19.4 Three Policy Issues

Question 1

What are the three policy issues we will explore in this chapter?

Answer 1

Is a current account deficit “bad” and a surplus “good”?

Is there a “correct” value for the Canadian dollar?

Should Canada have a fixed exchange rate?

Question 2

In most years, has Canada had a trade surplus or deficit?

Answer 2

In most years, Canada has a significant trade surplus since it exports more goods and services to the world than it imports.

Question 3

Does Canada tend to have a surplus or deficit on the capital-service portion of the current account?

Answer 3

But because it makes more investment payments (both interest and dividends) to foreigners than it receives from foreigners, it has a deficit on the capital-service portion of the current account.

Question 4

What was the overall current account deficit of Canada between 1972 - 1995?

Answer 4

During most of the 1972–1995 period, Canada had an overall current account deficit of between 2 and 4 percent of GDP.

Question 5

What happened to trade between 1999 to 2008 in Canada?

Answer 5

From 1999 to 2008, however, Canada’s trade surplus increased by more than the capital-service deficit, and the result was a significant turnaround in the current account balance.

Question 6

What happened to Canada’s exports as a result of the 2008 global recession?

Answer 6

The global recession in 2008, however, followed by a sluggish recovery in the world economy, caused Canada’s exports to fall far more than its imports and the result was a return to current account deficits.

Question 7

What do changes in Canada’s current account balance often reflect?

Answer 7

The changes in Canada’s current account balance often reflect different economic performance in Canada and its trading partners.

Question 8

What does Canada’s current account deficit typically equal?

Answer 8

Canada typically has a current account deficit equal to a small percentage of GDP.

Question 9

How were current account balences and deficits balenced?

Answer 9

Canada’s balance of payments accounts are defined in such a way that they must always balance, so during the 1972–1995 period the current account deficits were matched by capital account surpluses of the same size.

During these years, Canada was selling more assets to the rest of the world—both bonds and equity—than it was buying from the rest of the world.

Similarly, the current account surpluses from 1999 to 2008 were matched by capital account deficits, meaning that in those years Canada was buying more assets from foreigners than we were selling to foreigners.

Question 10

What do many people agure about current account deficits, as well as exports and imports?

Answer 10

Many people argue that a current account deficit is undesirable because it means that Canada is buying more goods and services from the world than it is selling to the world. Central to this view is the belief that exports are “good” because they generate income and imports are “bad” because they require expenditure.

Question 11

What are current account surpluses and deficits sometimes called?

Answer 11

As a carryover from a long-discredited eighteenth-century doctrine called mercantilism, a current account surplus is sometimes called a “favourable balance,” and a current account deficit is sometimes called an “unfavourable balance.”

Question 12

What do Mercantilists believe?

Answer 12

Mercantilists, both ancient and modern, believe that a country’s gains from trade arise only from having a “favourable” balance of trade—that is, by exporting more goods and services than it imports.

Question 13

What is the central point that is missed by Mercantilists?

Answer 13

But this belief misses the central point of comparative advantage that we explored in Chapter 17—that countries gain from trade because trade allows each country to specialize in the production of those products in which its opportunity costs are low.

This specialization also results in countries expanding both their exports and their imports. The gains from trade have nothing to do with whether there is a trade deficit or a trade surplus.

Question 14

What do the gains from trade depend on?

Answer 14

The lesson to be learned is that the gains from trade depend on the volume of trade (exports plus imports) rather than the balance of trade (exports minus imports).

Question 15

What view did former U.S. President Trump have on the benefits derived from international trade?

Answer 15

Former U.S. President Trump shared this view when he pointed to any U.S. trade deficit—by product or by country—as bad for American economic interests. People who hold these views appear to believe that the benefits derived from international trade are measured by the size of the trade surplus rather than by the volume of two-way trade.

Question 16

What is the exploitation doctrine of international trade?

Answer 16

The exploitation doctrine of international trade: one country’s surplus is another country’s deficit. Hence, one country’s gain, judged by its surplus, must be another country’s loss, judged by its deficit.

Question 17

Who were The Mercantilists?

Answer 17

The mercantilists were a group of economists who preceded Adam Smith. They judged the success of trade by the size of the trade balance.

In many cases, this doctrine made sense in terms of their objective, which was to use international trade as a means of building up the political and military power of the state, rather than as a means of raising the living standards of its citizens.

A current account surplus allowed the country (then and now) to acquire assets. (In those days, the assets took the form of gold.

Question 18

If the governments policy objective is to promote the welfare and living standards of its ordenary citizens, does the mercantilist focus work?

How does this relate to the principle of comparative advantage?

Answer 18

If the government’s policy objective is to promote the welfare and living standards of ordinary citizens, however, the mercantilist focus on the balance of trade makes no sense.

