Chapter 16 International Finance and Exchange Rate

International Trade and Global Financial Flows

• Definition: International trade involves the buying and selling of goods and services across national borders.
• Key Components:
  • Exports: Goods/services produced domestically and sold to foreign buyers.
  • Imports: Goods/services produced abroad and purchased by domestic buyers.
• Importance of Comparative Advantage: Countries trade based on their comparative advantages, e.g., Canada excels in oil & gas, forestry, mining, and agriculture due to educational investments.

Globalization and its Effects

• Definition: Globalization is the increasing integration of economies, cultures, and ideas on a global scale.
• Factors Leading to Rising World Trade:
  • Cheaper transportation and communication.
  • Advances in cargo shipping capacities (e.g., larger cargo ships).
  • Reduced costs associated with air transport.
  • Enhanced computer networks facilitating data exchange.

Canada's Trade Dynamics

• Major Exports: Oil & gas, forestry, mining, agriculture (40% to the US).
• Major Imports: Machinery, pharmaceuticals, consumer goods; reliance on intermediate goods like machines and car parts.
• Imports and Exports as a Share of GDP: Approximately 1/3 of Canadian GDP, indicating higher trade dependence than larger economies like China.

Trade Relationships

• Top Trading Partners: United States and China; highlights importance of the USMCA.
• Impact of US Tariffs:
  • Tariffs significantly affect Canadian exports; ~75% of Canadian exports go to the US.
  • Canada is more vulnerable to US trade policies than vice versa due to its smaller economy.

Financial Flows and Investment

• Definition: Financial flows involve cross-border investments.
• Types of Financial Flows:
  • Foreign Direct Investment (FDI): Investments like Honda’s auto plant in Ontario.
  • Portfolio Investment: Foreign purchases of Canadian stocks/bonds.
  • Loans/Deposits: Direct loans and deposits in Canadian banks.
• Factors Driving Financial Inflows:
  • Deregulation of financial sectors and removal of capital controls.
  • Growth in large institutional investors seeking portfolio diversification.
  • Technological advancements increasing investor comfort with international investments.

Exchange Rates and Currency Demand/Supply

• Nominal Exchange Rate: Price of a country’s currency in another currency, e.g., exchange rates between Canadian dollars and yen.
• Currency Exchange Formula:
  • $ext{Number of yen} = ext{Number of dollars} imes ext{Nominal exchange rate}$
• Market Dynamics:
  • Demand increases when:
  • Foreigners buy Canadian exports.
  • Foreign investments in Canada rise.
  • Supply increases when:
  • Canadians import foreign goods.
  • Canadians invest abroad (financial outflows).

Real Exchange Rate and Competitiveness

• Real Exchange Rate Definition: It measures domestic good prices against foreign competitors.
• Impact on Net Exports:
  • If domestic goods become cheaper relative to foreign goods, exports increase, and imports decrease.
• Real Exchange Rate Calculation:
  • $ext{Real exchange rate} = \frac{\text{Domestic price in dollars}}{\text{Foreign price in foreign currency} / \text{Nominal exchange rate}}$

Balance of Payments

• Definition: Summarizes a country's transactions with the rest of the world, consisting of:
  • Current Account: Difference between income received from abroad and payments made.
  • Financial Account: Tracks inflows and outflows of investments.
• Surplus/Deficit: A current account deficit indicates spending beyond earnings, often funded by selling assets or borrowing.
• Key Insight: Foreigners owning Canadian assets can be beneficial if it leads to profitable investments; however, excessive borrowing can be risky.

Conclusion Points

• International trade's significance is growing.
• The nominal exchange rate is crucial for determining how currencies swap.
• The real exchange rate influences net exports and overall competitiveness.
• The interplay between the current account and financial account reflects economic health.