chapter 5 International Trade and Exchange Rates

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					International Trade and
    Exchange Rates
        Chapter 5
• The Canadian economy is a small and
  relatively open economy.
  – linked to the rest of the world through trade in
    goods and services, and finance.
         Merchandise Trade
Statistics Canada, December 2009
   Merchandise Trade Balance
Statistics Canada, December 2009
      Goods and Services Trade

• In 2008, exports comprised 35% of GDP and
  imports comprised 34% of GDP.

• In 2008, the trade balance was close to $47
In contrast, the US economy is a large and
        relatively closed economy.

• In 2006, exports comprised 11.1% of GDP and
  imports comprised 16.6% of GDP.

• As of 2007 the trade balance is -$226 (US)
      Where do Canadian exports go?

• 78% to US
• 2.7% to UK
• 2.3% to Japan
• 2.2% to China
• 1.2% to Mexico
• 0.9% to Germany
(Industry Canada, 2009)
    Where do Canadians import from?

•   52.4% from US
•   9.8% from China
•   4.1% from Mexico
•   3.5% from Japan
•   2.9% from Germany
•   2.9% from UK
       What does Canada export?

•   Machinery and equipment 21%
•   Auto parts 19%
•   Industrial goods 19%
•   Energy 19%
•   Forestry products 8%
•   Agriculture & fish 7%
•   Consumer goods 4%
         What does Canada import?

•   Machinery and equipment 28%
•   Auto parts 20%
•   Industrial goods 20%
•   Consumer goods 13%
•   Energy 9%
•   Agriculture and fish 6%
•   Forestry products 1%
            International Finance

• Canadians can hold assets in foreign countries.

• Foreigners can hold assets in Canada.
I. The Balance of Payments Accounts

• A record of the transactions of a country with
  the rest of the world.
• It is comprised of 2 majors accounts: the
  current account and the capital account.
            Current Account
• Current Account: an account of trade in
  currently produced goods and services.

• Consists of 3 major components: net exports,
  net income from assets and net transfers.
1. Net Exports: $exports - $imports

• the merchandise trade balance refers to net
  exports of goods only.

• trade in services consists of items such as
  tourism and education.
2. Net income from assets: net returns of
  financial instruments
3. Net transfers: includes items such as foreign
  aid, gifts between family members of different
Current account balance = the sum of the 3
             Capital Account

• An account of trade in existing assets
The capital account consists of 2 items:
1. Capital account
2. Financial account

   Together they are referred to as the capital
The capital account: includes items such as
inheritances and trade in intellectual property
Financial account: a record of direct
investment and portfolio investment.
One final item in the capital account is official
reserves, which are assets held by central
banks that can be used to make international
     Official reserves are assets:

• If the amount is positive then the Bank of
  Canada has sold foreign reserves.
• If the amount is negative then the Bank of
  Canada has bought foreign reserves.
• The amount of official reserves equals the
  balance of payments deficit.
The overall balance of payments must equal
II. Savings and Investment in a small open

  In previous chapters we stated that in long
  run equilibrium, savings equals investment.
 This statement was made in the context of a
  closed economy.
The GDP identity:    Y = C + I + G + NX

From chapter 2:     S = I + (NX + YNR)

  where YNR is net investment income from
Since NX + YNR = the current account (CA)

Then,      S = I + CA

or, S - I = CA .... how do we interpret this
To simplify analysis in this chapter we make
the assumption that the current account
equals net exports...we use the terms
Therefore, S- I = NX
***So, in an open economy the long run
  equilibrium condition is that foreign
  investment must equal the trade balance.
III. The Importance of the World Real Interest

  The world real interest rate is the real rate of
  interest that prevails in international capital
  It is assumed that individuals, businesses and
  governments can borrow or lend at this rate.
Canada, being a small open economy, takes
the world real interest rate as an exogenous
        Fiscal Policy and Twin Deficits

• Expansionary fiscal policy results in a shift of
  the savings curve to the left.
• The leftward shift results in a higher domestic
  real interest rate and thus there is an excess of
  domestic investment over savings......we have
  a trade deficit and negative net foreign
This is called the twin deficit problem ----
budget deficit leads to a trade deficit.
Twin Deficit Problem
             IV. Exchange Rates

Exchange rate determination

• A nominal exchange rate indicates the number
  of Canadian dollars that must be given up in
  order to purchase a unit of foreign currency.
• For instance, on January 28, 2008 the Canada
  - US exchange rate was $0.99
The nominal exchange rate is determined by
supply and demand in the foreign exchange
  Flexible exchange rate system: exchange rate
  is determined in the foreign exchange market.
• A change in nominal exchange rate is referred
  to as a currency appreciation or depreciation.
• If the Cdn-US exchange rate changes from
  $1.11 to $1.01, then Canadian currency has
  appreciated and US currency has depreciated.
Fixed exchange rate system: central banks buy
and sell currency at a fixed rate in terms of
foreign exchange. This system is an example
of a price support.
• A change in the price of foreign exchange
  under the fixed system is referred to as
  currency devaluation or revaluation.

