Transcript 1 Canadian dollar - McGraw Hill Higher Education

Lecture notes
Prepared by Anton Ljutic
CHAPTER TEN
Exchange Rates and the Balance of
Payments
© 2004 McGraw–Hill Ryerson Limited
This Chapter Will Enable
You to:
• Calculate the value of the Canadian dollar in terms
of other currencies
• Identify who wants to buy and sell Canadian
dollars and why
• Explain why the value of the Canadian dollar
fluctuates
• Compare flexible and fixed exchange rate systems
• Construct a balance sheet of international
payments
• Understand what a balance of payments surplus
and deficit means
© 2004 McGraw–Hill Ryerson Limited
Exchange Rates
• An exchange rate is the rate at which one
currency is exchanged for another
• To convert one currency into another, we
use the following formula:
1 Canadian dollar = 1 / (1 unit of foreign currency)
Or,
1 unit of foreign currency = 1 / ( 1 Canadian dollar)
© 2004 McGraw–Hill Ryerson Limited
Currency Appreciation and Depreciation
• Currency appreciation
– The rise in the exchange rate of one currency
for another
• Currency depreciation
– The fall in the exchange rate of one currency
for another
© 2004 McGraw–Hill Ryerson Limited
Exchange Rate Regimes
• Flexible exchange rates
– A currency exchange rate determined by the
market forces of supply and demand and not
interfered with by government action
• Fixed exchange rates
– A currency exchange rate pegged by the
government and therefore prevented from rising
and falling
© 2004 McGraw–Hill Ryerson Limited
Determinant of long-term exchange rate values
• Purchasing power parity theory
– A theory suggesting that exchange rates will
change so as to equate the purchasing power of
each currency
© 2004 McGraw–Hill Ryerson Limited
Differences in Purchasing Power Between
Countries
• These five factors explain the differences in
purchasing power between countries:
– The fact that many services, such as haircuts, are not
traded internationally
– The existence of transportation and insurance costs
– The existence of tariffs and other trade restrictions
– The expression of particular preferences by consumers
– The effect on the value of currencies of trade in
financial assets
© 2004 McGraw–Hill Ryerson Limited
Flexible Exchange Rates and the Demand for
the Canadian Dollar (I)
Demand depends on:
• Foreigners who want to buy Canadian
exports or who want to travel to Canada
• Foreigners who want to purchase Canadian
investments
– Direct investment: The purchase of real assets
– Portfolio investment: The purchase of shares or
bonds representing less than fifty percent
ownership
© 2004 McGraw–Hill Ryerson Limited
Demand for the Canadian Dollar (II)
Demand also depends on:
• Canadians who receive income from abroad
• Currency speculators
– Buying a currency in the expectation that its
value will rise
• Arbitrage: The process of buying a
commodity in one market, where the price
is low, and immediately selling it in a
second market where the price is higher
© 2004 McGraw–Hill Ryerson Limited
The Demand Curve For The Canadian Dollar
The demand curve for the
Canadian dollar is a conventional
demand curve
P of
Can. $
P1
Figure 10.1
D
Q1
© 2004 McGraw–Hill Ryerson Limited
Q of Can $
The Supply Of Canadian Dollars
S
P of
Can. $
The supply curve for the Canadian
dollar is a conventional supply
curve
P1
Figure 10.2
Q1
Q of Can. $
© 2004 McGraw–Hill Ryerson Limited
Equilibrium in Foreign-Exchange Markets
S
P of
Can. $
An equilibrium exchange rate
ER1
Figure 10.3
D
Q1
Q of Can. $
© 2004 McGraw–Hill Ryerson Limited
Effect of Depreciation/Appreciation on Exports
• When the Canadian dollar depreciates, the
effective price of Canadian exports
decreases and total exports are likely to rise
• When the Canadian dollar appreciates, the
effective price of Canadian exports
increases, and total exports are likely to fall
© 2004 McGraw–Hill Ryerson Limited
The Supply and Demand of Currencies
• Quantity demanded of foreign currencies is
equal to quantity supplied of Canadian
dollars
• Quantity demanded of Canadian dollars is
equal to quantity supplied of foreign
currencies
© 2004 McGraw–Hill Ryerson Limited
Effect of Appreciation/Depreciation on Imports
• When the Canadian dollar appreciates, the
effective price of Canadian imports
decreases and total imports are likely to rise
• When the Canadian dollar depreciates, the
effective price of Canadian imports
increases and total imports are likely to fall
© 2004 McGraw–Hill Ryerson Limited
Changes in Demand and Supply
P of
Can. $
•An increase in demand
for a currency…
•the equilibrium exchange
will rise from ER1 to E2
•the equilibrium quantity
will rise from Q1to Q2
S
ER2
ER1
D2
D1
Q1
Q2
Q of Can. $
© 2004 McGraw–Hill Ryerson Limited
Figure 10.4
The Demand for the Canadian Dollar
• …is determined by:
– The level of foreign incomes
– The price of Canadian products relative to the
price of foreign products
– Foreigners’ tastes
– Comparative interest rates
© 2004 McGraw–Hill Ryerson Limited
The Effect of an Increase in Exports on AD
P of
Can. $
AS
P2
P1
An increase in
Canadian exports
increases AD
from AD1 to AD2.
