Econ 102 CH7

Financial Inflows

• investments by foreigners

Financial Outflows

• Investments by Canadians in foreign countires

Financial investment flows

• Foreign direct investment

• Portfolio investment

• Deposits and loans

Balance of Payments

• summarizes a country’s transactions with the rest of the world

• Current account balance

  • difference between the income that Canadians receive from abroad and the income that Canadians pay to people abroad

  • balance of payments on goods and services, plus net international transfer payments and factor income

• Financial Account Balance

  • difference between financial inflow and outflow

Equality between inflow and outflows

Current Account Deficit

• investment is larger than national saving

• -NX=C+I+G-Y

• use cash infusion (financial account surplus) to pay for it

• can reflect ppl living beyond their means and valuable investments in the future

  • Reducing the current account deficit means preventing businesses from making valuable investments

Nominal Exchange Rate

Demand for Canadian Dollars

• Trade Inflow: foreigners buy Canadian Exports

  • pay with Canadian $

• Financial Inflows: foreigners investing in Canada

Supply of Canadian $

• Trade flows: Canadians buying imports

  • exchange Canadian $ for foreign currency to pay for imports

• Financial outflows: Canadians investing abroad

Gov Intervention in Foreign exchange market

• Floating exchange rate regime: exchange rate fluctuates in response to market forces

• Fixed Exchange Rate Regime: exchange rate is set by the gov and never changes

• Managed Exchange Rate regime: gov buys and sells currency to reduce volatility/ keep currency cheap

Foreign Exchange Reserves

stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market

Foreign Exchange Controls

• licensing systems that limit the right of individuals to buy foreign currency

Benefits of a fixed exchange rate

• Provides a stable and predictable foreign exchange environment

• Help a country keep its export prices competitive,

• Imposes fiscal and monetary discipline on countries that have a history of excessive government spending and/or excess inflation

• Improves a country’s integration to global markets.

Costs of Fixed Exchange Rate

• Exchange market intervention requires large case reserves, and exchange controls distort economic incentives.

• Increases transmission of business cycles because economies are more integrated.

• If monetary policy is used to help fix the exchange rate, it isn’t available to use to stabilize the economy in recessions/booms.

  • Central banks cannot increase/decrease the money supply in response to a recession/expansion.

Monetary Policy Under Floating Exchange Rates

• Monetary policy works in part through the exchange rate

  • Central banks cut domestic interest rates leads to a depreciation in the currency;

  • Depreciation increases exports and reduced imports, which increases aggregate expenditure.

• Contractionary monetary policy has the reverse effect.

  • Central banks increasing domestic interest rates leads to an appreciation in the currency;

  • Appreciation decreases exports and increases imports, which decreases aggregate expenditure

Purchasing Power Parity

• the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.