chapter 10 Flashcards
Def
Exchange Rate
Price at which one currency exchanges for another currency
* Basically the exchange rate is the price for buying Canadian dollars with another country’s currency
Foreign Exchange market
worldwide market where all countries’ currencies are bought and sold in exchange for each other
* Largest financial market in the world
Currency appreciation
rise in the exchange rate of one country for another
Currency depreciation
fall in the exchange rate of one currency for another
The demanders of Canadian dollars of the foreign exchange market are
non-Canadians from the rest of the world
Law of demand for Canadian dollars
As the exchange rate rises, the quantity demanded of Canadian dollars decreases
The inverse relationship between the price of the Canadian dollar and the quantity demanded of Canadian dollars is caused by
the export effect
Export effect
A high value of the Canadian dollar makes Canadian exports more expensive for people in the US and rest of the world
Two main reasons why Canadians supply Canadian dollars on the foreign exchange market:
- To buy imports and assets from the rest of the world
- To speculate on the future value of the Canadian dollar
Law of Supply for Canadian Dollars
As the exchange rate rises, the quantity supplied of Canadian dollars increases
Import effect
A rise in the exchange rate increases the quantity supplied of Canadian dollars in the foreign exchange market
Equilibrium exchange rate
the intersection of the demand and supply curves, no leftover demands or supplies (shortages or surpluses)
Excess demand for Canadian dollars
Excess demand, quantity demanded is greater than quantity supply, so shortage
Excess supply of Canadian dollars
Excess supply, quantity supplied exceeds quantity demanded, surplus of Canadian dollars, competition among sellers to find customers for the Canadian dollars they can’t rid of causes the price of a Canadian dollar to fall
Reciprocal Exchange Rates
two exchange rates that are mirror images of each other
To find the reciprocal exchange rate
divide one by the other
When the Canadian dollar appreciates against any currency what happens to that other currency
that currency depreciates against the Canadian dollar and vice versa
Interest rate differential
difference in interest rates between countries
Increase in Canadian interest rate differential
makes Canadian assets more attractive to investors, increases demand and decreases supply of Canadian dollars, so the Canadian dollar appreciates
Decrease in Canadian interest rate differential
decreases demand and increases supply, Canadian dollar depreciates
Inflation rate differential
difference in inflation rates between countries
Increase in Canadian Inflation rate differential
decreases demand and increases supply, Canadian dollar depreciates
increases demand for foreign currency as inflation makes shit expensive
Decrease in Canadian inflation rate differential
increases demand and decreases supply, Canadian dollar appreciates relative to the US dollar
Increasing Real GDP in Canada – Imports
- When real GDP increases, aggregate income increases, so people buy more products and services income imports
- To buy more imports consumers’ demand for US dollars increases, which ONLY increases the supply of Canadian dollars
Increasing Real GDP in Canada – Investors
Increasing real GDP is economic growth, which investors see as Canada having a strong economy
* This means investors will invest more in Canada, decreasing the demand for US dollars, therefore demand increases and supply decreases in terms of Canadian dollars, which means the Canadian dollar appreciates
Decreasing real GDP in Canada
- Decreasing aggregate income decreases the amount of money Canadian consumers have, decreasing demand for imports, which decreases Canadians’ demand for US dollars, decreasing the supply of Canadian dollars
- Decrease in Canadian real GDP is an economic contraction, meaning investors worry about profits and Canadian assets become less attractive, decreasing demand and increasing supply of Canadian dollars, therefore depreciating the Canadian dollar
Increased ROW demand for Canadian exports causes the Canadian dollar to
slightly appreciate, demand for Canadian dollars increases, but there is no change in the supply
Factors that make the Canadian dollar appreciate
- Canadian interest rates rise relative to other countries
- Canadian inflation rate falls relative to inflation rates in other countries
- Real GDP in Canada increases
- World prices for Canadian resource exports rise
- Expectation that Canadian dollar will appreciate
Factors that cause the Canadian dollar to depreciate
- Canadian interest rates fall relative to other countries
- Canadian inflation rate rises relative to inflation rates in other countries
- Real GDP in Canada decreases
- ROW demand for Canadian exports decreases
- World prices for Canadian resource exports fall
- Expectation that Canadian dollar will depreciate
Def
International transmission Mechanism
How exchange rates affect real GDP, unemployment, and inflation
What shock
Appreciating Canadian dollar is a
negative aggregate demand shock: Decreases net exports, decreasing aggregate demand, decreasing real GDP, increasing unemployment, decreasing inflation
Why does appreciating = negative AD shock