This results in a rise
in P and GDP
AD2
AD1
Y1 Y2
© 2004 McGraw–Hill Ryerson Limited
Q
Figure 10.5
An Increase in the Supply of Canadian Dollars
P of
Can. $
S1 S
2
Following an increase
in the supply of
Canadian dollars, the
dollar depreciates and
the quantity of dollars
traded increases.
ER1
ER2
D
Q1 Q2
© 2004 McGraw–Hill Ryerson Limited
Q
Fixed Exchange Rates (I)
• They add a degree of certainty to
international trade
• They prevent instability in the export and
import industries
• They discourage currency speculation
• They appeal to people who tend to equate
the exchange rate with national prestige
© 2004 McGraw–Hill Ryerson Limited
Fixed Exchange Rates (II)
An Increase in Currency Demand Under Fixed Exchange Rates
P of
Can. $
S
ER2
ER1
fixed
shortage
D2
D1
Qs
Qd
© 2004 McGraw–Hill Ryerson Limited
Q of Can. $
Figure 10.7
The Effect of Currency Overvaluation
• Given fixed exchange rate, an increase in demand
for the Canadian dollar results in the dollar being
undervalued (compared with free-market value)
and a dollar shortage
• To support the fixed rate, the Bank of Canada
must supply the additional dollars demanded by
the market
• The supply of additional dollars and the strong
demand for Canadian exports will exert
inflationary pressure on Canada’s economy (until
an equilibrium is re-established)
© 2004 McGraw–Hill Ryerson Limited
Fixed Exchange Rates (III)
A Decrease in Currency Demand Under Fixed Exchange Rates
S
P of
Can. $
ER1
surplus
fixed
ER2
Figure 10.8
D1
D2
Qd
Qs
© 2004 McGraw–Hill Ryerson Limited
Q of Can. $
Overvalued Exchange Rates
• A government can defend its currency in four
ways:
– Introducing quotas or tariffs to reduce imports or
subsidies to boost exports
• Subsidy
– A payment by government for the purpose of increasing
some particular activity or increasing the output of a
particular good
– Introducing foreign-exchange controls
– Negotiating voluntary export restrictions
– Creating a recession at home
© 2004 McGraw–Hill Ryerson Limited
Devaluation And Dirty Float
• Devaluation
– The re-fixing by the government of an
exchange rate at a lower level
• Dirty float
– An exchange rate that is not officially fixed by
the government but is managed by the central
bank’s ongoing intervention in the market
© 2004 McGraw–Hill Ryerson Limited
The Balance Of Payments (I)
• It is an accounting of a country’s international
transactions that involves the payment and receipts
of foreign currencies
– Current account
• A subcategory of the balance of payments that shows the
income or expenditures related to exports and imports
– Capital account
• A subcategory of the balance of payments that reflects changes
in ownership of assets associated with foreign investment
© 2004 McGraw–Hill Ryerson Limited
Balance Of Payments (II)
– Official settlement’s account
• A subcategory of the balance of payments that
shows the change in a country’s official foreign
exchange reserves
– Balance of trade
• The value of a country’s exports of goods and
services less the value of its imports
© 2004 McGraw–Hill Ryerson Limited
Canada’s Balance of Payments 2001 ($ bil.)
Current Account
Export of goods and services
+ 468
Import of goods and services
- 413
= Balance of trade
+ 55
Investment income from abroad
+ 37
Investment income paid abroad
- 65
Net investment income
- 28
Transfers (net)
+2
= Current Account balance
+ 29
Capital Account
Foreign investment in Canada
+ 81
Less Canadian investment abroad
-107
= Capital Account balance
Balance of Current Account and Capital Account
- 26
+ 3
Official Settlements Account
Change in Canadian dollars (change in foreign reserves
Total Balance (sum of three accounts)
© 2004 McGraw–Hill Ryerson Limited
- 3
0
Chapter Summary:
What to Study and Remember
• Determining the value of the Canadian dollar in
terms of other currencies
• Identifying who wants to buy and sell Canadian
dollars and why
• Explaining why the value of the Canadian dollar
fluctuates
• Comparing flexible and fixed exchange rate
systems
• Constructing a balance sheet of international
payments
• Understanding what a balance of payments surplus
and deficit means
© 2004 McGraw–Hill Ryerson Limited