Chapter 9 The Exchange Rate and the Balance of Payments

The Foreign Exchange Market

• Foreign bank notes, coins, and bank deposits are considered foreign currency
• Foreign currency can be obtained in the foreign exchange market.
• The foreign exchange market is where one country's currency is exchanged for another.
• The price at which one currency exchanges for another is a foreign exchange rate.
• Currency depreciation is a fall in the value of one currency in terms of another.
• Currency appreciation is a rise in the value of one currency in terms of another.
• An exchange rate is a price that is determined in the foreign exchange market.
• Factors that influence the demand for Canadian dollars also influence the supply of other currencies.
• Factors that influence the demand for another country's money also influence the supply of Canadian dollars.
• The amount that traders plan to buy during a given time period at a given exchange rate is the quantity of Canadian dollars demanded.
• Demand for dollars is a derived demand.
• The exchange rate influences the quantity of Canadian dollars demanded for two reasons: export effect and expected profit effect.
• An inverse relationship exists between the exchange rate and the quantity of Canadian dollars demanded in the foreign exchange market.
• As the value of Canadian exports increases, the quantity of Canadian dollars demanded by buyers on the foreign exchange market increases.
• The larger the expected profit from holding Canadian dollars, the greater the quantity of Canadian dollars demanded today.
• The quantity of Canadian dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.
• There is a direct relationship between exchange rate and the quantity of Canadian dollars supplied in the foreign exchange market.
• Exchange rate influences the quantity of Canadian dollars supplied through the imports effect and expected profit effect.
• The larger the value of Canadian imports, the larger the quantity of Canadian dollars supplied on the foreign exchange market.
• For a given expected future Canadian dollar exchange rate, the lower the current exchange rate, the greater is the expected profit from holding Canadian dollars, and the smaller is the quantity of Canadian dollars supplied on the foreign exchange market.
• Equilibrium is achieved at the exchange rate where there is neither a shortage nor a surplus of currency.

Exchange Rate Fluctuation

• Changes in the demand for Canadian dollars occur when influences on the quantity of Canadian dollars change, besides the exchange rate.
• Examples of these influences include world demand for Canadian exports, the Canadian interest rate relative to the foreign interest rate, and the expected future exchange rate.
• The “Canadian interest rate differential” is the Canadian interest rate minus the foreign interest rate.
• At a given current exchange rate, if the expected future exchange rate for Canadian dollars rises, the demand for Canadian dollars increases and the demand curve shifts rightward.
• Changes in the supply of Canadian dollars occur when influences on the quantity of Canadian dollars change, other than the exchange rate.
• Examples of influences are Canadian demand for imports, the Canadian interest rates relative to the foreign interest rate, and the expected future exchange rate.
• At a given exchange rate, if the Canadian demand for imports increases, the supply of Canadian dollars on the foreign exchange market increases and the supply curve shifts rightward.
• If the Canadian interest differential rises, the supply for Canadian dollars decreases and the supply curve shifts leftward.
• The supply of Canadian dollars decreases and the demand curve for dollars shifts leftward when the expected future exchange rate for Canadian dollars rises, at a given current exchange rate.
• The exchange rate rises if demand for Canadian dollars increases and supply does not change.
• The exchange rate falls if demand for Canadian dollars decreases and supply does not change.
• The exchange rate falls if supply of Canadian dollars increases and demand does not change.
• The exchange rate rises if supply of Canadian dollars decreases and demand does not change.

Arbitrage, Speculation, and Market Fundamentals

• Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market.
• Arbitrage in the foreign exchange market and international loans and goods markets leads to the law of one price, no round-trip profit, interest rate parity, and purchasing power parity.
• The law of one price states that if an item can be traded in more the one place, the price will be the same in all locations.
• A round trip is using the currency A to buy currency B, and then using B to buy A; arbitrage removes profit from all transactions of this type.
• Return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.
• Interest rate parity prevails when the rates of returns on two currencies are equal.
• Interest rate parity means equal interest rates when exchange rate changes are taken into account.
• Purchasing power parity means equal value of money, and occurs when two quantities of money can buy the same quantity of goods and services.
• Speculation is trading on the expectations of making a profit.
• The expected future exchange rate influences both supply and demand, so it influences the current equilibrium exchange rate
• The dependence of today's exchange rate on forecasts of tomorrow's exchange rate can give rise to exchange rate volatility in the short run.
• The real exchange rate is the relative price of Canadian-produced goods and services to foreign-produced goods and services.
• The equation that links the nominal exchange rate (E) and real exchange rate (RER) is RER = (E x P)/P* where P is the Canadian price level and P* is the Japanese price level.
• The real forces of demand and supply in the markets for goods and services determine the real exchange rate in the long run.
• In the long run, the quantity of money in each country determines the price level in that country.
• A change in the quantity of money brings a change in the price level and a change in the exchange rate, for a given real exchange rate.

Exchange Rate Policy

• Three possible exchange rate policies are: flexible exchange rate, fixed exchange rate, and crawling peg.
• A flexible exchange rate policy permits the exchange rate to be determined by demand and supply.
• With flexible exchange rate policy there is no direct intervention in the foreign exchange market by the central bank.
• A fixed exchange rate policy pegs the exchange rate, and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply.
• If demand for Canadian dollars decreases, the Bank of Canada buys Canadian dollars to decrease supply.
• A crawling peg is an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market.
• A crawling peg works like a fixed exchange rate except that the target value changes.
• The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

Financing International Trade

• 3 balance of payments accounts: current account, capital and financial account, and official settlements account.
• The current account records receipts from exports, payments for imports, net interest paid abroad, and net transfers.
• The capital and financial account records foreign investment in Canada minus Canadian investment abroad.
• The official settlements account records the change in Canadian official reserves.
• Canadian official reserves are the government's holdings of foreign currency.
• If Canadian official reserves increase, the official settlements account is negative.
• The capital and financial account records foreign investment in Canada minus Canadian investment abroad.
• A net borrower borrows more from the rest of the world than it is lending to it.
• A net lender is lending more to the rest of the world than it is borrowing from it.
• The global loanable funds market helps lenders and borrowers seek the best advantage
• Countries with negative net exports have other countries supplying funds to them as the quantity of loanable funds is greater than national savings.
• Countries with positive net exports are net suppliers to other countries as the quantity of loanable funds is less than national savings.
• A debtor nation has, during its entire history, borrowed more from the rest of the world than it has lent to it.
• A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.
• The main item in the current account balance is net exports (NX)
• Current account balances equals net exports plus net interest income plus net transfers
• government sector surplus or deficit is equal to net taxes (T) minus government expenditure on goods and services (G).
• The private sector surplus or deficit is saving S, minus investment I.
• Net exports equals the sum of government sector balance and private sector balance: NX=(T–G)+(S–I)
• But in the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged.
• Nominal exchange rate plays no role in influencing the current account balance, in the long run.