Balance of Payments
Balance of payments,
floating exchange rate equilibria,
Accounting mechanisms
July 17, 2016
Balance of Payments
1
Balance of Payments
BOP   X  M   CI  CA
Balance of Trade
Capital Account
Reserve account
Financial account
FI  FO  FXB
July 17, 2016
Balance of Payments
2
Cash flows
 For example: the Balance of Trade
(Current account)
 BOT = X – M
 P
T
BOT 
t 1
July 17, 2016
x , cd , t
 Qx , t  ecd , usd , t  Pm, usd , t  Qm, t
Balance of Payments
3

Exchange rate equilibirum
 Demand for the dollar
 all foreigners buying Canadian
 all Canadians selling foreign assets
 Supply of the dollar
 Canadians buying foreign goods and services
 foreigners selling Canadian assets
 Where demand equals supply
 Equilibrium price (Exchange Rate) and Quantity
July 17, 2016
Balance of Payments
4
Equilibrium
S1
usd/cd
eo, 0, cd
D1
Qo, cd
July 17, 2016
Balance of Payments
Qcd
5
Demand for the dollar(Credits)
 Exports (X)
 British buying Canadian goods
 Germans vacationing in Newfoundland
 Capital inflows – real assets (CI)
 Walmart buying out Woolco
 Toyota building a plant in
 Financial inflows – financial assets (FI)
 US investors buying Canadian Imperial, Vulcan
 Germans buying NF CD denominated bonds
July 17, 2016
Balance of Payments
6
Supply of the dollar (Debits)
 Imports (I)
 Buying Sonys
 Spending a week at Disneyworld
 Canadians spending six months of the year in
Texas
 Capital Outflows – real assets (CO)
 Inco buying a property in Indonesia
 Couple retiring to Florida buying a condo there
 Financial Outflows - financial assets (FO)
 Buying shares in Microsoft
 Buying euro denominated bonds
July 17, 2016
Balance of Payments
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Current account –
balance of trade (BoT)
 goods
 value of exports of goods - imports of goods
 services
(communications, information, financial)
 value of exports of svcs - imports of svcs
 net income transfers
 interest & dividends pd on foreign investments
 pensions pd to Canadians living overseas
 transfers (sending checks to E. Europe)
July 17, 2016
Balance of Payments
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Balance of Trade
2001
2002
2003
2004
2005
BOT
62,850
50,088
44,416
50,312
51,132
Goods
70,659
57,311
56,262
65,482
64,850
Svcs
-7,809
-7,224
-11,846
-12,717
-13,718
July 17, 2016
Balance of Payments
9
Capital Account
 transactions to non-financial and nonproduced assets
 debt forgiveness
 transfer of goods and financial assets by
migrants leaving or entering a country
 transfer of ownership on fixed assets
 transfer of funds received to the sale or
acquisition of fixed assets
 gift and inheritance taxes, death levies,
patents, copyrights, royalties, and
uninsured damage to fixed assets.
July 17, 2016
Balance of Payments
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Financial account
 foreign direct investment
 investment in real assets
 portfolio investment
 equities
 debt
 intangibles
 patents, leases, goodwill
 errors and omissions
July 17, 2016
Balance of Payments
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Capital inflows – capital outflows
Financial Account
 Capital inflows
 Foreign direct investment in Canada
 Foreign portfolio investment in Canada
 Other investment in Canada
 Capital outflows
 Canadian foreign direct investment
 Canadian foreign portfolio investment
 Other foreign investment by Canada
July 17, 2016
Balance of Payments
12
Financial Account
2001
2002
2003
2004
2005
Fin Acct
-39,330
-30,297
-29,935
-24,814
-18,811
FDI
-15,875
-7,763
-10,038
-6,812
-4,960
Port
-22,598
-21,945
-20,086
-17,957
-14,548
Other
-857
-589
189
-44
696
July 17, 2016
Balance of Payments
13
Official reserves account
 Central Bank interventions in exchange
markets
 changes in official reserves by buying or
selling