• A devaluation (revaluation) occurs when the
  value of the currency in terms of foreign
  exchange is reduced (increased) by official
• In the fixed system, the central bank uses
  exchange market intervention to make up any
  excess supply or demand arising form private
• In order to carry out such intervention the
  central bank must hold an inventory of foreign
  exchange that can be sold in exchange for
  domestic currency when necessary.
If a country has an exchange rate crisis and
their central bank does not have enough
foreign currency to maintain the fixed rate,
the central bank will likely resort to a
A managed or dirty system is one in which
exchange rates are typically determined in the
foreign exchange market, but the central bank
may use intervention to smooth out large
fluctuations in exchange rates.
History of the Canadian exchange rate
• Throughout history Canada’ s exchange rate
  has intermittently been fixed and flexible.
• Since 1973, the exchange rate has been
• In the early 1970s Canadian currency
  appreciated and then started to depreciate
  slowly until 2003, when a sharp appreciation
• Bilateral exchange rate: an exchange rate that
  measures the value of one currency against
  another currency,
• Multilateral exchange rate: measurement of
  the value of one currency against a basket of
  other currencies
    Exchange rate in the long run

• The purchasing power parity (PPP) theory
  states that in the long run the nominal
  exchange rate moves primarily as a result of
  difference in price level behaviour between
  two countries.
• An oversimplified example: if a pen can be
  purchased in US for $2US and in Canada for
  $2CDN, then the exchange rate is 1:1.
   The logic behind purchasing power

• Based on a principle called the law of one
• This law asserts that a good must sell for the
  same price in all locations. If not,
  opportunities for profit would be left
• The process of taking advantage of difference
  in prices in different markets is called
• The logic of the law of one price leads to the
  theory of purchasing power parity.
        Limitations of the model:

1. Many goods are not easily traded.

2. Tradable goods are not always perfect

3. The existence of barriers to the movement of
• Consider, for instance a Big Mac, which is
  almost identical regardless of which country
  produced it.
• The Economist magazine gathers information
  every year on the price of a Big Mac in local
  currencies around the world, and puts the
  information together with exchange rates to
  test the theory of PPP.
• If PPP holds, then all Big Mac prices would be
  the same, if measured in US dollars.
• Purchasing power parity is not a precise
  theory of exchange rates, but it often is a
  reasonable first approximation.

• It is supposed to indicate which direction the
  currency will move in the long run.
          Real Exchange Rates

• The rate at which a person can trade the
  goods and services of one country for the
  goods and services of another.
• Suppose that you go shopping and find that a
  pair of Canadian blue jeans is twice as
  expensive as a pair of US blue jeans.

• We say that the real exchange rate is ½ pair of
  Canadian blue jeans per pair of US blue jeans.
• Similar to the nominal exchange rate, we
  express the real exchange rate as units of the
  domestic item per unit of the foreign item.

• Real and nominal exchange rates are closely
Real exchange rate =
Nominal exchange rate x foreign price
          Domestic price
• The real exchange rate is a key determinant of
  how much a country exports and imports.
• For instance, when Five Roses Inc. Is deciding
  whether to buy French or Canadian wheat to
  make flour, it will ask which wheat is cheaper
• As macroeconomists, we focus on the overall
  price rather than the prices of individual

• We use price indexes to measure the real
  exchange rate.
Real exchange rate = e x (Pf/P)

• e is the nominal exchange rate between the
  Canadian dollar and foreign currencies.
• P is the price index for a Canadian basket.
• Pf is the price index for a foreign basket.
• The real exchange rate measures the price of a
  basket of goods and services available
  domestically relative to a basket of goods and
  services available abroad.
• If the real exchange rate is greater than 1,
  then we expect demand for domestic
  produced goods to rise.
• Eventually the price will be driven up or the
  exchange rate will be driven down.
• In other words, we will move towards PPP
  over time.
• Since P and Pf refer to different baskets, we
  do not expect the real exchange rate to equal

• In the long run, we expect the real exchange
  rate to return to its average level.
           A Monetary Union

• The euro is a currency of a monetary union of
  many countries.
• In order for countries to participate in the
  monetary union they were required to meet
  specific economic targets.
Referred to as the “Maastrict criteria”

1. 2% maximum inflation rate
2. Budget deficit of less than 2% of GDP
3. Debt ratio less than 60% of GDP

  As well, there were to be no restrictions of capital
  flows and no devaluation in the two preceding