Open Economy Macro:
Exchange Rate And Trade
Policy
Chapter 16
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16 - 2
The Balance of Payments

The balance of payments is a
country’s record of all transactions
between its residents and the residents
of all foreign countries.
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The Balance of Payments

The current account is the part of the
balance of payments account in which
all short-term flows of payments are
listed.
 It
includes exports and imports of both
goods and services; net investment income;
and net transfers.
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The Balance of Payments

The capital and financial accounts
are the part of the balance of payments
account in which all long-term flows of
payments are listed.
 When
Canadian citizens buy foreign
securities or when foreigners buy
Canadian securities, they are listed here as
outflows and inflows, respectively.
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The Balance of Payments

The government can influence the
exchange rate by buying and selling
official reserves—government
holdings of foreign currencies.
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The Current Account

The difference between the value of
goods exported and the value of goods
imported is sometimes called the
balance of merchandise trade.
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The Current Account

Although the popular press often uses
this measure, the merchandise trade
balance is not a good summary
because services are an important
component of trade.
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The Current Account
Trade in services is just as important as
trade in goods.
 The key statistic for economists is the
balance of goods and services which
is the difference between the value of
goods and services exported and
imported.

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The Current Account
There is no reason that the goods and
services sent into a country must equal
the goods and services sent out in a
particular year.
 The current account includes payments
from past investments and net transfers.

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The Current Account

The last component of the current
account is net transfers, which include
foreign aid, gifts, and other payments to
individuals not exchanged for goods
and services.
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The Capital and Financial
Account

The capital and financial account
consists of
 The
capital account
 The financial account.
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The Capital and Financial
Account

The capital account measures
transactions such as international
inheritances, federal debt forgiveness
and the transfer of intangible assets.
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The Capital and Financial
Account
The financial account measures
transactions in financial assets and
liabilities.
 It includes Canadian portfolio
investment abroad and foreign
investment in Canadian stocks and
bonds.

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The Capital and Financial
Account
Current account balance is not
completely offset by the capital and
financial account balance.
 The reason for this are statistical
discrepancies – many transactions have
to be estimated.

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The Capital and Financial
Account

In thinking about what determines a
currency’s value, it is important to
remember both the demand for dollars
to buy goods and services and the
demand for dollars to buy assets.
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Balance of Payments
Equilibrium

Because the balance of payments
consists of both the capital account and
the current account, if the capital
account is in surplus and the trade
account is in deficit, there can still be a
balance of payments surplus.
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2001 Balance of Payments Account,
Table 16-1, p 383
1
2
3
4
5
6
7
8
9
10
Current Account
Merchandise
Exports
412,510
Imports
-351,003
Balance of Trade
Services
Exports
55,095
Imports
-61,926
Balance of Services
Balance of Goods and Services
61,507
-6,831
54,676
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2001 Balance of Payments Accounts,
Table 16-1, p 383
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Net Investment Income
-27,446
Net Transfers
1,870
Investment Transactions Balance
Balance of Current Account
Capital Account
Inflows
6,482
Outflows
-804
Balance of Capital Account
Financial Account
Assets
-107,388
Liabilities
80,889
Net Financial Account
Total Capital and Financial Account Balances
Statistical Discrepancy
Total
-25,576
29,100
5,678
-26,499
-20,821
-8,279
0
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Balance of Payments
Equilibrium

By definition, current account and the
capital and financial account must sum
to zero, because they are an accounting
identity.
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Balance of Payments
Equilibrium
If the currencies are freely
exchangeable, the quantity of currency
demanded must equal the quantity
supplied.
 Any deficit in the balance of payments,
then, must be offset by an equal surplus
in official reserve transactions.

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Exchange Rates
Exchange rate is the rate at which one
currency can be traded for another.
 When comparing the currencies of two
countries, the supply of one currency
equals the demand for another
currency.

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Exchange Rates
In order to demand one currency, you
must supply another.
 Equilibrium is where the quantity
supplied equals the quantity demanded.

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Exchange Rates and the
Balance of Payments
A deficit in the balance of payments
means that the quantity supplied of a
currency exceeds the quantity
demanded.
 A surplus in the balance of payments
means the opposite.

