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Chapter 9: The Exchange Rate and the Balance of Payments The Foreign Exchange Market: - Goods bought internationally use the currency of the country they are bought from

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money of other countries regardless of what form the money is in (Notes, coins, bank deposits) - Foreign Exchange Market is where currency of one country is exchanged for currency of another country o The market consists of thousands of people including importers, exporters, banks, international investors and speculators, international travellers, and specialist traders (foreign exchange brokers) Exchange Rates:

- Exchange rate is the price at which one currency exchanges for another currency in the foreign exchange market

- In 2017, one Canadian Dollar could buy 87 Japanese Yen – the exchange rate was 87 yen per dollar

- The exchange rate fluctuates up and down o Rises in the exchange rate is called appreciation of the dollar o Falls in the exchange rate is called depreciation of the dollar o When the exchange rate rises from 87 yen to 90 yen per dollar, the dollar appreciates against the yen An Exchange Rate is a Price:

- An exchange rate is a price – it is the price of one currency in terms of another

- Since there are many traders without any restrictions, the foreign exchange market is a competitive market (Supply and demand influence the prices)

- The demand for one money is the supply for another money o To exchange Canadian Dollars for Japanese Yen, you demand Yen and are supplying Dollars Demand in the Foreign Exchange Market: - The quantity of Canadian dollars demanded in the foreign exchange market is the amount that traders plan to buy during a given time period at a given exchange rate - Depends on four factors: o The exchange rate

o o o

World Demand for Canadian exports Interest rates in the United States and other countries The expected future exchange rate

- Factor 1: The Exchange Rate: o Other things remaining the same, the higher the exchange rate, the o o

smaller quantity of Canadian dollars dema ed If the market price of the dollar rises from 100 yen to 120 yen, quantity demanded decreases The exchange rate influences the quantity of Canadian dollars demanded for two reasons:

▪ Exports Effect: • The larger the value of Canadian exports, the higher the quantity of Canadian dollars demanded

• Value of exports depends on the price of goods and services expressed in the currency of the foreign buyer

• These prices depend on the exchange rate • Therefore, a lower exchange rate (and in turn, prices), the greater the volume of Canadian exports – the increased quantity of Canadian dollar demanded

▪ Expected Profit Effect: • If the future expected profit of holding a currency is high, •

the quantity of that currency demanded right now will increase For a given expected future exchange rate, the lower the exchange rate is today, the higher expected profit in the future

- Factor 2: World Demand for Canadian Exports o An increased world demand for Canadian exports increases the demand for Canadian dollars

- Factor 3: Canadian Interest Rate relative to the Foreign Interest Rate o People and businesses buy financial assets to make a return o The higher the i e on Canadian assets o o

compared with foreign assets, the more Canadian assets they buy What matters here is the Canadian interest relative to the foreign interest rate Canadian Interest Rate Differential = Canadian Interest Rate – Foreign Interest Rate

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The gr e, the greater is the demand for Canadian assets and Canadian dollars

- Factor 4: The Expected Future Exchange Rate o If the expected future exchange rate is higher, demand to hold the dollar today es Demand Curve for Canadian Dollars:

- Higher exchange rate = less quantity of Canadian dollars demanded - Lower exchange rate = more quantity of Canadian dollars demanded

Changes in the Demand for Canadian Dollars:

Supply in the Foreign Exchange Market:

- The quantity of Canadian dollar supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.

- The quantity supplied depends on four factors: o The Exchange Rate o Canadian demand for imports o Interest rates in the United States and other countries o The expected future exchange rate - Factor 1: The Exchange Rate: o The h xchange rate, the increased quantity of Canadian o o

dol upplied If the exchange rate rises from 100 yen to 120 yen per Canadian dollar, the quantity of Canadian dollar supplied increases The exchange rate influences quantity supplied for two reasons:

▪ Imports Effect: • The volume of imported goods and services from other • •

countries depends on how much the Canadian dollar can buy If the exchange rate is higher, the – the lowe goods Incentivized by this, people exchange the Canadian dollar for foreign currency – q s

▪ Expected Profit Effect:

• The higher the exchange rate is today, the larger the •

expected profit from selling Canadian dollars today and holding foreign currencies This selling leads to in d

