Chapter 10 Flashcards
Exchange rate
price one currency exchanges for another currency
- exchange rate is the price of 1 CAD
Foreign exchange market
worldwide market where currencies are bought and sold
currency depreciation
fall in exchange rate of one currency for another
currency appreciation
rise in exchange rate of one currency for another
Law of demand for CAD
as exchange rate rises, quantity demanded for C$ decreases
Law of supply for CAD
as exchange rate rises, quantity supplied of C$ increases
Below equilibrium exchange rate
excess demand (shortages) for C$ buyers competition causes exchange rate to rise
Above equilibrium exchange rate
excess supply (surpluses) for C$, sellers competition causes exchange rate to fall
reciprocal exchange rate
divide 1 by the other exchange rate
- so that when C$ appreciates against any currency, that currency depreciates against C$ and vice versa
interest rate differential
difference in interest rates between countries
- ex: increase in Canadian interest rate differential causes C$ to appreciate (increases demand and decreases supply of $C)
inflation rate differential
difference in inflation rate between countries
- ex: increase in Canadian inflation rate differential causes C$ to depreciate (decreases demand and increases supply of C$)
effects of increasing Canadian real GDP on C$
- increased investor confidence causes strong appreciation (big increase demand C$, decrease)
- increased imports cause small depreciation (small increase supply C$)
- net effect is C$ appreciates
Solo changes in demand for C$
- increasing ROW demand for Canadian exports causes slight appreciation of C$ (increased demand for C$)
- rising world prices for Canadian resource exports cause C$ to appreciate relative to currencies of non-resource producing countries (increased demand for C$)
International transmission mechanism
how exchange rates affect real GDP and inflation
- appreciating C$ is a negative AD shock
which decreases net exports:
- decreasing AD, real GDP
- increasing unemployment
- decreasing inflation
- pushes the economy into a contraction
depreciating C$
is a positive AD shock… which increases net exports
- increasing AD, real GDP
- decreasing unemployment
- increasing inflation
- pushes the economy into expansion
law of one price
profit seekers eliminate differences across markets in prices of the same product
- predictions where exchange rates settle based on the law of one price
purchasing power parity (PPP)
exchange rates adjust so that money has equal real purchasing power in any country
if PPP does not hold:
- ppl sell C$ for US$ and the increased supply of CAD causes the canadian dollar to depreciate
- when PPP does not exist, profit seeking forces and law of one price push exchange rate toward PPP rate
- PPP does not account for trading limitations and the role of speculators influencing exchange rates
rate of return parity (interest rate parity)
rates of return on investments are equal across countries, accounting for expected depreciation or appreciation of exchange rates
FORMULA: 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 foreign exchange market
fluid exchange rate
determined by government or central banks (earlier fold standard as fixed exchange rate) d
balance of payment acounts
measure a country’s international transactions through
- current account
- financial capital account
- statistical discrepancy
current account measures
flows from exports and imports
- canadian exports create positive inflow of C$
- imports create negative outflow of C$
current account deficit (negative balance)
when canadian spending on imports from ROW is greater than ROW spending on canadian exports
- there is a financial capital account surplus with ROW loaning canada extra foreign policy through investments
current account surplus (positive balance)
when ROW spending on canadian exports is greater than canadian spending on imports fromm ROW
- there is a financial capital account deficit
financial capital account
measures international investments in financial assets like bonds and direct investment in buying companies
financial account deficit (negative balance)
when canadian investments in ROW are greater than ROW investments in Canada
financial account surplus (positive balance)
when ROW investments in canada are greater than canadian investments in ROW
statistcal discrepancy
for missing data and errors is not important for balance of payment accounts