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Exchange Rates and the
Balance of Payments

Equilibrium is where the quantity
supplied a currency equals the quantity
demanded.
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The Supply of and Demand
for Euros, Fig. 16-1, p 387
Price of Euros
(in dollars)
Supply
$1.30
1.20
1.15
1.10
Demand
QD
QS Quantity of Euros
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16 - 26
Fundamental Forces
Determining Exchange Rates

Exchange rate analysis is usually
broken down into fundamental analysis
and short-run analysis.
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Fundamental Forces
Determining Exchange Rates

Fundamental analysis is a consideration
of the fundamental forces that
determine the supply of and demand for
currencies.
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Fundamental Forces
Determining Exchange Rates

These fundamental forces include a
country’s income, changes in a
country’s prices, and the interest rate in
a country.
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Changes in a Country’s
Income
When a country’s income falls, the
demand for imports falls.
 Then demand for foreign currency to
buy those imports falls.

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Changes in a Country’s
Income
This means that the supply of the
country’s currency to buy the foreign
currency falls.
 This finally leads to an increase in the
price of that country’s currency relative
to foreign currency.

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Changes in a Country’s Prices
If the Canada has more inflation than
other countries, foreign goods will
become cheaper.
 Canadian demand for foreign currencies
will tend to increase, and foreign
demand for dollars will tend to
decrease.

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Changes in a Country’s Prices

This rise in Canadian inflation will shift
the dollar supply to the right and the
dollar demand to the left.
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Changes in Interest Rates

A rise in Canadian interest rates relative
to those abroad will increase demand
for Canadian assets.
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Changes in Interest Rates

Demand for dollars will increase, while
simultaneously the supply of dollars will
decrease as fewer Canadians sell their
dollars to buy foreign assets.
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Changes in Interest Rates

A fall in Canadian interest rates or a rise
in foreign interest rates will have the
opposite effect.
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Exchange Rate Determination
Is More Complicated Than It
Seems

Large exchange rate fluctuations in
response to changing expectations
make trading difficult and have
significant real effect on economic
activity.
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Exchange Rate Determination
Is More Complicated Than It
Seems

If the market expects exchange rates to
change, it will become a self-fulfilling
prophesy.
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Exchange Rate Determination
Is More Complicated Than It
Seems

The resulting fluctuations serve no real
purpose, and cause problems for
international trade and the country’s
economy.
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International Trade Problems
From Shifting Values of
Currencies
Large fluctuations make real trade
difficult, and cause serious real
consequences.
 It is these consequences that have led
to calls for government to fix or stabilize
their exchange rates.

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How a Fixed Exchange Rate
System Works
One way the government can set the
exchange rate is to make its currency
nonconvertible.
 Most western economies have agreed
not to use this approach.

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How a Fixed Exchange Rate
System Works
A second way is for government to
adopt a fixed exchange rate policy.
 A fixed exchange rate policy is one in
which the government commits to
holding the exchange rate at a specified
rate through direct intervention.

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Fixing the Exchange Rate
The government can fix its exchange
rate by exchange rate intervention.
 Exchange rate intervention – buying
or selling a currency to affect its price.

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Direct Exchange Rate
Intervention

Currency support is the buying of a
currency by a government to maintain
its value at above its long-run
equilibrium value.
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Direct Exchange Rate
Intervention

A country can maintain a fixed
exchange rate only as long as it has the
official reserves (foreign currencies) to
maintain this constant rate.
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Direct Exchange Rate
Intervention

Once it runs out of official reserves, it
will be unable to intervene, and then
must either borrow or devalue its
currency.
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Price of euros (in dollars)
Direct Exchange Policy, Fig.16-2, p 392
Supply
Excess
supply
$1.30
D1
1.20
1.10
D0
Q1
QE
Q2
Quantity of euros
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Currency Stabilization
A more practical long-run exchange rate
policy is currency stabilization.
 Currency stabilization – the buying
and selling of a currency by the
government to offset temporary
fluctuations in supply and demand for
currencies.

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Currency Stabilization
In currency stabilization, the
government is not trying to change the
long-run equilibrium.
 It is simply trying to keep the exchange
rate at that long-run equilibrium.

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Currency Stabilization

Currency stabilization minimizes the
possibility that the government will run
out of official reserves.
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Currency Stabilization

If a country runs out of official reserves,
it must adjust its economy if it wants to
maintain a fixed exchange rate.
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Currency Stabilization

Given the small level of official reserves
relative to the enormous level of private
trading, significant amounts of
stabilization are impossible.
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Currency Stabilization

Strategic currency stabilization is often
used when a government has a small
level of official reserves.
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Currency Stabilization

Strategic currency stabilization is the
process of buying and selling at
strategic moments to affect the
expectations of traders, and hence to
affect their supply and demand.
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Stabilizing Fluctuations
Versus Deviating From LongRun Equilibrium
In theory, it is important to distinguish
whether the problem is long- or shortrun equilibrium.
 In practice, it is difficult to do so.

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Stabilizing Fluctuations
Versus Deviating From LongRun Equilibrium

The long-run equilibrium rate can only
be guessed, since no definitive
empirical measure of this rate exists.
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Estimating Long-Run
Equilibrium Exchange Rates

Purchasing power parity is one way
economists have of estimating the longrun equilibrium rate.
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Estimating Long-Run
Equilibrium Exchange Rates
Purchasing power parity (PPP) is a
method of calculating exchange rates
that attempts to value currencies at
rates such that each currency will buy
an equal basket of goods.
 Those exchange rates may or may not
be appropriate long-run exchange rates.

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Criticisms of the Purchasing
Power Parity Method
The difficulty with purchasing power
parity is the complex nature of trade and
consumption.
 The purchasing power parity will change
as the basket of goods changes.
 Because of this there is no single
measure of purchasing power parity.

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Criticisms of the Purchasing
Power Parity Method

Purchasing power parity measures
leave out asset demand for a currency,
an important element of demand for
currencies.
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Criticisms of the Purchasing
Power Parity Method

The critics contend that the current
exchange rate is the best estimate of
the long-run equilibrium exchange rate.
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Alternative Exchange Rate
Systems

There are three exchange rate regimes:
 Fixed
exchange rate – the government
chooses an exchange rate and offers to buy
and sell currencies at that rate.
 Flexible exchange rate – determination of
exchange rates is left totally up to the
market.
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Alternative Exchange Rate
Systems

There are three exchange rate regimes:
 Partially
flexible exchange rate – the
government sometimes affects the
exchange rate and sometimes leaves it to
the market.
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Advantages of Fixed Exchange
Rates
They provide international monetary
stability.
 They force governments to make
adjustments to meet their international
problems.

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Disadvantages of Fixed
Exchange Rates
They can become unfixed.
 When they are expected to become
unfixed, they create enormous
monetary instability.

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Disadvantages of Fixed
Exchange Rates
They force governments to make
adjustments to meet their international
problems.
 Notice that this is an advantage as well
as a disadvantage.

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Fixed Exchange Rates and
Monetary Stability

If the government picks an exchange
rate that is too high, its exports lag and
the country loses official reserves.
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Fixed Exchange Rates and
Monetary Stability
If the government picks an exchange
rate that is too low, it is paying more for
its imports than it needs to and is
building up official reserves.
 Some other country is losing official
reserves.

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Fixed Exchange Rates and
Monetary Stability

At times fixed exchange rates can
become highly unstable because
expectations of a change in the
exchange rate can force the change to
occur.
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Fixed Exchange Rates and
Policy Independence
Fixed exchange rates provide
international monetary stability and
force governments to make adjustments
to meet their international problems.
 If they become unfixed, they create
monetary instability.

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Fixed Exchange Rates and
Policy Independence

Because most countries’ official
reserves are limited, a country with fixed
exchange rates is limited in its ability to
conduct expansionary monetary and
fiscal policies.
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Fixed Exchange Rates and
Policy Independence
Many countries run out of official
reserves when a recession hits.
 They choose expansionary monetary
policy to achieve their domestic goals
rather than contractionary monetary
policy to maintain fixed exchange rates.

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Advantages of Flexible
Exchange Rates
They provide for orderly incremental
adjustment of exchange rates, rather
than large, sudden jumps.
 They help government in conducting
domestic monetary and fiscal policies.

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Disadvantages of Flexible
Exchange Rates

They allow speculation to cause large
jumps in exchange rates, which do not
reflect market fundamentals.
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Disadvantages of Flexible
Exchange Rates
They allow government to be flexible in
conducting domestic monetary and
fiscal policies.
 Notice that this is an advantage as well
as a disadvantage.

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Flexible Exchange Rates and
Monetary Stability

Proponents argue: why not treat
currency markets like any other market
and let private market forces determine
a currency’s value?
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Flexible Exchange Rates and
Monetary Stability

Opponents argue that flexible exchange
rates allow far too much fluctuation in
exchange rates, making trade difficult.
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Flexible Exchange Rates and
Policy Independence

Flexible exchange rate regimes allow
governments to be flexible in conducting
domestic monetary and fiscal policy.
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Flexible Exchange Rates and
Policy Independence
Some argue that flexible exchange
rates do not provide sufficient discipline
for macro policy.
 They are, however, open to private
speculation.

