Balance of Payments

1. Balance of Payments Chapter Three Eitman, Stonehill, and Moffett ESM Chapter 3 - Balance of Payments

2. Balance of Payments Balance of Trade CapitalAccount Reserve account Financial account ESM Chapter 3 - Balance of Payments

3. Cash flows • For example: the Balance of Trade (Current account) • BOT = X – M ESM Chapter 3 - Balance of Payments

4. Exchange rate equilibirum • Demand for the dollar • all foreigners buying Canadian • all Canadians selling foreign assets • Supply of the dollar • Canadians buying foreign goods and services • foreigners selling Canadian assets • Where demand equals supply • Equilibrium price (Exchange Rate) and Quantity ESM Chapter 3 - Balance of Payments

5. Equilibrium S1 usd/cd eo, 0, cd D1 Qo, cd Qcd ESM Chapter 3 - Balance of Payments

6. Demand for the dollar(Credits) • Exports (X) • British buying Canadian goods • Germans vacationing in Newfoundland • Capital inflows – real assets (CI) • Walmart buying out Woolco • Toyota building a plant in • Financial inflows – financial assets (FI) • US investors buying Canadian Imperial, Vulcan • Germans buying NF CD denominated bonds ESM Chapter 3 - Balance of Payments

7. Supply of the dollar (Debits) • Imports (I) • Buying Sonys • Spending a week at Disneyworld • Canadians spending six months of the year in Texas • Capital Outflows – real assets (CO) • Inco buying a property in Indonesia • Couple retiring to Florida buying a condo there • Financial Outflows - financial assets (FO) • Buying shares in Microsoft • Buying euro denominated bonds ESM Chapter 3 - Balance of Payments

8. Current account – balance of trade (BoT) • goods • value of exports of goods - imports of goods • services (communications, information, financial) • value of exports of svcs - imports of svcs • net income transfers • interest & dividends pd on foreign investments • pensions pd to Canadians living overseas • transfers (sending checks to E. Europe) ESM Chapter 3 - Balance of Payments

9. Balance of Trade ESM Chapter 3 - Balance of Payments

10. Capital Account • transactions to non-financial and non-produced assets • debt forgiveness • transfer of goods and financial assets by migrants leaving or entering a country • transfer of ownership on fixed assets • transfer of funds received to the sale or acquisition of fixed assets • gift and inheritance taxes, death levies, patents, copyrights, royalties, and uninsured damage to fixed assets. ESM Chapter 3 - Balance of Payments

11. Financial account • foreign direct investment • investment in real assets • portfolio investment • equities • debt • intangibles • patents, leases, goodwill • errors and omissions ESM Chapter 3 - Balance of Payments

12. Capital inflows – capital outflowsFinancial Account • Capital inflows • Foreign direct investment in Canada • Foreign portfolio investment in Canada • Other investment in Canada • Capital outflows • Canadian foreign direct investment • Canadian foreign portfolio investment • Other foreign investment by Canada ESM Chapter 3 - Balance of Payments

13. Financial Account ESM Chapter 3 - Balance of Payments

14. Official reserves account • Central Bank interventions in exchange markets • changes in official reserves by buying or selling • gold, silver • foreign currencies • Foreign denominated debt • Buy or sell options or futures in markets • SDRs (Special Drawing Rights at IMF) ESM Chapter 3 - Balance of Payments

15. Balance of payments • Assume BOP > 0 • Canadians are selling more abroad than they are buying • Goods, services • Capital goods • Financial goods • If exchange rates are allowed to seek an equilibrium (floating exchange rates) • Supply of the Canadian dollar increases in exchange markets • The exchange rate will adjust to accommodate imbalance ESM Chapter 3 - Balance of Payments

16. Effects of BOP • Fixed exchange rates • CB uses FXB to bring BOP = 0 • Floating exchange rates • CB ignores BOP • The exchange rate will adjust to accommodate imbalance • CB may intrude into the exchange market to reduce volatility ESM Chapter 3 - Balance of Payments

