Textbook Notes (369,153)
Canada (162,424)
Economics (479)
ECO102H1 (54)
Chapter 35

ECO100Y1 Chapter 35 Notes

10 Pages
102 Views

Department
Economics
Course Code
ECO102H1
Professor
Robert Gazzale

This preview shows pages 1,2 and half of page 3. Sign up to view the full 10 pages of the document.
Description
ECO100Y1 Textbook Notes Chapter 35 35.1 The Balance of Payments  Balance of payments accounts: a summary record of a country’s transactions with the rest of the world, including the buying and selling of goods/services and assets. o Transactions are classified based on whether they generate a receipt or a payment for Canada. o A receipt transaction is a credit item (item sold). o A payment transaction is a debit item (item purchased).  Two main categories to the balance of payments: o The 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 one country and invested in another.  Two main sections in the current account:  Trade account o This account records the value of exports and imports of goods/services. o Imports = debit items o Exports = credit items  Capital-service account o This account records the payments and receipts that represent income on assets (i.e. interest/dividends). o Payments to foreigners = debit items o Payments received by residents = credits items o The capital account  The part of the balance of payments accounts that records payments and receipts arising from the purchase and sale of assets (i.e. bonds, shares of companies, real estate etc.).  Purchase of assets = debit item  Since financial capital leaves Canada with a purchase of foreign assets, this is called a capital outflow.  Sale of Canadian assets = credit item  Since financial capital enters Canada with a sale of Canadian assets, this is called a capital inflow.  Direct investment: involves the purchase or sale of assets that alter the legal control of those assets (i.e. when a controlling interest of a company is purchased.  Portfolio investment: involves transactions in assets that do not alter the legal control of the assets (i.e. when a minority of a company’s shares is purchased).  Official financing account: the part of the capital account that shows the government’s transactions in its official foreign- exchange reserves.  Increasing reserves (purchasing foreign assets) = debit item.  Decreasing reserves (selling foreign assets) = credit item.  The balance of payments is the sum of the current account and capital account balances and in any given period this sum must equal 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.  The fact that the balance of payments always equals zero is because it is an accounting identity.  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” refers to a situation in which the government is buying official foreign-currency reserves.  In either of the above cases, the balance of payments is actually in balance.  Summary: o The current account shows all transactions in goods and services between Canada and the rest of the world (including investment income and transfers). o 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. o All transactions involving a payment from Canada appear as debit items. All transactions involving a receipt to Canada appear as credit items. o The balance of payments – the sum of the current account and the capital account – must, by definition, always 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. o Thus, trade between countries normally requires the exchange of the currency of one country for that of another.  Foreign-exchange transaction: the exchange of one currency for 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.  Transactions that generate a receipt for Canada in its balance of payments represent a supply of foreign exchange (funds provided to foreigners).  Transactions that are a payment from Canada in the balance of payments represent a demand of foreign exchange (foreigners demand funds).  One important source of supply of foreign exchange is foreigners who wish to buy Canadian-made goods and services (exports). o Each potential buyer wants to sell its own currency in exchange for Canadian dollars that it can then use to purchase Canadian goods/services.  To buy Canadian assets (capital inflow), holders of foreign currencies must first sell their foreign currency and buy Canadian dollars.  If the government of Poland were to want to increase its reserve holdings of Canadian dollars and reduce its reserve holdings of euros, it would be a supplier of euros and a demander of Canadian dollars in foreign-exchange markets.  The total supply of foreign exchange (or demand for Canadian dollars) by holders of foreign currencies is the sum of the supplies for: o Purchases of Canadian exports o Capital inflow to Canada o The purchase of Canadian dollars to add to currency reserves  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. o If the dollar is relatively cheaper, foreigners will demand more Canadian dollars and will be supplying more of their foreign currency.  Canadians seeking to purchase foreign products will be supplying Canadian dollars and demanding foreign exchange for this purpose. o The same goes with assets and reserves.  The demand curve 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 (to finance the extra imports). 35.3 The Determination of Exchange Rates  Three important cases in incorporating the role of official financing transactions: o When the central bank makes no transactions in the foreign-exchange market, there is said to be a purely flexible exchange rate.  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.  Used by most industrialized countries. o When the central bank intervenes in the foreign-exchange market to “fix” the exchange rate at a particular value, there is said to be a fixed exchange rate or pegged exchange rate.  Fixed exchange rate: an exchange rate that 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. o Between these two “pure” systems is a variety of possible intermediate cases, including the adjustable peg and the managed float.  Adjustable peg system: a system in which exchange rates are fixed in the short term but are occasionally changed in response to changes in economic events.  Managed float: a situation in which the central bank intervenes in the foreign-exchange market to smooth out some of the large, short-term fluctuations in a country’s exchange rate, while still leaving the market to determine the exchange rate in the longer term.  With regards to a flexible exchange rate (and a 2-currency model), an excess supply of foreign exchange (i.e. excess demand for Canadian dollars) leads to a fall in the exchange rate (appreciation of the Canadian dollar), which in turn reduces the amount of excess supply. o An excess demand will result in an increase in the exchange rate (depreciation of the Canadian dollar), which in turn decreases the amount of excess demand.  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 equals quantity supplied.  The Bretton Woods system (1944-1970s) was a fixed exchange-rate system that provided for circumstances under which exchange rates could be adjusted. o The International Monetary Fund (IMF) has its origins in the system, and one of its principal tasks was approving and monitoring exchange-rate changes.  The European Exchange Rate Mechanism (ERM) (1979-1999) was a fixed exchange-rate system for the countries in the EU. o Their currencies were fixed to one another but floated as a block against the U.S. dollar and other currencies. o Lasted until the adoption of the euro.  With regards to a fixed exchange rate (and a 2-currency model), an excess supply will result in the central bank will purchase foreign exchange (and sell dollars). o An excess demand will result in the central bank selling foreign exchange (and buying dollars).  An increase in the demand for foreign exchange or a decrease in the supply will cause the Canadian dollar to depreciate (the exchange rate to rise). o A decrease in the demand or an increase in supply will cause the dollar to appreciate (the exchange rate to fall).  The result of an increase in the domestic price of exports depends on whether demand is: o Elastic  The total amount spent on the Canadian product will decrease and hence less foreign exchange will be supplied to purchase the Canadian product.  Supply curve shifts to the left, increasing the exchange rate (depreciation of the Canadian dollar). o Inelastic  The total amount spent on the Canadian product will increase and hence more foreign exchange will be supplied to purchase the Canadian product.  Supply curve shifts right, decreasing the exchange rate (appreciation of the Canadian dollar).  The result of an increase in the foreign price of imports depends on whether demand is: o Elastic  The total amount spent on the foreign product will decrease and hence less foreign exchange will be demanded to purchase the foreign product.  Demand curve shifts to the left, decreasing the exchange rate (appreciation of the Canadian dollar). o Inelastic  The total amou
More Less
Unlock Document

Only pages 1,2 and half of page 3 are available for preview. Some parts have been intentionally blurred.

Unlock Document
You're Reading a Preview

Unlock to view full version

Unlock Document

Log In


OR

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit