Transcript Ch. 18 - Exchange Rates and The Balance of Payments

EXCHANGE RATES
AND THE
BALANCE OF PAYMENTS
SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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In this chapter you will learn
17.1 How international trade is financed
17.2 About a nation’s balance of payments
17.3 What a flexible exchange-rate system is
and its effects on the domestic economy
17.4 What a fixed exchange-rate system is and
its effects on the domestic economy
17.5 About the history of the world’s exchangerate regimes
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Financing International Trade
differing national currencies complicate
international trade
 currencies are exchanged in foreign
exchange markets

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Macroeconomics, Chapter 17
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Canadian Export Transaction
Assume $2 = £1
1. $300,000 in Canadian telecommunications
equipment purchased by a British buyer for
£150,000
2. £150,000 cheque drawn on British bank to
pay for equipment
3. £150,000 cheque is exchanged for $300,000
at a Canadian bank
4. Canadian bank sends £150,000 cheque to
London bank for future transactions
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Macroeconomics, Chapter 17
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Points to Remember
Canadian exports create:
 a foreign demand for Canadian $
 an increase in the supply of foreign
currency owned by Canadian banks
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Points to Remember
Canadian imports:
 create a domestic demand for foreign
currencies
 reduce the supplies of foreign
currencies held by Canadian banks
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Points to Remember
Canadian exports supply the foreign
currencies needed to “pay for” imports
 Demand for & supplies of foreign
currencies also arise from transactions
involving services & payment of interest
& dividends on foreign investments

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Macroeconomics, Chapter 17
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Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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The Balance of Payments

The Canadian balance of payments
shows the balance between
– all the payments that Canada receives
from foreign countries &
– all the payments which we make to them
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Current Account

shows the flows resulting from imports &
exports of goods & services
– the balance on goods is the net amount of
imports & exports of goods only
– the balance on goods & services includes goods
& services
– trade in services, investment income & transfers
are included to get the current account balance
– in 2002, Canada had a current account surplus of
$17.3 billion
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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The Canadian Balance of Payments
in 2002 (billions of dollars)
Table 17-1
Exports
Imports
Balance
- 356.1
- 66.1
+54.2
- 7.9
Current Account
Merchandise
Services
410.3
58.2
Balance on Goods and Services
+46.3
7. Net Investment Income
8. Net Transfers
- 30.4
+ 1.4
9. Current Account Balance
+17.3
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Macroeconomics, Chapter 17
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Capital Account

shows capital inflows & outflows
– purchase or sale of real or financial assets
– official settlements account

TIP:
– a + sign indicates a “source” of foreign
exchange,
– a - sign indicates a “use” of foreign
exchange
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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The Canadian Balance of Payments
in 2002 (billions of dollars)
Table 17-1
Balance
Capital Account
10. Capital inflows
11. Capital outflows
12. Capital
account balance
+ 69.1
- 75.7
-
6.6
Official settlements account
13. Official international reserves
Balance of payments
© 2005 McGraw-Hill Ryerson Ltd.
- 10.7
$
Macroeconomics, Chapter 17
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Payments Deficits & Surpluses



A drawing down of official international
reserves (a + official reserves entry)
measures a nation’s balance of payments
deficit
A building up of official reserves (a – official
reserves entry) measures a balance of
payments surplus
Deficits not necessarily bad, but cannot be
maintained indefinitely, because international
reserves are limited
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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GLOBAL PERSPECTIVE 17.1
Canada's Trade Balance with Selected Nations, 2002
U.S.
Japan
European Union
Other Countries
-20 -10
0
10
20
30
40
50
$ billions
60
70
80
90 100
The Balance of Payments, 1975-2002
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Foreign Exchange Markets
competitive markets
 linkages to all domestic & foreign prices

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Macroeconomics, Chapter 17
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Flexible Exchange Rates

