Learning Objectives

  • After this chapter, you will be able to:
    • LO1: Explain the balance-of-payments accounts, which include the current account and the capital and financial accounts.
    • LO2: Define exchange rates and describe how they are determined.
    • LO3: Summarize exchange rate systems and their evolution.

The Balance of Payments Accounts

  • Summary of transactions involving exchanging Canadian dollars for other currencies.
  • Receipts: Monetary inflows to Canada.
  • Payments: Monetary outflows from Canada.

The Current Account

Definition

  • Summarizes all foreign transactions associated with current economic activity in Canada involving Canadian dollars.

Components of the Current Account

  • Includes:
    • Trade in merchandise
    • Trade in services
    • Flows of investment income
    • Employee compensation
    • Transfers

Current Account Surplus and Deficit

  • Merchandise Balance of Trade: Merchandise export receipts minus merchandise import payments.
  • Balance of Trade: Export receipts minus import payments for goods and services.
  • Balance on the Current Account: Total receipts minus payments in the account.

Canada’s Current Account (Sample Data)

  • Receipts and Payments breakdown:
    • Merchandise Trade: Inflow: 635.8; Outflow: 630.6; Balance: 5.2
    • Trade in Services: Inflow: 130.3; Outflow: 131.6; Balance: -1.3
    • Investment Income: Inflow: 144.4; Outflow: 138.5; Balance: 5.8
    • Employee Compensation: Inflow: 1.0; Outflow: 5.3; Balance: -4.3
    • Transfers: Inflow: 15.6; Outflow: 19.5; Balance: -3.9
  • Current Account Net Balance: +1.5 billion CAD.

The Capital and Financial Accounts

Definitions

  • Capital Account: Summarizes the transfer of ownership of savings and intangible assets.
  • Financial Account: Includes:
    • Portfolio investment
    • Direct investment
    • Other financial investments

Capital and Financial Surpluses/Deficits

  • Surplus: When Canadians invest less abroad than foreigners do in Canada.
  • Deficit: When Canadians invest more abroad than foreigners invest in Canada.

Canada’s Capital and Financial Accounts (Sample Data)

  • Receipts and Payments breakdown:
    • Direct Investment: Inflow: 76.3; Outflow: 114.2; Balance: -37.9
    • Portfolio Investment: Inflow: 217.8; Outflow: 165.9; Balance: 51.9
    • Other Financial Investments: Inflow: 118.9; Outflow: 111.0; Balance: 7.9
  • Total Capital and Financial Account Balance: +21.9 billion CAD.

Balance-of-Payments Surpluses/Deficits

  • Surplus: Receipts exceed payments across current and capital accounts combined.
  • Deficit: Payments exceed receipts across current and capital accounts combined.

Changes in Official Reserves

Definition

  • Shows the impact of Bank of Canada’s buying/selling of foreign currency on Canadian dollar flow.
  • Equal in value and opposite in sign to the surplus or deficit noted in the balance of payments.

Indications of Changes in Reserves

  • Negative Change: Indicates that the Bank sold Canadian dollars (outflow) by buying foreign currency.
  • Positive Change: Indicates that the Bank bought Canadian dollars (inflow) by selling foreign currency.

Canada’s Balance of Payments (Sample Data)

  • Current Account Balance: 1.5 billion CAD
  • Capital and Financial Accounts: 21.9 billion CAD
  • Statistical Discrepancy: 1.9 billion CAD
  • Overall Balance: +25.3 billion CAD
  • Change in Official Reserves: -25.3 billion CAD

Exchange Rates

Definition

  • The value of one nation’s currency in terms of another currency.
  • Two exchange rates can be used to compare currencies (e.g., CAD to USD).

Pricing Impact of Exchange Rates

  • U.S. Dollar Price Calculation: Product price in CAD × USD to buy CAD.
  • Canadian Dollar Price Calculation: Product price in USD × CAD to buy USD.

Demand and Supply for Canadian Dollars

Demand for Canadian Dollars

  • Represents the relationship between the price of a Canadian dollar and the quantity demanded in exchange for another currency.
  • Negative Slope: Determined by foreign buyers of Canadian exports.

Supply of Canadian Dollars

  • Represents the relationship between the price of a Canadian dollar and the quantity supplied in exchange for another currency.
  • Positive Slope: Determined by Canadian buyers of foreign goods.

Appreciation and Depreciation of Currency

  • Equilibrium: Achieved when demand and supply for currency are equal.
  • Appreciation: A currency's value increases relative to another currency.
  • Depreciation: A currency's value decreases relative to another currency.

Foreign Exchange Market Influences

  • A surplus in the market leads to depreciation towards equilibrium.
  • A shortage in the market leads to appreciation towards equilibrium.

Factors Affecting Exchange Rates

  • Changes in price levels in each country.
  • Variations in demand for each country's products.
  • Adjustments in interest rates.
  • Speculation regarding currency expectations.

Exchange Rate Changes

  • Decrease in Demand and Increase in Supply leads to depreciation.
  • Increase in Demand and Decrease in Supply leads to appreciation.

Flexible vs. Fixed Exchange Rates

Definitions

  • Flexible Exchange Rates: Allow to move freely to their equilibrium levels.
  • Fixed Exchange Rates: Set or pegged by government at a certain value.

Effects of Fixed Exchange Rates

  • A low fixed exchange rate stimulates exports but risks inflation.
  • A high fixed exchange rate puts downward pressure on inflation and real output.

Evolution of Exchange Rate Systems

  • Three major systems in the past 150 years:
    • Gold Standard: 1879-1934
    • Bretton Woods System: 1945-1971
    • Managed Float: 1971-present.

Canadian Exchange Rates

  • Under floating rates, the CAD rose above USD 1 in the 1950s; fixed between 1962-1970 at USD 0.925; fluctuated under managed float since 1970.

Challenges in a Post-COVID World

  • Key recommendations:
    • Ensure equitable access to testing and medications.
    • Prioritize spending on health and poverty reduction post-COVID.
    • Support students affected by school closures due to the pandemic.

Chapter Recap

  • Covered:
    • Balance-of-payments accounts (current and capital & financial accounts).
    • Exchange rates and their determination.
    • Evolution of exchange rate systems.