Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Fourteen The Balance of Payments and Exchange Rates Macroeconomics by Curtis, Irvine, and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.Chapter 142 Learning Outcomes This chapter explains: The balance of payments accounts The determinants of the current account flows in the balance of payments The determinants of the capital account flows in the balance of payments The foreign exchange market and different exchange rate regimes The role for international policy co-ordination The European monetary system and the euro

©2007 McGraw-Hill Ryerson Ltd.Chapter The Balance of Payments Definitions: The balance of payments accounts The current account The capital account The change in official international reserves The balance of payments

©2007 McGraw-Hill Ryerson Ltd.Chapter The Canadian Balance of Payments, 2005 ($CDN billions) Exports (receipts) Imports (payments) Balance 1. Current account Trade in goods Trade in services Other, including transfers Capital account36.2 Investment: Foreign in Canada84.1- Canada in foreign countries Statistical discrepancy Change in official international reserves Balance of payments ( – 4)0

©2007 McGraw-Hill Ryerson Ltd.Chapter Determinants of the Current Account The real exchange rate Exports Imports Other items in the current account

©2007 McGraw-Hill Ryerson Ltd.Chapter The Capital Account Perfect capital mobility Return from lending $1000 for a year: $1000 Lent in Interest Rate (%)Exchange rate ($CDN/$US) Final Asset Value CanadaUSInitialFinal$CDN$US Canada US

©2007 McGraw-Hill Ryerson Ltd.Chapter The Capital Account Total return on foreign asset –Total return on foreign asset = i f + %Δer Interest parity Capital flow

©2007 McGraw-Hill Ryerson Ltd.Chapter The Foreign Exchange Market US Dollars D0D0 S0S0 er 0 =1.16 CDN$/US$ Demand for the US $ by Canadians wishing to buy US goods, services, and securities. Supply of the US $ from the sale of Canadian goods, services, and securities. Equilibrium exchange rate

©2007 McGraw-Hill Ryerson Ltd.Chapter The Foreign Exchange Market depreciatesThe Canadian dollar depreciates –Falls in external value when the CDN$/US$ exchange rate rises appreciatesThe Canadian dollar appreciates –Increases in external value when CDN$/US$ exchange rate falls

©2007 McGraw-Hill Ryerson Ltd.Chapter Exchange Rate Regimes Exchange rate regimes describe how exchange rates are determined. Fixed Exchange Rate: –A currency is convertible if the central bank will buy or sell unlimited quantities at a fixed exchange rate –Official exchange reserves –Central bank intervenes

©2007 McGraw-Hill Ryerson Ltd.Chapter Central Bank Intervention to Fix the Exchange Rate US Dollars D1D1 S1S1 er 1 CDN$/US$ D2D2 D3D3 AC E Excess Demand Excess Supply The bank supplies AC US dollars from official reserve holdings in exchange for Canadian dollars. The bank buys US dollars with Canadian dollars and adds to foreign exchange reserves.

©2007 McGraw-Hill Ryerson Ltd.Chapter Floating or Flexible Exchange Rates US Dollars D1D1 S1S1 er 1 CDN$/US$ D2D2 er 2 D3D3 A B C D E Excess Demand Excess Supply A rise in demand for US dollars would result in a rise in the exchange rate. Canadian dollar depreciates. A fall in demand for US dollars would result in a fall in the exchange rate as the Canadian dollar appreciates.

©2007 McGraw-Hill Ryerson Ltd.Chapter Fixed versus Flexible Exchange Rates Robustness Volatility Financial Discipline

©2007 McGraw-Hill Ryerson Ltd.Chapter Canadian Dollar Price of the U.S. Dollar

©2007 McGraw-Hill Ryerson Ltd.Chapter International Policy Coordination Policy coordination is an attempt by countries to formulate policy collectively. The Externality Argument for Coordination The Reputation Argument for Coordination

©2007 McGraw-Hill Ryerson Ltd.Chapter The European Monetary System and the Euro European Monetary System (EMS) –Establish a European Currency Unit (ECU) –Lend foreign exchange reserves –Exchange Rate Mechanism (ERM) The ERM in Practice From the ERM to the Euro

©2007 McGraw-Hill Ryerson Ltd.Chapter 1417 Chapter Summary Balance of payments, current account, and capital accountBalance of payments, current account, and capital account Perfect international capital mobilityPerfect international capital mobility means that an enormous quantity of funds shifts between currencies when the perceived rate of return differs across currencies interest rate parityThe interest rate parity condition says that, when capital mobility is perfect, the interest rate differentials across countries should be offset by expected exchange rate changes. The foreign exchange market and the exchange rateThe foreign exchange market and the exchange rate

©2007 McGraw-Hill Ryerson Ltd.Chapter 1418 Chapter Summary demandsupplyThe demand and supply for foreign currency Fixedcentral bank interventionFixed exchange rate regime and central bank intervention FloatingflexibleFloating or flexible exchange rates choiceThe choice between fixed and floating exchange rate regimes International policy coordinationInternational policy coordination The European Monetary SystemThe European Monetary System