1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-1 Introduction The dollar is the predominant global currency that many people throughout the world utilize to conduct transactions relating to international trade and finance. During the 2000s, some observers suggested that the euro, the currency used by a number of European nations, might replace the dollar as the global currency. Today the euro’s status is in doubt. To understand why this is so, you must first understand the determination of exchange rates, which is a key topic of this chapter.

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-2 Learning Objectives Distinguish between the balance of trade and the balance of payments Identify the key accounts within the balance of payments Outline how exchange rates are determined in the markets for foreign exchange

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-3 Learning Objectives (cont'd) Discuss factors that can induce changes in equilibrium exchange rates Understand how policymakers can go about attempting to fix exchange rates Explain alternative approaches to limiting exchange rate variability

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-4 Chapter Outline The Balance of Payments and International Capital Movements Determining Foreign Exchange Rates The Gold Standard and the International Monetary Fund Fixed versus Floating Exchange Rates

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-5 Did You Know That... In the spring of 2010, a pair of Levi’s 505 jeans priced at about 30 U.S. dollars in a U.S. Sears store could be purchased at a Sears Canada store at a price equivalent to 68 U.S. dollars? This situation came about because of a substantial change in the U.S. dollar-Canadian dollar exchange rate. In this chapter, you will learn about the determinants of exchange rates.

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-6 The Balance of Payments and International Capital Movements Balance of Trade –The difference between exports and imports of goods

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-7 The Balance of Payments and International Capital Movements (cont'd) Balance of Payments –A system of accounts that measures transactions of goods, services, income and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-8 Table 33-1 Surplus (+) and Deficit (–) Items on the International Accounts

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-9 The Balance of Payments and International Capital Movements (cont'd) Accounting Identities –Values that are equivalent by definition –Ultimately, net lending by households must equal net borrowing by businesses and governments

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-10 The Balance of Payments and International Capital Movements (cont'd) When family expenditures exceed income, the family must be doing one of the following: 1.Reducing its money holdings, or selling stocks, bonds, or other assets 2.Borrowing 3.Receiving gifts from friends or relatives 4.Receiving public transfers from a government

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-11 The Balance of Payments and International Capital Movements (cont'd) Disequilibrium –If expenditures exceed income, the situation cannot continue indefinitely Equilibrium –Households, businesses, and governments must eventually reach equilibrium

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-12 The Balance of Payments and International Capital Movements (cont'd) An accounting identity among nations –When people from different nations trade or interact, certain identities or constraints must also hold –Let’s look at the three categories of the balance of payments transactions

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-13 The Balance of Payments and International Capital Movements (cont'd) Three categories of balance of payments transactions 1.Current account transactions 2.Capital account transactions 3.Official reserve account transactions

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-14 The Balance of Payments and International Capital Movements (cont'd) Current Account –A category of balance of payments transactions that measures the exchange of merchandise, the exchange of services and unilateral transfers

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-15 The Balance of Payments and International Capital Movements (cont'd) Current account transactions –Merchandise trade exports and imports Tangible items—things you can feel, touch and see –Service exports and imports Intangible items that are bought and sold –Unilateral transfers Gifts from citizens and from governments

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-16 Table 33-2 U.S. Balance of Payments Account, Estimated for 2011(in billions of dollars)

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-17 The Balance of Payments and International Capital Movements (cont'd) Balancing the current account –Current account surplus Net exports plus unilateral transfers plus net investment income exceeds zero –Current account deficit Net exports plus unilateral transfers plus net investment income is negative

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-18 The Balance of Payments and International Capital Movements (cont'd) A current account deficit means that we are importing more goods and services than we are exporting A current account deficit must be paid by the export of money or money equivalent

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-19 The Balance of Payments and International Capital Movements (cont'd) Capital Account –A category of balance of payments transactions that measures flows of real and financial assets

