Ch 25 - Exchange Rate and the Balance of Payments

Tuesday, March 06, 2012

3:19 PM

 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
Depreciation	Fall in value of currency
Appreciation	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 Expectation
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 Expectation
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)

 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

 

 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