SayreMacro9e ch11

SAYRE // MORRIS
Ninth Edition
CHAPTER 11
Exchange Rates and the
Balance of Payments
Jason Dean, Wilfrid Laurier University
© 2018 McGraw-Hill Ryerson Limited 11- 1

CHAPTER 11

Balance of Payments
Learning Objectives:
1. Calculate the value of the Canadian dollar in terms
of other currencies and explain the purchasing
power parity theory
2. Identify who wants to buy and sell Canadian dollars
in foreign exchange markets
3. Explain why the value of the Canadian dollar
fluctuates

CHAPTER 11

Balance of Payments
Learning Objectives:
4. Compare flexible and fixed exchange rate systems
5. Explain the meaning of a balance of payments
surplus and deficit

Exchange Rates
• The rate at which one currency is exchanged for another
– To convert currencies from one to another, take the

reciprocal
– For example:
– if $1 US = $1.25 Cdn, then

$1 Cdn = 1 / 1.25 = $0.80 US

Exchange Rates
• Currency Appreciation
– The rise in the exchange rate of one currency for another
• Currency Depreciation
– The fall in the exchange rate of one currency for another

Test Your Understanding
a) Assume that a Swedish krona is worth $0.20 Canadian. How
much is a Canadian dollar worth in kronas?
b) Assume that 1 Canadian dollar equals 70 Japanese yen. How

much is a yen worth in Canadian dollars?

1/0.20 = 5 Swedish Krona


1/0.20 = 5 Swedish Krona

1/70 = 0.014 dollars or 1.4 cents

Purchasing Power Parity Theory
• A theory suggesting that exchange rates will change so as to
equate the purchasing power of each currency
– Arbitrage
– Buying a commodity in a market where price is low,

and immediately selling it in another market where
price is higher

• Example:
– Coal is 1000 krona/tonne in Sweden and

$200/tonne in Canada
– Implied exchange $1 = 5 krona (or 1 krona = $0.20)
– If price of coal in Canada increases to $250, everybody would buy coal

in Sweden
– Demand for krona would increase
– The krona would appreciate until difference in price disappeared, i.e.

when 1 krona = $0.25 (or $1 = 4 krona)

• Differences in purchasing power remain because:
– many services, such as haircuts, are not traded internationally
– of transportation and insurance costs
– of tariffs and other trade restrictions
– of particular preferences by consumers
– of the effect on the value of currencies of trade in financial

assets

Exchange Rate Systems
• Flexible Exchange Rate
– Exchange rate determined by the market forces of supply

and demand and not interfered with by government
action
• Fixed Exchange Rate
– Exchange rate pegged by government and therefore

prevented from rising or falling

Exchange Rate Systems
• Managed Exchange Rate
– A mix of fixed and flexible strategies
– The degree of fluctuation is managed by the central bank

to stabilize the rate
– Used by most countries, including Canada
– Also known as a dirty float

Flexible Exchange Rates
• Demand for Canadian Dollar:
– Foreigners who want to buy Canadian exports or who travel

in Canada
– Foreigners who want to purchase Canadian investments
– Canadians who receive income or gifts or transfers from

abroad
– Currency speculators
– Arbitragers

Demand for Canadian Dollars

• When the Canadian dollar depreciates:
– The effective prices of Canadian exports decrease
– Total exports are likely to rise
• When the Canadian dollar appreciates:
– The effective prices of Canadian exports increase
– Total exports are likely to fall

• Indicate whether demand for the Canadian dollar
would appreciate, depreciate, or not change:
a) Canadian exports rise.
b) Vancouver hosts the Winter Olympics.
c) IBM and the provincial government announce

the construction of a $2 billion data processing
complex in Halifax.
d) Migration from the Maritime provinces to

Ontario increases appreciably.
a) Canadian exports rise. appreciate

b) Vancouver hosts the Winter Olympics.

complex in Halifax.


b) Vancouver hosts the Winter Olympics. appreciate

complex in Halifax.



appreciate
complex in Halifax.



appreciate
complex in Halifax.

no change
• Supply of Canadian Dollar:
– To purchase goods from abroad, Canadians buy foreign

currency with Canadian dollars thus:
– increasing the supply of Canadian dollars in the

international money market
– When the dollar appreciates, the effective prices of

Canadian imports decrease, and total imports will rise

Supply of Canadian Dollars

Effects of Currency Fluctuations
Canadian $ Exports Imports
FALL RISE
• Commodity producers • Canadians shop more in the
hurt U.S.
Appreciates • Tourism down • More foreign cars sold here
• Foreigners invest less • Canadians invest more
abroad
RISE FALL
• Commodity producers • Americans shop in Canada
Depreciates helped • More domestic cars sold
• Tourism booms • Canadians invest less abroad
• Foreigners invest more

Equilibrium Exchange Rate
• Demand comes from

foreigners (exports)
• Supply comes from
Canadians (imports)
• At equilibrium
exchange rate,
quantity demanded
of C$ equals quantity
supplied

• Imagine that the Canadian dollar appreciates.
a) What would happen to Canadian imports?
b) What would happen to Canadian exports?

