Chapter 19: Exchange Rates and the Balance of Payments
Chapter 19: Exchange Rates and the Balance of Payments
Chapter Outline and Learning Objectives
Learning Objectives: After studying this chapter, you will be able to:
List the components of Canada’s balance of payments and explain why it must always balance.
Describe the demand for and supply of foreign exchange.
Discuss how exchange rates are determined and differentiate between fixed and flexible exchange rates.
Discuss why a current account deficit is not necessarily undesirable.
Understand the theory of purchasing power parity (PPP) and its limitations.
Explain how flexible exchange rates can mitigate the effects of external shocks.
19.1 The Balance of Payments
The balance of payments accounts serve as a comprehensive summary of a country’s transactions with the rest of the world, which includes:
Buying and selling of goods.
Buying and selling of services.
Financial transactions regarding assets.
Table 19-1 presents major components of the Canadian balance of payments accounts for the year 2020.
Table 19-1: Canadian Balance of Payments, 2020 (in billions of dollars)
Current Account
Trade Account
Merchandise exports: +524.1
Service exports: +114.7
Merchandise imports: -560.8
Service imports: -122.3
Trade balance: -44.3
Capital-Service Account
Net investment income: +5.9
Net private and government transfers: -4.3
Current Account Balance: -42.7
Capital Account
Net change in Canadian investments abroad (capital outflow): -207.2
Net change in foreign investment in Canada (capital inflow): +250.2
Official Financing Account
Changes in official international reserves: -0.9
Capital Account Balance: +42.1
Statistical Discrepancy: +0.6
Balance of Payments: 0.0
It is emphasized that while individual components may show deficits or surpluses, the overall balance of payments must equal zero.
In 2020, Canada had:
A trade deficit of $44.3 billion.
A total current account deficit of $42.7 billion.
A capital account surplus of $42.1 billion.
The statistical discrepancy of $0.6 billion accounts for measurement inaccuracies.
The Current Account
The current account captures:
Transactions from trade in goods and services.
Net investment income derived from foreign assets.
Divided into two sections:
Trade Account: Records payments and receipts from imports and exports of goods and services.
Capital-Service Account: Tracks payments and receipts representing income earned from asset holdings.
The Capital Account
It deals with international transactions in assets:
Capital Outflow: When Canadians buy foreign assets.
Capital Inflow: When foreigners buy Canadian assets.
The Official Financing Account pertains to government transactions in foreign-exchange reserves.
In 2020, the capital account surplus was $42 billion, indicating a net inflow into Canada.
Balance of Payments Must Balance
The balance of payments is expressed as:
ext{Balance of Payments} = ext{CA} + ext{KA} = 0
where CA is the current account balance and KA is the capital account balance.This accounting identity means:
Any surplus in one account must offset a deficit in another:
Current account surplus: implies capital outflow.
Current account deficit: implies capital inflow.
Note: The term "balance of payments deficit" often misrepresents the combined balances of the current and capital accounts excluding the official financial account.
19.2 The Foreign-Exchange Market
Currency exchange is crucial for international trade, necessitating the swap of domestic for foreign currencies.
Exchange Rate: The cost in domestic currency to purchase one unit of foreign currency. For instance, the Canadian-US exchange rate in April 2021 was 1.25, meaning $1.25 CDN bought $1 USD.
Currency Appreciation and Depreciation:
Appreciation: A decline in exchange rate, meaning the domestic currency is worth more against foreign currencies.
Depreciation: An increase in the exchange rate, meaning the domestic currency is worth less against foreign currencies.
Supply and Demand for Foreign Exchange
The foreign-exchange market supply curve is positively sloped. A depreciation increases the quantity of foreign exchange supplied.
The demand curve for foreign exchange is negatively sloped. An appreciation increases the quantity of foreign exchange demanded.
Demand for foreign exchange arises from:
Canadian imports or asset purchases.
Foreign entities trading Canadian dollars for another currency.
19.3 The Determination of Exchange Rates
Flexible Exchange Rate: Determined purely by market forces without central bank intervention.
Fixed Exchange Rate: Maintained within a narrow range by central bank interventions.
Bretton Woods system (1944): Established an adjustable peg system.
The foreign-exchange market matches currency demand and supply, reacting to changes in global economic conditions and national policies.
Changes in Flexible Exchange Rates
Exchange rates respond to variations in prices of major imports/exports:
Rising export prices can strengthen the Canadian dollar.
Rising import prices can impact either appreciation or depreciation depending on demand elasticity.
Inflation dynamics affect exchange rates:
Higher inflation in Canada leads to depreciation relative to other currencies.
Lower inflation leads to appreciation.
Monetary policy affects interest rates and capital flows:
Contractionary policies raise rates, attract capital, and appreciate the currency.
Expansionary policies lower rates, lead to capital outflow, and depreciate the currency.
Structural Changes Affecting Exchange Rates
Structural change refers to shifts in cost structures, product inventions, and changes in consumer preferences affecting trade patterns and, consequently, exchange rates.
19.4 Three Policy Issues
Is a current account deficit detrimental, while a surplus is beneficial?
Is there a proper value for the Canadian dollar?
Should Canada adopt a fixed exchange rate policy?
Current Account Deficits and Surpluses
The implications of current account deficits are debated:
Historical perspectives (like mercantilism).
The role of international borrowing and asset sales.
A current account deficit indicates borrowing or capital sales, which may not be negative.
Causes of Current Account Deficits
The formula for current account balance is:
ext{CA} = S + (T - G) - I
where S is national saving, T is tax revenue, G is government spending, and I is domestic investment.Another rearranged expression: ext{CA} = (S - I) + (T - G)
Highlights the balance between private saving and investment, alongside government surplus.
Causes for deficits can stem from high investment levels, decreased private saving, or increased government deficits.
Correct Value for the Canadian Dollar
A flexible exchange rate derives its value from market forces, establishing an equilibrium conductive to optimal flows.
Purchasing Power Parity (PPP)
The theory posits that the exchange rate between currencies ultimately reflects relative price levels:
PC = e imes PE
where PC and PE are price levels in Canada and Europe respectively, and e is the CAD price of euros.The predicted PPP exchange rate is:
e{PPP} = rac{PC}{P_E}
Empirical challenges exist as changes in relative prices and the presence of non-traded goods detract from PPP's predictive capability.
Should Canada Have a Fixed Exchange Rate?
Flexible rates serve as shock absorbers against trade shocks, mitigating the adverse effects on output and employment.
Fixed rates could create greater volatility, redistributing the effects of shocks but stabilizing the exchange rate visually.
With flexible rates, depreciation during negative shocks lessens adverse impacts on aggregate demand (AD) changes.
Summation
Advocates of fixed rates highlight the risk associated with foreign exchange volatility, whereas proponents of flexible rates underline the benefits of absorbing shocks without severe income disruptions.