© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 1 EXCHANGE RATES AND THE BALANCE OF PAYMENTS SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE.

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1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 1 EXCHANGE RATES AND THE BALANCE OF PAYMENTS SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

2 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 2 In this chapter you will learn 17.1 How international trade is financed 17.2 About a nation’s balance of payments 17.3 What a flexible exchange-rate system is and its effects on the domestic economy 17.4 What a fixed exchange-rate system is and its effects on the domestic economy 17.5 About the history of the world’s exchange- rate regimes

3 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 3 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

4 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 4 Financing International Trade n differing national currencies complicate international trade n currencies are exchanged in foreign exchange markets

5 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 5 Canadian Export Transaction Assume $2 = £1 1.$300,000 in Canadian telecommunications equipment purchased by a British buyer for £150,000 2.£150,000 cheque drawn on British bank to pay for equipment 3.£150,000 cheque is exchanged for $300,000 at a Canadian bank 4.Canadian bank sends £150,000 cheque to London bank for future transactions

6 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 6 Points to Remember Canadian exports create: n a foreign demand for Canadian $ n an increase in the supply of foreign currency owned by Canadian banks

7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 7 Points to Remember Canadian imports: n create a domestic demand for foreign currencies n reduce the supplies of foreign currencies held by Canadian banks

8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 8 Points to Remember n Canadian exports supply the foreign currencies needed to “pay for” imports n Demand for & supplies of foreign currencies also arise from transactions involving services & payment of interest & dividends on foreign investments

9 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 9 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

10 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 10 n 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

11 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 11 Current Account n 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

12 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 12 The Canadian Balance of Payments in 2002 (billions of dollars) ExportsImportsBalance 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 9. Current Account Balance +17.3 Table 17-1

13 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 13 Capital Account n shows capital inflows & outflows –purchase or sale of real or financial assets –official settlements account n TIP: –a + sign indicates a “source” of foreign exchange, –a - sign indicates a “use” of foreign exchange

14 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 14 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 account balance - 6.6 Official settlements account 13. Official international reserves - 10.7 Balance of payments Balance of payments $ 0 Table 17-1

15 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 15 Payments Deficits & Surpluses n A drawing down of official international reserves (a + official reserves entry) measures a nation’s balance of payments deficit n A building up of official reserves (a – official reserves entry) measures a balance of payments surplus n Deficits not necessarily bad, but cannot be maintained indefinitely, because international reserves are limited

16 GLOBAL PERSPECTIVE 17.1

17 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 17 The Balance of Payments, 1975-2002

18 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 18 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

19 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 19 Foreign Exchange Markets n competitive markets n linkages to all domestic & foreign prices

20 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 20 Flexible Exchange Rates n Rates by which national currencies are exchanged are determined by demand & supply

21 P Q D The Market for Foreign Currency (Pounds) Dollar price of 1 pound Quantity of pounds Figure 17-2 who are the demanders of pounds in fx markets?

22 P Q D S Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) who are the suppliers of pounds to fx markets? Figure 17-2

23 P Q D S dollar price of pounds is determined by demand & supply Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) Figure 17-2

24 P Q D S 2 Dollar price of 1 pound Quantity of pounds Q1Q1 The Market for Foreign Currency (Pounds) Figure 17-2

25 P Q D S Pound appreciates D Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) 2 Q1Q1 Figure 17-2

26 P Q D S D Pound depreciates Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) 2 Q1Q1 Figure 17-2

27 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 27 Determinants of Exchange Rate Changes n Changes in Tastes n Relative Income Changes n Relative Price-Level Changes –Purchasing Power Parity Theory n Relative Interest Rates n Speculation

28 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 28 Advantages of Flexible Rates n automatic adjustment to eventually eliminate balance of payments deficits or surpluses

29 P Q D S suppose tastes change & Canadians want to buy more British automobiles Dollar price of 1 pound Quantity of pounds 2 Adjustments Under Flexible Exchange Rates Figure 17-3

30 P Q D S demand for pounds increases Dollar price of 1 pound Quantity of pounds D 2 Adjustments Under Flexible Exchange Rates Figure 17-3

31 P Q D S Canadian balance of payments deficit Dollar price of 1 pound Quantity of pounds D 2 Adjustments Under Flexible Exchange Rates a b Figure 17-3

32 P Q D S Dollar price of 1 pound Quantity of pounds D 2 change in the exchange rate to $3=£1 would correct the deficit Adjustments Under Flexible Exchange Rates 3 c b a Figure 17-3

33 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 33 Flexible Exchange Rates n with a lower $, Canadians will want to import less, & the British will want to buy more Canadian goods & services

34 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 34 Disadvantages of Flexible Rates n reduced trade because of risks associated with constantly changing exchange rates n worsening terms of trade if there is a sizeable depreciation n challenges in designing domestic macroeconomic policies in nations heavily dependent on trade

35 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 35 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

36 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 36 Fixed Exchange Rates n Use of Reserves –currency interventions n Trade Policies n Exchange Controls & Rationing n restricted choice n black markets n distorted trade n favouritism

37 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 37 Fixed Exchange Rates n Use of Reserves –currency interventions n Trade Policies n Exchange Controls & Rationing n Domestic Macroeconomic Adjustments

38 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 38 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

39 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 39 Exchange Rate Systems n The Gold Standard: Fixed Exchange Rates 1879 - 1934 –currency defined in gold –fixed relationship between gold stock & money supply maintained –gold freely exported & imported

40 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 40 Exchange Rate Systems n Gold flows resulted in fixed exchange rates n Domestic macroeconomic adjustments sometimes distasteful n Gold standard collapsed in the worldwide depression of the 1930s –series of devaluations

41 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 41 Exchange Rate Systems n The Bretton Woods System 1944-1971 –adjustable-peg system –International Monetary Fund (IMF) n Maintaining pegged rates –Official international reserves –Gold sales –IMF borrowing

42 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 42 Exchange Rate Systems n Fundamental Imbalances: Adjusting the Peg n Demise of the Bretton Woods System –1971: the US floated the dollar

43 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 43 Exchange Rate Systems n The Current System: The Managed Float –G-7 Intervention in 1987 n “almost” flexible n proponents & critics –has functioned better than anticipated –a “nonsystem”

44 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 44 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems