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Chapter 25

The Exchange Rate and the Balance of Payments


The Foreign Exchange Market

Foreign notes, coins, and bank deposits are called foreign currency.
The foreign exchange market is the market in which the currency of one country is exchanged
for the currency of another.
The foreign exchange rate is the price at which one currency trades for another.
Currency depreciation is a fall in the value of one currency in terms of another currency.
Currency appreciation is the rise in the value of one currency in terms of another currency.
The exchange rate is determined by demand and supply in the foreign exchange market.
The quantity of Canadian dollars demanded in the foreign exchange market is the amount that
traders plan to buy during a given time period at a given exchange rate.
The quantity depends on many factors but the main ones are:
o The exchange rate
o World demand for Canadian exports
o Interest rates in Canada and other countries
o The expected future exchange rate
The law of demand for foreign exchange states that other things remaining the same, the higher
the exchange rate, the smaller is the quantity of Canadian dollars demanded on the foreign
exchange market.
The exchange rate influences the quantity of dollars demanded for two reasons:
o Exports effect
o Expected profit effect
Exports effect:
o The lower the exchange rate, the cheaper are Canadian-produced goods to foreigners,
and the greater the level of exports, the greater the quantity of Canadian dollars
demanded on the foreign exchange market.
Expected profit effect:
o The lower the exchange rate, the larger the expected profit from buying Canadian
dollars, and the greater the quantity of dollars demanded on the foreign exchange
market.

The figure below shows that the quantity of Canadian dollars that people plan to buy depends
on the exchange rate.

The quantity of Canadian dollars supplied in the foreign exchange market is the amount that
traders plan to sell during a given time period at a given exchange rate.
The quantity depends on many factors but the main ones are:
o The exchange rate
o Canadian demand for imports
o Interest rates in Canada and other countries
o The expected future exchange rate
The law of supply of foreign exchange states that other things remaining the same, the higher
the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign
exchange market.
The exchange rate influences the quantity of dollars supplied for two reasons:
o Imports effect
o Expected profit effect
Imports effect:
o The higher the exchange rate, the cheaper are foreign-produced goods to Canadians,
and the greater the level of imports, the greater the quantity of Canadian dollars
supplied on the foreign exchange market.
Expected profit effect:
o The higher the exchange rate, the larger the expected profit from selling Canadian
dollars, and the greater the quantity of dollars supplied on the foreign exchange market.

The figure below shows that the quantity of Canadian dollars that people plan to sell depends
on the exchange rate.

The exchange rate adjusts to make the quantity of dollars demanded equal the quantity
supplied.
The figure shows the equilibrium exchange rate.

If the exchange rate is 100 U.S. cents per Canadian dollar, there is a surplus of dollars and the
exchange rate falls.
If the exchange rate is 80 U.S. cents per Canadian dollar, there is a shortage of dollars and the
exchange rate rises.
Only when the exchange rate is 90 U.S. cents per Canadian dollar, does the exchange rate
remain constant.

Exchange Rate Fluctuations

A change in any influence other than the exchange rate on the quantity of Canadian dollars that
people plan to buy brings a change in the demand for dollars and a shift in the demand curve for
dollars.
These other influences are:
o Interest rates in Canada and other countries.
o World demand for Canadian exports.
o The expected future exchange rate.
The Canadian interest rate minus the foreign interest rate is called the Canadian interest rate
differential.
In the figure below, the demand for dollars increases and the demand curve shifts rightward if
world demand for Canadian exports increases, the Canadian interest rate differential increases
or the expected future exchange rate rises.
The demand for dollars decreases and the demand curve shifts leftward if world demand for
Canadian exports decreases, the Canadian interest rate differential decreases or the expected
future exchange rate falls.

A change in any influence other than the exchange rate on the quantity of Canadian dollars that
people plan to sell brings a change in the supply dollars and a shift in the supply curve of dollars.
These other influences are:
o Interest rates in Canada and other countries
o Canadian demand for imports
o The expected future exchange rate

In the figure below, the supply of dollars increases and the supply curve shifts rightward if
Canadian import demand increases, the Canadian interest rate differential decreases or the
expected future exchange rate falls.
The supply of dollars decreases and the supply curve shifts leftward if Canadian import demand
decreases, the Canadian interest rate differential increases or the expected future exchange
rate rises.

The exchange rate can fluctuate a great deal, even over a day, and certainly over weeks and
months.
What makes the exchange rate volatile?
The main reason is that demand and supply are interdependent they are influenced by the
same factors.
Purchasing power parity means equal value of money.
If all (or most) prices have increased in the United States and have not increased in Canada, then
people will generally expect that the value of the Canadian dollar on the foreign exchange
market must rise.
Interest rate parity means equal interest rates.
Adjusted for risk, interest rate parity always prevails.

Exchange Rate Policy

A flexible exchange rate policy is one that permits the exchange rate to be determined by
demand and supply with no direct intervention in the foreign exchange market by the central
bank.
A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the
government or central bank and that blocks the unregulated forces of demand and supply by
direct intervention in the foreign exchange market.
A crawling peg exchange rate policy is one that selects a target path for the exchange rate with
intervention in the foreign exchange market to achieve that path.

Financing International Trade

A countrys balance of payments accounts record its international trading, borrowing and
lending in three accounts:
o Current account
o Capital and financial account
o Official settlements account
The current account records payments for imports of goods and services from abroad, receipts
from exports of goods and services sold abroad, net interest paid abroad, and net transfers
(such as foreign aid payments).
The capital and financial account records foreign investment in Canada minus Canadian
investment abroad.
The official settlements account records the change in official Canadian reserves.
Official reserves are the governments holdings of foreign currency.
If Canadian official reserves increase, the official settlements account balance is negative and if
official Canadian reserves decrease, the official settlements account balance is positive.
The sum of the balances of the three accounts always equals zero.
A country that has a current account deficit and that borrows more from the rest of the world
than it lends to it is called a net borrower.
A net lender is a country that lends more to the rest of the world than it borrows from it.
A debtor nation is a country that during its entire history has borrowed more from the rest of
the world than is has lent to it.
A creditor nation is a country that has invested more in the rest of the world than other
countries have invested in it.
Net exports is the value of exports of goods and services minus the value of imports of goods
and services.
The government sector balance is equal to net taxes minus government expenditures on goods
and services.
The private sector balance is equal to saving minus investment.
Net exports is equal to the sum of the government sector surplus and the private sector surplus.