INTERNATIONAL TRADE AND EXCHANGE RATES
The Balance of Payments Accounts
Capital and Financial Account
Savings and Investment in a Small Open Economy
The Role of the World Real Rate of Interest
Fiscal Policy and the Twin Deficits
Exchange Rate Determination
Exchange Market Intervention
The Evolution of the Canadian Exchange Rate
Alternative Measures of the Exchange Rate
The Exchange Rate in the Long Run: Purchasing Power Parity
Working With Data
Changes from the Previous Edition
This was a new chapter in the sixth edition, and we have made no major changes for the seventh
edition. We start with a detailed description of the balance of payments accounts, centered on Table 5-1.
Section 5-2 discusses savings and investment in a small open economy, using the model that was
developed in Chapter 3. Section 5-3 discusses fixed and flexible exchange rates, and the evolution of the
Canada/U.S. exchange rate. Box 5-1 discusses the evolution of the Euro. The chapter concludes with a
discussion of purchasing power parity and the real exchange rate. The Policy in Action feature discusses
the relationship between monetary policy, inflation and the exchange rate in Canada.
Students should be able to distinguish between the capital account and the current account.
Students should understand the relationship between domestic savings and investment and foreign
borrowing and lending.
Students should be able to distinguish between fixed, freely floating and managed (or dirty) floating
exchange rate systems.
Students should be familiar with the issues related to the Euro.
Students should know the factors that may lead to a change in the value of a country's currency.
Students should know the difference between a currency appreciation (depreciation) and a currency
Students should be familiar with the concept of purchasing power parity.
Accomplishing the Objectives
The increased globalization of economic activity makes it mandatory that students understand the
important aspects of international trade and finance and how economic influences from abroad can affect
the Canadian economy. International trade deals with issues related to the export of domestically
produced goods and the import of goods produced abroad. International finance deals with the capital
flows that occur as portfolio managers around the world shift their holdings of domestic and foreign
assets (bonds issued by domestic and foreign governments or corporations). The actions of international
investors (who seek the highest yield on their assets) and foreign governments (who respond to domestic
policy actions) affect exchange rates, domestic income, and the ability of governments to conduct
independent domestic stabilization policies.
The balance of payments as the record of transactions between one country and the rest of the
world is introduced first. The two main accounts in the balance of payments are the current account
(which records trade in goods, services, and transfer payments) and the capital and financial account
(which records the trade in assets). The overall balance of payments surplus or deficit is the sum of the
current and capital account surpluses or deficits.
Section 5-2 modifies the savings investment model from Chapter 3 to take account of the open
economy. The excess of savings over investment, which is net foreign lending, must equal net exports, or
the trade balance. In Chapter 3, movements in the domestic real rate of interest ensured that savings
equals investment. Now, with the small open economy assumption, Canada takes the world real rate of
interest as given, and domestic savings does not have to equal domestic investment. This is illustrated in
Figures 5-1 and 5-2. The twin deficit problem is treated in Figure 5-3, and illustrated empirically in
Purchasing power parity is the long run theory of the evolution of the nominal exchange rate. A
country's competitiveness in foreign trade is measured by the real exchange rate, that is, the ratio of
foreign to domestic prices measured in the same currency. Two currencies are at purchasing power parity
(PPP) when one unit of the domestic currency can buy the same basket of goods in the home country and
in a foreign country. While the movement towards purchasing power parity tends to be very slow, market
forces generally prevent the exchange rate from moving too far or remaining indefinitely away from this
purchasing power parity.
Suggestions and Pitfalls
Students tend to be most interested in the discussion of current international problems, such as the
creation of a new European currency, factors that can affect the value of the Canadian dollar, or the
potential for an international debt crisis. To capture students' interest, instructors should relate the
theoretical framework discussed in this chapter to real world issues as often as possible.
To introduce the difference between the current account and the capital account and to stimulate
discussion among students, instructors can pose the following question: If a country runs a large trade
deficit, what is likely to happen to the value of the country's currency? The obvious answer is that, all else
being equal, the value of the domestic currency should decrease. However, this has to be related to
interest differentials and capital flows, which will be discussed later in the text.
Instructors may have already at least briefly discussed the relationship between budget deficits
(BD) and trade deficits (TD) when they discussed the national income accounting identities in Chapter 2
along with the equation
S - I = (G + TR - TA) + NX.
By changing this equation slightly we can derive
S - I = - (TA - G - TR) - (-NX) ==> S - I = BD - TD,
that is, the difference between private domestic saving and private domestic investment is equal to the
difference between the budget deficit and the trade deficit. This is the essence of the twin deficit
discussion, which students should find interesting,
Since the terminology in this chapter can be somewhat confusing, it is important to note the
difference between currency depreciation (appreciation) and currency devaluation (revaluation). Under a
system of floating exchange rates a currency depreciates (appreciates) when it becomes less (more)
expensive in relation to foreign currencies. Under a system of fixed exchange rates currency devaluation
(revaluation) takes place when the price at which foreign currencies can be bought is increased
(decreased) by official government action.
