Basics of International Finance National income accounting Records all the expenditures that contribute to a country’s income and output Balance of payments accounting Helps us keep track of both changes in a country’s indebtedness to foreigners and the fortunes of its export- and import-competing industries Gross national product (GNP) The value of all final goods and services produced by a country’s factors of production and sold on the market in a given time period. It is the basic measure of a country’s output. 1/1/2019 Econ 355, Nisha Malhotra

The National Income Identity for an Open Economy It is the sum of domestic and foreign expenditure on the goods and services produced by domestic factors of production: Y = C + I + G + EX – IM (12-1) where: Y is GNP C: The amount consumed by private domestic residents I : The amount put aside by private firms to build new plant and equipment for future production G is government purchases EX is exports IM is imports In a closed economy, EX = IM = 0. 1/1/2019 Econ 355, Nisha Malhotra

The Current Account and Foreign Indebtedness Current account (CA) balance The difference between exports of goods and services and imports of goods and services (CA = EX – IM) A country has a CA surplus when its CA > 0. A country has a CA deficit when its CA < 0. CA measures the size and direction of international borrowing. A country’s current account balance equals the change in its net foreign wealth. Example: Canada imports 20 bushels of wheat and exports only 10 bushels of wheat. The current account deficit of 10 bushels is the value of Canada’s borrowing from foreigners, which the country will have to repay in the future. 1/1/2019 Econ 355, Nisha Malhotra

The Balance of Payments Accounts (BOP) Three types of international transactions are recorded in the balance of payments: Exports or imports of goods or services Purchases or sales of financial assets Money, Stocks, government debt and purchase/sale of factories Transfers of wealth between countries They are recorded in the capital account. Capital Account: -result from non-market activities, or represent the acquisition or disposal of nonproduced, nonfinancial assets. Person moves to canada with her savings Foreign aid/ forgiveness of debt 1/1/2019 Econ 355, Nisha Malhotra

Double-entry book keeping-BOP Each transaction enters the BOP twice, once as a credit and once as a debit Example: A U.S. citizen pays $200 for dinner at a French restaurant in France by charging his Visa credit card. That is, the U.S. trades assets for services. This transaction creates the following two offsetting entries in the U.S. balance of payments: It enters the U.S. CA with a negative sign (-$200). It shows up as a $200 credit in the U.S. financial account. 1/1/2019 Econ 355, Nisha Malhotra

Double-entry book keeping-BOP 2003 Class of Econ 355 is so generous that it gives $5000 in foreign aid to Nisha in India. This transaction creates the following two offsetting entries It enters the Canadian capital account with a negative sign (-$5000). It shows up as a $5000 credit in the Canadian financial account. 1/1/2019 Econ 355, Nisha Malhotra

The Fundamental BOP Identity Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity: Current account + financial account + capital account = 0 ************************************************************************** Capital Inflow and Outflow Financial inflow also called -(capital inflow) A loan from the foreigners with a promise that they will be repaid Financial outflow also called - (capital outflow) A transaction involving the purchase of an asset from foreigners The loan enters financial account with a positive sign. The Canadian govt. is selling them an asset – a promise that this loan will be repaid in the future. A financial inflow is sometimes also called a capital inflow. 1/1/2019 Econ 355, Nisha Malhotra

Official Reserve Transactions Central bank-US/ (Bank of Canada) The institution responsible for managing the supply of money Official international reserves Foreign assets held by central banks as a cushion against national economic misfortune Official foreign exchange intervention Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies. 1/1/2019 Econ 355, Nisha Malhotra

The Exchange Rate THE EXCHANGE RATE refers to the value of the Canadian dollar against the currencies of other countries. Depreciation: When the value (purchasing power) of the Canadian dollar falls. (Moving from 1.3 per US dollar to 1.5 per US dollar) (.77 per CA dollar to .67 per CA dollar) imported goods become more expensive, and we tend to reduce the volume of our imports. At the same time, other countries will pay less for some of our products and that will tend to boost export sales. A Depreciation lowers the relative price of export and increases the relative price of imports. Appreciation: The opposite 1/1/2019 Econ 355, Nisha Malhotra

