Ch 25 - Exchange Rate and the Balance of Payments

Tuesday, March 06, 2012

3:19 PM

    Important Definition


    Foreign currency

    Foreign bank notes, coins, and bank deposits

    Foreign exchange market

    Market of currency exchange not in home country


    Exchange Rate

    Price at which one currency exchanges for another


    Fall in value of currency


    Rise in value of currency


    Nominal exchange rate

    Value of the Canadian dollar expressed in units of foreign currency per Canadian dollar (how much foreign currency is needed for one Canadian dollar.)

    Real exchange rate (RER)


    p = price level

    Purchasing Power Parity

    When RER = 1.
    Indifferent between buying a good in 2 places.


    Canadian dollar effective exchange rate (CERI)

    The average exchange rate of the Canadian dollar against other countries.

     (weighted based on international trade).


    Demand Dependencies

    Exchange rate
    Demand for exports
    Interest rates

    Exports effect

    Exchange rate determines the price of Canadian goods => affect exports

    Expected profit effect

    If CA is expect to increase in value, there's more demand. Vice versa.

    Shift Demand

    Demand for CA exports (Direct)
    Canadian interest rate vs. foreign  (Direct)

    Expected future exchange rate (Direct)



    Supply Dependencies

    Exchange rate
    Demand for imports
    Interest rates

    Imports effect

    Similar to exports effect.

    Expected profit effect

    See above.

    Shift Supply

    Demand for imports (Direct)
    Canadian interest rate differential (Inverse)
    Expect future exchange rate (Inverse)


    Market equilibrium

    Exchange rate


    Exchange rate expectations

    Interest rate parity

    Difference in interest rates between 2 countries = expected change in the exchange rate
    (If people don't expect exchange rate to change, money would flow away -> depreciation)

    Purchasing power parity

    A currency is worth the value of goods and services that it will buy
    Purchasing power parity = equal value of money



    Balance of payments accounts

    Records a countries international trading, borrowing and lending in three accounts:

    • Current
    • Capital
    • Official settlements

    Current Account

    Keep track of net flows from purchases of goods

    • Receipts from exports of goods sold abroad
    • Payments from imports of goods from abroad
    • Net interest paid abroad
    • Net transfers (foreign aid)


    Inflows: exports, received interest, transfers to Canada

    Outflows: imports, paid interest, transfers from Canada

    Capital Account

    Keep track of net flows from the purchase and sale of real/financial assets


    Official Settlements Account

    Keep track of holdings of foreign currencies.
    (If reserves increase,the account is negative, similar to buying foreign asset)

    Critical Note: Sum of 3 accounts always equals to 0.


    Net borrower

    Country that borrows more than lends
    (Surplus in capital account)

    Net lender

    Country that lends more than borrows
    (Deficit in capital account)


    Debtor nation

    Country that borrowed more than it lends

    Creditor nation

    Country that has invested more than others invested in it


    Borrowing is ok when…

    You can afford interest payments
    Using the money for productive capital that earns a return

    Not ok when…

    Using it for consumption


    We export what we don't consume


    Current Account Balance


    Question How does nominal exchange rate affect real exchange rate?

    Short run

    A fall will lower real exchange rate
    More costly imports; more competitive exports

    Long run

    Change will not affect real exchange rate


    Exchange rate policy

    Flexible exchange rate

    Rate determined by demand and supply; no intervention

    Fixed exchange rate

    Peg rate at a value determined by government or bank.
    Needs active intervention

    Crawling peg

    Fixed exchange rate is allowed to fluctuate within a band of rates


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