Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-1 Introduction The dollar is the predominant global currency that many people throughout.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-1

Introduction

The dollar is the predominant global currency that many people throughout the world utilize to conduct transactions relating to international trade and finance.

During the 2000s, some observers suggested that theeuro, the currency used by a number of Europeannations, might replace the dollar as the global currency.

Today the euro’s status is in doubt.

To understand why this is so, you must first understand the determination of exchange rates, which is a key topic of this chapter.


Learning Objectives

• Distinguish between the balance of trade and the balance of payments

• Identify the key accounts within the balance of payments

• Outline how exchange rates are determined in the markets for foreign exchange


Learning Objectives (cont'd)

• Discuss factors that can induce changes in equilibrium exchange rates

• Understand how policymakers can go about attempting to fix exchange rates

• Explain alternative approaches to limiting exchange rate variability


Chapter Outline

• The Balance of Payments and International Capital Movements

• Determining Foreign Exchange Rates• The Gold Standard and the International Monetary Fund

• Fixed versus Floating Exchange Rates


Did You Know That ...

• In the spring of 2010, a pair of Levi’s 505 jeans priced at about 30 U.S. dollars in a U.S. Sears store could be purchased at a Sears Canada store at a price equivalent to 68 U.S. dollars?

• This situation came about because of a substantial change in the U.S. dollar-Canadian dollar exchange rate.

• In this chapter, you will learn about the determinants of exchange rates.


The Balance of Payments and International Capital Movements

• Balance of Trade

– The difference between exports and imports of goods


The Balance of Payments and International Capital Movements (cont'd)

• Balance of Payments

– A system of accounts that measures transactions of goods, services, income and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period


Table 33-1 Surplus (+) and Deficit (–) Items on the International Accounts



• Accounting Identities

– Values that are equivalent by definition

– Ultimately, net lending by households must equal net borrowing by businesses and governments



• When family expenditures exceed income, the family must be doing one of the following:

1.Reducing its money holdings, or selling stocks, bonds, or other assets

2.Borrowing

3.Receiving gifts from friends or relatives

4.Receiving public transfers from a government



• Disequilibrium– If expenditures exceed income, the situation cannot continue indefinitely

• Equilibrium– Households, businesses, and governments must eventually reach equilibrium



• An accounting identity among nations

– When people from different nations trade or interact, certain identities or constraints must also hold

– Let’s look at the three categories of the balance of payments transactions



• Three categories of balance of payments transactions

1.Current account transactions

2.Capital account transactions

3.Official reserve account transactions



• Current Account

– A category of balance of payments transactions that measures the exchange of merchandise, the exchange of services and unilateral transfers



• Current account transactions

– Merchandise trade exports and imports• Tangible items—things you can feel, touch and see

– Service exports and imports• Intangible items that are bought and sold

– Unilateral transfers• Gifts from citizens and from governments


Table 33-2 U.S. Balance of Payments Account, Estimated for 2011(in billions of dollars)



• Balancing the current account

– Current account surplus

• Net exports plus unilateral transfers plus net investment income exceeds zero

– Current account deficit

• Net exports plus unilateral transfers plus net investment income is negative



• A current account deficit means that we are importing more goods and services than we are exporting

• A current account deficit must be paid by the export of money or money equivalent



• Capital Account

– A category of balance of payments transactions that measures flows of real and financial assets


Capital account Current account 0


• The current account and capital account must sum to zero

– In the absence of interventions by finance ministries or central banks


Figure 33-1 The Relationship Between the Current Account and the Capital Account



• Official reserve account transactions

1.Foreign currencies

2.Gold

3.Special drawing rights (SDRs)

4.Reserve position in the IMF

5.Financial assets held by an official agency (such as the U.S. Treasury)



• Special Drawing Rights– Reserve assets created by the International Monetary Fund for countries to use in settling international payment obligations

• International Monetary Fund– An agency founded to administer an international foreign exchange system and to lend to member countries that had balance of payments problems

– The IMF now functions as a lender of last resort



• Question– What affects the balance of payments?

• Answers– Relative rate of inflation

– Political stability• Capital flight


Determining Foreign Exchange Rates

• When you buy foreign products, you have dollars

• But the foreign country can’t pay workers in dollars

• So there must be a way of exchanging these dollars


Determining Foreign Exchange Rates (cont’d)

• Foreign Exchange Market– A market in which households, firms and governments buy and sell national currencies

• Exchange Rates– The price of one nation’s currency in terms of another


The Foreign Exchange MarketThe participants:

1. Commercial banks and other depository institutions: transactions involve buying/selling of bank deposits in different currencies for investment.

2. Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets.

3. Private firms: conduct foreign currency transactions to buy/sell goods, assets or services.

4. Central banks: conduct official international reserves transactions.


Determining Foreign Exchange Rates (cont'd)

• Every Canadian transaction involving the importation of foreign goods constitutes a supply of dollars (and a demand for some foreign currency), and the opposite is true for export transactions


Exchange Rates

• Comparative value of one currency in terms of another

• An exchange rate is the rate at which one currency is exchanged for another

• Exchange rates can be expressed in two ways:


1 Canadian dollar = 1 / (1 unit of foreign currency)

e.g $1 CAN = $0.76 US

Or,1 unit of foreign currency = 1 / ( 1

Canadian dollar)e.g. $1 US = $1.32 CAN

If a Canadian dollar is worth 5 Mexican pesos, then a Mexican peso is worth 20 cents Canadian

If the price of lemons in Mexico is 2 pesos each, then a Canadian needs 40 cents to buy a lemon in Mexico


Currency Appreciation and Depreciation

• Currency appreciation– The rise in the exchange rate of one currency for another

– If the value of the Canadian dollar rises in terms of a foreign currency, it has appreciated

– You need less Canadian $ to buy the foreign currency

• Currency depreciation– The fall in the exchange rate of one currency for another

– If the value of the Canadian dollar declines in terms of a foreign currency it has depreciated


• What determines the value of any given currency?