- higher Canadian dollar makes Canadian exports more expensive for customers in the US and the ROW
- When non-Canadians must pay more of their own currencies for Canadian exports, they buy fewer exports → decreases aggregate demand
- Higher Canadian dollar makes imports from ROW cheaper for Canadian customers → increase in imports decreases aggregate demand
What shock
Depreciating Canadian dollar is a
positive aggregate demand shock: increases net exports, increasing aggregate demand, increasing real GDP, decreasing unemployment, increasing inflation
Why is depreciating = positive AD shock
- Lower Canadian dollar makes Canadian exports cheaper for customers in the US and ROW → they buy more of them, so exports increase which increases aggregate demand
- Lower Canadian dollar makes imports from the ROW more expensive, so they buy fewer imports → decrease in imports increases aggregate demand
Impact on inflation
Appreciating Canadian dollar is
deflationary: when the exchange rate of the Canadian dollar rises, exports decrease and imports increases; the falling price of imports decreases the Canadian inflation rate, making the decrease in inflation rate deflationary
Impact on inflation
Depreciating Canadian dollar is
inflationary: when the exchange rate of the Canadian dollar falls, exports increases and imports decrease; excess exports leads to higher inflation
Def
Law of one price
profit seekers eliminate differences in prices of the same product or service across markets and establish a single price
Purchasing Power Parity
exchange rates adjust so that money has equal real purchasing power in any country
What happens when purchasing power parity exists
- Canadian dollars have the same real purchasing power in both countries where something is being bought
- The PPP exchange rate equalizes the purchasing power of money on both sides of the border
What happnes when purchasing power parity doesn’t exist
- As long as there is a difference in the purchasing power of money across the border, the exchange rate keeps falling
- When the exchange rate is different from the PPP rate, profit-seeking forces and the law of one price push the exchange rate back toward the PPP rate
The Big Mac Purchasing Power Parity Rate
- the exchange rate that equalizes the cost of hamburgers in the US and other countries
- Exchange rate that makes hamburgers cost the same in the US and other countries
Limitations of Purchasing Power Parity
- The PPP assumes all products and services are traded easily and without cost across borders → in reality, there are many costs, including transportation and storage
- The PPP assumes demand and supply of dollars on the foreign exchange market are only to buy exports or imports
- Overall, it does not account for trading limitations and the major role of speculators in influencing exchange rates
Rate of Return Parity (interest rate parity)
rates of return on investments are equal across countries, accounting for the expected depreciation or appreciation of exchange rates
Rate of Return in Country A =
rate of return in country B - expected (depreciation or appreciation) of currency A against currency B
Floating exchange rate
determined by demand and supply in the foreign exchange market
Most countries have this
Fixed exchange rate
determined by government or central banks
China is the only country that currently fixed its exchange rate
Balance of Payments
measure a country’s international transactions
two parts to the balance of payments accounts
the current account and the financial account
Current Account
Exports, Imports, and Interest and Transfer Payments
* The current account measures Canada’s yearly exports and imports of products and services
positive numbers on the balance of payments account
Flow of Canadian dollars into Canada
products out = money in
negative numbers on the balance of payments account
Flows of Canadian dollars out of Canada
products in = money out
Current account deficit
negative balance, when Canadian spending on imports from ROW is greater than ROW spending on Canadian exports
Financial account
Investments between Canada and ROW, measure international investments in financial assets like bonds and direct investment in buying companies
financial account surplus
when ROW investments in Canada are greater than Canadian investments in ROW
Statistical discrepancy
the financial account has a statistical discrepancy category to deal with errors and missing information
Why International Payments Account must Balance
Current account balance + financial account balance + statistical discrepancy = 0
- The demand for a different currency on the Forex is also a supply of your own currency
Current account deficit and financial account surplus
Canadians spent more on imports from ROW than ROW spent on Canadian imports, while a financial account surplus means that ROW invested more in Canada than Canadians invested in ROW, which balances things out (w/ statistical discrepancy), = 0
The ROW “loaned” Canadians the extra foreign currency necessary to finance Canada’s purchases of ROW exports
Current account surplus and financial account deficit
ROW spent more on Canadian exports than Canada spent on ROW imports, while a financial account deficit means that Canada invests more in ROW than ROW invests in Canada, = 0
Canada “loans” ROW the extra Canadian dollars to finance ROW purchases of Canadian product and service exports
