Chapter 11: Exchange Rates and Payments with the Rest of the World

Exchange Rate

Price one currency exchanges for another currency

• Ex. if C$1.00 = US$0.90; it takes 90 cents US to buy 1 Canadian dollar

Foreign Exchange Market

Worldwide market where currencies bought and sold

• The only people who are going to the foreign exchange market are those interested/needing another currency

Currency Depreciation vs. Appreciation

Currency Depreciation: fall in exchange rate of one currency for another

• Ex. Before: $1 USD = ¥150 — After: $1 USD = ¥130

• $1 USD buys less Euros

Currency Appreciation: rise in exchange rate of one currency for another

• Ex. Before: $1 USD = €0.90 — After: $1 USD = €1.00

• $1 USD buys more Euros

Law of Demand for Canadian Dollars

As exchange rate rises, quantity demanded of C$ decreases (inverse relationship)

With higher value of C$:

• R.O.W. buys less

• Quantity demanded for C$ decreases

Law of Supply for Canadian Dollars

As exchange rate rises, quantity supplied of C$ increases (direct relationship)

With higher value of C$:

• R.O.W imports and assets less expensive for Canadians, so Canadians buy more of them

• To buy more R.O.W imports and assets, Canadians demand more foreign currency, so quantity supplied of C$ increases

Foreign Exchange Market for Canadian Dollars

• At equilibrium exchange rate: quantity demanded = quantity supplied of C$

• Below equilibrium exchange rate: quantity demanded > quantity supplied — excess demand (shortages) for C$, buyers competition causes exchange rate to rise

• Above equilibrium exchange rate: quantity demanded < quantity supplied — excess supply (surpluses) for C$, buyers competition causes exchange rate to fall

Supply of one currency is demand for another currency

• Americans demanding C$ supply US$ in exchange

• Canadians demanding US$ supply C$ in exchange

Reciprocal Exchange Rate

Divide 1 by the other exchange rate

Ex. if C$1.00 = US$0.90, reciprocal exchange rate is US$1.00 = 1/0.90 = C$1.11

• It takes C$1.11 to buy US $1.00

• When C$ appreciates against any currency, the currency depreciates against C$, and vice-versa

Interest Rate Differential

Difference in interest rates between countries

• Increase in Canadian interest rate differential causes C$ to appreciate (increases demand and decreases supply of C$)

• Decrease in Canadian interest has opposite effect

Inflation Rate Differential

Difference in inflation rates between countries

• Increase in Canadian inflation rate differential causes C$ to depreciate (decreases demand and supply of C$)

• Decrease in Canadian interest has opposite effect

Effects of increasing real GDP on C$

• Increased investor confidence causes strong appreciation

• Net effect is C$ appreciates

Solo changes in demand fir C$

• Increasing R.O.W demand for Canadian exports causes slight appreciation of C$ (increases demand for C$)

• Rising world prices for Canadian resource exports causes C$ to appreciate relative to currencies of non-resource producing countries (increases demand for C$)

Currency speculators are the most important force for…

Fluctuations of foreign exchange rates

• Daily value world goods trade 2022 = US$68 billion

• Daily value foreign currency exchange 2022 = US$8 trillion

• Expected rise in future price of the C$ causes appreciation of C$ (increases demand for C$)

• Speculators reinforce and speed up effects of other forces on the price of C$

Forces Changing the Price of the Canadian Dollar

International Transmission Mechanism

How exchange rate affect real GDP and inflation

Appreciating C$

• Negative aggregate demand shock

• Decreases net exports

• Decreasing aggregate demand

• Decreasing real GDP

• Increasing unemployment

• Causes disinflation

• Pushes economy into a contractions

• Puts downward pressure on the Canadian price level

Depreciating C$

• Positive aggregate demand shock

• Increases net exports

• Increasing aggregate demand

• Increasing real GDP

• Decreasing unemployment

• Increases inflation

• Pushes the economy into an expansion

• Puts upward pressure on the Canadian price level

Advantages and disadvantages to both higher and lower exchange rates

Appreciating C$

• Makes imports less expensive

• But a negative demand shock

  • Hurts exporters/exports decrease

  • Decrease real GDP

  • Increasing unemployment

  • Decreasing inflation

Depreciating C$

• Makes imports more expensive

• But a positive demand shock

  • Helps exporters/exports increase

  • Increasing real GDP

  • Decreasing unemployment

  • Increasing inflation

Law of One Price

• Predictions where exchange rates settle

• Profit seekers eliminate differences across markets in prices of same product

• This is arbitrage — buying and selling of products (or funds) to profit from a difference in price

Purchasing Power Parity (PPP)

Exchange rates adjust so that money has equal purchasing power in any country

• Does not account for trading limitations

• Is the best available standard for judging exchange rates

• Does not account for the role of speculators in influencing exchange rates

Ex. C$15 buys exactly the same products in Canada, and when converted into US$ at PP exchange rate, and in the United States

If purchasing power parity does NOT hold, for example, Canadian $ more valuable than US $ for some purchases

• People sell C$ for US$ —> increase supply Canadian $

• Canadian $ depreciates

• When PP does not exist, profit-seeking forces and law of one price push exchange rate toward PPP rate

• PPP does not account for trading limitations and role of speculators influencing exchange rates

Rate of Return Parity (Interest Rate Parity)

Rates of return on investments are equal across countries, accounting for expected depreciation or appreciation of exchange rates

Ex. Rate of Return in Japan = Rate of Return in Canada - Expected depreciation or appreciation of yen against C$

Floating Exchange Rate vs Fired Exchange Rate

Floating Exchange Rate: determined by demand and supply in foreign exchange market

Fixed Exchange Rate: determined by governments or central banks

Balance of Payments Accounts

Measure a country’s international transactions

1. Current account

2. Financial (capital account)

3. Statistical discrepancy

Flow of C$

On Balance of payments accounts

• Into Canada are positive numbers

• Out of Canada are negative numbers

1. Current Account

Measures flows of exports, imports (and net investment/labour/transfer income

• Canadian exports create a positive inflow of C$

• Imports create a negative outflow of C$

• Deficit/negative balance when Canadian spending on imports fromR.O.W. > R.O.W. spending on Canadian exports

• Surplus/positive balance when R.O.W. spending on Canadian exports > Canadian spending on imports from R.O.W.

2. Financial Account (Capital Account)

Measures international investments in financial assets like bonds and direct investment in buying business

• Canadian investments in R.O.W. are negative outflows of C$

• R.O.W. investments in Canada are positive inflow of C$

• Deficit/negative balance when Canadian investments in R.O.W > R.O.W investments in Canada

• Surplus/positive balance when R.O.W. investments in Canada > Canadian investments in R.O.W

3. Statistical Discrepancy

For missing data and errors; is not important for balance of payments

• The balance of payments accounts must sum to zero (current account balance + financial account balance + statistical discrepancy = 0)

• In the absence of statistical discrepancy, when there is a current account surplus, there is a financial account deficit, and vice-versa

When there is a current account surplus…

There is a financial account deficit

• If R.O.W spends more on Canadian exports than Canadians spend on R.O.W imports, where does R.O.W. get extra C$?

  • From financial account deficit, with Canadians “loaning” R.O.W. extra C$ through investments

When there is current account deficit…

There is a financial account surplus

• If Canada spends more on R.O.W. imports than R.O.W. spends on Canadian exports, where does Canada get extra foreign currency?