Copyright © 2005 Pearson Education Canada Inc.17-1 Chapter 17 Exchange Rates and the Balance of Payments

Copyright © 2005 Pearson Education Canada Inc.17-2 Learning Objectives 17.1Distinguish between the balance of trade and the balance of payments. 17.2Identify the key accounts within the balance of payments. 17.3Outline how exchange rates are determined in the markets for foreign exchange.

Copyright © 2005 Pearson Education Canada Inc.17-3 Learning Objectives 17.4Discuss factors that can induce changes in equilibrium exchange rates. 17.5Outline how policy makers can go about attempting to fix exchange rates Explain alternative approaches to limiting exchange rate variability.

Copyright © 2005 Pearson Education Canada Inc.17-4 The Balance of Payments and International Capital Movements Balance of Trade  The value of goods and services bought and sold in the world market. Balance of Payments  A summary record of a country’s economic transactions with foreign residents and governments over a year.

Copyright © 2005 Pearson Education Canada Inc.17-5 The Balance of Payments and International Capital Movements Surplus Items (+)Deficit Items(-) Exports of merchandise Private and governmental gifts from foreigners Foreign use of domestically owned transportation Foreign tourists’ expenditures in this country Foreign military spending in this country Interest and dividend receipts from foreigners Sales of domestic assets to foreigners Funds deposited in this country by foreigners Sales of gold to foreigners Sales of domestic currency to foreigners Imports of merchandise Private and governmental gifts to foreigners Use of foreign-owned transportation Tourism expenditures abroad Military spending abroad Interest and dividends paid to foreigners Purchases of foreign assets Funds placed in foreign depository institutions Purchases of gold from foreigners Purchases of foreign currency

Copyright © 2005 Pearson Education Canada Inc.17-6 The Balance of Payments and International Capital Movements Accounting Identities  Statements that certain numerical measurements are equal by accepted definition.

Copyright © 2005 Pearson Education Canada Inc.17-7 The Balance of Payments and International Capital Movements When family expenditures > income, the family must do one of the following: 1) Draw down its wealth 2) Borrow 3) Receive gifts from friends or relatives 4) Receive a public transfer Cannot continue indefinitely

Copyright © 2005 Pearson Education Canada Inc.17-8 The Balance of Payments and International Capital Movements Three Categories of Balance of Payments Transactions 1) Current Account Transactions 2) Capital Account Transactions 3) Official Settlement Account Transactions

Copyright © 2005 Pearson Education Canada Inc.17-9 The Balance of Payments and International Capital Movements Current Account Transactions  Merchandise trade transactions Importing and exporting of merchandise Balance = merchandise exports - merchandise imports

Copyright © 2005 Pearson Education Canada Inc The Balance of Payments and International Capital Movements Current Account Transactions  Service Exports and Imports Invisible or intangible items oShipping oInsurance oTourism oBanking oIncome from investments

Copyright © 2005 Pearson Education Canada Inc The Balance of Payments and International Capital Movements Capital Account Transactions  Deals with the buying and selling of real and financial assets.

Copyright © 2005 Pearson Education Canada Inc The Balance of Payments and International Capital Movements The current account and capital account are related.

Copyright © 2005 Pearson Education Canada Inc The Balance of Payments and International Capital Movements Official Settlement Account Transactions 1) Foreign currencies 2) Gold 3) Special drawing rights (SDRs) Reserve assets created by the International Monetary Fund that countries can use to settle international payments

Copyright © 2005 Pearson Education Canada Inc The Balance of Payments and International Capital Movements Official Settlement Account Transactions 4) The reserve position in the International Monetary Fund 5) Financial assets held by an official agency, such as the Bank of Canada

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates Foreign Exchange Market  The market for buying and selling foreign currencies. Foreign Exchange Rates  The price of one currency in terms of another.

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates Flexible Exchange Rates  Exchange rates that are allowed to fluctuate in the open market in response to changes in supply and demand.  Sometimes called ‘floating exchange rates’.

