The Balance of Payments, the Exchange Rate, and Trade

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1 Balance of Payments The Balance of Payments, the Exchange Rate, and Trade Policy The balance of payments is a country s record of all transactions between its residents and the residents of all foreign countries. Chapter 16 2 Balance of Payments The current account is the part of the balance of payments account in which all short-term flows of payments are listed. It includes exports and imports of both goods and services; net investment income; and net transfers. Balance of Payments The capital and financial accounts are the part of the balance of payments account in which all long-term flows of payments are listed. When Canadian citizens buy foreign securities or when foreigners buy Canadian securities, they are listed here as outflows and inflows, respectively. 3 4 Balance of Payments The government can influence the exchange rate by buying and selling official reserves government holdings of foreign currencies. Balance of Payments The buying and selling of official reserves is recorded in the financial account. It is the part of the balance of payments accounts that records the amount of its own currency or foreign currencies that a country buys or sells. 5 6

2 Current Account The balance of merchandise trade is the difference between the import and export of goods The merchandise trade balance is not a good summary measure because it doesn t include services. Current Account Trade in services is just as important as trade in goods. The key statistic for economists is the balance of goods and services, which is the difference between goods and services exported and imported. 7 8 Current Account There is no reason that the goods and services sent into a country must equal the goods and services sent out in a particular year. Current Account The last component of the current account is net transfers, which includes foreign aid, gifts, and other payments to individuals not exchanged for goods and services. The current account includes payments from past investments and net transfers Capital and Financial Account Capital and Financial Account The capital account measures transactions such as international inheritances, federal debt forgiveness and the transfer of intangible assets. The financial account measures transactions in financial assets and liabilities. It includes Canadian portfolio investment abroad and foreign investment in Canadian stocks and bonds

3 Capital and Financial Account The current account balance is not completely offset by the capital and financial account balance Capital and Financial Account A currency s value is determined by both the demand for dollars to buy goods and services and the demand for dollars to buy assets. The reason for this is statistical discrepancies many transactions have to be estimated Balance of Payments Equilibrium 2001 Balance of Payments Accounts The balance of payments consists of both the capital and financial account and the current account. There can still be a balance of payments surplus if the capital and financial account is in surplus and the trade account is in deficit Balance of Payments Equilibrium Official Transactions Account Because they are an accounting identity, the current account and capital and financial account must sum to zero. The quantity of currency supplied, including government s, must equal the quantity of currency demanded, including government s

4 Balance of Payments Equilibrium If the currencies are freely exchangeable, the quantity of currency demanded must equal the quantity supplied. Any deficit in the balance of payments must be offset by an equal surplus in official reserve transactions. Exchange Rates The exchange rate is the rate at which one currency can be traded for another. When comparing the currencies of two countries, the supply of one currency equals the demand for another currency Exchange Rates The Supply of and Demand for Euros In order to demand one currency, you must supply another. Equilibrium is where the quantity supplied of a currency equals the quantity demanded. Price of euros (in dollars) $ S D Q D Q S Quantity of euros Fundamental Forces Determining Exchange Rates Exchange rate analysis is usually broken down into fundamental analysis and short-run analysis. Fundamental Forces Determining Exchange Rates Fundamental analysis the consideration of the fundamental forces that determine the supply of and demand for currencies: A country s income. A country s prices. The interest rate

5 A Country s Income A Country s Income When a country s income falls, the demand for imports falls. Then demand for foreign currency to buy those imports falls. This means that the supply of the country s currency to buy the foreign currency falls. This finally leads to an increase in the price of that country s currency relative to foreign currency A Country s Prices If Canada has higher inflation than other countries, foreign goods become cheaper. Canadian demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease. The rise in Canadian inflation will shift the dollar supply to the right and the dollar demand to the left. Interest Rates A rise in Canadian interest rates relative to those abroad will increase demand for Canadian assets. Demand for dollars will increase, and the supply of dollars will decrease as fewer Canadians sell their dollars to buy foreign assets Exchange Rate Determination Is Complicated Fundamentals can be overwhelmed by expectations of a change in exchange rates. If the market expects exchange rates to change, it will become a self-fulfilling prophesy. International Trade Problems From Shifting Values of Currencies Large fluctuations make real trade difficult, and cause serious real consequences. It is these consequences that have led to calls for government to fix or stabilize their exchange rates

