Chapter 9: The Exchange Rate and Balance of Payments

What is an open economy?

Interacts with the rest of the world in terms of:

1. Flows of goods/services (X and M)

2. Flows of funds (foreign direct investment, foreign portfolio investment)

3. Flows of people (migration)

What’s an asset?

Form of wealth that transfers purchasing power from present to future.

How are different prices expressed?

Prices of goods/services are expressed in terms of money

Exchange rate

Price of 1 country’s money in terms of another’s

Nominal exchange rate can be expressed in 2 ways

1. Direct (US)

2. Indirect (EU)

Appreciation of currency vs depreciation of currency

Strengthening vs weakening

Foreign currency =

bank notes + coins + demand deposits of a foreign country

FOREX is the…

foreign exchange market

What is the FOREX?

Market where one country’s currency is exchanged for another’s

Real exchange rate is…

The rate at which one country’s goods/services are traded for another’s

Formula for real exchange rate, (E)

(E) = Ep / P*

Where…

P = domestic price level, P* = foreign price level, E = nominal exchange rate

What are the variables in FOREX?

y = Qs, Qd of $ CAD

x = nominal exchange rate, E

Characteristics of a competitive market

1. Many buyers

2. Many sellers

3. Standard product

4. Easy entry & exit

5. Full information

People demand $CAD to buy…

CANADIAN goods, assets, businesses, etc.

People supply $CAD to buy…

FOREIGN goods, assets, businesses, etc.

Demand relationship

Negative relationship between Qd and E

Supply relationship 

Positive relationship between Qs and E

What affects demand?

• Export effect

• Expected profit effect

What effects supply?

• Import effect

• Expected profit effect

FOREX is supply and demand of what?

$CAD

Demand factors for $CAD

• World demand for CA exports (x)

• CA interest rate relative to foreign (i, if)

• Expected exchange rate (Ee)

Supply factors for $CAD

• CA demand for imports (M)

• CA interest rate relative to foreign (i, if)

• Expected exchange rate (Ee)

Supply and demand cause a ____ in the curve

SHIFT

Shifts in demand:

• X goes up, demand goes up

• i > if, demand goes up

• Ee goes up, demand goes up

Shifts in supply:

• M goes up, supply goes up

• i > if, supply goes down

• Ee goes up, supply goes down

When demand goes up, E goes…

up!

When supply goes up, E goes…

down!

Expectations for exchange rate are driven by…

1. Purchasing power parity (PPP)

2. Interest rate parity (IRP)

What is PPP?

Based on the law of 1 price: E = P/P*

What’s the law of 1 price?

A standard product should cost the same everywhere!

What is IRP?

If rates of return of 2 currencies are equal, IRP holds!

i = if + (Ee - E) / E

What is an assumption for PPP?

Real rate = 1

Assumptions for IRP?

r = rw

• perfect capital mobility

• small open economy

PPP is for what market?

goods market

IRP is for what market?

asset market

nominal interest rate =

real rate + inflation

Limitations of PPP

• Trade restrictions

• Labor being more expensive in developed countries

• Non traded goods

Limitations of IRP

• Tax considerations

• Restrictions on capital mobility

Exchange rate system is split into 2

1. Flexible exchange rate

2. Fixed exchange rate

What is a flexible exchange rate?

• Demand and supply determines E in the forex market

• No govt intervention

What is a fixed exchange rate?

• Predetermined, set by central bank

• CB uses monetary policy to keep E @ the taget level

What is an EXOGENOUS variable?

Independent (x), what changes

What is an ENDOGENOUS variable?

Dependant (y), what we measure

Balance of payments (BOP) is…

Country’s record of all international transactions

3 components of BOP

1. Current account (CA)

2. Capital account (KA)

3. Official settlements account

What is current account?

• Trade balance

• Net interest income

• Net transfers

What is capital account?

• Purchase of assets from R.O.W.

• Bonds, stock, real estate, … = NET FOREIGN INVESTMENT

What is official settlements account?

• Official settlement balance = change in foreign currency reserve in Central Bank