Using the exchange rate to calculate the price for Canon Canon Powershot SD100 3.2 Megapixel 2x Optical/3.2x Digital Zoom Digital Camera www.tigredirect.com PRICE: US $329.99 5% tax & free shipping=346.49 www.tigerdirect.ca PRICE: CA $445.99 14.5% tax & free shipping=510.55 Buying the camera in the US-price in Canadian dollars (US $) * (CA $/US $) us$346.49 * 1.32= ca $457.37 1/1/2019 Econ 355, Nisha Malhotra

The Foreign Exchange market Exchange rates are determined by the interaction of buyers and sellers of foreign currencies in the foreign exchange market. Commercial Banks, Corporations, Nonbank financial institutions and Central banks. Demand for deposit in a currency depends on the expected rate of return for this asset. Choosing to hold Euro or Dollar deposit- Need to know-how the money value of the deposit will change and how the exchange rate will change Money value depend on the currency’s interest rate Change in exchange rate- rate of depreciation of the currency 1/1/2019 Econ 355, Nisha Malhotra

Demand for foreign currency asset The expected rate of return difference between dollar and euro deposits is: R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1) where: R$ = interest rate on one-year dollar deposits R€ = today’s interest rate on one-year euro deposits E$/€ = today’s dollar/euro exchange rate (number of dollars per euro) Ee$/€ = dollar/euro exchange rate (number of dollars per euro) expected to prevail a year from today 1/1/2019 Econ 355, Nisha Malhotra

Determination of the Equilibrium Dollar/Euro Exchange Rate Interest Parity: The Basic Equilibrium Condition The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. R$= R€ + (Ee$/€ -E$/€ )/E$/€ 1/1/2019 Econ 355, Nisha Malhotra

Equilibrium in the Foreign Exchange Market Determination of the Equilibrium Dollar/Euro Exchange Rate Rates of return (in dollar terms) Exchange rate, E$/€ R$ Return on dollar deposits Expected return on euro deposits E2$/€ 2 1 E1$/€ E3$/€ 3 1/1/2019 Econ 355, Nisha Malhotra

Relationships Interest rates & Current Exchange Rate An increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies Rates of return (in dollar terms) Exchange rate, E$/€ Dollar return R2$ Expected euro return R1$ 1 E1$/€ 1' 2 E2$/€ 1/1/2019 Econ 355, Nisha Malhotra

Relationships Expectations about the future exchange rate & Current Exchange Rate A rise in the expected future exchange rate causes a rise in the current exchange rate. Rates of return (in dollar terms) Exchange rate, E$/€ Dollar return R$ Expected euro return Rise in the future Exchange rate 2 E2$/€ 1 E1$/€ 1/1/2019 Econ 355, Nisha Malhotra

Relationships Money supply and the exchange rate in the short run Money supply & interest rate--Increase in the level of the nominal money supply lowers the interest rate Since people are holding more money than they desire, they bid for assets that pay interest. The economy as a whole cannot reduce its money holdings, so interest rates are driven down as unwilling money holders compete to lend their excess cash balance. Interest rate & exchange rate (interest parity condition)-- decrease in dollar interest rate depreciates the currency Thus, an in crease in a country’s money supply causes its currency to depreciate in the foreign exchange market. Long Run-Price level increases and no change in the interest rate and output. It does lead to a permanent depreciation in the currency. Price level and the future expectations are given 1/1/2019 Econ 355, Nisha Malhotra

(Dollar interest rate) (Dollar/Euro exchange rate) Relationships Money supply and the exchange rate Money-Market/Exchange Rate Linkages Canada Bank of Canada Europe European System of Central Banks (Canada money supply) MSCA MSE (European money supply) Canada money market European money market Foreign exchange market R$ (Dollar interest rate) R€ (Euro interest rate) E$/€ (Dollar/Euro exchange rate) 1/1/2019 Econ 355, Nisha Malhotra