17. Exchange rate equilibrium • Demand for the dollar • all foreigners buying Canadian • all Canadians selling foreign assets • Supply of the dollar • Canadians buying foreign goods and services • foreigners selling Canadian assets • Where demand equals supply • Equilibrium price (Exchange Rate) and Quantity ESM Chapter 3 - Balance of Payments

18. Equilibrium S1 usd/cd eo, 0, cd D1 Qo, cd Qcd ESM Chapter 3 - Balance of Payments

19. Demand for the dollar(Credits) • Exports (X) • British buying Canadian goods • Germans vacationing in Newfoundland • Capital inflows – real assets (CI) • Walmart buying out Woolco • Toyota building a plant in • Financial inflows – financial assets (FI) • US investors buying Canadian Imperial, Vulcan • Germans buying NF CD denominated bonds ESM Chapter 3 - Balance of Payments

20. Supply of the dollar (Debits) • Imports (I) • Buying Sonys • Spending a week at Disneyworld • Canadians spending six months of the year in Texas • Capital Outflows – real assets (CO) • Inco buying a property in Indonesia • Couple retiring to Florida buying a condo there • Financial Outflows - financial assets (FO) • Buying shares in Microsoft • Buying euro denominated bonds ESM Chapter 3 - Balance of Payments

21. BOP surplus from the Canadian perspective • US consumers buying more Canadian stuff • Demanding cd with which to buy Canadian stuff • free float allows a new equilibrium • usd price of the cd increases • cd appreciates • US goods lower in price to Canadians • usd depreciates • Canadian goods higher in price to the U.S. • Corrects BOP imbalance, so that BOP approaches 0 ESM Chapter 3 - Balance of Payments

22. Excess Demand for cd S1 usd/cd en, 0, cd eo, 0, cd D2 D1 Qo, cd Qn, cd Qcd ESM Chapter 3 - Balance of Payments

23. BOP deficit from US perspective • US consumers buying more Canadian stuff • Supplying usd into the market to buy cd • free float allows a new equilibrium • cd price of the usd decreases • cd appreciates • US goods lower in price to Canadians • usd depreciates • Canadian goods higher in price to the U.S. • Corrects BOP imbalance, so that BOP approaches 0 ESM Chapter 3 - Balance of Payments

24. Excess Supply of usd S1 cd/usd S2 eo, 0, usd en, 0, usd D1 Qo, usd Qn, usd Qusd ESM Chapter 3 - Balance of Payments

25. Benefits of floating exchange rates • International prices adjust instantaneously • With Canadian dollar appreciation • Canadian stuff more expensive internationally • cd more expensive in terms of other currencies • International prices decrease for Canadians • In the future the BOP should approach zero • Foreign demand for Canadian stuff decreases • Domestic demand for foreign stuff increases ESM Chapter 3 - Balance of Payments

26. Depreciation • Negative aspects of depreciation • Creates image that the currency is weak • Canadian dollar has depreciated nearly 40% in the last decade • Imports become more expensive • Positive aspects of depreciation • Exports become cheaper to foreigners • Central bank may try to fix the exchange rate • Keep the trend line of the exchange rate flat ESM Chapter 3 - Balance of Payments

27. Appreciation • Negative aspects of appreciation • Impacts exports as exports are more expensive to foreigners • Positive aspects of appreciation • Imports become cheaper • Central bank may try to fix the exchange rate • Keep the trend line of the exchange rate flat ESM Chapter 3 - Balance of Payments

28. Trend & volatility e T ESM Chapter 3 - Balance of Payments

29. Trend & volatility • The red line represents observed exchange rates • The brown line represents a minimum least squares regression of the observed exchange rates • Volatility is estimated by the standard error of estimate of the observed values from those predicted by the regression line ESM Chapter 3 - Balance of Payments