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Partially Flexible Exchange
Rates
Most nations have opted for a policy,
partially flexible exchange rates, that
stands between these two extremes.
 Sometimes, these are referred to as
“managed” exchange rates or a “dirty”
float.

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Partially Flexible Exchange
Rates

If policy makers believe there is a
fundamental misalignment in a country’s
exchange rate, they allow market forces
to determine it.
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Partially Flexible Exchange
Rates

If they believe the currency’s value is
falling because of speculation, they step
in and fix the exchange rate, either
supporting or pushing down their
currency’s value.
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Partially Flexible Exchange
Rates

Partially flexible exchange rate regimes
combine the advantages and
disadvantages of fixed and flexible
exchange rates.
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Which View Is Right?
Which view is correct is much in debate.
 In order to decide, it is necessary to go
beyond the arguments and look at the
history of the various regimes.

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The View of Foreign Exchange
Traders

Most foreign-exchange traders feel their
take on the market is better than that of
governments’.
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The View of Foreign Exchange
Traders
When these traders know that
government might enter the market,
they stop focusing on fundamentals and
switch to trying to guess what the
regulators will do.
 Such guessing-games tend to
destabilize the market, not stabilize it.

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The View of Central Banks
Economists

Economists at central banks maintain
that government intervention helps to
stabilize currency markets.
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Monetary Union in North
America
Should Canada and the United States
adopt a common currency?
 Twelve members of the European Union
replaced their national currencies by
euro – a common currency in Europe.

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Monetary Union in North
America

Possible options for North America:
 Moving
back to fixed exchange rates.
 Creating a new North American currency
(the amero).
 Adopting the U.S. dollar.
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Fixed Exchange Rates
Fixing the value of the Canadian dollar
to the U.S. dollar makes sense from a
practical stand-point.
 There are potential benefits and costs of
such an action.

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Fixed Exchange Rates

Benefits:
A
fixed exchange rate would force
Canadian firms to be competitive - Steady
decline in the value of the Canadian dollar
has postponed cost-cutting decisions of
firms, as Canadian products became
relatively cheap.
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Fixed Exchange Rates

Costs:
 Any
advantages of a flexible rate vis-à-vis
other nations would be lost.
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A New Currency
If a common currency could be agreed,
we have to decide the rate at which the
two economies would enter the
monetary union.
 Which central bank gets to determine
monetary policy?

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A New Currency

A common currency is beneficial when
 states
respond in similar fashion to
disturbances
 An economy is relatively open.
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Adopting the U.S. Dollar

As long as Canada benefits from a
separate currency and floating
exchange rate, it is not feasible to
consider either the adoption of a
common currency, nor adoption of the
U.S. dollar.
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Adopting the U.S. Dollar

Canadian and U.S. economy differ in
important aspects - Canada is a net
exporter of primary commodities. As
such, it benefits from a flexible
exchange.
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Trade Policy

Trade policy involves government
creating trade restrictions on imports in
order to meet the balance of payments
constraint without using traditional
macro policy or exchange rate policy.
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Trade Policy

Economists generally oppose such
trade restrictions.
 They
prevent competition.
 They lower world welfare.
 They lead other countries to retaliate.
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Varieties of Trade Restrictions
The most common trade restrictions are
tariffs and quotas.
 Other trade restrictions are voluntary
restraint agreements, embargoes,
regulatory trade restrictions, and
nationalistic appeals.

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Tariffs

Tariffs, also called customs restrictions,
are taxes governments place on
internationally traded goods—generally
imports.
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Tariffs
Tariffs are the most-used and mostfamiliar type of trade restriction.
 Tariffs operate in the same way a tax
does.

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Tariffs

They make imported goods relatively
more expensive than they otherwise
would have been and thereby
encourage the consumption of
domestically produced goods.
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The Impact of Tariffs on
Imported Goods, Fig. 16-3, p403
S1
Price of
imported
goods
P1
S0
Tariff
P0
D0
Q1
Q0
Quantity of
imported goods
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Tariffs

International organizations promoting
free trade:
 The
General Agreement on Tariffs and
Trade (GATT) – a regular international
conference to reduce trade barriers.
 World Trade Organization (WTO) - a
successor to GATT.
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Quotas
Quotas are quantity limits placed on
imports.
 Quotas differ from tariffs in the
distribution of revenue.
 Foreign producers prefer quotas to
tariffs.

