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CHAPTER 16: Foreign Exchange. Topics. 16.1 Financing International Trade 16.2 Balance of Payments 16.3 Flexible Exchange Rates 16.4 Fixed Exchange Rates 16.5 History . Foreign Exchange. Foreign Exchange Market: Major banks worldwide

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topics
Topics

16.1 Financing International Trade

16.2 Balance of Payments

16.3 Flexible Exchange Rates

16.4 Fixed Exchange Rates

16.5 History

foreign exchange
Foreign Exchange

Foreign Exchange Market:

  • Major banks worldwide
  • Currency of one nation traded for currency of another nation

Exchange Rate:

  • International value of a currency
  • Expressed in terms of another currency
foreign exchange4
Foreign Exchange

Q: If the US dollar is worth $1.43 Canadian, how much is a Canadian dollar worth in US funds?

A: US$ 0.70

US$1.00 = C$1.43

Divide both sides by 1.43

OR take the reciprocal:

1 1

rateUS = rateC = 1.43 = .70

foreign exchange5
Foreign Exchange

http://www.xe.com/ucc/convert.cgi

slide6
BALANCE OF PAYMENTS

Summary of a nation’s international payments and receipts for one year.

balance of payments
Balance of Payments

PAYMENTS (C$ leaving Canada)

  •  supply of C$ in foreign exchange market
  •  price of C$ (exchange rate)

RECEIPTS (C$ coming into Canada)

  •  supply of C$ in foreign exchange market
  •  price of C$ (exchange rate)
chapter 17 balance of payments
CHAPTER 17Balance of Payments

PAYMENTS(C$ leaving Canada)

  • Canadians buy foreign products (import)
  • Canadians travel abroad
  • Canadian firms pay dividends abroad
  • Canadians buy foreign investments

PAYMENTS INCREASE SUPPLY $C

ForeignExchangeMarket

ForeignExchangeMarket

C$

balance of payments9
Balance of Payments

RECEIPTS(C$ coming into Canada)

  • Foreigners buy Canadian products (exports)
  • Foreigners travel to Canada
  • Foreign firms pay dividends to Cdns
  • Foreigners buy Canadian investments

RECEIPTS DECREASE SUPPLY $C

ForeignExchangeMarket

ForeignExchangeMarket

$C

balance of payments10
Balance of Payments

Payments and receipts are subdivided into:

CURRENT ACCOUNT

  • Day to day transactions in goods and services
  • Includes interest and dividends

CAPITAL ACCOUNT

  • Sales and purchases of capital assets
  • Includes real (“direct investment”) and financial assets
canada s balance of payments 2002 in billions
CURRENT ACCOUNT:

Merchandise Exports +410.3

Merchandise Imports -356.1

Balance of Trade +54.2

Exports of Services +58.2

Imports of Services - 66.1

Balance on Goods/Serv +46.3

Net Investment Income - 30.4

Net Transfers* +1.4

Current Acct Balance +17.3

* Foreign aid, pensions, remittances

CAPITAL ACCOUNT:

Change in foreign investment in Cda +69.1

Change in Canadianinvestment abroad -75.7

Capital Acct Balance-6.6

OFFICIAL SETTLEMENTS ACCT:

Official Int’l Reserves -10.7

Balance of Payments 0

Source: Statistics Canada

Canada’s Balance of Payments2002 (in $billions)
slide12
OFFICIAL SETTLEMENT ACCOUNT
  • Central banks hold foreign currencies in official international reserves (foreign exchange reserves)
  • Drawing down of reserves (“+” entry) measures balance of payments deficit
  • Building up of reserves (“–” entry) measures balance of payments surplus
  • Deficits can’t be maintained indefinitely; reserves are limited
group exercise
Group Exercise

Do Question 3 on p. 407 in your text.

slide14
Calculate:
  • Balance of trade
  • Balance on goods/services
  • Balance on current acct
  • Balance on capital acct
slide15
Balance of trade: 40 – 30 = $10 surplus
  • Balance on goods/services:

55 exports – 40 imports = $15 surplus

  • Balance on current acct: $15 – 5 net invmt + 10 net tsfs = $20 surplus
  • Balance on capital acct Frn invmt +10 Cdn invmt abroad -40 = $30 deficit
balance of payments16
Balance of Payments

If PAYMENTS > RECEIPTS

  • Balance of Payments DEFICIT

If RECEIPTS > PAYMENTS

  • Balance of Payments SURPLUS
slide17
FLEXIBLE EXCHANGE RATES

Exchange rates determined by supply & demand

slide18

The Market for Foreign Currency (Pounds)

Figure 16-2

P

S

Dollar price of 1 pound

2

D

Q1

Q

Quantity of pounds

slide19

The Market for Foreign Currency (Pounds)

D

Figure 16-2

P

S

Pound

appreciates

Dollar price of 1 pound

2

D

Q1

Q

Quantity of pounds

slide20

The Market for Foreign Currency (Pounds)

Pound

depreciates

D

Figure 16-2

P

S

Dollar price of 1 pound

2

D

Q1

Q

Quantity of pounds

flexible exchange
Flexible Exchange

Advantages:

  • Automatic adjustment
  • Can eliminate balance of payments deficits or surpluses

Disadvantages:

  • Risk of constantly changing exchange rates
  • Worsening terms of trade with large depreciation
  • Complicates domestic macroeconomic policies
slide22
FIXED

EXCHANGE RATES

Currency exchange rates are set by government

slide23

The Market for Foreign Currency (Pounds)

D

Figure 16-2

P

S

BUT governmentwants to maintainexchange rate…

Pressure on Pound

Dollar price of 1 pound

2

D

Q1

Q

Quantity of pounds

slide24

The Market for Foreign Currency (Pounds)

D

Figure 16-2

P

S

Sell foreign

currency

reserves

Dollar price of 1 pound

2

D

Q1

Q

Q2

Quantity of pounds

slide25

The Market for Foreign Currency (Pounds)

D

Figure 16-2

P

S

S1

Dollar price of 1 pound

2

D

Q1

Q

Q2

Quantity of pounds

fixed exchange
Fixed Exchange

Advantages:

  • Avoids risk, uncertainty of fluctuations

Disadvantages:

  • Requires intervention to maintain rate
  • “Currency intervention”: buy/sell currency
  • Other options: exchange controls, domestic macroeconomic policies
managed float
Managed Float
  • Used by most nations since 1971
  • Rates set by market forces
  • Governments occasionally intervene
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