Exchange Rates and The Balance of Payments
Exchange Rate:
The rate at which one currency is exchanged for another.
1 Canadian dollar =
________1________ 1 unit of foreign currency ________1________ 1 Canadian dollar
1 unit of foreign currency =
Currency appreciation: Currency depreciation:
The rise in the exchange rate of one currency for another. The fall in the exchange rate of one currency for another.
When one currency appreciates in terms of another, the other currency immediately depreciates in value. This is true by definition.
Flexible Exchange Rate: A currency exchange rate determined by the market forces of supply and demand and not interfered with by government action. Fixed Exchange Rate:
A currency exchange rate pegged by government and therefore prevented from rising or falling.
Purchasing Power Parity Theory: A theory suggesting that exchange rates will change so as to equate the purchasing power of each currency.
(The purchasing power parity theory says that if the same product is sold at different prices in different countries, it would be worthwhile buying it where it is cheap and selling it where it is expensive. But this action, by itself, will cause the exchange rates to change until there is no longer any difference in the relative prices.)
However, prices are not the same world-wide. The five factors that explain differences in purchasing power between countries are:
the fact that many services, such as haircuts, are not traded internationally the existence of transportation and insurance costs the existence of tariffs and other trade restrictions the expression of particular preferences by consumers the effect on the value of currencies of trade in financial assets
Flexible Exchange Rates and the Demand for the Canadian Dollar
Those who have a demand for the Canadian dollar are:
foreigners who want to buy Canadian exports or who travel in Canada foreigners who want to purchase Canadian investments Canadians who receive income from abroad currency speculators
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.
The demand curve for the Canadian dollar is downward-sloping. On the vertical axis we need to express the price of the Canadian dollar in terms of another currency. At a higher exchange rate the quantity of Canadian dollars demanded will be low; at a low exchange rate, the quantity demanded will be high.
Effective Exchange Rate: compares the value of the Canadian dollar in terms of the average of all currencies of countries with which Canada trades.
When the Canadian dollar appreciates, the effective price of Canadian exports increases and total exports are likely to fall.
(A higher Canadian dollar means that the effective price of Canadian financial investments will also be higher for foreigners, so that foreign investment is likely to decrease.)
When the Canadian dollar depreciates, the effective price of Canadian exports decreases and total exports are likely to rise.
The Supply of Canadian Dollars
In obtaining foreign currencies, we must automatically supply Canadian dollars. Therefore, the supply of Canadian dollars comes from our demand for foreign currencies.
Quantity demanded of foreign currencies = Quantity supplied of Canadian dollars Quantity demanded of Canadian dollars = Quantity supplied of foreign currencies
The supply curve for the Canadian dollar is upward-sloping because an increase in the price (of a currency) will lead to an increase in the quantity supplied. When the Canadian dollar appreciates, the effective price of Canadian imports decreases and total imports are likely to rise. When the Canadian dollar depreciates, the effective price of Canadian imports increases and total imports are likely to fall.
Equilibrium in Foreign-Exchange Markets
Note: The demand for Canadian dollars comes from foreigners (Canadian exports) and the Supply comes from Canadians (Canadian imports). At equilibrium, not only are the quantity supplied and the quantity demanded of Canadian dollars equal, but the quantities demanded and supplied of foreign currencies in Canada will also be equal. (Foreign currencies are made available to Canadians whenever a foreigner
purchases Canadian products or investments, and at equilibrium such currencies will just be sufficient to satisfy the demand by Canadians for these currencies.)
Changes in Demand and Supply
The demand for the Canadian dollar is determined by:
the level of incomes in the countries that buy Canadian goods and services the price of Canadian products that are traded abroad foreigners’ tastes towards Canadian goods comparative interest rates (Higher interest rates in Canada encourage foreigners to put money
into Canada and the demand for Canadian dollars increases.)
An increase in the demand for Canadian goods and services will increase Canadian exports, despite the appreciation of the Canadian dollar, and will increase Canadian imports because of the appreciation.
Export-led Boom: Foreigners buy more Canadian goods and this raises aggregate demand within Canada, creating new jobs, raising GDP and, finally, the price level. An export-led boom may have the effect of reducing the size of the Canadian multiplier. This is because the boom will likely increase the prices of Canadian products and, further, will raise the value of the Canadian exchange rate. Both of these effects will dampen down the initial rise in exports.
What happens on the international market very much affects what happens internally.
Fixed Exchange Rates
The arguments in favour of fixed exchange rates are:
they add a degree of certainty to international trade they prevent instability in the export and import industries they discourage currency speculation they appeal to people who tend to equate the exchange rate with national prestige
Undervalued Canadian Dollar
Given a fixed exchange rate, an increase in the demand for the Canadian dollar results in the dollar being undervalued, compared with what a free-market value would be. Since the government has fixed the exchange rate, it must ensure, for normal trading to continue, that enough Canadian dollars are made available. The Bank of Canada will have to supply this shortage by expanding the money supply. This strong demand for Canadian exports and the continual increase in money supply by the Bank of Canada will eventually be inflationary. Once this inflation occurs for a long enough time, the price of Canadian goods will rise until the demand for them declines. This decline in the demand for Canadian goods will decrease the demand for the Canadian dollar and equilibrium will eventually be restored. This adjustment process could be long and painful.
Overvalued Canadian Dollar
If the Canadian government fixes the value of the Canadian dollar and the demand for the dollar drops, the exchange rate is now above what would be the free-market equilibrium rate. Thus, there would be a surplus of Canadian dollars on the world market. Since foreigners are buying fewer Canadian goods and services and therefore buying fewer Canadian dollars, the amount of foreign currencies for Canadians to buy is reduced. You can look at this situation as either a surplus of Canadian dollars on the world market or as a shortage of foreign currencies in Canada. Faced with an insufficient supply of foreign currencies from normal trading, the government, through the Bank of Canada, has got to make good the deficiency. At least some of the official international reserves will have to be made available to Canadians. This depletion of the central bank’s foreign reserves cannot continue indefinitely, so the government will be forced to take some kind of action.
A government can defend an overvalued exchange rate in four ways: introducing quotas or tariffs - risk of violating international trade agreements introducing foreign-exchange controls - risk distorting trade and production, favouring some importers over others, and restricting
consumer choice
negotiating voluntary export restrictions - not an easy option to exercise creating a recession at home by reducing aggregate demand
A government that finds it politically impossible to impose any of the above policies, or that finds that those policies fail after being tried, will be forced to devalue its currency. This option could have serious political ramifications.
Devaluation: the re-fixing by government of an exchange rate at a lower level.
Dirty Float: an exchange rate that is not officially fixed by government but is managed by the central bank’s ongoing intervention in the market.
In order to prevent the depreciation of the dollar, the government sells foreign reserves and buys dollars so as to hold up the demand for the dollar. To prevent an appreciation of the dollar, the government will do the opposite and sell dollars in exchange for foreign currency.
The Balance of Payments
Balance of Payments:
an accounting of a country’s international transactions that involves the payment and receipts of foreign currencies. (Like an income statement.) a subcategory of the balance of payments that shows the income or expenditures related to exports and imports. a subcategory of the balance of payments that reflects changes in ownership of assets associated with foreign investment. the value of a country’s exports of goods and services less the value of its imports.
Current Account: Capital Account: Balance of Trade:
Since the balance of payments includes both private and government currency dealings, it will always balance. If there is a deficit, the government will make up the shortage of foreign currencies; if there is a surplus, the government will make up the shortage of Canadian dollars.