Imports would rise as foreign products become

relatively cheaper for Canadians

Imports would rise as foreign products become

relatively cheaper for Canadians
Exports would fall as Canadian products become

relatively more expensive for foreign buyers

Demand for Canadian Currency
• Determined by:
– The level of foreign incomes
– The price of Canadian products relative to the price of

foreign products
– Foreigners’ tastes
– Comparative interest rates

Increase in Demand for a Currency

Effect of Increased Exports on AD

Increase in Supply of a Currency

• Which of the following factors would cause the Canadian
dollar to appreciate?
a) A big increase in the popularity of wood-built homes

in China
b) A drop in Canadian interest rates
c) A big increase in Canadian incomes
d) The United States experiences significantly higher

inflation rates than Canada
e) Japan experiences a big increase in economic growth


appreciate
in China
b) A drop in Canadian interest rates



appreciate
in China
b) A drop in Canadian interest rates depreciate



appreciate
in China
c) A big increase in Canadian incomes depreciate



appreciate
in China

appreciate


appreciate
in China

appreciate
e) Japan experiences a big increase in economic growth appreciate

• Assume that the demand for Canadian exports decreases.
What would be the effect on:
a) The value of the Canadian dollar
b) The level of aggregate demand
c) The level of GDP
d) The price level

a) The value of the Canadian dollar depreciates

b) The level of aggregate demand
c) The level of GDP
d) The price level


b) The level of aggregate demand decrease
c) The level of GDP
d) The price level


c) The level of GDP decrease
d) The price level


c) The level of GDP decrease
d) The price level decrease

Fixed Exchange Rates
• Arguments for fixed exchange rates:
– Add certainty to international trade
– Prevent instability in import and export industries
– Discourage currency speculation
– Appeal to people who equate exchange rate with national

prestige

Fixed Exchange Rates:
Increase in Currency Demand
• Increase in
demand does not
lead to currency
appreciation
• Result is a
shortage of
Canadian dollars
on world market
• Canadian dollar
is undervalued

Increase in Currency Demand
• Increase in demand results in undervalued dollar, inexpensive
Canadian goods
• At fixed rate, more dollars are demanded, creating a

shortage
• To maintain normal trade, Canada must provide more dollars
• Increased money supply can lead to inflation
• Eventually, Canadian goods become more expensive,

reducing demand for dollars
Decrease in Currency Demand
• Decrease in
demand does not
lead to currency
depreciation
• Result is a surplus
of Canadian
dollars on world
market
• Canadian dollar
is overvalued

• Decrease in demand results in overvalued dollar, causing a
surplus on world market
• Supply of foreign currency available for trade is insufficient
• Central bank’s foreign reserves are depleted
• Eventually, government must take some action

• Choices for government action include:
– Reduce imports through tariffs or quotas
– Introduce foreign exchange controls
– Negotiate voluntary trade restrictions
– Create a recession in Canada
– Devalue the currency

• Assume that the demand for the Canadian dollar increases.
Describe the adjustment mechanism to this change, given:
a) flexible exchange rates
b) fixed exchange rates


The Canadian dollar will appreciate


The Canadian dollar will appreciate
A shortage of Canadian dollars on the world market arises
because of the higher demand for Canadian exports. The
Bank of Canada will need to increase the money supply in
order to address this shortage. Doing this will, eventually,
lead to inflation.
The Balance of Payments
• Balance of Payments
– An accounting of a country’s international transactions

that involves the payment and receipt of foreign
currencies
• Current Account
– A subcategory of the balance of payments that shows the

income or expenditure related to exports and imports

• Capital Account
– A sub-category of the balance of payments that reflects

changes in ownership of assets associated with foreign
investment

• Balance of Trade
– The value of a country’s exports of goods and services less

the value of its imports
• Foreign Factor Income
– Income (in the way of wages, interest, or dividends) that

nationals receive from providing their services to another
country

TABLE 11.4 - Canada’s Balance of International Payments 2015 ($billions)
Demand for Canadian Dollars Supply of Canadian Dollars Balance
Current Account
Import of goods and
Exports of goods and services 625 services 671
Foreign factor income from
abroad 91 Balance of trade −46
Transfers received from abroad 11 Factor income paid abroad 105
Net foreign factor income −14
Transfers paid abroad 14
Transfers (net) −3
Balance on Current Account −63
Canadian investment
Capital Account abroad 190
Foreign investment in Canada 258 Net foreign investment 68
Balance on Capital Account 68
Statistical discrepancy 6
Overall Balance (current + capital
11
+statistical discrepancy)
Source: Adapted from the Statistics Canada CANSIM database, http://cansim2.statcan.ca, Tables 376-0101, 376-0102, November 1, 2016.

