Chapter 19 - Exchange Rates and the Balance of Payments

Question 1

What is the balance of payments?

Answer 1

A summary of a country’s transactions with the rest of the world. Including buying and selling of goods, services and assets.

Overall balance of payments always has to balance (equal to 0). But the individual components do not have to. (CA + KA = 0)

For example, In 2020, Canada had a trade deficit of $44.3 billion. (trade balance of -44.3 billion)

Question 2

What are the individual components of the balance of payments?

Answer 2

1 - Current Account: it records transactions arising from trade in goods and services. It also includes investment income earned from foreign asset holdings. The current account is divided into two sections.
i) Trade account: records payments and receipts from import and export of good and services,
ii) Capital-Service account: records income earned from asset holdings.

2 - Capital Account: it records international transactions in assets. Including bonds, shares of companies (stocks), real estate and factories.

Question 3

Whats capital inflow/outflow?

Answer 3

When Canadians purchase foreign assets, financial capital is leaving Canada and going abroad. That is capital outflow.
When Canadians sell assets to foreigners, financial capital is entering Canada. That is capital Inflow.

Question 4

What happens if there is any surplus in the current account?

Answer 4

There must be an equal deficit in the capital account. Because CA + KA = 0

Question 5

What is an Exchange rate?

Answer 5

The exchange rate is the number of units of domestic currency required to purchase one unit of foreign
currency. – For example, in April 2021 the Canadian-US exchange rate was 1.25 ‒ it takes $1.25 CDN to purchase one USD.

Question 6

Explain the appreciation vs depreciation of a domestic currency.

Answer 6

An appreciation of the domestic currency is a fall in the exchange rate—the domestic currency has become more valuable so it takes fewer units of domestic currency to purchase one unit of foreign currency.

A depreciation of the domestic currency is a rise in the exchange rate—the domestic currency has become less valuable so that it takes more units of domestic currency to purchase one unit of foreign currency.

Question 7

How does an appreciation of the Canadian dollar influence the foreign exchange market (forex)?

Answer 7

An appreciation of the Canadian dollar increases the quantity of foreign exchange demanded

Question 8

What are the slopes of demand and supply curves in the foreign exchange market (forex)?

Answer 8

The supply curve of foreign exchange is positively sloped.
The demand curve for foreign exchange is negatively sloped.

Question 9

What are the two determinations of exchange rates?

Answer 9

1 - A flexible exchange rate: an exchange rate that is let free to be determined by the forces of demand and supply in the free market, with no intervention from central banks
2 - A fixed exchange rate: an exchange rate that is maintained, within a small range around its publicly stated value, by the intervention in the market by a country’s central bank

Question 10

Assuming a flexible exchange rate, how do price changes and inflation affect the Canadian dollar?

Answer 10

• A rise in the ‘world price’ of Canadian exports causes the Canadian dollar to appreciate.
• A rise in the foreign prices of Canadian imports can cause the Canadian dollar to appreciate or
  depreciate, depending on the price responsiveness of demand for those imports.
• If Canada has higher inflation than other countries, the Canadian dollar will be depreciating relative to other currencies.
• If Canada has lower inflation than other countries, the Canadian dollar will be appreciating.

Question 11

Assuming a flexible exchange rate, how do monetary policies affect the Canadian dollar?

Answer 11

• A contractionary monetary policy in Canada will lead to a rise in Canadian interest rates, a capital inflow, and an appreciation of the dollar.
• An expansionary monetary policy in Canada will lead to a reduction in Canadian interest rates, a capital outflow, and a depreciation of the Canadian dollar.

Question 12

What are the three policy issues mentioned in the chapter?

Answer 12

1 - Is a current account deficit “bad” and a surplus “good”?
2 - Is there a “correct” value for the Canadian dollar?
3 - Should Canada have a fixed exchange rate?

Question 13

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

Answer 13

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

Question 14

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

Answer 14

With a flexible exchange rate, the foreign exchange market determines the value of the exchange rate. The equilibrium (intersection of supply and demand curves) determines the “correct” exchange rate.

Question 15

Should Canada Have a Fixed Exchange Rate?

Answer 15

a

Question 16

What does the Purchasing Power Parity (PPP) theory state?
Does it hold / Is it empirically proven to work?

Answer 16

Purchasing power parity is the theory that, over the long term, the exchange rate between two currencies adjusts to reflect relative price levels. (Alternate: a theory that states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services)

If P_C and P_E are the price levels of Canada and Europe, and e is the Canadian-dollar price of euros, then the theory of purchasing power parity predicts that: P_C = e x P_E

Doesn’t always work/ poor predictor of exchange rate; This theoretical concept may not be true in the real world, especially in the short run.