September 4, 2015Balance of Payments1 Balance of payments, floating exchange rate equilibria, Accounting mechanisms.

April 19, 2023 Balance of Payments 1

Balance of Payments

Balance of payments, floating exchange rate equilibria,Accounting mechanisms


Balance of Payments

CACIMXBOP

FXBFOFI

Balance of Trade

Financial account Reserve account

Capital Account


Cash flows

For example: the Balance of Trade (Current account) BOT = X – M

BOT P Q e P Qx cd t x t cd usd t m usd t m tt

T

, , , , , , , ,

1


Exchange rate equilibirum Demand for the dollar

all foreigners buying Canadian all Canadians selling foreign assets

Supply of the dollar Canadians buying foreign goods and services foreigners selling Canadian assets

Where demand equals supply Equilibrium price (Exchange Rate) and Quantity


Equilibrium

usd/cd

Qcd

D1

S1

eo, 0, cd

Qo, cd


Demand for the dollar(Credits) Exports (X)

British buying Canadian goods Germans vacationing in Newfoundland

Capital inflows – real assets (CI) Walmart buying out Woolco Toyota building a plant in

Financial inflows – financial assets (FI) US investors buying Canadian Imperial, Vulcan Germans buying NF CD denominated bonds


Supply of the dollar (Debits) Imports (I)

Buying Sonys Spending a week at Disneyworld Canadians spending six months of the year in

Texas Capital Outflows – real assets (CO)

Inco buying a property in Indonesia Couple retiring to Florida buying a condo there

Financial Outflows - financial assets (FO) Buying shares in Microsoft Buying euro denominated bonds


Current account – balance of trade (BoT) goods

value of exports of goods - imports of goods services (communications, information, financial)

value of exports of svcs - imports of svcs

net income transfers interest & dividends pd on foreign investments pensions pd to Canadians living overseas transfers (sending checks to E. Europe)


Balance of Trade

2001 2002 2003 2004 2005

BOT 62,850 50,088 44,416 50,312 51,132

Goods 70,659 57,311 56,262 65,482 64,850

Svcs -7,809 -7,224 -11,846 -12,717 -13,718


Capital Account transactions to non-financial and non-

produced assets debt forgiveness transfer of goods and financial assets by

migrants leaving or entering a country transfer of ownership on fixed assets transfer of funds received to the sale or

acquisition of fixed assets gift and inheritance taxes, death levies,

patents, copyrights, royalties, and uninsured damage to fixed assets.


Financial account foreign direct investment

investment in real assets portfolio investment

equities debt

intangibles patents, leases, goodwill

errors and omissions


Capital inflows – capital outflowsFinancial Account

Capital inflows Foreign direct investment in Canada Foreign portfolio investment in Canada Other investment in Canada

Capital outflows Canadian foreign direct investment Canadian foreign portfolio investment Other foreign investment by Canada


Financial Account

2001 2002 2003 2004 2005

Fin Acct -39,330 -30,297 -29,935 -24,814 -18,811

FDI -15,875 -7,763 -10,038 -6,812 -4,960

Port -22,598 -21,945 -20,086 -17,957 -14,548

Other -857 -589 189 -44 696


Official reserves account Central Bank interventions in exchange

markets

changes in official reserves by buying or selling gold, silver foreign currencies Foreign denominated debt Buy or sell options or futures in markets SDRs (Special Drawing Rights at IMF)


Balance of payments Assume BOP > 0

Canadians are selling more abroad than they are buying Goods, services Capital goods Financial goods

If exchange rates are allowed to seek an equilibrium (floating exchange rates) Supply of the Canadian dollar increases in

exchange markets The exchange rate will adjust to accommodate

imbalance


Effects of BOP

Fixed exchange rates CB uses FXB to bring BOP = 0

Floating exchange rates CB ignores BOP The exchange rate will adjust to

accommodate imbalance CB may intrude into the exchange

market to reduce volatility


Exchange rate equilibrium Demand for the dollar

all foreigners buying Canadian all Canadians selling foreign assets

Supply of the dollar Canadians buying foreign goods and services foreigners selling Canadian assets

Where demand equals supply Equilibrium price (Exchange Rate) and Quantity


Equilibrium

usd/cd

Qcd

D1

S1

eo, 0, cd

Qo, cd


Demand for the dollar(Credits) Exports (X)

British buying Canadian goods Germans vacationing in Newfoundland

Capital inflows – real assets (CI) Walmart buying out Woolco Toyota building a plant in

Financial inflows – financial assets (FI) US investors buying Canadian Imperial, Vulcan Germans buying NF CD denominated bonds


Supply of the dollar (Debits) Imports (I)

Buying Sonys Spending a week at Disneyworld Canadians spending six months of the year in

Texas Capital Outflows – real assets (CO)

Inco buying a property in Indonesia Couple retiring to Florida buying a condo there

Financial Outflows - financial assets (FO) Buying shares in Microsoft Buying euro denominated bonds


BOP surplus from the Canadian perspective US consumers buying more Canadian stuff

Demanding cd with which to buy Canadian stuff

free float allows a new equilibrium usd price of the cd increases

cd appreciates US goods lower in price to Canadians

usd depreciates Canadian goods higher in price to the U.S.