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Quotas
In a tariff, the government receives the
tariff payment.
 In a quota, revenues accrue as
additional profits to producers of the
protected good.

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Quotas
With quotas, an increase in domestic
demand will be met by the less-efficient
domestic producers.
 Under a tariff, part of any increase in
domestic demand will be met by moreefficient foreign producers.

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Voluntary Restraint
Agreements
To avoid imposing new tariffs on their
goods, countries often enter into
voluntary restraint agreements.
 Voluntary restraint agreements are
those in which countries voluntarily
restrict their exports.

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Voluntary Restraint
Agreements

The effect of voluntary restraint
agreements is the same as the effect of
quotas.
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Voluntary Restraint
Agreements

In the case of the voluntary quotas
imposed on Japanese auto
manufacturers, consumers lost since
they paid higher prices both for
domestic and imported cars.
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Embargoes
An embargo is an all-out restriction on
import or export of a good.
 Embargoes are usually created for
international political reasons rather
than for primary economic reasons.

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Regulatory Trade Restrictions

Regulatory trade restrictions are
indirect methods of imposing
governmental procedural rules that limit
imports.
 An
example: limiting or prohibiting
foodstuffs to be imported if certain
pesticides are used.
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Regulatory Trade Restrictions

A second type of restriction involves
making import and customs restrictions
so detailed and time consuming that
importers simply give up.
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Nationalistic Appeals

Given two products of equal quality and
appeal, Canadians prefer to “Buy
Canadian.”
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Economist Dislike Trade
Restriction Policies
Despite the political popularity of trade
restrictions, most economists support
free trade.
 A free trade policy allows unrestricted
trade among countries.

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Economist Dislike Trade
Restriction Policies

Trade restrictions lower aggregate
output.
 One
nation benefits while most other
nations are hurt.
 They work only if there is no retaliation,
and retaliation is the rule.
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Economist Dislike Trade
Restriction Policies

Trade restrictions lower international
competition.
 This
competition is necessary to keep
domestic firms on their toes, keeping costs
and prices down.
 Domestic companies become less efficient.
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Economist Dislike Trade
Restriction Policies

They often result in harmful trade wars
that hurt everyone.
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Strategic Trade Policies
Strategic trade policies are threats to
implement tariffs to bring about a
reduction in tariffs or some other
concession from the other country.
 The threats must be credible.

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International Trade
Agreements Affecting Canada

Those are:
 The
Canada-U.S. Free Trade Agreement
(FTA)
 The North American Free Trade
Agreement (NAFTA)
 Free Trade Areas of the Americas (FTAA)
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The Canada-U.S. Free Trade
Agreement (FTA)
FTA was signed in 1987, and it came
into effect in 1989.
 It set into motion a process that
removed most tariff and non-tariff
barriers between the two countries over
a 10-year period.

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The Canada-U.S. Free Trade
Agreement (FTA)

Who are the winners and losers of tariff
reduction?
 The
elimination of tariffs would decrease
domestic price, benefiting consumers.
 Some high-cost firms will have to leave the
industry, and domestic production will
decline.
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The Benefits of Tariff
Reduction, Fig. 16-4, p 408
P
S
PT
A
PW
B
D
Q1
Q2
Q3 Q4
Q
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The North American Free
Trade Agreement (NAFTA)
In 1993 Canada, U.S. and Mexico
signed the North American Free Trade
Agreement (NAFTA).
 It extended the FTA to eliminate other
impediments to international trade.
 Among other goals, it promoted free
trade in services.

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The North American Free
Trade Agreement (NAFTA)
NAFTA brought as many critics as the
FTA.
 The critics believed that Canadian
economy will be “Americanized”.

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Free Trade Areas of the
Americas (FTAA)
Free Trade Areas of the Americas
(FTAA) agreement includes all
economies of the Americas.
 The problem with free trade is that it is
not necessarily a fair trade, so some
observers believe that rich nations may
be dictating the terms and taking
advantage of the small developing
nations.

© 2003 McGraw-Hill Ryerson Limited.
Open Economy Macro:
Exchange Rate And Trade
Policy
End of Chapter 16
© 2003 McGraw-Hill Ryerson Limited.