Textbook Notes (368,013)
Canada (161,562)
Economics (385)
ECO100Y5 (290)
Chapter 35

ECO100 Textbook Chapter 35- Exchange Rates and the Balance of Payments.docx

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Department
Economics
Course
ECO100Y5
Professor
Kalina Staub
Semester
Winter

Description
Chapter 35- Exchange Rates and the Balance of Payments 35.1 The Balance of Payments • Balance of Payments Account- A summary record of a country’s transactions with the rest of the world, including the buying, and selling of goods, services, and assets The Current Account • Current Account- The part of the balance of payments accounts that records payments and receipts arising from trade in g/s and from interest and dividends that are earned on assets owned in one country and invested in another; consists of two sections: 1. Trade Account o Trade Account- In a balance of payments, this account records the value of exports and imports of goods and services o Canadian imports of g/s require payment to foreigners  debits on trade account o Canadian exports of g/s generate a receipt to Canada  credits on trade account 2. Capital Service Account o Capital Service Account- In the balance of payments, this account records the 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 • When Canadians purchase foreign assets, financial capital is leaving Canada and going abroad (capital outflow) • When Canadians sell assets to foreigners, financial capital is entering Canada from abroad (capital inflow) • Capital account distinguishes between direct investment and portfolio investment  Direct investment involves the purchase or sale of assets that alter the legal control of those assets while portfolio investments involves transactions in assets that do not alter the legal control of the assets • Government’s transactions in its official foreign exchange reserves in the official financing account which is included as part of the capital account because official reserves are assets rather than goods/services The Balance of Payments Must Balance • The current account balance represents the difference between the payments and receipts from international transactions in g/s while the capital account balance is the difference between payments and receipts from international transactions in assets • The balance of payments is the sum of current account and capital account balances • The current account plus the capital account must equal zero; balance of payments is always equal to zero (Balance of payments = CA+KA=0) • Any surplus on the current account must be matched by an 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 zero No Such Thing as a Balance of Payments Deficit • Strictly speaking, a balance of payments deficit or surplus cannot exist • When the terms are used, a “balance of payments deficit” probably refers to a situation in which the government is selling official foreign currency reserves • A “balance of payments surplus” probably refers to a situation in which the government is buying official foreign currency reserves • In both cases, as always, the balance of payments is actually in balance 35.2 The Foreign­Exchange Market • Trade between countries normally requires the exchange of the currency of one country for that of another • Exchange Rate- The number of units of domestic currency required to purchase one unit of foreign currency • Appreciation- A fall in the exchange rate; the 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 rate; the domestic currency has become less valuable so that it takes more units of domestic currency to purchase one unit of foreign currency • Because Canadian dollars are traded for euros in the foreign exchange market, it follows that a demand for euros implies a supply of Canadian dollars and that a supply of euros implies a demand for Canadian dollars The Supply of Foreign Exchange • Whenever foreigners purchase Canadian goods, services, or assets, they supply foreign currency to the foreign exchange market and demand, in return, Canadian dollars with which to pay for their purchases ; The supply of foreign exchange arises from Canada’s sales of g/s/assets  Canadian Exports o Source of supply of foreign exchange is foreigners who wish to buy Canadian-made g/s; Each potential buyer wants to sell its own currency in exchange for Canadian dollars that it can then use to purchase Canadian goods/services  Asset Sales: Capital Inflows o To buy Canadian assets, holders of foreign currencies must first sell their foreign currency and buy Canadian dollars; when Canadians sell assets to foreigners, there is a capital inflow to Canada  Reserve Currency o Firms, banks, and governments often accumulate and hold foreign exchange reserves, just as individuals maintain savings accounts; these reserves may be in several different currencies  The Total Supply of Foreign Exchange o The supply of foreign exchange is the sum of the suppliers for all the purposes o Because people, firms, and government in all countries purchase goods/assets from many other countries, the demand for any one currency will be the aggregate demand of individuals, firms, and governments in a number of different countries  The Supply Curve for Foreign Exchange o The supply curve for foreign exchange is positively sloped when it is plotted against the exchange rate; a depreciation of the Canadian dollar (a rise in the exchange rate) increases the quantity of foreign exchange supplied The Demand for Foreign Exchange • Canadians seeking to purchase foreign products will be supplying Canadian dollars and demanding foreign exchange; they will supply Canadian dollars and demand foreign exchange • The demand for foreign exchange is negatively sloped when it is plotted against the exchange rate; an appreciation of the Canadian dollar (a fall in the exchange rate) increases the quantity of foreign exchange demanded 35.3 Determination of Exchange Rates • Three important cases not included in the demand and supply curves 1. When the central bank makes no transactions in the foreign exchange market, there is said to be a purely floating or flexible exchange rate 2. When the central bank intervenes in the foreign exchange market to fix/peg the exchange rate at a particular value, there is said to be a fixed exchange rate or pegged exchange rate 3. Between these two “pure” systems is a variety of possible intermediate cases, including the adjustable peg and the managed float o In the adjustable peg system, central banks fix specific values for their exchange rates, but they explicitly recognize that circumstances may arise in which they will change that value o In a managed float, the central bank seeks to have some stabilizing influence on the exchange rate but does not try to fix it at some publicly announced value Flexible Exchange Rates • Flexible Exchange Rate- An exchange rate that is left free to be determined by the forces of demand and supply on the free market, with no intervention by central banks • A foreign exchange market is like other competitive markets in that the forces of demand and supply lead to an equilibrium price at which quantity demanded = quantity supplied • In the absence of central bank intervention, the exchange rate adjusts to clear the foreign exchange market; View FIGURE 35.2 for fixed and flexible exchange rates Fixed Exchange Rates • Fixed Exchange Rate- An exchange rate that is maintained within a small range around its publicly stated par value y the intervention in the foreign exchange market by a country’s central bank • If the central bank chooses to fix the exchange rate at a particular value, its official financing transactions must offset any excess demand or supply of foreign exchange that arises at that exchange rate Changes in Flexible Exchange Rates • An increase in the demand for foreign exchange in the supply will cause the Canadian dollar to depreciate (the exchange rate to rise); a decrease in the demand or an increase in supply will cause the dollar to appreciate ( the exchange rate to fall); View FIGURE 35.3 for changes in the flexible exchange rate  A rise in the world price of exports o Higher world price  world’s consumers are prepared to offer more foreign currency per unit of these Canadian exports  increase in supply of foreign exchange occurs even if the volume of Canadian exports is unchanged  increase in supply of foreign exchange causes a reduction in the exchange rate  appreciation of the Canadian dollar  A rise in the foreign price of imports o Exchange rated often respond to changes in the prices of major exports and imports; A rise in the world price of Canadian exports causes the Canadian dollar to appreciate; If demand for foreign products is inelastic, a rise in the price of Canadian imports causes the Canadian dollar to depreciate  Changes in overall price levels o Instead of a change in the price of a specific product, there is a change in all prices because of general inflation
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