Chapter 9

Chapter Overview

• Title: The Exchange Rate and the Balance of Payments

• Course: Macroeconomics (ECON 2020U)

• Institution: University of Ontario Institute of Technology

Learning Objectives

After studying this chapter you will be able to:

• Explain how the exchange rate is determined.

• Explain the trends and fluctuations in exchange rates.

• Describe the effects of alternative exchange rate policies.

• Understand the Balance of Payments and the causes of international deficits and surpluses.

The Foreign Exchange Market

• Definition:

  • To buy goods/services from another country, one needs the foreign currency (bank notes, coins, and deposits).

  • This currency is acquired in the foreign exchange market or FX market.

• Trading Currencies:

  • The FX market facilitates the exchange of one currency for another, allowing foreigners to obtain U.S. dollars in return for their currency.

Exchange Rates

• Definition:

  • The exchange rate is the price at which one currency can be exchanged for another.

  • Currency Depreciation: Fall in the currency's value compared to another.

  • Currency Appreciation: Rise in the currency's value compared to another.

Determinants of Exchange Rate

• Factors influencing exchange rates:

  • Demand for Canadian dollars in the FX market.

  • Supply of Canadian dollars in the market.

Demand in the FX Market

• Determinants of Demand:

  1. Exchange rate.

  2. World demand for Canadian exports.

  3. Interest rates (Canada and internationally).

  4. Expected future exchange rate.

• Law of Demand for Foreign Exchange:

  • The demand for Canadian dollars is derived from its use to purchase Canadian goods/services. A higher exchange rate reduces demand for Canadian dollars.

Effects on Demand

• Exports Effect:

  • Increased Canadian exports lead to higher demand for Canadian dollars, particularly if the exchange rate is lower, enhancing export value.

• Expected Profit Effect:

  • Higher expected profits from holding Canadian dollars increase current demand if today's exchange rate is lower.

Supply in the FX Market

• Definition:

  • Quantity of Canadian dollars traders plan to sell at a given exchange rate.

• Determinants of Supply:

  1. Exchange rate.

  2. Demand for Canadian imports.

  3. Interest rates (Canada and internationally).

  4. Expected future exchange rate.

• Law of Supply of Foreign Exchange:

  • Higher exchange rates lead to greater supply of Canadian dollars in the FX market.

Effects on Supply

• Imports Effect:

  • Increased Canadian imports raise Canadian dollar supply as more domestic currency is exchanged for foreign currency.

• Expected Profit Effect:

  • Lower current exchange rates suggest higher expected profits from holding foreign currencies and decrease the current supply of Canadian dollars.

Market Equilibrium

• Equilibrium Exchange Rate:

  • Achieved when there is neither a surplus nor a shortage of Canadian dollars in the market.

• If the exchange rate is too high, a surplus occurs, driving it down. If too low, a shortage occurs, driving it up.

Exchange Rate Fluctuations

• Influences on Demand Changes:

  • World demand for Canadian exports.

  • Changes in Canadian interest rates compared to foreign rates.

  • Changes in expected future exchange rates.

• Influences on Supply Changes:

  • Increased Canadian demand for imports leads to higher supply of Canadian dollars.

  • Higher interest rates that reduce the supply of Canadian dollars.

Exchange Rate Policies

• Flexible Exchange Rate:

  • Exchange rate determined by market demand and supply, with no direct central bank intervention.

• Fixed Exchange Rate:

  • Pegged exchange rate maintained by central bank intervention to stabilize the currency.

• Crawling Peg:

  • A gradually adjusted exchange rate controlled by government measures to avoid volatility.

Financing International Trade

• Balance of Payments:

  • Records a country’s international transactions (trading, borrowing, lending).

  • Accounts:

    1. Current account.

    2. Capital and financial account.

    3. Official settlements account.

• Current Account Balance:

  • Comprises exports, imports, net interest income, and transfers.

  • Calculated as exports - imports + net interest income + net transfers.

• Debt and Creditors:

  • A net borrower has borrowed more than it has lent; Canada is currently a net borrower.

  • A debtor nation has primarily borrowed more historically, while a creditor nation has invested more abroad.

National Accounts

• Key Relationships:

  • Current Account Balance (CAB) = NX + Net Interest Income + Net Transfers.

  • Government sector surplus/deficit = Net Taxes (T) - Government Expenditure (G).

  • Private sector surplus/deficit = Saving (S) - Investment (I).

  • Net Exports (NX) = Government sector balance + Private sector balance.