• What causes changes in this value?

• Prices are determined by Demand and Supply

• Or• May be determined by government


Exchange Rate Regimes

• Flexible exchange rates– A currency exchange rate determined by the market forces of supply and demand and not interfered with by government action

• Fixed exchange rates– A currency exchange rate pegged by the government and therefore prevented from rising and falling

– Revaluation: increase in the rate– Devaluation: decrease in the rate


What determines Exchange rates

• Interest Parity Theory

• Purchasing Power Parity Theory (long run)

• .


• In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries’ products are traded.

– The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels


The Law of One Price

• Law of one price– Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

• This law applies only in competitive markets free of transport costs and official barriers to trade.– Example: If the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for £30 in London.


Purchasing Power Parity

• Theory of Purchasing Power Parity (PPP)– The exchange rate between two counties’ currencies equals the ratio of the counties’ price levels.

– It compares average prices across countries.



• PPP asserts that all countries’ price levels are equal when measured in terms of the same currency.


• The Relationship Between PPP and the Law of One Price– The law of one price applies to individual commodities, while PPP applies to the general price level.

– If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries.

– Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly.



• Absolute PPP and Relative PPP– Absolute PPP

• It states that exchange rates equal relative price levels.

– Relative PPP• It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.

• Percentage change in exchange rates equals the differences in the inflation rates



If goods are homogenous, the law of one price is more likely to hold

PPP may not hold because of• differentiated products• Transaction costs• Tariffs and freight charges• Non- tradeable goods in the basket


Demand for the Canadian DollarWho wants to buy and sell Canadian

dollars and why?Demand depends on:1. Foreigners who want to buy

Canadian exports or who want to travel to Canada, Tourism Canada

2. Foreigners who want to purchase Canadian investments– Direct investment: The purchase of

real assets– Portfolio investment: The purchase of

shares or bonds representing less than fifty percent ownership


3. Canadians who receive income from abroad, including Canadians who have foreign investments. These investments earn returns which would be converted to Canadian dollars

4. Currency speculators– Buying a currency in the expectation

that its value will rise• Arbitrage: The process of buying a

commodity in one market, where the price is low, and immediately selling it in a second market where the price is higher


5. Arbitrage: The process of buying a currency in one market, where the price is low, and immediately selling it in a second market where the price is higher

Note unlike speculators, those engaged in arbitrage are not concerned about the future value of the Canadian dollar


• The supply of Canadian Dollars:Comes from our demand for foreign currencies.

In obtaining foreign goods, we must automatically supply Canadian dollars


Determinants of Exchange RatesWhat causes a change in demand and SS?

1. International Trade :Balance of Payments: An accounting of

a country’s international transactions that involves the payment and receipts of foreign currencies

Balance of Trade: The value of a country’s exports minus

the value of its imports


• When Canada has a deficit in its balance of trade (more imports than exports),

• Remember, imports create SS of CAN $ and exports create demand

• SS of Canadian dollar exceed demand for Canadian dollars (ceteris paribus)

• Depreciation of the Canadian dollar


2. The level of foreign incomesIf foreign incomes increase, then the demand for all available products, including Canadian goods will increaseIncrease in demand for Canadian exports = shift in the DD curve to the right appreciation of the dollar


3. The price of Canadian products relative to the price of foreign products

A decrease in the price of Canadian goods will result in a high demand for these goods

A high demand for Canadian dollar


4. Comparative interest ratesIf Canada has a higher interest rate

than the US, capital will flow into Canada. This means a higher demand for the Canadian dollar.

A low interest rate depreciates the dollar


• An increase in aggregate income in Canada, relative to the world

Cause more imports, More supply of CAN $ Depreciation of the CAN$


Current Foreign Exchange Rate Arrangements


Fixed versus Floating Exchange Rates (cont'd)

• Central banks can keep exchange rates fixed as long as they have enough foreign exchange reserves to deal with potentially long-lasting changes in the demand for or supply of their nation’s currency


Fixed versus Floating Exchange Rates (cont'd)

• Foreign Exchange Risk

– The possibility that changes in the value of a nation’s currency will result in variations in market value of assets

– Limiting foreign exchange risk is a classic rationale for adopting a fixed exchange rate


Table 33-3 Key Currencies Throughout World History


Issues & Applications: Will the Euro’s Global Currency Status Be Short-Lived? (cont’d)

• Question– Why has the euro’s status become in doubt only a few years later?

• Answer – Since early 2010, however, the euro’s value has been prone to sudden drops, which induced individuals and businesses in many nations to avoid its foreign exchange risk by shifting funds away from euro-denominated bank deposit accounts, bonds, and stocks and towards dollar-denominated accounts, bonds, and stocks instead.

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 33-1 Introduction The dollar is the predominant global currency that many people throughout.

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