Since most students are at least somewhat familiar with the events in Europe in the 1990s, the
material in Box 5-1 provides a good basis for a lively classroom discussion. The material relating to the
German re-unification can be used to show parallels with the policy mix employed in the Canada in the
early 1980s and to demonstrate why it is hard to maintain fixed exchange rates when the countries
involved choose to pursue different policy objectives
The discussion of the issues surrounding the introduction of the Euro as the common currency for
the countries of the European Union will definitely spark students' interest. Many may have traveled in
Europe already and are therefore familiar with the different national currencies. They may have realized
that, starting in the late 1990s, menu prices in some restaurants were already listed in Euros, even though
the meal still had to be paid in the national currency, since the Euro was not yet officially available for
purchasing items. Special attention should be given to the benefits and drawbacks for a country that gives
up its national currency (and the exchange rate as a policy tool) in exchange for increased political and
Instructors should make sure to point out that the purchasing power parity relationship suggests
that, in the long run, exchange rate movements in a freely floating exchange rate system mainly reflect
differentials in the inflation rate between countries. In the short run, however, real disturbances can affect
the terms of trade and therefore the exchange rate. Exchange rate movements in the short run often are
explained by interest rate differentials between countries. Students will want to go to the Economist
website at http://www.economist.com/markets/Bigmac/Index.cfm, and look at the Big Mac PPP index for
the various currencies of the world. We find that students are very surprised that the most expensive Big
Mac in the survey, measured in U.S. dollars (in 2000) is in Israel.
Solutions to the Problems in the Textbook
1. Current account has three major components: net exports; net income from assets; and net transfers.
We have already seen net exports in Chapter 2 as a component of the National Accounts. Net income
from assets refers to returns on financial instruments. For instance, if you held a bond that was issued
by the United States Government, any interest that you earn on that bond is a credit in the income
from assets account. Conversely, payments to foreigners who own Canadian financial instruments
would be a debit item in income from assets. Net income from assets refers to the difference between
these two items. The final item, transfers, refers to items such as foreign aid or a gift from family
members in one country to family members in another country. This is a small item.
2. A country with a balance-of-payments deficit has made more payments of currency to foreigners than
it receives and the country’s central bank generally provides the needed funds. If the central bank
refuses to do so, the country will experience a decrease in money supply, which will eventually lead
to a recession. As domestic income goes down, less will be spent on imports. Since the domestic price
level is likely to decrease in a recession, people from abroad will begin to demand more of the
country’s goods and exports will increase, ultimately leading to a new equilibrium in the external
3. The nominal exchange rate is a price which is determined by supply and demand in the foreign
exchange market. Under a flexible (or floating) exchange rate system, the central bank allows the
exchange rate to be determined activity in the foreign exchange market, without intervention. A
change in the foreign exchange rate under a flexible rate system is referred to as a currency
appreciation or depreciation. We say that we experience a currency appreciation when it becomes
more expensive for foreigners to buy Canadian currency. Therefore, if the U.S. dollar price of one
Canadian dollar changes from $0.71 to $0.74, this is a currency appreciation. Conversely, we say that
we experience a currency depreciation when it becomes less expensive for foreigners to buy
Canadian currency. In this case, if the U.S. dollar price of one Canadian dollar changes from $0.71 to
$0.69, this is a currency depreciation.
4. Under a system of fixed exchange rates, a devaluation of the currency takes place when the price at
which foreign currencies can be bought is increased by official government action. Under a system of
floating exchange rates, currency depreciation takes place when there is an excess supply of the
domestic currency on foreign exchange markets, therefore making it less expensive to buy domestic
currency in terms of foreign currencies.
5. The purchasing power parity theory suggests that exchange rate movements mainly reflect the
differentials in national inflation rates. This theory holds up reasonably well in the long run,
especially when inflation rates are high and caused by changes in monetary growth. However, in the
short run, even a monetary disturbance will affect foreign competitiveness, since exchange rates move
faster than the price level. Similarly, when a real disturbance occurs, the purchasing power parity
relationship will no longer hold, since the adjustment will affect the terms of trade. Examples of such
real disturbances are changes in technology, shifts in export demand, or shifts in potential output in
6. Economists work with simplified models that are designed to represent the real world as much as
possible. Any assumptions made should approximate reality. Economists do care whether the
purchasing power parity relationship holds, since many models in international economics assume
that it does, and it seems intuitively correct.
7. In the model developed in Chapter 3, national savings had to equals national investment because the
domestic real interest rate was assumed to be flexible enough to ensure that the market was always in
equilibrium. For a small open economy, we assume that there is some exogenous (fixed) world real
rate of interest, and this allows domestic savings to be different from domestic investment.