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates Quantity of French Wine per Week (litres) Price per Litre ($) Demand Schedule for French Wine in Canada per Week Price perQuantity Demanded Litre(litres) $ D

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates Euros Required to Purchase Quantity Demanded (P = 20 euros/litre) Quantity Demanded Euros (litres) Required Derived Demand for Euros in Canada with Which to Pay for Imports of Wine DollarQuantity ofQuantity of Price ofDollar PriceWine DemandedEuros Demanded One Euroof Wine(litres)per Week $.50$

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates D1D1 Quantity of Euros Demanded per Week Price per Euro ($)

Copyright © 2005 Pearson Education Canada Inc Determining Foreign Exchange Rates Supply of French Euros  Price of Canadian jeans = $10  Exchange rate =.25 for 1 euro  40 euros = 1 pair of jeans  Exchange rate =.50 for 1 euro  20 euros = 1 pair of jeans

Copyright © 2005 Pearson Education Canada Inc S Derived supply results from the representative French purchaser of Canadian jeans Determining Foreign Exchange Rates Quantity of Euros per Week Price per Euro ($) D1D1 Derived demand is taken from the table shown previously. E

Copyright © 2005 Pearson Education Canada Inc S Results from the total French demand for Canadian jeans Determining Foreign Exchange Rates Millions of Euros per Year Price per Euro ($) D E Equilibrium exchange rate -- Canadian dollar price of a Euro 0

Copyright © 2005 Pearson Education Canada Inc S Factors That Can Induce Changes in Equilibrium Exchange Rates Millions of Euros per Year Price per Euro ($) D1D E1E1 D2D2 The demand schedule for French wine shifts to the right E2E2 Value of the euro increases -- Canadian dollar price of wine will increase; the French euro price of jeans will decline

Copyright © 2005 Pearson Education Canada Inc S Factors That Can Induce Changes in Equilibrium Exchange Rates Millions of Euros per Year Price per Euro ($) D1D E 0 S1S1 200 E1E1 Following the shift the value of the Euro falls and the amount of Euros demanded increases.10

Copyright © 2005 Pearson Education Canada Inc Factors That Can Induce Changes in Equilibrium Exchange Rates Market Determinants of Exchange Rates 1) Changes in real interest rates 2) Changes in productivity 3) Changes in product preferences 4) Perceptions of economic stability

Copyright © 2005 Pearson Education Canada Inc The Gold Standard and the International Monetary Fund Gold Standard  An international monetary system in which nations fix their exchange rates in terms of gold.  Fixes all currencies in terms of all others.  Balance of payments deficits or surpluses are made up by shipments of gold.

Copyright © 2005 Pearson Education Canada Inc The Gold Standard and the International Monetary Fund International Monetary Fund (IMF)  An institution set up to manage the international monetary system.

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates Fixed Exchange Rates:  Central banks had to intervene in the market to ensure the exchange rate remained the same.  Must have sufficient foreign exchange reserves available to deal with long- lasting changes in the demand or supply of their currency.

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates Thailand’s Fixed Exchange Rate: The Bank of Thailand buys baht with dollars shifting the demand for baht to the right The supply of baht shifts to the right as Thai residents demand more U.S. goods The value of the baht will fall S Quantity of Baht per Week Dollars per Baht D1D E1E1 0 S1S1.30 D1D1 E3E3 E2E2

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates Pros and Cons of a Fixed Exchange Rate  Foreign Exchange Rate Risk The possibility that variations in the market value of assets can take place as a result of changes in the value of a nation’s currency.  Hedge A financial strategy that is intended to offset the risk arising from exchange rate variations.

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates The Exchange Rate as a Shock Absorber  Exchange rate variations can be beneficial, especially if a nation’s residents are relatively immobile.

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates “Dirty” Floats  A Dirty float is a system which falls between the flexible and fixed exchange rate policies, in which central banks occasionally enter foreign exchange markets to influence rates.

Copyright © 2005 Pearson Education Canada Inc Fixed versus Floating Exchange Rates Crawling Peg  An exchange rate arrangement in which a country pegs the value of its currency to the exchange value of another nation’s currency but allows the par value to change at regular intervals.

Copyright © 2005 Pearson Education Canada Inc Fixed Versus Floating Exchange Rates Target Zone  A range of permitted exchange rate variations between upper and lower exchange rate bands that a central bank defends by selling or buying foreign exchange reserves.