The principle of comparative advantage shows that average living standards are maximized by having individuals, regions, and countries specialize in the things they produce comparatively well and then trading to obtain the things they produce comparatively poorly.

With specialization, domestic consumers get access to products they want at the lowest possible prices, while domestic firms are able to sell their products at higher prices than would otherwise be possible.

The more specialization takes place, the more trade occurs and thus the more average living standards increase.

Question 19

What are the gains from trade to be judged by?

Answer 19

For the country as a whole, the gains from trade are to be judged by the volume of trade rather than by the balance of trade.

A situation in which there is a large volume of trade even though each country has a zero balance of trade is thus entirely satisfactory.

Question 20

What will a change in policy that results in an equal increase in both exports and imports generate?

Answer 20

A change in policy that results in an equal increase in both exports and imports will generate gains because it allows for specialization according to comparative advantage, even though it causes no change in either country’s trade balance.

Question 21

What does it mean for the capital account and the capital assets if Canada has a current account deficit?

Answer 21

If Canada has a current account deficit, it must also have a capital account surplus, which means that it is a net seller of assets to the rest of the world.

These assets are either bonds, in which case Canadians are borrowing from foreigners, or they are shares in firms (equities), in which case Canadians are selling their capital stock to foreigners.

Question 22

What does Canada increase when they sell bonds to foreigners?

Answer 22

It is true that by selling bonds to foreigners, Canadians increase their indebtedness to foreigners and will eventually have to redeem the bonds and pay interest.

Question 23

What is Canada giving up by selling income-earning equities?

Answer 23

And by selling income-earning equities to foreigners, Canadians give up a stream of income that they would otherwise have.

Question 24

What does Canada gain by selling bonds and income-earning assets to foreigners?

Answer 24

in both cases, they get a lump sum of funds that can be used for any type of consumption or investment.

Question 25

What two activities is a country that has a current account deficit partaking in?

Answer 25

A country that has a current account deficit is either borrowing from the rest of the world or selling some of its assets to the rest of the world. This is not necessarily undesirable.

Question 26

What does the wisdom of borrowing depend on?

Answer 26

Surely the wisdom of borrowing depends on why Canadians are borrowing. It is therefore important to know why there is a current account deficit.

Question 27

Equation for Current Account

Answer 27

This equation says that the current account balance in any year is exactly equal to the excess of national saving, S+(T-G) , over domestic investment, I.

Question 28

If Canadians (and their governments) save more than is needed to finance the amount of domestic investment, where do the excess funds go?

Answer 28

They are used to acquire foreign assets, and thus Canada has a current account surplus CA > 0

Question 29

What must Canadias do if they do not save enough to finance the amount of domestic investment,

Answer 29

If Canadians do not save enough to finance the amount of domestic investment, the balance must be financed by foreign funds.

Thus, Canada has a current account deficit .

Question 30

Why does the CA provide a solid foundation for analyzing our questions about the desirability of current account deficits and surpluses.

Answer 30

Question 31

CA equation that says that the current account balance is equal to the excess of private saving over investment plus the government budget surplus.

Answer 31

Question 32

Three separate reasons for any given increase in the current account deficit (a fall in CA).

Answer 32

• a reduction in private saving, other things being equal, will lead to a rise in the current account deficit.
• Second, a rise in domestic investment, other things being equal, will increase the current account deficit.

Finally, other things being equal, a rise in the government’s budget deficit (a smaller value of T - G) will raise the current account deficit.

This third case is often referred to as a situation of twin deficits. That is, a rise in the government’s budget deficit will also have the effect (if S and I remain constant) of increasing the current account deficit.

Question 33

What are three possible causes of an increase in a country’s current account deficit?

Answer 33

An increase in the level of investment,

A decrease in the level of private saving, and

An increase in the government’s budget deficit

Question 34

When is a given current account deficit desirable?

Answer 34

A country’s current account deficit can change for a number of reasons. Whether any given change is desirable depends crucially on its underlying cause.

Question 35

What is the exchange rate determined by in a country that chooses to use a flexible exchange rate?

Answer 35

With a flexible exchange rate, the foreign-exchange market determines the value of the exchange rate.

With respect to the forces of demand and supply, the equilibrium exchange rate is the “correct” exchange rate.

Question 36

Why is the “correct” value of the Canadian exchange rate frequently changing?

Answer 36

As various forces lead to frequent changes in the demand for and supply of the Canadian dollar in foreign-exchange markets, the “correct” value of the Canadian exchange rate is frequently changing.

Question 37

What do some economists that accept the current exchange rate as determined by the foreign-exchange market is correct, aslo argue?

Answer 37

Some economists accept that the current exchange rate, as determined by the foreign-exchange market, is indeed the correct rate, but they also argue that there exists a “fundamental” value of the exchange rate that will hold in the long run. These economists argue that the exchange rate’s long-run value is determined by purchasing power parity.

