EXCHANGE RATES AND THE BALANCE OF PAYMENTS

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© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

1

EXCHANGE RATES

AND THE

BALANCE OF PAYMENTS

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

2


The Canadian
balance of payments

shows the balance between


all the payments that Canada receives
from foreign countries &


all the payments which we make to them


The Balance of Payments

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

3

Current Account


shows the flows resulting from imports &
exports of goods & services


the
balance on goods

is the net amount of
imports & exports of goods only


the
balance on goods & services

includes goods
& services


trade in services, investment income & transfers
are included to get the
current account balance


in 2002, Canada had a current account surplus of
$17.3 billion

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

4

The Canadian Balance of Payments

in 2002 (billions of dollars)




Exports

Imports

Balance

Current Account



Merchandise


410.3


-

356.1


+54.2

Services



58.2


-

66.1


-

7.9


Balance on Goods and Services



+46.3


7. Net Investment Income




-

30.4

8. Net Transfers







+ 1.4


9. Current Account Balance




+17.3

Table 17
-
1

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

5

Capital Account


shows capital inflows & outflows


purchase or sale of real or financial assets


official settlements account


TIP
:


a + sign indicates a “source” of foreign
exchange,


a
-

sign indicates a “use” of foreign
exchange


© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

6

The Canadian Balance of Payments

in 2002 (billions of dollars)








Balance

Capital Account




10. Capital inflows





+ 69.1


11. Capital outflows




-

75.7


12. Capital


account balance



-

6.6



Official settlements account

13. Official international reserves



-

10.7


Balance of payments






$ 0

Table 17
-
1

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

7

Payments Deficits & Surpluses


A drawing down of official international
reserves (a + official reserves entry)
measures a nation’s balance of payments
deficit


A building up of official reserves (a


official
reserves entry) measures a balance of
payments surplus


Deficits not necessarily bad, but cannot be
maintained indefinitely, because international
reserves are limited

GLOBAL PERSPECTIVE 17.1

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

9

The Balance of Payments, 1975
-
2002

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

10

Foreign Exchange Markets


competitive markets


linkages to all domestic & foreign
prices


r
ates by which national currencies are
exchanged are determined by demand
& supply


© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

11

Financing International Trade


differing national currencies complicate
international trade


currencies are exchanged in foreign
exchange markets

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

12

P

Q

D

S

Dollar price of 1 pound

Quantity of pounds

The Market for Foreign Currency (Pounds)

Figure 17
-
2

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

13

Factors
A
ffecting
D
emand



Canadian
exports create:


a foreign demand for Canadian $


an increase in the supply of foreign
currency owned by Canadian
banks


Foreign direct investment in Canada


Tourism


All other transactions associated with
foreigners buying Canadian things

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

14

Factors Affecting Supply


Canadian
imports:


create a domestic demand for foreign
currencies


reduce the supplies of foreign currencies
held by Canadian
banks


Canadian Direct Investment abroad


All other transactions Canadians make
in foreign countries


P

Q

D

S

Pound

appreciates

D


Dollar price of 1 pound

Quantity of pounds

The Market for Foreign Currency (Pounds)

2

Q
1

Figure 17
-
2

P

Q

D

S

D



Pound

depreciates

Dollar price of 1 pound

Quantity of pounds

The Market for Foreign Currency (Pounds)

2

Q
1

Figure 17
-
2

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

17

Determinants of
Exchange

Rate
Changes


Changes in Tastes


Relative Income Changes


Relative Price
-
Level Changes


Purchasing Power Parity Theory


Relative Interest Rates


Speculation

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

18

Flexible Exchange Rates


with a lower $, Canadians will want to
import less, & the British will want to buy
more Canadian goods &
services


automatic adjustment to eventually
eliminate balance of payments deficits
or surpluses




© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

19

Exchange Rate Systems


The Gold Standard: Fixed Exchange
Rates

1879
-

1934


currency defined in gold


fixed relationship between gold stock &
money supply maintained


gold freely exported & imported


© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

20

Exchange Rate Systems


Gold flows resulted in fixed exchange
rates


Domestic macroeconomic adjustments
sometimes distasteful


Gold standard collapsed in the
worldwide depression of the 1930s


series of devaluations

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

21

Exchange Rate Systems


The Bretton Woods System
1944
-
1971


adjustable
-
peg system


International Monetary Fund

(IMF)


Maintaining pegged rates


Official international reserves


Gold sales


IMF borrowing

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

22

Exchange Rate Systems


Fundamental Imbalances: Adjusting the
Peg


Demise of the Bretton Woods System


1971: the US floated the dollar

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

23

Disadvantages of Flexible Rates


reduced trade because of risks
associated with constantly changing
exchange rates


worsening terms of trade if there is a
sizeable depreciation


challenges in designing domestic
macroeconomic policies in nations
heavily dependent on trade

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

24

Fixed Exchange Rates


Use of Reserves


currency interventions


Trade Policies


Exchange Controls & Rationing


restricted choice


black markets


distorted trade


favouritism

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

25

Fixed Exchange Rates


Use of Reserves


currency interventions


Trade Policies


Exchange Controls & Rationing


Domestic Macroeconomic Adjustments

© 2005 McGraw
-
Hill Ryerson Ltd.

Macroeconomics, Chapter 17

26

Exchange Rate Systems


The Current System: The Managed
Float


G
-
7
Intervention in 1987


“almost” flexible


proponents & critics


has functioned better than anticipated


a “nonsystem”