Corrects BOP imbalance, so that BOP approaches 0


Excess Demand for cd

usd/cd

Qcd

D1

D2

S1

eo, 0, cd

en, 0, cd

Qo, cd Qn, cd


BOP deficit from US perspective US consumers buying more Canadian

stuff Supplying usd into the market to buy cd

free float allows a new equilibrium cd price of the usd decreases

cd appreciates US goods lower in price to Canadians

usd depreciates Canadian goods higher in price to the U.S.

Corrects BOP imbalance, so that BOP approaches 0


Excess Supply of usd

cd/usd

Qusd

D1

S2

S1

eo, 0, usd

en, 0, usd

Qo, usd Qn, usd


Benefits of floating exchange rates International prices adjust instantaneously

With Canadian dollar appreciation Canadian stuff more expensive internationally

cd more expensive in terms of other currencies

International prices decrease for Canadians

In the future the BOP should approach zero Foreign demand for Canadian stuff decreases Domestic demand for foreign stuff increases


Depreciation Negative aspects of depreciation

Creates image that the currency is weak Canadian dollar has depreciated nearly 40% in

the last decade Imports become more expensive

Positive aspects of depreciation Exports become cheaper to foreigners

Central bank may try to fix the exchange rate Keep the trend line of the exchange rate flat


Appreciation Negative aspects of appreciation

Impacts exports as exports are more expensive to foreigners

Positive aspects of appreciation Imports become cheaper

Central bank may try to fix the exchange rate Keep the trend line of the exchange rate

flat


Trend & volatility

e

T


Trend & volatility The red line represents observed exchange

rates The brown line represents a minimum least

squares regression of the observed exchange rates

Volatility is estimated by the standard error of estimate of the observed values from those predicted by the regression line

e tcd t

^

,


Reasons given for intervention Alter the trend, reduce beta, long-run policy

Fix exchange rates in some fashion Positive aspects

Maintain international prices relatively constant Reduce the need to hedge exchange rate risk Maintain “Strong Currency”

Negative aspects Can only affect trend in the short run Eventually results in a very steep adjustment

Reduce volatility Reduces the cost of hedging, volatility and bid-ask

spread are directly related Short-run policy


Intervention

usd/cd

Qcd

D1

D2

S1

eo, 0, cd

en, 0, cd

Qo, cd Qn, cd

S2

B of C buys usdwith cd


Intervention If FXB = 0, then BOP > 0, exchange rates adjust Bank of Canada accommodates

FXB = X – M + CI – CO + FI – FO, pushes BOP toward 0 Buys up excess usd in the market, no change in

exchange rate Underlying cause for BOP surplus not fixed in

short run Canadian prices are still too low internationally

Domestic consequences BOC has increased base money, inflationary pressure

Bank of Canada can chose to sterilize or not


Unsterilized Intervention Bank of Canada balance sheet

gold silver cd denominated

t-bills foreign currency

denominated t-bills

cash currency chartered bank

reserves held at the Bank of Canada

Bof C buys US dollars as an asset

Canadian dollar liability increases


Domestic Affects of an Unsterilzed Intervention Base money increases by amount of

purchase pressure exerted on prices to

increase Long-run, inflation in the economy

Canadian goods more expensive to Canadians

Canadian goods more expensive to foreigners

Long-run, balance of payments adjusts


Foreign Affects of anUnsterlized Intervention short run

exchange rate is not allowed to adjust

long run higher Canadian inflation

US goods cost relatively less to Canadians Canadian goods cost relatively more to US

consumers Long-run, Canadian prices adjust, BOP

adjusts


Sterilized Intervention Bank of Canada balance sheet

gold silver cd denominated t-

bills foreign currency

denominated t-bills

cash currency chartered bank

reserves held at the Bank of Canada

B of C sells equal value in other assets

Bof C buys US dollars as an asset No increase in

B of C liabilities


Domestic Affects of an Sterilzed Intervention Base money remains constant prices remain constant

Both domestic and foreign prices remain the same

BOP pressures exacerbated Canadian prices too low in real terms International prices too high in real terms Canadian dollar undervalued

Continual intervention required by the Bank of Canada


Foreign Affects of anSterlized Intervention short run

exchange rate is not allowed to adjust From their point of view, BOP deficits continue Interventions continue

long run pressure continually increases on exchange rate to

appreciate BOT deficit remains eventually the cd price of the usd will increase

Finally there is a large scale revaluation Firms cannot adjust slowly to small price changes Firms now must adjust to a large-scale price change


Depreciation Negative aspects of depreciation

Creates image that the currency is weak Canadian dollar has depreciated nearly 40% in

the last decade Imports become more expensive

Positive aspects of depreciation Exports become cheaper to foreigners

Central bank may try to fix the exchange rate Keep the trend line of the exchange rate flat


Appreciation Negative aspects of appreciation

Impacts exports as exports are more expensive to foreigners

Positive aspects of appreciation Imports become cheaper

Central bank may try to fix the exchange rate Keep the trend line of the exchange rate

flat

September 4, 2015Balance of Payments1 Balance of payments, floating exchange rate equilibria, Accounting mechanisms.

Documents

canadian assets

foreign assets supply

canada slide

cd slide

foreign goods

balance of payments6

balance of payments7

quantity slide