6 Fixed Exchange Rates Fixed Exchange Rates The government can fix its exchange rate by exchange rate intervention. Exchange rate intervention buying or selling a currency to affect its price. Currency support is the buying of currency by government to maintain its value above its long-run equilibrium value Fixed Exchange Rates Direct Exchange Policy A country can maintain a fixed exchange rate only as long as it has the official reserves (foreign currencies) to maintain this constant rate. Price of euros (in dollars) $1.60 Excess supply S Once it runs out of official reserves, it will be unable to intervene, and then must either borrow or devalue its currency Q 1 Q E Q 2 D 1 D 0 Quantity of euros Currency Stabilization Currency Stabilization A more practical long-run exchange rate policy is currency stabilization. Currency stabilization the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies. In currency stabilization, the government is not trying to change the long-run equilibrium. It is simply trying to keep the exchange rate at that long-run equilibrium

7 Currency Stabilization Currency Stabilization Currency stabilization minimizes the possibility that the government will run out of official reserves. If a nation runs out of official reserves, it must adjust its economy if it wants to maintain a fixed exchange rate. Strategic currency stabilization is often used when a government has a small level of official reserves. Strategic currency stabilization buying and selling at strategic moments to affect the expectations of traders, and hence to affect their supply and demand Stabilizing Fluctuations Versus Deviating From Long-Run Equilibrium Exchange rate intervention only works if the short-run equilibrium is the problem. The government will eventually run out of official reserves if the problem is long run, or if it estimates the wrong equilibrium. Stabilizing Fluctuations Versus Deviating From Long-Run Equilibrium In theory, it is important to distinguish whether the problem is long-run or short-run equilibrium. In practice, it is difficult to do so Estimating Long-Run Equilibrium Exchange Rates The long-run equilibrium rate can be estimated using purchasing power parity. Purchasing power parity (PPP) a method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods. Criticisms of Purchasing Power Parity Those exchange rates may or may not be appropriate long-run exchange rates. The difficulty with purchasing power parity is the complex nature of trade and consumption. Purchasing power parity will change as the basket of goods changes

8 Criticisms of Purchasing Power Parity Criticisms of Purchasing Power Parity Purchasing power parity measures leave out asset demand for a currency, an important element of demand for currencies. The critics contend that the current exchange rate is the best estimate of the long-run equilibrium exchange rate Exchange Rate Systems There are three exchange rate regimes: Fixed exchange rate the government chooses an exchange rate and offers to buy and sell currencies at that rate. Flexible exchange rate exchange rates are determined by the market. Partially flexible exchange rate the government sometimes affects the exchange rate and sometimes leaves it to the market. Advantages of Fixed Exchange Rates They provide international monetary stability. They force governments to make adjustments to meet their international problems Disadvantages of Fixed Exchange Rates They can become unfixed. When they are expected to become unfixed, they create enormous monetary instability. Disadvantages of Fixed Exchange Rates They force governments to make adjustments to meet their international problems. This is an advantage as well as a disadvantage

9 Fixed Exchange Rates and Monetary Stability If the government picks an exchange rate that is too high, its exports lag and the country loses official reserves. Fixed Exchange Rates and Monetary Stability If the government picks an exchange rate that is too low, it is paying more for its imports than it needs to and is building up official reserves. Some other country is losing official reserves Fixed Exchange Rates and Monetary Stability At times, fixed exchange rates can become highly unstable because expectations of a change in the exchange rate can force the change to occur. Fixed Exchange Rates and Policy Independence Fixed exchange rates place limitations on a central bank s actions. A country s limited official reserves limit its ability to conduct expansionary monetary and fiscal policy Fixed Exchange Rates and Policy Independence When a serious recession hits, many countries run out of official reserves, and are forced to abandon fixed exchange rates. They choose expansionary monetary policy to achieve their domestic goals rather than contractionary monetary policy to maintain fixed exchange rates. Fixed Exchange Rates and Policy Independence If Canada fixes its exchange rate to the Euro, it can end up importing Europe s monetary policy. If the European Central Bank pursues expansionary monetary policy, the value of the Euro will fall and the Canadian dollar will rise

