Chapter 35
Exchange Rates &
The Balance of Payments
The Balance of Payments
-balance of payments (BOP) accounts record a
summary of a country's transactions with the rest
of the world
-each transaction either involves the receipt of
funds to Canada or the payment of funds by
Canada
-divided into 3 “accounts”
The Current Account (CA)
-all transactions related to current obligations are
capture in two sections:
CA =
Trade Account Balance (NX = X – IM)
= + receipts from the export of goods and
services
– payments made for the import of goods and
services
+ Capital-Service Account Balance (R)
= + “investment” income and direct transfers
paid to Canadians by foreigners
– “investment” income and direct transfers
paid to foreigners by Canadians
The Capital Account (KA)
-intern’l transactions involving asset holdings
KA =
+ net change in foreign owned Canadian assets
– net change in Canadian owned foreign assets
-direct investment is the purchase of real assets
and changes in position that involves control
-portfolio investment other financial “investments
-Canadian purchases of foreign assets is referred
to as capital outflow
-Canadian assets purchased from abroad is
referred to as capital inflow
The Official Financing Account (OF)
-or official settlements account
-records transactions in the official reserves held
by the central bank in the form of foreign
currencies and bonds denominated in foreign
currencies
-increases are a minus item ($C leaving to pay
for these assets)
-decreases are a plus item ($C coming in as
these assets are sold)
-usually included as part of the capital account
since it involves assets
-since the BofC does not systematically buy or
sell foreign reserves this amount is small and we
will treat it as essentially zero.
The Balance of Payments Must Balance
BOP = CA + KA = 0
Why?
-because every unit of currency bought across a
border (really “exchanged for another currency”)
is also a unit of currency sold across a border
-any transaction in the BOP leads to both a credit
item and an equal-value debit item
-this is an accounting identity – must always hold
-the overall balance of payments always balances,
but the individual components do not have to
-if any of the accounts is in deficit, there must be
an offsetting surplus on the other(s)
EXAMPLE:
-suppose a Canadian wants to buy $100 C worth
of foreign currency to buy an import
-if successful this transaction would lead to
reduction in the current account of $100 C
-that is, ∆CA = –100.
-but where can the Canadian get the $100 C worth
of foreign currency?
-there are two possibilities:
1. from a foreigner who wants $100 C to buy
a Canadian export or make an income
payment or transfer to a Canadian
-leads to an offsetting change in the
current account, ∆CA = +100.
2. from a foreigner who wants $100 C to buy
a Canadian asset
-leads to an offsetting change in the
capital account, ∆KA = +100.
-for another example of this line of reasoning see
Applying Economic Concepts 35-1 which looks
at an individual’s BOP with the world
A Balance of Payments Deficit
-since the BOP always balances, what does it
mean when you hear that a country has a “BOP
deficit”
-what it really means is that the central bank in
the country is selling foreign currency reserves
-the opposite is true for a “BOP surplus”.
-sometimes “BOP deficit” only means that the
country has a current account deficit
The Foreign Exchange Market
-trade between countries generally requires the
exchange of one country's currency for another
country's currency
-the exchange rate is simply a price, the rate at
which one currency trades for another
domestic $
e=
foreign $
EXAMPLE: $1.25C/$US rather than the more
commonly reported $0.80US/$C
-an increase in e is a depreciation of the Canadian
dollar (our dollar loses value)
-a decrease in e is an appreciation of the Canadian
dollar (our dollar gains value)
-the foreign exchange market functions just like
any other market: the equilibrium exchange rate is
determined by the forces of supply and demand
Supply of Foreign Exchange
-why would a holder of foreign currency supply it
in “exchange” for the domestic currency?
1. wants to purchase Canadian goods or
services
2. needs to pay a Canadian some “investment
income” or wants to make a direct transfer to
a Canadian
(current account reasons)
3. wants to purchase Canadian assets
(capital account reasons)
4. wants to increase holdings of Can $ as a
currency reserve (ex, foreign central bank)
(foreign official financing account reasons)
Supply Curve of Foreign Exchange
-add up all the “supplies” above
-hold all other factors constant and vary e
-the supply curve is positively sloped when it is
plotted against the exchange rate
-an increase in e (depreciation) causes the
quantity of foreign exchange supplied to
increase – why?
-an increase in e makes Canadian goods and
assets cheaper for foreigners to buy
-need $C to make these purchases so they
supply more of their currency in exchange
Demand for Foreign Exchange
-why would a holder of domestic currency
demand foreign currency in “exchange” for the
domestic currency?
-same reasons discussed above, but in reverse
Demand Curve for Foreign Exchange
-add up all the “demands”
-hold all other factors constant and vary e
-the demand curve is negatively sloped when it is
plotted against the exchange rate
-an increase in e (depreciation) causes the
quantity of foreign exchange demanded to
decrease – why?
