ECON 102 - Chapter 11
Exchange Rates and the Balance of Payments
Introduction
Prepared by Ifeanyi Uzoka, Sheridan College
Reference: Principles of Macroeconomics SAYRE, MORRIS, GHAYAD, Eleventh Edition.
Focus of Chapter 11: Exchange Rates and the Balance of Payments.
Learning Objectives
Calculate the value of the Canadian dollar in terms of other currencies.
Explain the concept of purchasing power parity theory.
Identify the actors in the foreign exchange markets.
Understand who buys and sells Canadian dollars.
Explain factors causing fluctuations in the value of the Canadian dollar.
Compare flexible and fixed exchange rate systems.
Explain balance of payments surplus and deficit.
Section 1: Exchange Rates
Definition
Exchange Rate: The rate at which one currency is exchanged for another.
Conversion Example: If $1 USD = $1.25 CAD, then:
Currency Appreciation and Depreciation
Currency Appreciation: A rise in the exchange rate of one currency for another.
Currency Depreciation: A fall in the exchange rate of one currency for another.
Practical Calculations
Currency Exchange Calculation Example:
Assume a Swedish krona is worth $0.20 CAD:
How much is a CAD worth in kronas?
Japanese Yen Conversion:
If 1 CAD = 70 JPY, how much is a yen worth?
Section 2: Purchasing Power Parity Theory
Definition
Purchasing Power Parity Theory (PPP): A theory suggesting that exchange rates will adjust so that identical goods will have the same price across different countries in their respective currencies.
Key Concepts in PPP
Arbitrage: The act of buying a commodity in a market where the price is low and selling it in another where the price is higher.
Mechanism of Arbitrage:
Buying in a cheaper market increases demand and subsequently increases the price.
Selling in a more expensive market increases supply, eventually decreasing the price.
This leads to price equalization across markets.
Examples
Coal Pricing Example:
Given:
Price in Sweden: 1000 SEK/tonne
Price in Canada: $250/tonne
Exchange Rate: 1 SEK = $0.20 (i.e., $1 = 5 SEK).
The price of coal in Sweden in CAD turns out to be:
Demand Shifts: If coal is cheaper in Sweden, everyone will buy from there, driving up demand for SEK until prices balance.
Limitations of PPP
Differences in purchasing power may persist due to:
Non-tradable services (e.g., haircuts).
Transportation and insurance costs.
Trade restrictions like tariffs.
Consumer preferences.
Impact of financial assets on currency values.
Section 3: Demand and Supply for Canadian Dollars
Demand for Canadian Dollars
Sources of Demand Include:
Foreigners seeking Canadian exports or travel to Canada.
Foreigners looking to purchase Canadian investments.
Canadians receiving foreign currency transfers.
Currency speculators and arbitragers.
Effects of Currency Fluctuation
Depreciation of CAD:
Makes Canadian exports cheaper, likely increasing total exports.
Appreciation of CAD:
Makes Canadian exports more expensive, likely reducing total exports.
Understanding Demand Changes
Examples of Situations Impacting Demand:
Popularity of Canadian products rises → CAD appreciates.
Hosting the Winter Olympics in Vancouver → CAD appreciates.
New $2 billion investment complex announced in Halifax → CAD appreciates.
Increased migration to Ontario from Maritime provinces → No change in CAD value.
Section 4: Supply of Canadian Dollars
Supply of Canadian Dollars
Sources of Supply Include:
Canadians buying foreign imports or traveling abroad.
Canadians investing in foreign assets.
Foreigners receiving currency transfers from Canadians.
Currency speculators and arbitragers.
Effects of CAD Appreciation
If CAD appreciates:
Imports increase as foreign products become cheaper.
Determinants of CAD Supply
Factors influencing supply:
Price instruments in the foreign market.
Conventional supply curve relationships.
Section 5: Effects and Consequences of Currency Fluctuations
Impact of Currency Changes on Trade
Exchange Rate Fluctuations Table:
Effects of CAD Appreciation:
Commodity producers may suffer due to decreased competitiveness.
Increased foreign tourism in Canada declines as travel expenses rise.
Decrease in foreign investment as returns appear lower.
Effects of CAD Depreciation:
Commodity producers benefit due to better competitive pricing.
Influx of Canadian tourists abroad increases.
Once the dollar depreciates, foreigners find Canadian goods cheaper, increasing investments.
Section 6: Equilibrium in Foreign Exchange Markets
Equilibrium Concept:
Determined when the demand for CAD from foreign buyers equals the supply from Canadians seeking foreign currencies.
Test Your Understanding
Hypothetical scenarios involving appreciation and depreciation effects on imports and exports are provided to assess understanding.
Section 7: Fixed Exchange Rates
Definition
Fixed Exchange Rate: An exchange rate that is maintained at a predetermined level by the government.
Advantages of Fixed Exchange Rates
Provide stability and eliminate uncertainty in international trade.
Prevent volatility in export/import industries.
Deter currency speculation, maintaining stable economic conditions.
Enhance national pride by linking exchange rates with national significance.
Adjustments Under Fixed Rates
In cases of rising demand, Canadian dollars can become undervalued due to fixed rates leading to shortages, requiring intervention by the Bank of Canada to increase dollars circulating through the economy, potentially causing inflation.
Conversely, decreased demand can lead to overvaluation, necessitating government intervention to mitigate surplus situations leading to trade imbalances.
Section 8: Managed Exchange Rate
Definition
Managed Exchange Rate ('Dirty Float'): A system where the central bank intervenes to stabilize the currency to avoid extreme fluctuations while allowing some degree of freedom in the market.
Section 9: Balance of Payments
Definition
Balance of Payments: An accounting framework documenting all financial transactions between residents of a country and the rest of the world, involving payment and receipt of foreign currencies.
Components of Balance of Payments
Current Account:
Tracks income from exports and expenditure on imports.
Capital Account:
Reflects changes in asset ownership associated with foreign investments.
Official Settlements Account:
Details changes in national foreign currency reserves.
Balance of Trade
Definition: The value of a country's exports minus the value of imports, synonymous with net exports.
Sample Data for Canada's Balance of Payments (2022)
Current Account:
Exports of goods: 779 billion USD
Imports of goods: (757 billion USD)
Balance of Merchandise Trade: +22 billion USD
Balance on Capital Account:
Foreign investments (in and out): +22 billion USD
Overall Balance:
Final balance (current + capital): +14 billion USD
Impacts of Balance of Payments Surplus and Deficit
Surplus: Results in an inflow of foreign reserves, indicating strong demand for CAD.
Deficit: Necessitates selling of foreign reserves, leading to decreased demand for CAD in global markets.
Graphs and Data Representations:
Several graphical representations illustrate the fluctuations of the Canadian dollar over the years as well as trade balances.
Key Concepts to Remember
Understanding currency exchange dynamics, the significance of purchasing power parity, demand-supply relationships in the foreign exchange market, and the implications of fixed versus flexible rates is vital for comprehending broader macroeconomic principles.