30. Reasons given for intervention • Alter the trend, reduce beta, long-run policy • Fix exchange rates in some fashion • Positive aspects • Maintain international prices relatively constant • Reduce the need to hedge exchange rate risk • Maintain “Strong Currency” • Negative aspects • Can only affect trend in the short run • Eventually results in a very steep adjustment • Reduce volatility • Reduces the cost of hedging, volatility and bid-ask spread are directly related • Short-run policy ESM Chapter 3 - Balance of Payments

31. Intervention S1 S2 usd/cd B of C buys usd with cd en, 0, cd eo, 0, cd D2 D1 Qo, cd Qn, cd Qcd ESM Chapter 3 - Balance of Payments

32. Intervention • If FXB = 0, then BOP > 0, exchange rates adjust • Bank of Canada accommodates • FXB = X – M + CI – CO + FI – FO, pushes BOP toward 0 • Buys up excess usd in the market, no change in exchange rate • Underlying cause for BOP surplus not fixed in short run • Canadian prices are still too low internationally • Domestic consequences • BOC has increased base money, inflationary pressure • Bank of Canada can chose to sterilize or not ESM Chapter 3 - Balance of Payments

33. gold silver cd denominated t-bills foreign currency denominated t-bills cash currency chartered bank reserves held at the Bank of Canada Unsterilized Intervention Bank of Canada balance sheet Bof C buys US dollars as an asset Canadian dollar liability increases ESM Chapter 3 - Balance of Payments

34. Domestic Affects of an Unsterilzed Intervention • Base money increases by amount of purchase • pressure exerted on prices to increase • Long-run, inflation in the economy • Canadian goods more expensive to Canadians • Canadian goods more expensive to foreigners • Long-run, balance of payments adjusts ESM Chapter 3 - Balance of Payments

35. Foreign Affects of anUnsterlized Intervention • short run • exchange rate is not allowed to adjust • long run • higher Canadian inflation • US goods cost relatively less to Canadians • Canadian goods cost relatively more to US consumers • Long-run, Canadian prices adjust, BOP adjusts ESM Chapter 3 - Balance of Payments

36. gold silver cd denominated t-bills foreign currency denominated t-bills cash currency chartered bank reserves held at the Bank of Canada Sterilized Intervention Bank of Canada balance sheet Bof C buys US dollars as an asset No increase in B of C liabilities B of C sells equal value in other assets ESM Chapter 3 - Balance of Payments

37. Domestic Affects of an Sterilzed Intervention • Base money remains constant • prices remain constant • Both domestic and foreign prices remain the same • BOP pressures exacerbated • Canadian prices too low in real terms • International prices too high in real terms • Canadian dollar undervalued • Continual intervention required by the Bank of Canada ESM Chapter 3 - Balance of Payments

38. Foreign Affects of anSterlized Intervention • short run • exchange rate is not allowed to adjust • From their point of view, BOP deficits continue • Interventions continue • long run • pressure continually increases on exchange rate to appreciate • BOT deficit remains • eventually the cd price of the usd will increase • Finally there is a large scale revaluation • Firms cannot adjust slowly to small price changes • Firms now must adjust to a large-scale price change ESM Chapter 3 - Balance of Payments

39. Depreciation • Negative aspects of depreciation • Creates image that the currency is weak • Canadian dollar has depreciated nearly 40% in the last decade • Imports become more expensive • Positive aspects of depreciation • Exports become cheaper to foreigners • Central bank may try to fix the exchange rate • Keep the trend line of the exchange rate flat ESM Chapter 3 - Balance of Payments

40. Appreciation • Negative aspects of appreciation • Impacts exports as exports are more expensive to foreigners • Positive aspects of appreciation • Imports become cheaper • Central bank may try to fix the exchange rate • Keep the trend line of the exchange rate flat ESM Chapter 3 - Balance of Payments

41. ESM Chapter 3 - Balance of Payments