10 Fixed Exchange Rates and Policy Independence Fixed Exchange Rates and Policy Independence To maintain the fixed exchange rate, the Bank of Canada must also pursue an expansionary monetary policy, and sell Canadian dollars. Price of Cdn $ (in Euros) $ Excess supply S 1 S 2 D 2 Q 1 Q 2 D 1 Quantity of CDN $ Advantages of Flexible Exchange Rates They provide for orderly incremental adjustment of exchange rates, rather than sudden large jumps. They allow the government flexibility in conducting domestic monetary and fiscal policies. Disadvantages of Flexible Exchange Rates They allow speculation to cause large jumps in exchange rates, which do not reflect market fundamentals Disadvantages of Flexible Exchange Rates They allow government too much flexibility in conducting domestic monetary and fiscal policies. Flexible Exchange Rates and Exchange Rate Stability Proponents argue: why not treat currency markets like any other market and let private market forces determine a currency s value? Opponents argue that flexible exchange rates allow far too much fluctuation in exchange rates, making trade difficult

11 Partially Flexible Exchange Rates Most nations have opted for a policy, partially flexible exchange rates, that stands between these two extremes. Sometimes, these are referred to as managed exchange rates or a dirty float. Partially Flexible Exchange Rates If policy makers believe there is a fundamental misalignment in a country s exchange rate, they allow market forces to correct it. If they believe the currency s value is falling because of speculation, they step in and fix the exchange rate Partially Flexible Exchange Rates Partially flexible exchange rate regimes combine the advantages and disadvantages of fixed and flexible exchange rates. Which View Is Right? Which view is correct is much in debate. In order to decide, it is necessary to go beyond the arguments and look at the history of the various regimes Which View Is Right? Which View Is Right? Most foreign-exchange traders feel their understanding of the market is better than that of policymakers. When these traders know that government might enter the market, they stop focusing on fundamentals and switch to trying to guess what the regulators will do. Such guessing games tend to destabilize the market, not stabilize it. That is why economists at central banks believe that government intervention helps to stabilize currency markets

12 Monetary Union in North America Advantages of a Common Currency Should Canada and the United States adopt a common currency? In 2002, twelve European nations fixed their exchange rates and adopted the euro as their common currency. A common currency ties the country politically together. It eliminates the cost of exchanging currency which provides an incentive to increase trade. It provides price transparency Advantages of a Common Currency A common currency makes it more likely that companies will think of Europe as a single market. Individuals throughout the world would want to hold their assets in euros rather than dollars. Disadvantages of a Common Currency Member countries have lost the ability to conduct independent monetary policy. Adopting a common currency also means giving up part of the country s national identity Monetary Union in North America Fixed Exchange Rates Possible options for North America: Moving back to fixed exchange rates. Fixing the value of the Canadian dollar to the U.S. dollar makes sense from a practical standpoint. Creating a new North American currency (the amero). There are potential benefits and costs of such an action. Adopting the U.S. dollar

13 Fixed Exchange Rates Benefits: A fixed exchange rate would force Canadian firms to be competitive. The steady decline in the value of the Canadian dollar throughout the 1990 s postponed costcutting decisions of firms, as Canadian products became relatively cheap. Fixed Exchange Rates Costs: Any advantages of a flexible rate vis-à-vis other nations would be lost A New Currency A New Currency If a common currency could be agreed upon, we have to decide the rate at which the two economies would enter the monetary union. Which central bank gets to determine monetary policy? A common currency is beneficial when countries respond similarly to disturbances an economy is relatively open Adopting the U.S. Dollar Adopting the U.S. Dollar As long as Canada benefits from a separate currency and floating exchange rate, it is not wise to consider either the adoption of a common currency, or the adoption of the U.S. dollar. The Canadian and U.S. economies differ in important aspects. Canada is a net exporter of primary commodities. As such, it benefits from a flexible exchange rate

