International finance

International finance

Flow of goods and services

Exports: domestically produced goods and services sold abroad

Imports: goods and services produced abroad sold domestically

Net exports = Exports - Imports

Trade surplus: Net exports > 0

Trade deficit: Net exports < 0

Balanced trade: Net exports = 0

The flow of financial resources is made up of:

• Financial inflows: investments by foreigners in Canada

• Financial outflows: investments by canadians in foreign countries

Forms of financial flows:

1. Foreign direct investment (ex: italian company opens a subsidiary in canada)

2. Portfolio investment (ex: japanese investor purchases canadian bonds)

3. Deposits and loans (ex: foreign deposits in canadian banks)

Why have financial flows grown?

• Deregulation of financial sector and removal of capital controls

  • Capital controls = rules designated to limit financial flow across countries

• Large institutional investors (pensions funds and mutual funds) have grown over time

  • Seek to diversify their portfolios

• Technology: secure international wire transfers

• Financial innovation

Nominal exchange rate: The rate at which you can trade currency of one country for currency of another.

• In general we will define the nominal exchange rates in units of foreign currency per unit of domestic currency (ex: USD per CAD)

Nominal exchange rate = units of foreign currency / units of domestic currency

Units of foreign currency = nominal exchange rate x units of domestic currency

Depreciation: when the price of a currency falls

Appreciation: when the price of currency rises

Higher price of a dollar:

• Appreciation of the dollar

• Depreciation of the other currency

• Stronger dollar

• Higher exchange rate

• Imports are cheaper

• Exports are more expensive for foreign buyers

Lower price of a dollar

• Depreciation of the dollar

• Appreciation of the other currency

• Weaker dollar

• Lower exchange rate

• Imports are more expensive

• Exports are cheaper for foreign buyers

Foreign exchange market: The market in which currencies are bought and sold. The price of a Canadian dollar is the nominal exchange rate.

The market for canadian dollars:

• Demanders:

  • From the trade flows: foreigners buying canadian exports

  • From financial inflows: foreigners investing in canada

• Suppliers:

  • From trade flows: canadians buying imports

  • From financial outflows: canadians investing abroad

Market for Canadian dollars

• Downward sloping demand

  • A lower price of the Canadian dollar means canadian exports are cheap

  • Buyers from the other country will need more Canadian dollars to pay for those Canadian exports = quantity demanded rises.

• Upward sloping supply

  • A higher price of the canadian dollar means canadian imports (from the other country) are cheap

  • Canadian imports from the other country rise, canadians need to exchange more canadian dollars into the other currency to pay for imports = quantity supplied rises.

• The equilibrium exchange rate is determined by the demand and supply of canadian dollars.

Demand shifters:

• Increase in canadian exports:

• Increase in world GDP

• Lower barriers to foreign markets (ex: tariffs)

• Increased domestic innovation or marketing

• Higher foreign prices

• Lower domestic prices

• Increase in financial inflows

  • Higher canadian interest rates

  • Higher canadian business profitability

  • Higher foreign political risk

  • Higher expected future value of canadian dollar

Supply shifters

• Increase in imports into canada

  • Increase in canadian gdp

  • Lower barriers protecting domestic producers

  • Increased foreign innovation or marketing¸Higher domestic prices

  • Lower foreign prices

• Increase in financial outflows

  • Lower canadian interest rates

  • Lower canadian business profitability

  • Lower foreign political risk

  • Lower expected future value of canadian dollar

Real exchange rate: the rate at which a person can trade the goods and services of one country for those of another.

It is a key determinant of how much a country exports and imports

Balance of payments

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

• It tracks two sets of transactions:

  • Current account: how much income crosses national borders each year

  • Financial account: tracks the financial flows across borders

• Current account balance: measures the difference between the income that canadians receive from abroad and the income that Canadians pay to people abroad.

• Financial account balance: measures the difference between financial inflows and financial outflows.