Unit 4: The Global Economy: International Trade and Development Chapter 12: Trade Theory,...

Unit 4: The Global Economy:

International Trade and Development

Chapter 12: Trade Theory, Agreements, and PatternsChapter 13: Financing International TradeChapter 14: International Economic Issues

Buying and Selling Internationally

• We learned in Chapter 12 how important international trade is to the Canadian economy• Makes up one-third of GDP• More than 50% of all good produced by private sector

are exported

• Exports provide income for Canadians, produce tax revenues for our federal and provincial governments, and pay for our imports

• This chapter will examine how these massive amounts of goods and services flowing in and out of Canada are financed


• The major difference in buying and selling internationally, as opposed to domestically, is the necessity of using different currencies

• Exporters demand payment for their goods in their own countries’ currencies• Can’t pay for raw materials

and employees’ wages using foreign currency


• Suppose a Canadian manufacturer is selling $10 million worth of industrial machinery to a British company

• The British importer would have to exchange pounds for Canadian dollars in order to complete the sale

• If the exchange rate is £1 = Can$2.30…• The importer would pay a British bank £4,347,826

(10,000,000 ÷ $2.30) to obtain the $10 million necessary to pay the Canadian exporter


• But where would the British bank obtain the Canadian funds?

• Let’s suppose that Canadian importers want to buy $10,000,000 worth of fine china from Britain• Would have to exchange $10,000,000 for £4,347,826 at

a Canadian bank in order to pay the British exporter

• The British bank has pounds and needs dollars, and the Canadian bank has dollars and needs pounds• Both banks can meet their customers’ needs by getting

together and completing a transaction


• In the past, currency exchanges were carried out on a bank-bank basis

• Today, either bank can obtain foreign currency from the foreign exchange market• A computerized global network

of banks, investment dealers, and financiers

• The conversion of currencies is a service provided for a fee, or commission


• There are a number of intangible transactions that are also defined as either exports or imports• Known as invisible, or non-merchandise trade• Includes exchange of services, tourism, and

interest and profits earned abroad• i.e. all the payments and receipts that occur

between two countries and that necessitate a conversion of one currency into another


• A Canadian export (or receipt) is an international transaction in which a foreign currency must be converted into Canadian dollars• Ex: An American tourist who converts US dollars into

Canadian dollars to pay for hotels, meals, etc.

• A Canadian import (or payment) is an international transaction in which Canadian dollars must be converted into foreign currency• Ex: Foreigners who earn interest from deposits in

Canadian banks, then convert it into their respective currencies

Exchange Rates

• An exchange rate is the price at which one currency can be purchased for another

• The exchange rate of the Canadian dollar is usually expressed in terms of US dollars• For example, the statement “the Canadian dollar is worth

0.625 US dollars” means that Can$1.00 will obtain US$0.625 in the exchange market

• Another way of looking at the exchange rate of our dollar is to price other currencies in terms of Canadian dollars• For example, the statement “the US dollar is worth 1.60

Canadian dollars” means that US$1.00 will obtain Can$1.60 in the exchange market

How Exchange Rates are Determined

• The value of a currency is measured by its price in terms of other currencies

• If that price increases, the currency is said to have appreciated in value• Ex: If the Canadian dollar rises from US$0.62

to US$0.64, an appreciation of the Canadian dollar, in terms of the US dollar, is said to have occurred

• A currency depreciates when its price falls in terms of other currencies


• If the exchange rate is expressed in terms of the amount of Canadian dollars it takes to buy a foreign currency, the dollar appreciates when that amount falls• Ex: If the exchange rate for Canadian dollars and

British pounds changes from £1 = Can$2.24 to £1 = Can$2.20, the dollar has appreciated against the pound, and the pound has depreciated against the dollar

• A dollar depreciation occurs when the value of foreign currency raises in terms of Canadian dollars


• In order to understand how these rates are determined, we apply a familiar economic tool• Demand and supply analysis

• We’ll assume that the exchange rates are flexible, or floating• They are determined entirely in the market by

the forces of demand and supply, with no government intervention

The Demand for Canadian Dollars

• A demand for Canadian dollars is created in the foreign exchange market by the foreign importers of our good or service• They need to pay for

Canadian goods in Canadian dollars

• Figure 18.3a shows the demand for Canadian dollars by French importers


• The vertical axis represents the exchange rate between the euro and the Canadian dollar• Note that the dollar appreciates in value as the numbers rise

• The horizontal axis represents the quantity of Canadian dollars demanded by French importers• When the exchange rate falls, or depreciates, French

importers demand more dollars because our exports become less expensive to them (i.e. the euro “buys” more dollars)

• Ex: At an exchange rate of Can$1.00 = €0.75, a tonne of newsprint worth Can$10,000 costs €7500; the same tonne costs €7000 when the Canadian dollar falls to Can$1.00 = €0.70


• Dollar depreciation (which causes the euro to appreciate) increases the demand for our exports, thus the quantity of Canadian dollars demanded will rise as well

• If the dollar appreciates, our exports become more expensive to French importers, so they demand fewer Canadian dollars

• So the demand curve has the familiar inverse, or negative relationship between the exchange rate (vertical axis) and the number of dollars demanded (horizontal axis)• As the dollar appreciates, fewer dollars are demanded• As the dollar depreciates, more dollars are demanded

The Supply of Canadian Dollars

• When Canadians import goods and services, we must pay foreign exporters in their own currency

• We supply Canadian dollars in the exchange market and demand foreign currency in exchange


• When the dollar appreciates in terms of the euro (one dollar now buys more euros), Canadians find that French goods and services are less expensive

• By demanding more euros in order to buy these goods and services, Canadians supply more dollars

• Imported French perfume prices at €60 costs Can$85.71 when the exchange rate is Can$1.00 = €0.70• When the dollar appreciates to Can$1.00 =

€0.75, the price of the perfume falls to $80.00, and imports rise


• Alternatively, dollar depreciation makes foreign imports more expensive for Canadians• Fewer euros are demanded and fewer

Canadian dollars are supplied

• So the supply curve has the familiar direct, or positive, relationship between the exchange rate and the number of dollars supplied• As the dollar appreciates, more dollars are

supplied• As the dollar depreciates, fewer dollars are

supplied

The Exchange Rate at Equilibrium

• The actual exchange rate will be set at the point where the quantity of euros demanded equals the quantity of Canadian dollars supplied• i.e. where demand and supply are at

equilibrium

• As shown in Figures 18.4a and 18.4b, demand and supply intersect at Can$1.00, or €0.75


• Figure 18.4a shows that if the exchange rate were set too high, at Can$1.00 = €0.80…• The supply of Canadian

dollars would exceed the demand for them

• The exchange rate would fall to Can$1.00 = €0.75


• Figure 18.4b shows that if the exchange rate were set too low, at Can$1.00 = €0.65…• The demand for

Canadian dollars would exceed the supply of them

• The exchange rate would rise to Can$1.00 = €0.75


• Assuming no other forces are operating in this market, the exchange rate moves toward equilibrium at Can$1.00 = €0.75

• However, we know other forces are always present, and the exchange rate does change

Causes of Fluctuations in the Exchange Rate

• We have learned how changes in the exchange rate of the Canadian dollar affect our exports and imports

• But what causes the exchange rate itself to change?

• Although economists don’t agree on the exact causes of specific declines, let’s consider some of the reasons that usually explain fluctuations in the exchange rate

A Change in Demand for Canadian Goods

• Figure 18.5 shows a rise in Canadian exports as the demand curve moves to the right from D1 to D2• Such an increase creates an

increased demand for Canadian dollars because Canadian exporters want to be paid in their own currency

• The exchange rate rises, or appreciate, from $0.75 to $0.80, where the demand for dollars equals the supply of them


• Conversely, a decrease in exports would move the demand curve left, from D1 to D3• Causes the exchange rate to fall, or

depreciate, as a result of the new equilibrium point

• In order to find out what causes these changes in demand, let’s explore two factors


Canadian exports tend to increase when the economies of our trading partners, particularly the US, are growing

• During the 1990s, the US economy was prospering, which increased the demand for Canadian products

• However, the demand for our products was partially offset by a slowdown in the economy of another significant trading partner, Asia, during the late 1990s• As a result, the demand in the Asian market for Canada’s

natural resource products decreased

• The key point here is that the demand for exports depends, to a large extent , on the economic health of our trading partners


Canadian interest rates affect the demand for Canadian dollars

• If interest rates in Canada rise, Canadian bonds and bank deposits become more attractive to foreign financiers and traders, increasing the demand for Canadian dollars

• If Canadian rates fall, the inflow of foreign capital seeking interest rate profits declines, and the demand for the dollar falls

A Change in the Supply of Canadian Dollars

• Figure 18.6 shows a rise in Canada’s imports as the supply curve moves to the right from S1 to S2• Creates an increased

supply of Canadian dollars

• Causes the equilibrium point to shift to E2, where the supply of Canadian dollars equals the demand for them