- Factor 2: Canadian Demand for Imports o If the demand for imports increases, the supply of Canadian dollars increase

- Factor 3: Canadian Interest Rate relative to the Foreign Interest Rate o Opposite of demand – with a higher Canadian interest rate differential, people hold the Canadian dollar and do not buy foreign currency

- Factor 4: The Expected Future Exchange Rate o If the future exchange rate is lower, people will sell, and the quantity supplied increases Supply Curve for Canadian Dollars: - Higher exchange rate = rise in the quantity supplied

- Lower exchange rate = fall in the quantity supplied

Changes in the Supply of Canadian Dollars

Market Equilibrium:

- High exchange rate = surplus of dollars - Low exchange rate = shortage of dollars

- The foreign exchange market is constantly pulled towards its equilibrium by foreign exchange traders trying to sell high and buy low Arbitrage, Speculation, and Market Fundamentals: Arbitrage: - The practice of seeking to profit by buying in one market and selling for a higher price in another related market

- Arbitrage achieves the following outcomes: o The Law of one price o No round-trip profit o Interest rate parity o Purchasing power parity - The Law of One Price: o e: if an item is traded in more than one place, the o o

price will be the same in all locations If there is a discrepancy in prices – in London the exchange rate is 0.60 UK pounds per dollar and in Toronto the exchange rate is 0.61 UK pounds per dollar Within a few seconds, the demand for UK pounds increases in London and the supply of UK pounds increase in Toronto

▪ The arbitrage raises the exchange rate - No Round-Trip Profit: o Round Trip: Using Currency A to buy Currency B, and then using o

Currency B to buy Currency A Arbitrage removes profit from all transactions of this type

- Interest Rate Parity: o Equal rate of return on assets in different currencies - Purchasing Power Parity (PPP): o The prices in two countries are equal when converted at the exchange o

rate If goods cost more in one country – that good is usually overvalued

o

▪ A deprecation of currency would restore PPP If goods cost less in one country – that good is usually undervalued ▪ An appreciation of currency would restore PPP

Speculation:

- Speculation: Trading on the expectation of making a profit o Contrasts with arbitrage (trading on the certainty of making a profit) - The Expected Future Exchange Rate: o Unique in Three Ways: ▪ Exchange rate forecasts are hedged with uncertainty ▪ There are many divergent forecasts ▪ Forecasts influence the outcome

- Exchange Rate Volatility: o Exchange rate is very volatile – is influenced by news on the o o

expected future exchange rate Makes day-to-day changes impossible to predict

But long term trends are more predictable and depend on market fundamentals Market Fundamentals:

- The market fundamentals that determine the exchange rate in the long -

run are the real exchange rate and the quantities of money in each economy Three market fundamentals that influence the exchange rate are world demand for Canadian exports, Canadian demand for imports, and the C al

- The Real Exchange Rate: o Relative price of Canadian produced goods and services to foreign o o o o o o o o

produced goods and services Long Run: The exchange rate is determined by the demand and supply in the markets for goods and services It is a measure of real GDP of other countries that a unit of Canadian real GDP buys RER = (E x P) / P* E = Exchange Rate P = Canadian Price Level P* = Other Country Price Level Equation can also be expressed as: E = (RER X P*) / P

▪ Nominal Exchange rate is determined by the quantity of money in two countries

- The country with the appreciating currency has the lower inflation rate Exchange Rate Policy: - There are three exchange rate policies: o Flexible exchange rate

o o

Fixed exchange rate Crawling peg

- Flexible Exchange Rate: o Exchange rate that is determined by supply and demand in the foreign exchange market with no direct intervention by the central bank

o

Can still be influenced by the central bank raising interest rates while foreign countries maintain the same rates

- Fixed Exchange Rate: o An exchange rate with a value that is determined by a decision of the

o o o o

government or the central bank and is achieved by central bank intervention in the foreign exchange market to block the unregulated forces of demand and supply Can be used to control inflation rates because it anchors the currency to the U.S. Dollar (China) If the Bank of Canada wants the exchange rate to be steady, whenever the rate rises above the set amount, the Bank sells dollars, if it falls below the set amount, the Bank buys dollars Same principle with demand – if demand rises, the Bank sells, if demand drops, the Bank buys However, if the demand permanently changes, the fixed exchange rate must be abandoned

