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Balance of Payments. Chapter Three Eitman, Stonehill, and Moffett. Balance of Payments. Balance of Trade. Capital Account. Reserve account. Financial account. Cash flows. For example: the Balance of Trade (Current account) BOT = X – M. Exchange rate equilibirum. Demand for the dollar

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Balance of payments l.jpg

Balance of Payments

Chapter Three

Eitman, Stonehill, and Moffett

ESM Chapter 3 - Balance of Payments


Balance of payments2 l.jpg
Balance of Payments

Balance of Trade

CapitalAccount

Reserve account

Financial account

ESM Chapter 3 - Balance of Payments


Cash flows l.jpg
Cash flows

  • For example: the Balance of Trade (Current account)

    • BOT = X – M

ESM Chapter 3 - Balance of Payments


Exchange rate equilibirum l.jpg
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

ESM Chapter 3 - Balance of Payments


Equilibrium l.jpg
Equilibrium

S1

usd/cd

eo, 0, cd

D1

Qo, cd

Qcd

ESM Chapter 3 - Balance of Payments


Demand for the dollar credits l.jpg
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

ESM Chapter 3 - Balance of Payments


Supply of the dollar debits l.jpg
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

ESM Chapter 3 - Balance of Payments


Current account balance of trade bot l.jpg
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)

ESM Chapter 3 - Balance of Payments


Balance of trade l.jpg
Balance of Trade

ESM Chapter 3 - Balance of Payments


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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.

ESM Chapter 3 - Balance of Payments


Financial account l.jpg
Financial account

  • foreign direct investment

    • investment in real assets

  • portfolio investment

    • equities

    • debt

  • intangibles

    • patents, leases, goodwill

  • errors and omissions

ESM Chapter 3 - Balance of Payments


Capital inflows capital outflows financial account l.jpg
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

ESM Chapter 3 - Balance of Payments


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Financial Account

ESM Chapter 3 - Balance of Payments


Official reserves account l.jpg
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)

ESM Chapter 3 - Balance of Payments


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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

ESM Chapter 3 - Balance of Payments


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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

ESM Chapter 3 - Balance of Payments


Exchange rate equilibrium l.jpg
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

ESM Chapter 3 - Balance of Payments


Equilibrium18 l.jpg
Equilibrium

S1

usd/cd

eo, 0, cd

D1

Qo, cd

Qcd

ESM Chapter 3 - Balance of Payments


Demand for the dollar credits19 l.jpg
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

ESM Chapter 3 - Balance of Payments


Supply of the dollar debits20 l.jpg
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

ESM Chapter 3 - Balance of Payments


Bop surplus from the canadian perspective l.jpg
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

ESM Chapter 3 - Balance of Payments


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Excess Demand for cd

S1

usd/cd

en, 0, cd

eo, 0, cd

D2

D1

Qo, cd

Qn, cd

Qcd

ESM Chapter 3 - Balance of Payments


Bop deficit from us perspective l.jpg
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

ESM Chapter 3 - Balance of Payments


Excess supply of usd l.jpg
Excess Supply of usd

S1

cd/usd

S2

eo, 0, usd

en, 0, usd

D1

Qo, usd

Qn, usd

Qusd

ESM Chapter 3 - Balance of Payments


Benefits of floating exchange rates l.jpg
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

ESM Chapter 3 - Balance of Payments


Depreciation l.jpg
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

ESM Chapter 3 - Balance of Payments


Appreciation l.jpg
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

ESM Chapter 3 - Balance of Payments


Trend volatility l.jpg
Trend & volatility

e

T

ESM Chapter 3 - Balance of Payments


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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

ESM Chapter 3 - Balance of Payments


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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

ESM Chapter 3 - Balance of Payments


Intervention l.jpg
Intervention

S1

S2

usd/cd

B of C

buys usd

with cd

en, 0, cd

eo, 0, cd

D2

D1

Qo, cd

Qn, cd

Qcd

ESM Chapter 3 - Balance of Payments


Intervention32 l.jpg
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

ESM Chapter 3 - Balance of Payments


Unsterilized intervention bank of canada balance sheet l.jpg

gold

silver

cd denominated

t-bills

foreign currency denominated t-bills

cash

currency

chartered bank reserves held at the Bank of Canada

Unsterilized Intervention Bank of Canada balance sheet

Bof C buys US dollars

as an asset

Canadian dollar

liability increases

ESM Chapter 3 - Balance of Payments


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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

ESM Chapter 3 - Balance of Payments


Foreign affects of an unsterlized intervention l.jpg
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

ESM Chapter 3 - Balance of Payments


Sterilized intervention bank of canada balance sheet l.jpg

gold

silver

cd denominated t-bills

foreign currency denominated t-bills

cash

currency

chartered bank reserves held at the Bank of Canada

Sterilized Intervention Bank of Canada balance sheet

Bof C buys US

dollars as an asset

No increase in

B of C liabilities

B of C sells equal

value in other assets

ESM Chapter 3 - Balance of Payments


Domestic affects of an sterilzed intervention l.jpg
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

ESM Chapter 3 - Balance of Payments


Foreign affects of an sterlized intervention l.jpg
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

ESM Chapter 3 - Balance of Payments


Depreciation39 l.jpg
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

ESM Chapter 3 - Balance of Payments


Appreciation40 l.jpg
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

ESM Chapter 3 - Balance of Payments