• The value of the dollar has depreciated from $0.75 to $0.70

A Change in the Supply of Canadian Dollars

• A decrease in imports would move the supply curve to the left• Causes the equilibrium rate (E3) to rise to $0.80, or to

appreciate to the point where supply equals demand

• These different equilibrium rates also cause changes in the quantity of dollars (Q1, Q2, Q3) actually transacted

• Imports tend to increase when the Canadian economy is growing and to decrease when it is in recession, similar to the demand for domestic goods

Exchange Rate Systems: Fixed Exchange Rates

• Until the 1970s, most nations had fixed exchange rates• They fixed, or pegged, their

exchange rate in terms of the US dollar

• In order to maintain the pegged rate, governments bought or sold their own currencies in the foreign exchange market and kept foreign currencies in special reserve funds


• Suppose the Canadian dollar was pegged at US$0.75 and, because of a fast-growing US economy, demand for Canadian exports was rising• The demand for Canadian dollars would move upward,

pressuring the Canadian dollar upward

• To prevent the dollar from appreciating beyond its pegged rate, the Bank of Canada would intervene in the exchange market by purchasing US dollars and supplying Canadian dollars

• Figure 18.7a shows the result• The supply curve moves to the right, which causes the

exchange rate to move down to its pegged rate


• Conversely, the Canadian dollar could be pressured downward by a fall in exports or by a rise in Canadian import

• Suppose Canadian imports were rising from S1 to S2, as shown in Figure 18.7b

• To prevent the Canadian dollar from depreciating, the Bank of Canada would have to use the US dollars in its reserve fund to buy Canadian dollars on the foreign exchange market• Would increase demand for Canadian dollars from D1 to D2,

restoring the exchange rate to its pegged value

• However if increases in market demand for dollars were met with equal increases in market supply, the government would not have to intervene in order to support the pegged value


• Although central banks tried to prevent the devaluation or depreciation of their nation’s currency by using foreign reserves to purchase it, the actions of corporations and individual speculators often nullified the central banks’ efforts

• For example, if these groups believed that the Canadian dollar was pegged too high, they would cash in their Canadian investments and invest the money in other countries• They were counting on the fact that the amount of money

they were moving out would be so large that the Bank of Canada couldn’t buy back the Canadian dollars with the limited foreign exchange reserves on hand


• If they were proved correct, the Bank of Canada would be forced to devalue the dollar• i.e. reduce its value in relation to other

currencies

• The businesses and speculators would then reconvert their investments into Canadian funds at a profit

• For this and other reasons, fixed exchange rates were abandoned in 1973


• Under the market value system that replaced the fixed rate system, the value of the Canadian dollar continues to be greatly influenced by international confidence in the Canadian economy

• For example, as Quebec approached each referendum on sovereignty-association (an arrangement that would grant the province political independence), the Canadian dollar took a direct hit on the money markets

• As the size of Canada’s public debt continued to grow during the 1980s, the dollar lost value in international money markets


• At this point, it’s important to clarify our terms

• If currency loses value in money markets as a result of some government or central bank intervention, this is described as currency devaluation

• If a currency loses value as a result of the transactions of business and speculators, this is described as currency depreciation

• Revaluation and appreciation both refer to currency value gains, but they result from different actions

Exchange Rate Systems: Flexible Rates

• A flexible, or floating, exchange rate is set solely by demand and supply, without government intervention

• Few nations are willing to allow their exchange rate to float without some intervention from time to time

• Since the 1970s, most nations have used a system called a managed float, a compromise between flexible and fixed rates


• Under this system, the government allows the international market to set the exchange rate in the long run, as it would under a flexible exchange rate system, but intervenes from time to time to smooth out short-term fluctuations

• In Canada, the Bank of Canada mainly uses interest rates to control short-term fluctuations in the exchange rate• If the dollar is depreciating, the Bank can raise

rates to increase the demand for the dollar• If the dollar is appreciating, it can lower rates


• The Bank of Canada can also use foreign exchange reserves to buy and sell Canadian dollars in the international market, in the same way it would under a fixed exchange system

• In 2002, the Bank had approximately $34 billion in foreign exchange reserves, which could be used to prevent the dollar from falling

The Balance of Payments

• Nations keep track of their international payments and receipts in their balance of payments account

• This account is divided into two main parts:• The current account• The capital and financial account

The Current Account

• The current account includes 3 components:• Goods (or visibles)• Include raw materials and processed or manufactured

goods

• Services (or invisibles)• Include tourism; transportation charges for shipping

goods by rail, sea, and air; commercial services such as management and consulting; and government assistance to other nations, the UN, and other international organizations

• Investment income• Composed of dividends and interest earned from

investments in Canada and abroad

The Current Account

• Figure 18.9 illustrates the structure of Canada’s current account from 1989 to 2000• It indicates whether Canada has a surplus or

deficit balance on each of the three components

• Also indicates whether the three add up to an overall surplus or deficit balance on the entire account

The Current Account

• The goods trade balance shows that between 1989 and 2000 Canada always exported more visible, or merchandise, goods than it imported, producing a surplus balance

• Services, or invisibles, tended to record a slight deficit balance

• While not indicated in Figure 18.9, goods and services are often combined to arrive at the balance of trade• This balance almost always records a surplus, reflecting

Canada's traditional role as an exporting nation

The Current Account

• Investment income shows a deficit balance in Figure 18.9• Means that foreign investors are collecting

more interest and dividends from their investments in Canada than Canadian investors are collecting from their investments abroad

• This investment deficit is large enough that, when combined with the other two balances on goods and services, Canada usually records a current account deficit

The Current Account

• How can a country pay out more than it receives?

• The answer is found in the capital and financial account, which must record a surplus

• Alternatively, if the current account records a surplus, then the capital and financial account must record a deficit

The Capital and Financial Account

• The capital and financial account is subdivided into two accounts:• Capital account• Financial account

Capital Account

• The capital account includes:• Migrants’ funds• Inheritances• Government pension payments to Canadians living abroad

• These items are further subdivided into inflows and outflows• For example, when Canadians receive an inheritance from

a relative in another country, it is considered an inflow• When immigrants to Canada send money to their home

country, it is an outflow• A government pension paid to a “snowbird” in Florida is

also considered an outflow

Financial Account

• The financial account includes two types of investment

• The first is direct investment, either by Canadians abroad (CDI), or by foreigners in Canada (FDI)• Involves investors who either establish a new plant or

business or take over an existing one by purchasing controlling shares

• When foreigners invest in our country, it’s an inflow, or receipt for Canada

• When Canadians invest abroad, it is an outflow, or payment

Financial Account

• The second type is portfolio investment• Involves investors who receive dividends or

interest on stocks or bonds, but who don’t control a company, as is the case with direct investment

• Purchases of Canadians stocks or bonds by foreigners represent an inflow, or receipt for Canada

• Similar purchases of foreign stocks or bonds by Canadians represent an outflow, or payment

Financial Account

• In Figure 18.10, we see a pattern of more foreign portfolio investment than Canadian, except for the periods 1996 and 1999-2000

Official International Reserves

• The official international reserves are another important component of the financial account

• Managed by the Bank of Canada, the official reserves are composed of foreign currencies, mostly US dollars, and gold• In 2002, they totaled $34 billion

• The reserves are similar to a bank account held by an individual• When income exceeds expenditures for a period of time, the

individual’s bank account increases• However, when expenditures exceed income, the individual

must use the savings in the account to make up the difference

Official International Reserves

• The official reserves can be used by the Bank of Canada in the same way• If Canada’s current account

and capital account are in surplus, then the official reserves increase

• If the current account and the capital account are in deficit, then the official reserves can be drawn down to pay for the shortfall

Balancing the Account

• When the accounts are totaled, the current account and the capital and financial account should balance, as indicated in Figure 18.11

Current Account

Total receipts 526 226

Total payments 499 334

Balance 26 894

Capital and Financial Account

Capital account balance

5261

Financial account balance

-20 426

Balance -15 164

Current minus Capital/Financial

11 730

Statistical discrepancy -11 730

Balance of Payments 0

Figure 18.11: Canada’s balance of international payments(in millions of dollars), 2000. This table shows a simplified balanceof payments for Canada in 2000.


• In order to understand this concept, let’s start with the current account• Measures exports and imports of goods and services

• Foreigners need Canadian dollars in order to buy Canadian exports

• Canada supplies these dollars by importing foreign goods• Remember that when we import goods and services,

we convert Canadian dollars into foreign currency


• If Canada is exporting more goods and services than its importing, the supply of Canadian dollars will be insufficient for foreigners to buy our exports

• This is where the financial and capital account comes into play• It must finance foreign demand for our dollars by

recording more outflows of Canadian money than inflows of foreign money

• It runs a deficit to pay for the surplus on Canada’s current account


• The opposite occurs if the current account runs a deficit

• If Canadians are importing more than they are exporting, they are demanding more foreign money than foreign buyers are supplying

• The financial and capital account of Canada records more inflows of foreign money than outflows• It runs a surplus to pay for the deficit on the

current account


• Since its impossible to track all transactions, the current account doesn’t balance exactly with the capital and financial account

• An adjustment called the statistical discrepancy is calculated to being the two main divisions of the account into balance

Unit 4: The Global Economy: International Trade and Development Chapter 12: Trade Theory,...

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