© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 1 EXCHANGE RATES AND THE BALANCE OF PAYMENTS SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 2 In this chapter you will learn 17.1 How international trade is financed 17.2 About a nation’s balance of payments 17.3 What a flexible exchange-rate system is and its effects on the domestic economy 17.4 What a fixed exchange-rate system is and its effects on the domestic economy 17.5 About the history of the world’s exchange- rate regimes

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 3 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 4 Financing International Trade n differing national currencies complicate international trade n currencies are exchanged in foreign exchange markets

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 5 Canadian Export Transaction Assume $2 = £1 1.$300,000 in Canadian telecommunications equipment purchased by a British buyer for £150,000 2.£150,000 cheque drawn on British bank to pay for equipment 3.£150,000 cheque is exchanged for $300,000 at a Canadian bank 4.Canadian bank sends £150,000 cheque to London bank for future transactions

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 6 Points to Remember Canadian exports create: n a foreign demand for Canadian $ n an increase in the supply of foreign currency owned by Canadian banks

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 7 Points to Remember Canadian imports: n create a domestic demand for foreign currencies n reduce the supplies of foreign currencies held by Canadian banks

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 8 Points to Remember n Canadian exports supply the foreign currencies needed to “pay for” imports n Demand for & supplies of foreign currencies also arise from transactions involving services & payment of interest & dividends on foreign investments

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 17 9 Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter n The Canadian balance of payments shows the balance between –all the payments that Canada receives from foreign countries & –all the payments which we make to them The Balance of Payments

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Current Account n shows the flows resulting from imports & exports of goods & services –the balance on goods is the net amount of imports & exports of goods only –the balance on goods & services includes goods & services –trade in services, investment income & transfers are included to get the current account balance –in 2002, Canada had a current account surplus of $17.3 billion

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Canadian Balance of Payments in 2002 (billions of dollars) ExportsImportsBalance Current Account Merchandise Services Balance on Goods and Services Net Investment Income Net Transfers Current Account Balance Current Account Balance Table 17-1

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Capital Account n shows capital inflows & outflows –purchase or sale of real or financial assets –official settlements account n TIP: –a + sign indicates a “source” of foreign exchange, –a - sign indicates a “use” of foreign exchange

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Canadian Balance of Payments in 2002 (billions of dollars) Balance Capital Account 10. Capital inflows Capital outflows Capital account balance account balance Official settlements account 13. Official international reserves Balance of payments Balance of payments $ 0 Table 17-1

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Payments Deficits & Surpluses n A drawing down of official international reserves (a + official reserves entry) measures a nation’s balance of payments deficit n A building up of official reserves (a – official reserves entry) measures a balance of payments surplus n Deficits not necessarily bad, but cannot be maintained indefinitely, because international reserves are limited

GLOBAL PERSPECTIVE 17.1

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Balance of Payments,

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Foreign Exchange Markets n competitive markets n linkages to all domestic & foreign prices

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Flexible Exchange Rates n Rates by which national currencies are exchanged are determined by demand & supply

P Q D The Market for Foreign Currency (Pounds) Dollar price of 1 pound Quantity of pounds Figure 17-2 who are the demanders of pounds in fx markets?

P Q D S Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) who are the suppliers of pounds to fx markets? Figure 17-2

P Q D S dollar price of pounds is determined by demand & supply Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) Figure 17-2

P Q D S 2 Dollar price of 1 pound Quantity of pounds Q1Q1 The Market for Foreign Currency (Pounds) Figure 17-2

P Q D S Pound appreciates D Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) 2 Q1Q1 Figure 17-2

P Q D S D Pound depreciates Dollar price of 1 pound Quantity of pounds The Market for Foreign Currency (Pounds) 2 Q1Q1 Figure 17-2

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Determinants of Exchange Rate Changes n Changes in Tastes n Relative Income Changes n Relative Price-Level Changes –Purchasing Power Parity Theory n Relative Interest Rates n Speculation

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Advantages of Flexible Rates n automatic adjustment to eventually eliminate balance of payments deficits or surpluses

P Q D S suppose tastes change & Canadians want to buy more British automobiles Dollar price of 1 pound Quantity of pounds 2 Adjustments Under Flexible Exchange Rates Figure 17-3

P Q D S demand for pounds increases Dollar price of 1 pound Quantity of pounds D 2 Adjustments Under Flexible Exchange Rates Figure 17-3

P Q D S Canadian balance of payments deficit Dollar price of 1 pound Quantity of pounds D 2 Adjustments Under Flexible Exchange Rates a b Figure 17-3

P Q D S Dollar price of 1 pound Quantity of pounds D 2 change in the exchange rate to $3=£1 would correct the deficit Adjustments Under Flexible Exchange Rates 3 c b a Figure 17-3

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Flexible Exchange Rates n with a lower $, Canadians will want to import less, & the British will want to buy more Canadian goods & services

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Disadvantages of Flexible Rates n reduced trade because of risks associated with constantly changing exchange rates n worsening terms of trade if there is a sizeable depreciation n challenges in designing domestic macroeconomic policies in nations heavily dependent on trade

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Fixed Exchange Rates n Use of Reserves –currency interventions n Trade Policies n Exchange Controls & Rationing n restricted choice n black markets n distorted trade n favouritism

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Fixed Exchange Rates n Use of Reserves –currency interventions n Trade Policies n Exchange Controls & Rationing n Domestic Macroeconomic Adjustments

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Exchange Rate Systems n The Gold Standard: Fixed Exchange Rates –currency defined in gold –fixed relationship between gold stock & money supply maintained –gold freely exported & imported

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Exchange Rate Systems n Gold flows resulted in fixed exchange rates n Domestic macroeconomic adjustments sometimes distasteful n Gold standard collapsed in the worldwide depression of the 1930s –series of devaluations

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Exchange Rate Systems n The Bretton Woods System –adjustable-peg system –International Monetary Fund (IMF) n Maintaining pegged rates –Official international reserves –Gold sales –IMF borrowing

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Exchange Rate Systems n Fundamental Imbalances: Adjusting the Peg n Demise of the Bretton Woods System –1971: the US floated the dollar

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Exchange Rate Systems n The Current System: The Managed Float –G-7 Intervention in 1987 n “almost” flexible n proponents & critics –has functioned better than anticipated –a “nonsystem”

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 17 Topics 17.1 Financing International Trade 17.2 The Balance of Payments 17.3 Foreign Exchange Markets: Flexible Exchange Rates 17.4 Fixed Exchange Rates 17.5 International Exchange-Rate Systems