-an increase in e makes foreign goods and
assets more expensive for Canadians to buy
-need less foreign currency to make these
purchases so they demand less of the
foreign currency
Determination of Exchange Rates
Flexible Exchange Rate Regime
-the domestic central bank does not systematically
buy or sell currency in the foreign exchange
market (OF = 0)
-equilibrium in this regime occurs at the exchange
rate where the supply and demand for foreign
exchange are equal, just like in any other
competitive market
Exchange
Rate (e)
S
e*
D
Quantity of Foreign Currency
Fixed Exchange Rate Regime
-the central bank systematically buys or sells
currency in the foreign exchange market to
maintain the exchange rate at a predetermined rate
-note that we did not include the actions of the
domestic central bank in our definitions of supply
and demand
ef > e*
-in the absence of intervention, would imply
excess supply of foreign currency
-central bank must “demand” or buy this
amount or e will fall
(adds to its foreign currency reserves)
ef < e*
-in the absence of intervention, would imply
excess demand for foreign currency
-central bank must “supply” or sell this
amount or e will rise
(reduces its foreign currency reserves)
Exchange Rate Changes
-changes in flexible exchange rates are brought
about by shifts in either the demand or supply
curve for foreign exchange
e
S
e*
D
Quantity of Foreign Currency
-some of the events that can influence equilibrium
e affect only supply or demand
-but some affect both, but in fairly predictable
ways
Increase in costs in domestic export industries
-this will result in an increase in the price of those
exported goods
-if % ↓ Q < % ↑ P total value of exports rises
so supply of foreign exchange shifts right, e ↓
(inelastic foreign demand for exports)
-if % ↓ Q > % ↑ P total value of exports falls
so supply of foreign exchange shifts left, e ↑
(elastic foreign demand for exports)
Changes in “world” prices for domestic exports
-that is, a demand induced export price change
-supply of foreign exchange shifts in the same
direction as world price change
-generates the change in e
(Canadian dollar as a “petro-currency”?)
Changes in prices for domestic imports
-suppose there is an increase in the price of
imported goods
-if % ↓ Q < % ↑ P total value of imports rises,
demand for foreign exchange shifts right, e ↑
(inelastic domestic demand for imports)
-if % ↓ Q > % ↑ P total value of imports falls,
demand for foreign exchange shifts left, e ↓
(elastic domestic demand for imports)
Changes in overall price levels
-captured by comparing the domestic inflation
rate (π) with the foreign inflation rate (πf)
π > πf
π = πf
π < πf
-both S + D for foreign exchange affected
Short –term capital movements
r < rf
-capital outflow
r > rf
-capital inflow
-both S + D for foreign exchange affected
Long –term capital movements
-depend on long-run profit opportunities
-that is, the long-run rate of return to capital
Long –term structural change
-changes in trade patterns will generally generate
exchange rate changes
Three Policy Issues
Current Account Deficits or Surpluses
-reports that Canada’s current account has
“deteriorated” or “improved” (meaning that the
current account balance has fallen or risen) imply
that higher current account balances are good
-but a current account deficit is not a bad thing in
and of itself
-a current account deficit just implies a capital
account surplus
-whether a capital account surplus is good or bad
depends on the source of the surplus
Causes of CA deficits (KA surpluses)
-some national income accounting
-if we denote the capital service account balance
as R
GNP = GDP + R
= C + I + G + NX + R
= C + I + G + CA
-but, GNP = C + Sp + T
(must do something with the money)
-so,
C + I + G + CA = C + Sp + T
Æ CA = (Sp – I) + (T – G)
-or,
CA = Sp + Sg – I
-or,
Sp + Sg – CA = I
-or,
Sp + Sg = I + CA
-or,
Sp + Sg + KA = I
The “Correct” Value for the Canadian Dollar
-commentators often argue that the Canadian
dollar is “overvalued” or “undervalued”
-implication seems to be that there is
something wrong with the operation of the
foreign-exchange market
-Purchasing Power Parity (PPP) holds that a unit
of currency should be able to purchase the same
amount of goods everywhere
-otherwise arbitrage opportunities exist
-PPP predicts that in the long-run the exchange
rate between the euro and the Canadian dollar
should satisfy:
PC = e × PE
where PC denotes the price level in Canadian
dollars, PE denotes the price level in euros
-PPP does not hold in general due to the existence
of non-traded goods like services and the fact that
substitutes across border are generally imperfect
-long-run predictor of where e is going?
Should Canada Have a Fixed Exchange Rate?
-some people argue that exchange rate
fluctuations increase the costs of international
trade by creating uncertainty and advocate fixing
the Canadian dollar to the U.S. dollar
-those who argue for adhering to a flexible
exchange rate regime note that a country will
always experience shocks to its terms of trade
-a flexible exchange rate absorbs some of the
shock and reduces the impact on output and
employment
-a fixed exchange rate would simply redistribute
the effect of the shock – the exchange rate would
be smoother but output more volatile
-also, if the exchange rate is fixed, the BofC
would have to conduct its monetary policy in
order to fix the currency
-would be buying and selling foreign currency
(adjusting the domestic money supply at the
same time) with this in mind, rather than
pursuing its current inflation targeting policy
-contractionary AD shock (due to a terms of trade
shock or anything else)
P
LRAS
SRAS
ADo
AD1
Y*
-but
Y
↓ PY shifts MD down
Æ decrease in r
Æ depreciation of e
Æ increase in NX
Æ AD shifts back partway
(or in a small open economy all the way)