gold, silver
foreign currencies
Foreign denominated debt
Buy or sell options or futures in markets
SDRs (Special Drawing Rights at IMF)
July 17, 2016
Balance of Payments
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Balance of payments
 Assume BOP > 0
 Canadians are selling more abroad than they are
buying
 Goods, services
 Capital goods
 Financial goods
 If exchange rates are allowed to seek an
equilibrium (floating exchange rates)
 Supply of the Canadian dollar increases in
exchange markets
 The exchange rate will adjust to accommodate
imbalance
July 17, 2016
Balance of Payments
15
Effects of BOP
 Fixed exchange rates
 CB uses FXB to bring BOP = 0
 Floating exchange rates
 CB ignores BOP
 The exchange rate will adjust to
accommodate imbalance
 CB may intrude into the exchange
market to reduce volatility
July 17, 2016
Balance of Payments
16
Exchange rate equilibrium
 Demand for the dollar
 all foreigners buying Canadian
 all Canadians selling foreign assets
 Supply of the dollar
 Canadians buying foreign goods and services
 foreigners selling Canadian assets
 Where demand equals supply
 Equilibrium price (Exchange Rate) and Quantity
July 17, 2016
Balance of Payments
17
Equilibrium
S1
usd/cd
eo, 0, cd
D1
Qo, cd
July 17, 2016
Balance of Payments
Qcd
18
Demand for the dollar(Credits)
 Exports (X)
 British buying Canadian goods
 Germans vacationing in Newfoundland
 Capital inflows – real assets (CI)
 Walmart buying out Woolco
 Toyota building a plant in
 Financial inflows – financial assets (FI)
 US investors buying Canadian Imperial, Vulcan
 Germans buying NF CD denominated bonds
July 17, 2016
Balance of Payments
19
Supply of the dollar (Debits)
 Imports (I)
 Buying Sonys
 Spending a week at Disneyworld
 Canadians spending six months of the year in
Texas
 Capital Outflows – real assets (CO)
 Inco buying a property in Indonesia
 Couple retiring to Florida buying a condo there
 Financial Outflows - financial assets (FO)
 Buying shares in Microsoft
 Buying euro denominated bonds
July 17, 2016
Balance of Payments
20
BOP surplus from the Canadian
perspective
 US consumers buying more Canadian stuff
 Demanding cd with which to buy Canadian stuff
 free float allows a new equilibrium
 usd price of the cd increases
 cd appreciates
 US goods lower in price to Canadians
 usd depreciates
 Canadian goods higher in price to the U.S.
 Corrects BOP imbalance, so that BOP
approaches 0
July 17, 2016
Balance of Payments
21
Excess Demand for cd
S1
usd/cd
en, 0, cd
eo, 0, cd
D2
D1
Qo, cd
July 17, 2016
Qn, cd
Balance of Payments
Qcd
22
BOP deficit from US perspective
 US consumers buying more Canadian
stuff
 Supplying usd into the market to buy cd
 free float allows a new equilibrium
 cd price of the usd decreases
 cd appreciates
 US goods lower in price to Canadians
 usd depreciates
 Canadian goods higher in price to the U.S.
 Corrects BOP imbalance, so that BOP
approaches 0
July 17, 2016
Balance of Payments
23
Excess Supply of usd
S1
cd/usd
S2
eo, 0, usd
en, 0, usd
D1
Qo, usd Qn, usd
July 17, 2016
Balance of Payments
Qusd
24
Benefits of
floating exchange rates
 International prices adjust instantaneously
 With Canadian dollar appreciation
 Canadian stuff more expensive internationally
 cd more expensive in terms of other currencies
 International prices decrease for Canadians
 In the future the BOP should approach zero
 Foreign demand for Canadian stuff decreases
 Domestic demand for foreign stuff increases
July 17, 2016
Balance of Payments
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Depreciation
 Negative aspects of depreciation
 Creates image that the currency is weak
 Canadian dollar has depreciated nearly 40% in
the last decade
 Imports become more expensive
 Positive aspects of depreciation
 Exports become cheaper to foreigners
 Central bank may try to fix the exchange
rate
 Keep the trend line of the exchange rate flat
July 17, 2016
Balance of Payments
26
Appreciation
 Negative aspects of appreciation
 Impacts exports as exports are more
expensive to foreigners
 Positive aspects of appreciation
 Imports become cheaper
 Central bank may try to fix the
exchange rate
 Keep the trend line of the exchange rate
flat
July 17, 2016
Balance of Payments
27
Trend & volatility
e


