Chapter 10B | Exchange Rates and Payments with the Rest of the World Flashcards
International Transmission Mechanisms
Exchange rates affect real GDP and inflation through the international transmission mechanism affecting net exports, aggregate demand, and the price level.
International transmission mechanism
- how exchange rates affect real GDP and inflation
Appreciating C$ is negative aggregate demand shock
Decreases net exports;
Decreases aggregate demand.
Decreasing real GDP
Increasing unemployment
Decreases inflation
Depreciating C$ is positive aggregate demand shock
Increases net exports;
Increasing aggregate demand
Increasing real GDP
Decreasing unemployment
Increases inflation
Purchases the economy into expansion
Advantages and disadvantages to both higher and lower exchange rates
Appreciating C$ makes imports less expensive, but is negative demand shock, hurting exporters, decreasing real GDP, increasing unemployment, decreasing inflation
Depreciating C$ makes imports more expensive, but is positive demand shock, helping exporters, increasing real GDP, decreasing unemployment, increasing inflation
There is no socially “best” exchange rate
only trade-offs between winning and losing groups
Purchasing Power Parity and Rate of Return Anchors
The law of one price, purchasing power parity, and rate of return parity are the best available standards for predicting where exchange rates eventually settle, despite their limitations.
How do we predict where exchange rates settle
Law of one price
Law of one price
profit seekers eliminate differences across markets in prices of same product
Purchasing power parity (PPP)
exchange rates adjust so that money has equal real purchasing power in any country
C$15 buys exactly same products in Canada – and when converted into US$ at PPP exchange rate – and in the United States
If $1 Canadian = 67 cents US, then PPP
Money, when converted to other currency buys same real goods
If purchasing power parity does not hold, for example, Canadian $ more valuable than U.S. dollar for purchases (C$1=US$1)
People sell C$ for US$ = supply Canadian $ goes up
Canadian $ depreciates
When PPP does not exist
profit-seeking forces and law of one price push exchange rate toward PPP rate
What does PPP not account for
PPP does not account for trading limitations and the role of speculators influencing exchange rates
Return of parity (interest rate parity)
rates of return on investments are equal across countries, accounting for expected depreciation or appreciation of exchange rates
Rate of Return Formula example
Rate of Return In Japan = Rate of Return in Canada - expected (depreciation [-] or appreciation [+]) of yen against C$
3% = 5% - (+2%)
Japanese investor converts yen into C$ to invest at 5%. At year end, must convert C$ back to yen. Yen appreciated by 2%, so C$ depreciated by 2%.
Outcome
5% return in Canada - 2% loss converting C$ back to yen = 3% return (same as rate if invested in Japan)
Different systems for determining exchange rates
Floating exchange rate
Fixed exchange rate
Floating exchange rate
determined by demand and supply in foreign exchange market
Fixed exchange rate
determined by governments or central banks [Earlier gold standard as fixed exchange rate]
International Balance of Payments
The two main parts of the balance of payments accounts – the current account and the financial account – must add up to zero.
Balance of payments accounts
measure a country’s international transactions
Current account
Financial (capital) account
Statistical discrepancy
Flows of C$
Into Canada are positive numbers on balance of payments accounts
Out of Canada are negative numbers
Current account measures flows from
exports, imports (and net investment/labour/transfer
income)
- Canadian exports creative positive inflow of C$; imports create negative outflow of C$
- Current account deficit
- Current account surplus
Current account deficit
(negative balance) when Canadian spending on imports from R.O.W. is greater than R.O.W. spending on Canadian exports (and net investment/labour/transfers)
Current account surplus
(positive balance) when R.O.W. spending on Canadian exports is greater than Canadian spending on imports from R.O.W. (and net investment/labour/transfers)
Financial (capital) account measures
international investments in financial assets like bonds and direct investment in buying companies
- Canadian investments in R.O.W. are negative outflows of C$; R.O.W. investments in Canada are positive inflow of C$
- Financial account deficit
- Financial account surplus
Financial account deficit
negative balance) when Canadian investments in R.O.W. greater than R.O.W. investments in Canada
Financial account surplus
(positive balance) when R.O..W investments in Canada are greater than Canadian investments in R.O.W.
Statistical discrepancy for missing data and errors is not important for balance of payments accounts
Statistical discrepancy for missing data and errors is not important for balance of payments accounts
Balance of Payments Formula
Current Account Balance + Financial Account Balance + Statistical Discrepancy = 0
The balance of payments accounts must add to zero
When there is a current account surplus there is financial (capital) account deficit
If R.O.W. spends more on Canadian exports than Canadians spend on R.O.W. imports, where does R.O.W. get extra C$?
From financial account deficit, with Canadians “loaning” R.O.W. extra C$ through investments
