Open Economy Macro: Exchange Rate And Trade Policy. Chapter 16. The Balance of Payments. The balance of payments is a country’s record of all transactions between its residents and the residents of all foreign countries. The Balance of Payments.
The Balance of Payments • The balance of payments is a country’s record of all transactions between its residents and the residents of all foreign countries.
The Balance of Payments • The current account is the part of the balance of payments account in which all short-term flows of payments are listed. • It includes exports and imports of both goods and services; net investment income; and net transfers.
The Balance of Payments • The capital and financial accounts are the part of the balance of payments account in which all long-term flows of payments are listed. • When Canadian citizens buy foreign securities or when foreigners buy Canadian securities, they are listed here as outflows and inflows, respectively.
The Balance of Payments • The government can influence the exchange rate by buying and selling official reserves—government holdings of foreign currencies.
The Current Account • The difference between the value of goods exported and the value of goods imported is sometimes called the balance of merchandise trade.
The Current Account • Although the popular press often uses this measure, the merchandise trade balance is not a good summary because services are an important component of trade.
The Current Account • Trade in services is just as important as trade in goods. • The key statistic for economists is the balance of goods and services which is the difference between the value of goods and services exported and imported.
The Current Account • There is no reason that the goods and services sent into a country must equal the goods and services sent out in a particular year. • The current account includes payments from past investments and net transfers.
The Current Account • The last component of the current account is net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods and services.
The Capital and Financial Account • The capital and financial account consists of • The capital account • The financial account.
The Capital and Financial Account • The capital account measures transactions such as international inheritances, federal debt forgiveness and the transfer of intangible assets.
The Capital and Financial Account • The financial account measures transactions in financial assets and liabilities. • It includes Canadian portfolio investment abroad and foreign investment in Canadian stocks and bonds.
The Capital and Financial Account • The reason for this are statistical discrepancies – many transactions have to be estimated. • Current account balance is not completely offset by the capital and financial account balance.
The Capital and Financial Account • In thinking about what determines a currency’s value, it is important to remember both the demand for dollars to buy goods and services and the demand for dollars to buy assets.
Balance of Payments Equilibrium • Because the balance of payments consists of both the capital account and the current account, if the capital account is in surplus and the trade account is in deficit, there can still be a balance of payments surplus.
Balance of Payments Equilibrium • By definition, current account and the capital and financial account must sum to zero, because they are an accounting identity.
Balance of Payments Equilibrium • If the currencies are freely exchangeable, the quantity of currency demanded must equal the quantity supplied. • Any deficit in the balance of payments, then, must be offset by an equal surplus in official reserve transactions.
Exchange Rates • Exchange rate is the rate at which one currency can be traded for another. • When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.
Exchange Rates • In order to demand one currency, you must supply another. • Equilibrium is where the quantity supplied equals the quantity demanded.
Exchange Rates and the Balance of Payments • A deficit in the balance of payments means that the quantity supplied of a currency exceeds the quantity demanded. • A surplus in the balance of payments means the opposite.
Exchange Rates and the Balance of Payments • Equilibrium is where the quantity supplied a currency equals the quantity demanded.
Supply Price of Euros (in dollars) $1.30 1.20 1.15 1.10 Demand QD QS Quantity of Euros The Supply of and Demand for Euros, Fig. 16-1, p 387
Fundamental Forces Determining Exchange Rates • Exchange rate analysis is usually broken down into fundamental analysis and short-run analysis.
Fundamental Forces Determining Exchange Rates • Fundamental analysis is a consideration of the fundamental forces that determine the supply of and demand for currencies.
Fundamental Forces Determining Exchange Rates • These fundamental forces include a country’s income, changes in a country’s prices, and the interest rate in a country.
Changes in a Country’s Income • When a country’s income falls, the demand for imports falls. • Then demand for foreign currency to buy those imports falls.
Changes in a Country’s Income • This means that the supply of the country’s currency to buy the foreign currency falls. • This finally leads to an increase in the price of that country’s currency relative to foreign currency.
Changes in a Country’s Prices • If the Canada has more inflation than other countries, foreign goods will become cheaper. • Canadian demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.
Changes in a Country’s Prices • This rise in Canadian inflation will shift the dollar supply to the right and the dollar demand to the left.
Changes in Interest Rates • A rise in Canadian interest rates relative to those abroad will increase demand for Canadian assets.
Changes in Interest Rates • Demand for dollars will increase, while simultaneously the supply of dollars will decrease as fewer Canadians sell their dollars to buy foreign assets.
Changes in Interest Rates • A fall in Canadian interest rates or a rise in foreign interest rates will have the opposite effect.
Exchange Rate Determination Is More Complicated Than It Seems • Large exchange rate fluctuations in response to changing expectations make trading difficult and have significant real effect on economic activity.
Exchange Rate Determination Is More Complicated Than It Seems • If the market expects exchange rates to change, it will become a self-fulfilling prophesy.
Exchange Rate Determination Is More Complicated Than It Seems • The resulting fluctuations serve no real purpose, and cause problems for international trade and the country’s economy.
International Trade Problems From Shifting Values of Currencies • Large fluctuations make real trade difficult, and cause serious real consequences. • It is these consequences that have led to calls for government to fix or stabilize their exchange rates.
How a Fixed Exchange Rate System Works • One way the government can set the exchange rate is to make its currency nonconvertible. • Most western economies have agreed not to use this approach.
How a Fixed Exchange Rate System Works • A second way is for government to adopt a fixed exchange rate policy. • A fixed exchange rate policy is one in which the government commits to holding the exchange rate at a specified rate through direct intervention.
Fixing the Exchange Rate • The government can fix its exchange rate by exchange rate intervention. • Exchange rate intervention – buying or selling a currency to affect its price.
Direct Exchange Rate Intervention • Currency support is the buying of a currency by a government to maintain its value at above its long-run equilibrium value.
Direct Exchange Rate Intervention • A country can maintain a fixed exchange rate only as long as it has the official reserves (foreign currencies) to maintain this constant rate.
Direct Exchange Rate Intervention • Once it runs out of official reserves, it will be unable to intervene, and then must either borrow or devalue its currency.
Direct Exchange Policy, Fig.16-2, p 392 Excess supply Supply $1.30 Price of euros (in dollars) D1 1.20 1.10 D0 Q1 QE Q2 Quantity of euros
Currency Stabilization • A more practical long-run exchange rate policy is currency stabilization. • Currency stabilization – the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies.
Currency Stabilization • In currency stabilization, the government is not trying to change the long-run equilibrium. • It is simply trying to keep the exchange rate at that long-run equilibrium.
Currency Stabilization • Currency stabilization minimizes the possibility that the government will run out of official reserves.
Currency Stabilization • If a country runs out of official reserves, it must adjust its economy if it wants to maintain a fixed exchange rate.