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-20 Capital account  Current account  0 The Balance of Payments and International Capital Movements (cont'd) The current account and capital account must sum to zero –In the absence of interventions by finance ministries or central banks

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-21 Figure 33-1 The Relationship Between the Current Account and the Capital Account

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-22 The Balance of Payments and International Capital Movements (cont'd) Official reserve account transactions 1.Foreign currencies 2.Gold 3.Special drawing rights (SDRs) 4.Reserve position in the IMF 5.Financial assets held by an official agency (such as the U.S. Treasury)

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-23 The Balance of Payments and International Capital Movements (cont'd) Special Drawing Rights –Reserve assets created by the International Monetary Fund for countries to use in settling international payment obligations International Monetary Fund –An agency founded to administer an international foreign exchange system and to lend to member countries that had balance of payments problems –The IMF now functions as a lender of last resort

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-24 The Balance of Payments and International Capital Movements (cont'd) Question –What affects the balance of payments? Answers –Relative rate of inflation –Political stability Capital flight

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-25 Determining Foreign Exchange Rates When you buy foreign products, you have dollars But the foreign country can’t pay workers in dollars So there must be a way of exchanging these dollars

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-26 Determining Foreign Exchange Rates (cont’d) Foreign Exchange Market –A market in which households, firms and governments buy and sell national currencies Exchange Rates –The price of one nation’s currency in terms of another

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-27 The Foreign Exchange Market The participants: 1.Commercial banks and other depository institutions: transactions involve buying/selling of bank deposits in different currencies for investment. 2.Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets. 3.Private firms: conduct foreign currency transactions to buy/sell goods, assets or services. 4.Central banks: conduct official international reserves transactions.

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-28 Determining Foreign Exchange Rates (cont'd) Every Canadian transaction involving the importation of foreign goods constitutes a supply of dollars (and a demand for some foreign currency), and the opposite is true for export transactions

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-29 Exchange Rates Comparative value of one currency in terms of another An exchange rate is the rate at which one currency is exchanged for another Exchange rates can be expressed in two ways:

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-30 1 Canadian dollar = 1 / (1 unit of foreign currency) e.g $1 CAN = $0.76 US Or, 1 unit of foreign currency = 1 / ( 1 Canadian dollar) e.g. $1 US = $1.32 CAN If a Canadian dollar is worth 5 Mexican pesos, then a Mexican peso is worth 20 cents Canadian If the price of lemons in Mexico is 2 pesos each, then a Canadian needs 40 cents to buy a lemon in Mexico

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-31 Currency Appreciation and Depreciation Currency appreciation –The rise in the exchange rate of one currency for another –If the value of the Canadian dollar rises in terms of a foreign currency, it has appreciated –You need less Canadian $ to buy the foreign currency Currency depreciation –The fall in the exchange rate of one currency for another –If the value of the Canadian dollar declines in terms of a foreign currency it has depreciated

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-32 What determines the value of any given currency? What causes changes in this value? Prices are determined by Demand and Supply Or May be determined by government

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-33 Exchange Rate Regimes Flexible exchange rates –A currency exchange rate determined by the market forces of supply and demand and not interfered with by government action Fixed exchange rates –A currency exchange rate pegged by the government and therefore prevented from rising and falling –Revaluation: increase in the rate –Devaluation: decrease in the rate

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-34 What determines Exchange rates Interest Parity Theory Purchasing Power Parity Theory (long run).

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-35 In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries’ products are traded. –The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-36 The Law of One Price Law of one price –Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. This law applies only in competitive markets free of transport costs and official barriers to trade. –Example: If the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for £30 in London.

37. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-37 Purchasing Power Parity Theory of Purchasing Power Parity (PPP) –The exchange rate between two counties’ currencies equals the ratio of the counties’ price levels. –It compares average prices across countries.

38. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-38 Purchasing Power Parity PPP asserts that all countries’ price levels are equal when measured in terms of the same currency.

39. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-39 The Relationship Between PPP and the Law of One Price –The law of one price applies to individual commodities, while PPP applies to the general price level. –If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries. –Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly. Purchasing Power Parity

40. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-40 Absolute PPP and Relative PPP –Absolute PPP It states that exchange rates equal relative price levels. –Relative PPP It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels. Percentage change in exchange rates equals the differences in the inflation rates Purchasing Power Parity

41. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-41 If goods are homogenous, the law of one price is more likely to hold PPP may not hold because of differentiated products Transaction costs Tariffs and freight charges Non- tradeable goods in the basket

42. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-42 Demand for the Canadian Dollar Who wants to buy and sell Canadian dollars and why? Demand depends on: 1.Foreigners who want to buy Canadian exports or who want to travel to Canada, Tourism Canada 2.Foreigners who want to purchase Canadian investments –Direct investment: The purchase of real assets –Portfolio investment: The purchase of shares or bonds representing less than fifty percent ownership

43. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-43 3.Canadians who receive income from abroad, including Canadians who have foreign investments. These investments earn returns which would be converted to Canadian dollars 4.Currency speculators –Buying a currency in the expectation that its value will rise Arbitrage: The process of buying a commodity in one market, where the price is low, and immediately selling it in a second market where the price is higher

44. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-44 5.Arbitrage: The process of buying a currency in one market, where the price is low, and immediately selling it in a second market where the price is higher Note unlike speculators, those engaged in arbitrage are not concerned about the future value of the Canadian dollar

45. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-45 The supply of Canadian Dollars: Comes from our demand for foreign currencies. In obtaining foreign goods, we must automatically supply Canadian dollars

46. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-46 Determinants of Exchange Rates What causes a change in demand and SS? 1.International Trade : Balance of Payments: An accounting of a country’s international transactions that involves the payment and receipts of foreign currencies Balance of Trade: The value of a country’s exports minus the value of its imports

47. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-47 When Canada has a deficit in its balance of trade (more imports than exports), Remember, imports create SS of CAN $ and exports create demand SS of Canadian dollar exceed demand for Canadian dollars (ceteris paribus)  Depreciation of the Canadian dollar

48. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-48 2.The level of foreign incomes If foreign incomes increase, then the demand for all available products, including Canadian goods will increase Increase in demand for Canadian exports = shift in the DD curve to the right  appreciation of the dollar

49. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-49 3.The price of Canadian products relative to the price of foreign products A decrease in the price of Canadian goods will result in a high demand for these goods  A high demand for Canadian dollar

50. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-50 4.Comparative interest rates If Canada has a higher interest rate than the US, capital will flow into Canada. This means a higher demand for the Canadian dollar.  A low interest rate depreciates the dollar

51. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-51 An increase in aggregate income in Canada, relative to the world Cause more imports,  More supply of CAN $  Depreciation of the CAN$

52. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-52 Current Foreign Exchange Rate Arrangements

53. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-53 Fixed versus Floating Exchange Rates (cont'd) Central banks can keep exchange rates fixed as long as they have enough foreign exchange reserves to deal with potentially long-lasting changes in the demand for or supply of their nation’s currency

54. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-54 Fixed versus Floating Exchange Rates (cont'd) Foreign Exchange Risk –The possibility that changes in the value of a nation’s currency will result in variations in market value of assets –Limiting foreign exchange risk is a classic rationale for adopting a fixed exchange rate

55. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-55 Table 33-3 Key Currencies Throughout World History

56. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-56 Issues & Applications: Will the Euro’s Global Currency Status Be Short-Lived? (cont’d) Question –Why has the euro’s status become in doubt only a few years later? Answer –Since early 2010, however, the euro’s value has been prone to sudden drops, which induced individuals and businesses in many nations to avoid its foreign exchange risk by shifting funds away from euro-denominated bank deposit accounts, bonds, and stocks and towards dollar- denominated accounts, bonds, and stocks instead.