14 Trade Policy Trade policy involves government creating trade restrictions on imports in order to meet the balance of payments constraint without using traditional macro policy or exchange rate policy. Trade Policy Economists generally oppose such trade restrictions. They prevent competition. They lower world welfare. They lead other countries to retaliate with similar trade restrictions Varieties of Trade Restrictions The most common trade restrictions are tariffs and quotas. Other trade restrictions are voluntary restraint agreements, embargoes, regulatory trade restrictions, and nationalistic appeals. Tariffs Tariffs (or customs duties) are taxes on internationally traded goods generally imports. Tariffs are the most-used and most-familiar type of trade restriction. Tariffs operate in the same way a tax does Tariffs Impact of Tariffs on Imported Goods They make imported goods relatively more expensive than they otherwise would have been and thereby encourage the consumption of domestically produced goods. Price of imported goods P P 1 P 0 S 1 S 0 Tariff D 0 Q 1 Q 0 Quantity of imported goods 83 84

15 Tariffs Quotas International organizations promoting free trade: The General Agreement on Tariffs and Trade (GATT) a regular international conference to reduce trade barriers. World Trade Organization (WTO) - the successor to GATT. Quotas are quantity limits placed on imports. Quotas differ from tariffs in the distribution of revenue. Foreign producers prefer quotas to tariffs Quotas In a tariff, the government receives the tariff payment. In a quota, the higher revenues accrue as additional profits to producers of the protected good. Quotas With quotas, an increase in domestic demand will be met by the less-efficient domestic producers. Under a tariff, part of any increase in domestic demand will be met by moreefficient foreign producers Voluntary Restraint Agreements Voluntary Restraint Agreements To avoid imposing new tariffs on their goods, countries often enter into voluntary restraint agreements, in which countries voluntarily restrict their exports. In the case of the voluntary quotas imposed on Japanese auto manufacturers, consumers lost since they paid higher prices both for domestic and imported cars. The effect of voluntary restraint agreements is the same as the effect of quotas

16 Embargoes Regulatory Trade Restrictions An embargo is an all-out restriction on the import or export of a good. Embargoes are usually created for international political reasons rather than for primary economic reasons. Regulatory trade restrictions are indirect methods of imposing governmental procedural rules that limit imports. An example: limiting or prohibiting foodstuffs to be imported if certain pesticides are used Regulatory Trade Restrictions Nationalistic Appeals A second type of restriction involves making import and customs restrictions so detailed and time consuming that importers simply give up. Given two products of equal quality and appeal, Canadians prefer to Buy Canadian Economists Dislike Trade Restrictions Despite the political popularity of trade restrictions, most economists support free trade. A free trade policy allows unrestricted trade among countries. Economists Dislike Trade Restrictions Trade restrictions lower aggregate output. One nation benefits while most other nations are hurt. They work only if there is no retaliation, and retaliation is the rule. They often result in harmful trade wars that hurt everyone

17 Economists Dislike Trade Restrictions Trade restrictions lower international competition. This competition is necessary to keep domestic firms on their toes, keeping costs and prices down. Strategic Trade Policies Strategic trade policies are threats to implement tariffs to bring about a reduction in tariffs or some other concession from the other country. The threats must be credible. Domestic companies become less efficient International Trade Agreements Affecting Canada Those are: The Canada-U.S. Free Trade Agreement (FTA) The North American Free Trade Agreement (NAFTA) Free Trade Areas of the Americas (FTAA) Canada-U.S. Free Trade Agreement (FTA) FTA was signed in 1987, and it came into effect in It set into motion a process that removed most tariff and non-tariff barriers between the two countries over a 10-year period Canada-U.S. Free Trade Agreement (FTA) Benefits of a Tariff Reduction Who are the winners and losers of tariff reduction? P S The elimination of tariffs would decrease the domestic price, benefiting consumers. Some high-cost firms will have to leave the industry, and domestic production will decline. P T P W A B Q 1 Q 2 Q 3 Q 4 D Q

18 North American Free Trade Agreement (NAFTA) In 1993, Canada, U.S., and Mexico signed the North American Free Trade Agreement (NAFTA). It extended the FTA to eliminate other impediments to international trade. North American Free Trade Agreement (NAFTA) NAFTA brought as many critics as the FTA. The critics believed that t the Canadian economy will be Americanized. Among other goals, it promoted free trade in services Free Trade Area of the Americas (FTAA) The FTAA includes all economies of the Americas. The problem with free trade is that it is not necessarily fair trade. Some believe that rich nations may be dictating the terms and taking advantage of the small developing nations. The Balance of Payments, the Exchange Rate, and Trade Policy End of Chapter

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