▪ If it rises – eventually the bank would stop buying foreign currency because the stockpile has risen too high

▪ If it lowers – the bank would eventually run out of foreign currency reserves needed to buy the Dollar

- Crawling Peg:

o

An exchange rate that follows a path determined by a decision of the government or the central bank and is achieved in a similar way to a fixed exchange rate o The peg seeks to prevent large swings in the expected future exchange rate that change demand and supply and make the exchange rate fluctuate too wildly o China operates a crawling peg by buying and selling U.S. dollar reserves Financing International Trade: Balance of Payments Accounts: - Records its international trading, borrowing, and lending in three accounts: o Current account o Capital and financial account

o

Official settlements account

- Current Account: o Records: ▪ Receipts from exports of goods and services sold abroad ▪ Payments for imports of goods and services from abroad ▪ Net interest income paid abroad ▪ Net transfers abroad (foreign aid payments) o The current account balance equals the sum of exports – imports, net -

interest income, net transfers Capital and Financial Account: o Records:

▪ Foreign investment in Canada – Canadian investment abroad + o o

Statistical Discrepancy This account has a statistical discrepancy that arises from errors and omissions in measuring international capital transactions Tells us how much we borrowed from the rest of the world

- Official Settlements Account: o Records: ▪ The change in Canadian Official Reserves (Government holdings o

of foreign currency) If Canadian Official Reserves increase, the official settlements account balance is negative

▪ This is because holding foreign money is like investing abroad ▪ Canadian investment abroad is a minus item in the capital and

financial and in the official settlements account

o - To pay for our current account deficit, we must either borrow more from abroad than we lend abroad or use our official reserves to cover the shortfalls

- The capital and financial account balance + the current account balance = the change in the Canadian official reserves

An Individual’s Balance of Payments Accounts

- An individual’s current account records: o Income from supplying the services of factors of production o Expenditure on goods and services

Borrowers and Lenders:

- Net Borrower: a country that is borrowing more from the rest of the world than it is lending to it

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a country that is lending more to the rest of the world than it is borrowing from it

- Most countries are net borrowers - International borrowing and lending takes place in the global market for loanable funds The Global Loanable Funds Market:

- DLFw is the demand for loanable funds in the global loanable funds market - DLFs is the demand for loanable funds in the global loanable funds market o Where these two curves meet is the world equilibrium real interest rate

- An International Borrower:

o o

If the country was isolated from the global market, the real interest rate would be 6% a year (Where SLFd and DLFd intersect) But, if the country is integrated into the global economy, with an interest rate of 6% a year, funds would flood into it

▪ Since the real interest rate is 5% a year in the global market, suppliers of loanable funds would seek the higher return in the country The shortage is made up through net foreign borrowing

o - An International Lender:

o

In the global economy, with an interest rate of 4% a year, funds would quickly flow out of it o People want to lend more than domestic borrowers demand – leads to net foreign lending Debtors and Creditors:

- Debtor Nation: a country that during its entire history has borrowed more from the rest of the world than other countries have lent it

- Creditor Nation: a country that during its entire history has invested more in the rest of the world than other countries have invested in it

- Canada mainly borrows to finance private and public investment that will increase productivity, the borrowing does not go towards consumption Current Account Balance (CAB): - CAB = Net Exports (NX) + net interest income + Net transfers o Net exports is the largest and fluctuates the most, the other two are usually small/similar Net Exports:

- Net Exports = Exports – Imports - Government Sector Balance = Net Taxes – Government Expenditure o If this number is positive, a government sector surplus is lent to other o o

sectors If this number is negative, a government deficit must be financed by borrowing from other sectors The Government sector deficit is the sum of the deficits of the Bank of Canada, provincial, and local governments

- Private Sector Balance = Saving – Investment o The Private Sector Balance and the Government Sector Balance o o

tend to move in the same direction If Saving > Investment, a private sector surplus is lent to other sectors If Investment > Saving, a private sector deficit is financed by borrowing from other sectors

- Net Exports = Government Sector Balance + Private Sector Balance Where is the Exchange Rate?

- The exchange rate plays a factor in the short run – a fall in the dollar lowers the real exchange rate

- In the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged and has no effect on the current account balance...