Exchange Rates  Any transaction that appears in the balance-of- payments accounts involves trading Canadian dollars for another currency  Transactions that are receipts involves foreign currency being sold to buy Canadian dollars  e.g. a French company that purchases Canadian paper sold in France trades European euros for Canadian dollars to pay the Canadian paper company  Transactions that are payments: e.g. a Canadian buying the services of a Japanese architect exchanges Canadian dollars for Japanese yen to pay the architect

Foreign Exchange Rate  Recall: Exchange Rate is the value of one nation’s currency in terms of another currency  e.g. at any given moment, one Canadian dollar may trade for 90 American cents, 130 Japanese yen, or 0.70 European euros  Canadian dollar is usually compared to the American dollar – will be this way for the rest of the chapter  The exchange rate can be expressed as a formula:

Exchange Rates and Prices  When a Canadian export with a Canadian price of $20 is sold in the United States, its American dollar price is found by:  American dollar price = Canadian dollar price x American dollars to buy CDN$1  US$16.00 = CDN$20.00 x US$0.80/CDN$  Canadian prices of foreign goods are calculated in reverse; for example, an American product is imported to Canada that has an American price of $40  Canadian dollar price = American dollar price x Canadian dollars to buy US$1  CDN$50.00 = US$40.00 x CDN$1.25/US$

Foreign Exchange Markets  To see how exchange rates are set, we must look at the demand for and supply of Canadian currency Demand for Canadian Dollars  Relationship between price of a Canadian dollar and quantity of Canadian dollars demanded in exchange for another currency  Relationship is inverse: e.g. a jump in the price of the Canadian dollar in terms of the American dollar reduces the quantity of Canadian dollars demanded  EX. Foreigners buying Canadian exports of goods and services exchange their own currencies for Canadian dollars to pay Canadian producers  EX. Foreigners acquiring Canadian financial assets buy Canadian dollars to settle their purchases

Demand for Canadian Dollars cont’d  A higher Canadian dollar means that Canadian goods and services have higher American prices  EX. If the exchange rate for Canadian dollars is US$0.75, then a Canadian export with a price of CDN$2 originally has an American price of US$1.50 (= $2 x $0.75)  If the value of the Canadian dollar increases from US$0.75 to US$0.80, the American price of the export rises to $1.60 (= $2 x $0.80)  Since American buyers find Canadian exports more expensive, they purchase fewer of them  This decreases both Canadian export receipts and the quantity of Canadian dollars demanded in exchange for American dollars

Supply of Canadian Dollars

A Foreign Exchange Market Price of Canadian Dollar (in $US) Quantity of Canadian Dollars (billions)  The equilibrium value equals the exchange rate  If the price falls to c, then there’s a shortage of Canadian dollars  If there’s no government intervention, the forces of demand and supply push the price back up to equilibrium (the Canadian dollar appreciates) c c c Shortage

A Foreign Exchange Market Price of Canadian Dollar (in $US) Quantity of Canadian Dollars (billions)  The equilibrium value equals the exchange rate  If the price rises to a, then there’s a surplus of Canadian dollars  If there’s no government intervention, the Canadian dollar will depreciate, returning to the equilibrium value a a Surplus

Changes in Demand & Supply  Demand and supply shifts in foreign exchange markets are related to either trade or financial conditions  If the curves shift, the equilibrium exchange rate changes  4 main factors affect the equilibrium value of exchange rate:  1. Price Differences  2. Product Demand  3. Interest Rates  4. Speculation

Price Differences  If a country’s price levels rise faster than price levels in other countries, then its products become more expensive than foreign products  EX. Canada’s rate of inflation outpaces inflation in the United States  Regardless of the exchange rate, if things in Canada become more expensive, Americans will be buy less of them  This reduces the amount of Canadian currency demanded on this foreign exchange market  Demand for Canadian dollars falls  Canadians now buy more American products since they are cheaper  Increases the supply of Canadian dollars since Canadians exchanging their Canadian dollars for American dollars

Product Demand  If the quality of a product improves, then the demand increases  This would be a rightward shift in the demand curve  This would also results in Canadians buying more of their own products, and less American products  This decreases the supply of Canadian dollars since people hold onto it  Supply curve shift left  Both these trends cause Canadian dollar to appreciate in value, from the original equilibrium point, to the final equilibrium point

Interest Rates  If Bank of Canada implements expansionary monetary policy, causing interest rates in Canada to fall, bonds become less appealing to Canadian and American investors  Demand for Canadian dollars decreases  Demand curve shifts left  Canadians will also reduce their purchases of domestic bonds to buy foreign financial assets  Canadians will sell their Canadian dollars on foreign exchange markets, which will increase the supply of Canadian dollars  Supply curve shifts right  The movement of both demand and supply curves results in a depreciated Canadian dollar

Speculation  Some people, buy and sell on foreign exchange markets quickly to profit from short-run changes in currency values  These profit-seekers are known as speculators  Speculators affect the demand and supply of a certain currency, so this leads to changes in the exchange rates  How do speculators know the exchange rates are changing?  They respond to changes in:  Interest rates  Inflation rates  Political climate