laws of supply and demand apply to the market of foreign exchange A Supply-Side Increase in the Domestic Price of Exports:  Reduction in the supply of foreign exchange will cause an increase in the exchange rate  If the demand is inelastic, then more will be spend and the supply of foreign exchange will cause a reduction in the exchange rate A Rise in the Foreign Price of Imports:  Rise in the foreign price of goods with an elastic demand curve will shift the demand curve left o The Canadian dollar will appreciate  Rise in the foreign price of goods with an inelastic
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