T
July 17, 2016
Balance of Payments
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Trend & volatility
 The red line represents observed exchange
rates
 The brown line represents a minimum least
squares regression of the observed
exchange rates
^
e cd , t      t
 Volatility is estimated by the standard error
of estimate of the observed values from
those predicted by the regression line
July 17, 2016
Balance of Payments
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Reasons given for intervention
 Alter the trend, reduce beta, long-run policy
 Fix exchange rates in some fashion
 Positive aspects



Maintain international prices relatively constant
Reduce the need to hedge exchange rate risk
Maintain “Strong Currency”
 Negative aspects


Can only affect trend in the short run
Eventually results in a very steep adjustment
 Reduce volatility
 Reduces the cost of hedging, volatility and bid-ask
spread are directly related
 Short-run policy
July 17, 2016
Balance of Payments
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Intervention
S1
S2
usd/cd
B of C
buys usd
with cd
en, 0, cd
eo, 0, cd
D2
D1
Qo, cd
July 17, 2016
Balance of Payments
Qn, cd
Qcd
31
Intervention
 If FXB = 0, then BOP > 0, exchange rates adjust
 Bank of Canada accommodates
 FXB = X – M + CI – CO + FI – FO,
pushes BOP toward 0
 Buys up excess usd in the market, no change in
exchange rate
 Underlying cause for BOP surplus not fixed in
short run
 Canadian prices are still too low internationally
 Domestic consequences
 BOC has increased base money, inflationary pressure
 Bank of Canada can chose to sterilize or not
July 17, 2016
Balance of Payments
32
Unsterilized Intervention
Bank of Canada balance sheet
 gold
 silver
 cd denominated
t-bills
 foreign currency
denominated t-bills
 cash
 currency
 chartered bank
reserves held at
the Bank of
Canada
Bof C buys US dollars
as an asset
Canadian dollar
liability increases
July 17, 2016
Balance of Payments
33
Domestic Affects of an
Unsterilzed Intervention
 Base money increases by amount of
purchase
 pressure exerted on prices to
increase
 Long-run, inflation in the economy
 Canadian goods more expensive to
Canadians
 Canadian goods more expensive to
foreigners
 Long-run, balance of payments adjusts
July 17, 2016
Balance of Payments
34
Foreign Affects of an
Unsterlized Intervention
 short run
 exchange rate is not allowed to adjust
 long run
 higher Canadian inflation
 US goods cost relatively less to Canadians
 Canadian goods cost relatively more to US
consumers
 Long-run, Canadian prices adjust, BOP
adjusts
July 17, 2016
Balance of Payments
35
Sterilized Intervention
Bank of Canada balance sheet
 gold
 silver
 cd denominated tbills
 foreign currency
denominated t-bills
 cash
 currency
 chartered bank
reserves held at
the Bank of
Canada
Bof C buys US
dollars as an asset
B of C sells equal
value in other assets
July 17, 2016
Balance of Payments
No increase in
B of C liabilities
36
Domestic Affects of an
Sterilzed Intervention
 Base money remains constant
 prices remain constant
 Both domestic and foreign prices remain the
same
 BOP pressures exacerbated
 Canadian prices too low in real terms
 International prices too high in real terms
 Canadian dollar undervalued
 Continual intervention required by the Bank
of Canada
July 17, 2016
Balance of Payments
37
Foreign Affects of an
Sterlized Intervention
 short run
 exchange rate is not allowed to adjust
 From their point of view, BOP deficits continue
 Interventions continue
 long run
 pressure continually increases on exchange rate to
appreciate
 BOT deficit remains
 eventually the cd price of the usd will increase
 Finally there is a large scale revaluation
 Firms cannot adjust slowly to small price changes
 Firms now must adjust to a large-scale price change
July 17, 2016
Balance of Payments
38
Depreciation
 Negative aspects of depreciation
 Creates image that the currency is weak
 Canadian dollar has depreciated nearly 40% in
the last decade
 Imports become more expensive
 Positive aspects of depreciation
 Exports become cheaper to foreigners
 Central bank may try to fix the exchange
rate
 Keep the trend line of the exchange rate flat
July 17, 2016
Balance of Payments
39
Appreciation
 Negative aspects of appreciation
 Impacts exports as exports are more
expensive to foreigners
 Positive aspects of appreciation
 Imports become cheaper
 Central bank may try to fix the
exchange rate
 Keep the trend line of the exchange rate
flat
July 17, 2016
Balance of Payments
40