Question 38

What is Purchasing power parity (PPP)?

Answer 38

Purchasing power parity (PPP)

The theory that, over the long term, the exchange rate between two currencies adjusts to reflect relative price levels.

 The theory holds that a currency will tend to have the same purchasing power when it is spent in its home country as it would have if it were converted to foreign exchange and spent in the foreign country.

Question 39

What is another way of describing Purchasing power parity?

Answer 39

Another way to say the same thing is that the price of identical baskets of goods should be the same in the two countries when the price is expressed in the same currency.

If we let Pc and Pe be the price levels in Canada and Europe, respectively, and let e be the Canadian-dollar price of euros (the exchange rate), then the theory of purchasing power parity predicts the following equality in the long run:

Question 40

Formula for PPP exchange rate

Answer 40

Question 41

What does the theory of purchasing power parity predict?

Answer 41

The theory of purchasing power parity predicts that if the actual exchange rate (e) does not equal the PPP exchange rate —in which case the actual exchange rate is either “overvalued” or “undervalued”—then demands and supplies of Canadian and European goods will change until the equality holds.

Thus, the theory of PPP predicts that the actual exchange rate will eventually equal the PPP exchange rate.

Question 42

Does the actualy exchange rate deviate from the PPP exchange rate?

Answer 42

The actual exchange rate deviates from the PPP exchange rate for extended periods.

Question 43

Why is the argument that prices should eventually be equated across two countries sensible?

Answer 43

The argument that the prices should (eventually) be equated across the two countries is sensibl

if the prices are not equated across the two countries, there would be an incentive to purchase in the cheaper country rather than in the more expensive country, and this would lead to changes in the exchange rate until Equation 19-3 did hold.

Question 44

What is one problem when we apply the theory of purchasing power parity to national price indexes?

Answer 44

One problem, however, when we apply the theory of purchasing power parity to national price indexes, such as the Consumer Price Index or the implicit GDP deflator, is that the two baskets of goods are typically not the same—for two reasons.

Question 45

When we apply the theory of purchasing power parity to national price indexes, such as the Consumer Price Index or the implicit GDP deflator, is that the two baskets of goods are typically not the same—for two reasons. What are they?

Answer 45

Different Countries Produce Different Goods

Non-Traded Goods Are Important

Question 46

The implication of these price level differences for the theory of PPP is important…

Answer 46

As long as changes in the relative prices of goods occur, such as a change in the price of forest products relative to wine, then (the Canadian GDP deflator) will change relative to (the European GDP deflator) even though the prices of individual goods might be equated across the two countries.

In other words, in the presence of changing relative prices, there is no reason to expect the actual exchange rate to equal the PPP exchange rate.

Question 47

How do non-traded goods effect the PPP?

Answer 47

Many products in any country are not traded internationally, such as haircuts, restaurant meals, dry cleaning, car-repair and landscaping services, and tickets to theatres or sporting events.

But, since such products cannot be traded across international boundaries, there is nothing that will force their prices to be equal across the two countries.

If haircuts are more expensive in Paris than in Winnipeg (as they are), we do not expect people to shift their consumption of haircuts away from Paris toward Winnipeg, and thus we should not expect the actual exchange rate to move to make Equation 19-3 hold.

Question 48

Changes in relative prices and the presence of non-traded goods imply that…

Answer 48

Changes in relative prices and the presence of non-traded goods imply that the theory of purchasing power parity is generally a poor predictor of the actual exchange rate, even in the long run.

Question 49

Some economists have suggested that Canada peg the value of its currency to the U.S. dollar. Why

Answer 49

Advocates of a fixed Canadian exchange rate see this policy as a means of avoiding the significant fluctuations in the Canadian–U.S. dollar exchange rate that would otherwise occur.

They argue that exchange-rate fluctuations generate uncertainty for importers and exporters and thus increase the costs associated with international trade.

Question 50

What is the main advantage of a flexible over a fixed exchange rate?

Answer 50

That the exchange rate adjusts in response to shocks is actually the main advantage of a flexible over a fixed exchange rate.

A flexible exchange rate acts as a “shock absorber,” dampening the effects on the country’s output and employment from external shocks.

Question 51

How do flexible exchange rates act as “shock absorbers”?

Answer 51

Flexible exchange rates adjust to external shocks and thus dampen the effect on output and employment.

Question 52

If the Bank of Canada fixes the exchange rate at , the reduction in the supply of foreign exchange from to leads to…

Answer 52

If the Bank of Canada fixes the exchange rate at , the reduction in the supply of foreign exchange from to leads to an excess demand for foreign currency.

To keep the exchange rate fixed at e0, the Bank must sell sufficient foreign-exchange reserves to satisfy this excess demand.