4. Savings equals 25, 20, 15, 10, and net foreign lending equals 10,8, -5, -13.
5. This figure shows the cost of barley in England relative to that in Holland over a long span of time.
On average, the real barley exchange rate tended towards equalization, but there have been long
periods of substantial deviation from equality. We conclude that PPP holds over the long run, but is
only one determinant of the exchange rate in the short run.
1. True or false? Why?
“If the U.S. dollar price of a Canadian dollar is 0.80, then the Canadian dollar price of a U.S.
dollar is 1.20?
False. The exchange rate e = 0.80 is defined as the domestic currency price of a unit of foreign currency.
Thus the foreign price of a domestic currency unit is 1/e = 1/0.8 = 1.25.
2. "The U.S. experience of the early 1980s clearly demonstrated that huge budget deficits do not
necessarily crowd out investment." Comment on this statement.
The huge U.S. budget deficits were financed to a large extent by borrowing from abroad, that is, high U.S.
interest rates attracted foreign funds. This led to an appreciation of the U.S. dollar and U.S. goods became
relatively more expensive on world markets. Large U.S. trade deficits developed as exports declined and
imports increased. Therefore, the increase in the budget deficit did not crowd out investment but instead
crowded out net exports.
3. "A trade imbalance can persist as long as the central bank wants it to." Comment.
Under a system of fixed exchange rates, the central bank of a country with a balance of payments deficit
has to sell foreign currency. This will reduce high-powered money and therefore domestic money supply,
which will result in a recession, a reduction in domestic prices, and an improvement in the trade balance.
This adjustment process can only be suspended through sterilization (the central bank offsets the decrease
in high-powered money through simultaneous open market purchases). A persistent balance of payments
deficit can only exist if the central bank actively keeps money supply above the level that would ensure an
external balance. Under a system of flexible exchange rates, a central bank can maintain an imbalance
through intervention in the foreign exchange market.
4. Should a country ever borrow from abroad to finance a balance of trade deficit? Explain.
When deciding whether to finance a balance of trade deficit by borrowing from abroad, it is important to
know if the imbalance appears to be temporary or permanent. A temporary imbalance can be financed by
borrowing from abroad, if a country feels confident that it will be able to repay its debt. As long as there
is sufficient domestic investment to produce and export additional output, there should be relatively little
concern about borrowing from abroad.
However, a permanent imbalance cannot be financed by borrowing from abroad, since a country
cannot indefinitely spend more than its income. When a country runs a balance of payments deficit, the
demand for foreign exchange is by definition larger than the amount being supplied, and the central bank
has to sell the difference. Unless the central bank sterilizes its foreign exchange market intervention, this
will result in a reduction in high-powered money and thus money supply. This may ultimately lead the
domestic economy into a recession with high unemployment. To avoid this situation, the government may
instead decide on a combination of expenditure-reducing and expenditure-switching policies.
5. "If the rate of inflation in Canada increases, then the value of the Canadian dollar will decline."
Comment on this statement.
As domestic inflation increases, Canadian goods become more expensive compared to foreign goods.
Foreigners buy fewer Canadian goods, decreasing the demand for dollars in foreign exchange markets
and the value of the Canadian dollar. Canadians buy more foreign goods, increasing the supply of dollars
in foreign exchange markets and depreciating the value of the dollar further.
6. Comment on the following statement:
"The purchasing power parity theory does a good job of explaining exchange rate movements."
The purchasing power parity theory suggests that exchange rate movements mainly reflect the
differentials in national inflation rates. In the long run, the purchasing power parity theory holds up
reasonably well, especially when inflation rates are high and caused by monetary changes. However, in
the short run, even a monetary disturbance will affect competitiveness, since exchange rates move much
more rapidly than prices. Similarly, when a real disturbance occurs, the purchasing power parity
relationship will no longer hold, since the adjustment will affect the equilibrium terms of trade. Examples
of such real disturbances are changes in technology, shifts in export demand, and shifts in potential output
in different countries.
7. How are the following concepts related: the trade balance, the current account and the balance
The (merchandise) trade balance is a component of the current account and includes only trade in goods.
Adding services and transfers gives us the current account. The current account and the capital account
sum to the balance of payments.
8. What happens if the balance of payments does not equal zero?
The central bank must then acquire or sell foreign exchange.
9. How is smuggling accounted for in the balance of payments?
This gives one source of the “statistical discrepancy.”
10. Why are fixed exchange rates like a price support system in agriculture?
The government is prepared to buy and sell any amount of currency at a fixed price. To do so, the
government requires stocks of foreign exchange.
11. During the Great Depression, countries attempted to increase demand for their goods by tariffs
and trade restrictions. Can all countries achieve their targets at the same time?
No, one country’s exports are another country’s imports. If we achieve a reduction in imports and thus
increase demand for our goods, this occurs at the expense of the rest of the world where unemployment