Exchange Rates and Balance of Payments Summary

Exchange Rates and Balance of Payments

  • Lesson Objectives

    • Define arbitrage and its effects.

    • Describe and calculate balance of payments accounts.

    • Explain global borrowing and lending in loanable funds market.

Arbitrage

  • Definition: Profit from buying at a lower price in one market and selling at a higher price in another.

  • Achieves:

    • Law of One Price

    • Interest Rate Parity

    • Purchasing Power Parity

Key Concepts in Arbitrage

  • Law of One Price: Identical goods will have the same price in different locations if traded.

  • Interest Rate Parity:

    • Currency value based on earnings (interest rate + expected appreciation).

    • Equal returns on two currencies indicates parity, influenced by market forces.

  • Purchasing Power Parity (PPP):

    • Value of money related to quantity of goods/services it can buy.

Balance of Payments Accounts

  • Records international trade, borrowing, lending.

  • Three Accounts:

    1. Current Account

    2. Capital and Financial Account

    3. Official Settlements Account

Current Account

  • Records:

    • Exports and imports of goods/services

    • Net interest payments abroad

    • Net transfers (e.g., foreign aid)

  • Balance Calculation:
    extBalance=extExports−extImports+extNetInterest+extNetTransfersext{Balance} = ext{Exports} - ext{Imports} + ext{Net Interest} + ext{Net Transfers}

Capital and Financial Account

  • Records:

    • Foreign investment in Canada minus Canadian investment abroad.

  • Official Settlements Account:

    • Change in Canadian official reserves; negative balance if reserves increase.

Global Loanable Funds Market

  • Integrated global market for borrowing/lending.

  • Lenders seek highest real interest rates; borrowers seek lowest rates.

  • Funds flow toward highest interest rates, creating equilibrium.

Concluding Remarks

  • Revisit objectives: Arbitrage, balance of payments accounts, global lending/borrowing.