Rates by which national currencies are
exchanged are determined by demand
& supply
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Macroeconomics, Chapter 17
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The Market for Foreign Currency (Pounds)
Figure 17-2
Dollar price of 1 pound
P
who are the
demanders of
pounds in fx
markets?
D
Quantity of pounds
Q
The Market for Foreign Currency (Pounds)
Figure 17-2
P
Dollar price of 1 pound
S
who are the
suppliers of
pounds to fx
markets?
D
Quantity of pounds
Q
The Market for Foreign Currency (Pounds)
Figure 17-2
P
Dollar price of 1 pound
S
dollar price of
pounds is
determined by
demand & supply
D
Quantity of pounds
Q
The Market for Foreign Currency (Pounds)
Figure 17-2
Dollar price of 1 pound
P
S
2
D
Q1
Quantity of pounds
Q
The Market for Foreign Currency (Pounds)
Figure 17-2
Dollar price of 1 pound
P
2
S
Pound
appreciates
D
D
Q1
Quantity of pounds
Q
The Market for Foreign Currency (Pounds)
Figure 17-2
Dollar price of 1 pound
P
S
Pound
depreciates
2
D
Q1
Quantity of pounds
D
Q
Determinants of Exchange Rate
Changes
Changes in Tastes
 Relative Income Changes
 Relative Price-Level Changes

– Purchasing Power Parity Theory
Relative Interest Rates
 Speculation

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Advantages of Flexible Rates

automatic adjustment to eventually
eliminate balance of payments deficits
or surpluses
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Adjustments Under Flexible Exchange Rates
Figure 17-3
Dollar price of 1 pound
P
S
suppose
tastes
change
& Canadians
want to buy
more British
automobiles
2
D
Quantity of pounds
Q
Adjustments Under Flexible Exchange Rates
Figure 17-3
Dollar price of 1 pound
P
S
demand for
pounds
increases
2
D
D
Quantity of pounds
Q
Adjustments Under Flexible Exchange Rates
Figure 17-3
Dollar price of 1 pound
P
S
Canadian
balance of
payments
deficit
2
a
b
D
D
Quantity of pounds
Q
Adjustments Under Flexible Exchange Rates
Figure 17-3
Dollar price of 1 pound
P
3
2
c
a
Schange in
the
exchange
rate to
$3=£1
would
b correct the
deficit
D
D
Quantity of pounds
Q
Flexible Exchange Rates

with a lower $, Canadians will want to
import less, & the British will want to buy
more Canadian goods & services
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Disadvantages of Flexible Rates
reduced trade because of risks
associated with constantly changing
exchange rates
 worsening terms of trade if there is a
sizeable depreciation
 challenges in designing domestic
macroeconomic policies in nations
heavily dependent on trade

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
35
Fixed Exchange Rates

Use of Reserves
– currency interventions
Trade Policies
 Exchange Controls & Rationing



distorted trade
favouritism
© 2005 McGraw-Hill Ryerson Ltd.


restricted choice
black markets
Macroeconomics, Chapter 17
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Fixed Exchange Rates

Use of Reserves
– currency interventions
Trade Policies
 Exchange Controls & Rationing
 Domestic Macroeconomic Adjustments

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
38
Exchange Rate Systems

The Gold Standard: Fixed Exchange
Rates 1879 - 1934
– currency defined in gold
– fixed relationship between gold stock &
money supply maintained
– gold freely exported & imported
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Macroeconomics, Chapter 17
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Exchange Rate Systems
Gold flows resulted in fixed exchange
rates
 Domestic macroeconomic adjustments
sometimes distasteful
 Gold standard collapsed in the
worldwide depression of the 1930s

– series of devaluations
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Macroeconomics, Chapter 17
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Exchange Rate Systems

The Bretton Woods System 1944-1971
– adjustable-peg system
– International Monetary Fund (IMF)

Maintaining pegged rates
– Official international reserves
– Gold sales
– IMF borrowing
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
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Exchange Rate Systems
Fundamental Imbalances: Adjusting the
Peg
 Demise of the Bretton Woods System

– 1971: the US floated the dollar
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Macroeconomics, Chapter 17
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Exchange Rate Systems

The Current System: The Managed
Float
– G-7 Intervention in 1987
“almost” flexible
 proponents & critics

– has functioned better than anticipated
– a “nonsystem”
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
43
Chapter 17 Topics
17.1 Financing International Trade
17.2 The Balance of Payments
17.3 Foreign Exchange Markets: Flexible
Exchange Rates
17.4 Fixed Exchange Rates
17.5 International Exchange-Rate
Systems
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 17
44