Table 11.5 - Canada’s External Performance (balances in $billions)
Balance of
Balance of Current Payments
Balance of Trade— All Account Overall Value of
Year Trade— U.S. countries Balance Balance C$ (in US$)
2003 +81 +45 +15 −5 0.71
2004 +92 +55 +29 −3 0.77
2005 +99 +50 +26 +2 0.83
2006 +86 +35 +20 +1 0.88
2007 +73 +29 +13 +5 0.93
2008 +78 +28 +2 +2 0.94
2009 +23 −23 −46 +12 0.88
2010 +21 −32 −58 +4 0.97
2011 +34 −22 −48 +8 0.98
2012 +26 −36 −66 +2 1.00
2013 +29 −30 −60 +5 0.97
2014 +34 −19 −45 +6 0.91
2015 +21 −46 −63 +11 0.78
Source: Adapted from the Statistics Canada CANSIM database, http://cansim2.statcan.ca, Tables 376–0101 and 376–0102,November 1, 2016.

Balance of Payments
Current Account
Export of goods and services +164
Import of goods and services _____
= Balance of trade +2
Foreign factor income from abroad +8
Foreign factor income paid abroad _____
Net foreign factor income +15
Transfers (net) _____
= Current Account balance +17
Capital Account
Foreign investment in Canada less Canadian investment abroad +18
= Capital Account balance +18
Overall balance (Current Account and Capital Account) _____
Balance of Payments
Current Account
Import of goods and services - 162
_____
Capital Account
Balance of Payments
Current Account
_____
+7
Capital Account
Balance of Payments
Current Account
_____
+7
Capital Account
Overall balance (Current Account and Capital Account) +35
_____
CHAPTER 11
Key Concepts to Remember:
1. Currency exchange rate calculations

2. Purchasing power parity theory
3. Demand, supply, and equilibrium in money markets
4. Fixed exchange rates vs. flexible exchange rates
5. Balance of payments

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SAYRE // MORRIS

© 2018 McGraw-Hill Ryerson Limited 11- 1

Exchange Rates and the

© 2018 McGraw-Hill Ryerson Limited 11- 2

Exchange Rates and the

© 2018 McGraw-Hill Ryerson Limited 11- 3

– To convert currencies from one to another, take the

– if $1 US = $1.25 Cdn, then

© 2018 McGraw-Hill Ryerson Limited 11- 4

– The rise in the exchange rate of one currency for another

– The fall in the exchange rate of one currency for another

© 2018 McGraw-Hill Ryerson Limited 11- 5

b) Assume that 1 Canadian dollar equals 70 Japanese yen. How

© 2018 McGraw-Hill Ryerson Limited 11- 6

1/0.20 = 5 Swedish Krona

b) Assume that 1 Canadian dollar equals 70 Japanese yen. How

© 2018 McGraw-Hill Ryerson Limited 11- 7

1/0.20 = 5 Swedish Krona

b) Assume that 1 Canadian dollar equals 70 Japanese yen. How

1/70 = 0.014 dollars or 1.4 cents

© 2018 McGraw-Hill Ryerson Limited 11- 8

– Buying a commodity in a market where price is low,

© 2018 McGraw-Hill Ryerson Limited 11- 9

– Coal is 1000 krona/tonne in Sweden and

– Implied exchange $1 = 5 krona (or 1 krona = $0.20)

– If price of coal in Canada increases to $250, everybody would buy coal

– Demand for krona would increase

– The krona would appreciate until difference in price disappeared, i.e.

© 2018 McGraw-Hill Ryerson Limited 11- 10

– many services, such as haircuts, are not traded internationally

– of transportation and insurance costs

– of tariffs and other trade restrictions

– of particular preferences by consumers

– of the effect on the value of currencies of trade in financial

© 2018 McGraw-Hill Ryerson Limited 11- 11

– Exchange rate determined by the market forces of supply

• Fixed Exchange Rate

– Exchange rate pegged by government and therefore

© 2018 McGraw-Hill Ryerson Limited 11- 12

– A mix of fixed and flexible strategies

– The degree of fluctuation is managed by the central bank

– Used by most countries, including Canada

– Also known as a dirty float

© 2018 McGraw-Hill Ryerson Limited 11- 13

– Foreigners who want to buy Canadian exports or who travel

– Foreigners who want to purchase Canadian investments

– Canadians who receive income or gifts or transfers from

© 2018 McGraw-Hill Ryerson Limited 11- 14

© 2018 McGraw-Hill Ryerson Limited 11- 15

– The effective prices of Canadian exports decrease

– Total exports are likely to rise

• When the Canadian dollar appreciates:

– The effective prices of Canadian exports increase

– Total exports are likely to fall

© 2018 McGraw-Hill Ryerson Limited 11- 16

a) Canadian exports rise.

b) Vancouver hosts the Winter Olympics.

c) IBM and the provincial government announce

d) Migration from the Maritime provinces to

a) Canadian exports rise. appreciate

c) IBM and the provincial government announce

d) Migration from the Maritime provinces to

a) Canadian exports rise. appreciate