But the negative shock to aggregate demand still occurs and thus output and employment in Canada fall, as shown in part (ii) of Figure 19-6.

If this shock is large and persistent enough, Canadian wages will eventually fall and the AS curve will eventually shift downward, returning real GDP to the level of potential output.

But the closing of the recessionary gap may be slow and painful.

Question 53

If Canada instead has a flexible exchange rate, the reduction in the world prices of raw materials will still lead to…

Answer 53

If Canada instead has a flexible exchange rate, the reduction in the world prices of raw materials will still lead to a reduction in the supply of foreign exchange but in this situation it will cause a depreciation of the Canadian dollar.

The exchange rate will increase from to . The AD curve will shift to the left, reducing Canada’s GDP, just as in the fixed-exchange-rate case, but it will not shift as far.

Question 54

With a flexible exchange rate, what will hapen to sectors Canadian economy producing raw materials during a reduction in the world price of raw materials?

Answer 54

The sectors of the Canadian economy producing raw materials will still be in recession, for there has been a reduction in demand for these products. But the overall Canadian downturn will be dampened by the depreciation of the Canadian dollar.

Question 55

One of the advantages of flexible exchange rates is that, in response to shocks to export prices….

Answer 55

One of the advantages of flexible exchange rates is that, in response to shocks to export prices, the exchange rate can act as a shock absorber, dampening the effects of the shock on output and employment.

Question 56

What does having a fixed exchange rate not prevent?

Answer 56

Note that having a fixed exchange rate does not prevent a country from being subjected to shocks from the rest of the world.

Some advocates of fixed exchange rates seem to think that by fixing the value of a country’s currency, the country is shielding itself from undesirable fluctuations.

But shocks to a country’s export prices will always occur. As long as there are changes in the demand for and supply of various products around the world, there will also be changes in these prices.

Question 57

In conclustion what does a flexible/fixed exchange rate do in response to shocks in its exports prices?

Answer 57

A country will always experience shocks in its export prices.

A flexible exchange rate absorbs some of the shock, reducing the effect on output and employment.

A fixed exchange rate simply redistributes the effect of the shock—the exchange rate is smoother but output and employment are more volatile.

Question 58

What are the costs involved in exporting and importing goods and services?

Answer 58

Despite the benefits of international trade, there are costs involved in exporting and importing goods and services.

The transaction costs of international trade involve the costs associated with converting one currency to another, as must be done either by the importer or by the exporter of the product that is traded.

Question 59

What gets higher the with the volume of trade between two countries?

Answer 59

The greater is the volume of trade between two countries, the higher are the aggregate transaction costs associated with international trade.

Question 60

The volatility of flexible exchange rates generates another type of cost for importers and exporters…..

Answer 60

Specifically, the unpredictability of the exchange rate leads to uncertainty about the profitability of any specific international transaction.

Such uncertainty, given risk-averse firms, can be expected to lead to a smaller volume of international trade and thus to fewer benefits from such trade.

Question 61

What happens if hte presence of foreign-exchange risk leads to less international trade?

Answer 61

If the presence of foreign-exchange risk leads to less international trade, there will be a reduction in the gains from trade.

Question 62

Many of the people who advocate Canada’s move to a fixed exchange rate point to what as a main benefit?

Answer 62

Many of the people who advocate Canada’s move to a fixed exchange rate point to the avoidance of this foreign-exchange risk as the main benefit.

They argue that if the Canadian dollar were pegged in value to the U.S. dollar, both importers and exporters would face less uncertainty on the most important part of their trade—that between Canada and the United States.

With the greater certainty, they argue, would come greater trade flows and thus an increase in the overall gains from trade.

Question 63

Why do many economists disagree with the fact that there would be less uncertenty with a fixed exchange rate?

Answer 63

Many economists disagree. While accepting the basic argument regarding the risks created by flexible (and volatile) exchange rates, they note that importers and exporters already have the means to avoid this uncertainty.

Question 64

What are forward markets?

Answer 64

In particular, traders can participate in forward markets in which they can buy or sell foreign exchange *in the future *at prices specified today.

Question 65

One final point should be noted about the choice between fixed and flexible exchange rates, in reguards to inflation.

Answer 65

If the Bank of Canada chooses to allow the exchange rate to fluctuate in response to shocks, it can focus its monetary policy on the control of inflation.

In other words, it can adjust its monetary policy—sometimes tightening and other times loosening—to keep inflation close to the stated 2 percent target. But if the Bank chooses instead to fix the exchange rate, it is not also able to control inflation.

Question 66

Efforts by the Bank of Canada to maintain a fixed exchange rate are likely to…

Answer 66

Efforts by the Bank of Canada to maintain a fixed exchange rate are likely to be inconsistent with its efforts to keep inflation close to the 2 percent target.