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CHAPTER 16: Foreign Exchange

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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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### CHAPTER 16:ForeignExchange

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
• Currency of one nation traded for currency of another nation

Exchange Rate:

• International value of a currency
• Expressed in terms of another currency
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 Exchange

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

BALANCE OF PAYMENTS

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

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 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 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 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
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)
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

Do Question 3 on p. 407 in your text.

Calculate:
• Balance of trade
• Balance on goods/services
• Balance on current acct
• Balance on capital acct
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 Payments

If PAYMENTS > RECEIPTS

• Balance of Payments DEFICIT

If RECEIPTS > PAYMENTS

• Balance of Payments SURPLUS
FLEXIBLE EXCHANGE RATES

Exchange rates determined by supply & demand

The Market for Foreign Currency (Pounds)

Figure 16-2

P

S

Dollar price of 1 pound

2

D

Q1

Q

Quantity of pounds

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

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

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
FIXED

EXCHANGE RATES

Currency exchange rates are set by government

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

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

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

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
• Used by most nations since 1971
• Rates set by market forces
• Governments occasionally intervene