Lecture Macroeconomics - Chapter 18: Exchange rates and the balance of payments

In this chapter you will learn: What determines the supply of and demand for a nation’s currency, about a nation’s balance of payments, what a flexible exchange rates system is and its effects on the domestic economy, what a fixed exchange rates system is and its effects on the domestic economy, about the history of the world’s international exchange-rate systems.

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CHAPTER 18

EXCHANGE RATES

AND THE BALANCE OF PAYMENTS

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In this chapter you will learn

What determines the supply of and demand

for a nation’s currency

About a nation’s balance of payments

What a flexible exchange rates system is and

its effects on the domestic economy

What a fixed exchange rates system is and its

effects on the domestic economy

About the history of the world’s international

exchange-rate systems

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Chapter 18 Topics

Financing International Trade

The Balance of Payments

Flexible Exchange Rates

Fixed Exchange Rates

International Exchange Rate Systems

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Assume $2 = £1

1 $300,000 in Canadian telecommunications

equipment purchased by a British buyer for

£150,000

2 £150,000 cheque drawn on British bank to

pay for equipment

3 £150,000 cheque is exchanged for $300,000

at a Canadian bank

4 Canadian bank sends £150,000 cheque to

London bank for future transactions

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Points to Remember

Canadian exports create:

a foreign demand for Canadian $

an increase in the supply of foreign

currency owned by Canadian banks

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Points to Remember

Canadian imports:

create a domestic demand for foreign

currencies

reduce the supplies of foreign

currencies held by Canadian banks

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Points to Remember

Canadian exports supply the foreign

currencies needed to “pay for” imports

Demand for & supplies of foreign

currencies also arise from transactions

involving services & payment of interest

& dividends on foreign investments

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Chapter 18 Topics

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The Canadian

The Canadian balance of payments balance of payments

shows the balance between

– all the payments that Canada receives

from foreign countries &

– all the payments which we make to them

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Current Account

shows the flows resulting from imports

& exports of goods & services

– the trade the trade balance balance is the net amount of

imports & exports of goods only

– the balance on goods & services the balance on goods & services

includes services as well

– trade in services, investment income &

transfers are included to get the

transfers are included to get the current current

account balance

– normally a deficit

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The Canadian Balance of Payments

Balance on Goods and Services +47.9

7 Net Investment Income - 30.3

9 Current Account Balance +18.9

balance of trade Table 18-1

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Capital Account

shows capital inflows & outflows

– purchase or sale of real or financial assets

– official settlements account

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The Canadian Balance of Payments

Official settlements account

13 Official international reserves - 2.3

Balance of payments balance of payments surplus $ 0

Table 18-1

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Payments Deficits & Surpluses

A drawing down of official international

reserves measures a nation’s balance

of payments deficit

A building up of official reserves

measures a balance of payments

surplus

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GLOBAL PERSPECTIVE 18.1

Canada's trade balance with selected

nations, 2000

-20 0 20 40 60 80 100 U.S.

Japan EU Other OECD

All other

$ billions

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Chapter 18 Topics

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Rates by which national currencies are

exchanged are determined by demand

& supply

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Q D

The Market for Foreign Currency (Pounds)

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D

S

dollar price of pounds is determined by demand & supply

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Q D

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D

S

Pound appreciates

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Q D

S

D

Pound depreciates

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Determinants of Exchange Rates

Changes in Tastes

Relative Income Changes

Relative Price-Level Changes

– Purchasing Power Parity Theory

Relative Interest Rates

Speculation

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Advantages of Flexible Rates

automatic adjustment to eventually

eliminate balance of payments deficits

or surpluses

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D

S

suppose tastes change

& Canadians want to buy more British automobiles

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Q D

S

demand for pounds increases

Adjustments Under Flexible Exchange Rates

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D

S

Canadian balance of payments deficit

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Q D

change in

the exchange rate to

$3=£1 would correct the deficit

b a

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with a lower $, Canadians will want to

import less, & the British will want to

buy more Canadian goods & services

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Disadvantages of Flexible Rates

Uncertainty & Diminished Trade

Terms of Trade Change

Instability

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Chapter 18 Topics

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Use of Reserves

Trade Policies

Exchange Controls & Rationing

Domestic Macroeconomic Adjustments

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Chapter 18 Topics

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Exchange Rate Systems

The Gold Standard: Fixed Exchange

Rates

money supply maintained

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Gold flows resulted in fixed

exchange rates

Domestic macroeconomic

adjustments sometimes distasteful

Gold standard collapsed in the

worldwide depression of the 1930s

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The Bretton Woods System

1944-1971

– International Monetary Fund (IMF) International Monetary Fund (IMF)

Maintaining pegged rates

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Fundamental Imbalances: Adjusting

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The Current System: The Managed Float

– G-7 Interventions

In Support of the Managed Float

– world trade continues to expand

– severe economic turbulence successfully

weathered

Concerns with the Managed Float

– exchange rate volatility

– trade imbalances persist

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Chapter 18 Topics

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