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CHAPTER 16: Foreign Exchange

CHAPTER 16: Foreign Exchange. Topics. 16.1 Financing International Trade 16.2 Balance of Payments 16.3 Flexible Exchange Rates 16.4 Fixed Exchange Rates 16.5 History . Foreign Exchange. Foreign Exchange Market: Major banks worldwide

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CHAPTER 16: Foreign Exchange

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  1. CHAPTER 16:ForeignExchange

  2. Topics 16.1 Financing International Trade 16.2 Balance of Payments 16.3 Flexible Exchange Rates 16.4 Fixed Exchange Rates 16.5 History

  3. Foreign Exchange Foreign Exchange Market: • Major banks worldwide • Currency of one nation traded for currency of another nation Exchange Rate: • International value of a currency • Expressed in terms of another currency

  4. Foreign Exchange Q: If the US dollar is worth $1.43 Canadian, how much is a Canadian dollar worth in US funds? A: US$ 0.70 US$1.00 = C$1.43 Divide both sides by 1.43 OR take the reciprocal: 1 1 rateUS = rateC = 1.43 = .70

  5. Foreign Exchange http://www.xe.com/ucc/convert.cgi

  6. BALANCE OF PAYMENTS Summary of a nation’s international payments and receipts for one year.

  7. Balance of Payments PAYMENTS (C$ leaving Canada) •  supply of C$ in foreign exchange market •  price of C$ (exchange rate) RECEIPTS (C$ coming into Canada) •  supply of C$ in foreign exchange market •  price of C$ (exchange rate)

  8. CHAPTER 17Balance of Payments PAYMENTS(C$ leaving Canada) • Canadians buy foreign products (import) • Canadians travel abroad • Canadian firms pay dividends abroad • Canadians buy foreign investments PAYMENTS INCREASE SUPPLY $C ForeignExchangeMarket ForeignExchangeMarket C$

  9. Balance of Payments RECEIPTS(C$ coming into Canada) • Foreigners buy Canadian products (exports) • Foreigners travel to Canada • Foreign firms pay dividends to Cdns • Foreigners buy Canadian investments RECEIPTS DECREASE SUPPLY $C ForeignExchangeMarket ForeignExchangeMarket $C

  10. Balance of Payments Payments and receipts are subdivided into: CURRENT ACCOUNT • Day to day transactions in goods and services • Includes interest and dividends CAPITAL ACCOUNT • Sales and purchases of capital assets • Includes real (“direct investment”) and financial assets

  11. CURRENT ACCOUNT: Merchandise Exports +410.3 Merchandise Imports -356.1 Balance of Trade +54.2 Exports of Services +58.2 Imports of Services - 66.1 Balance on Goods/Serv +46.3 Net Investment Income - 30.4 Net Transfers* +1.4 Current Acct Balance +17.3 * Foreign aid, pensions, remittances CAPITAL ACCOUNT: Change in foreign investment in Cda +69.1 Change in Canadianinvestment abroad -75.7 Capital Acct Balance-6.6 OFFICIAL SETTLEMENTS ACCT: Official Int’l Reserves -10.7 Balance of Payments 0 Source: Statistics Canada Canada’s Balance of Payments2002 (in $billions)

  12. OFFICIAL SETTLEMENT ACCOUNT • Central banks hold foreign currencies in official international reserves (foreign exchange reserves) • Drawing down of reserves (“+” entry) measures balance of payments deficit • Building up of reserves (“–” entry) measures balance of payments surplus • Deficits can’t be maintained indefinitely; reserves are limited

  13. Group Exercise Do Question 3 on p. 407 in your text.

  14. Calculate: • Balance of trade • Balance on goods/services • Balance on current acct • Balance on capital acct

  15. Balance of trade: 40 – 30 = $10 surplus • Balance on goods/services: 55 exports – 40 imports = $15 surplus • Balance on current acct: $15 – 5 net invmt + 10 net tsfs = $20 surplus • Balance on capital acct Frn invmt +10 Cdn invmt abroad -40 = $30 deficit

  16. Balance of Payments If PAYMENTS > RECEIPTS • Balance of Payments DEFICIT If RECEIPTS > PAYMENTS • Balance of Payments SURPLUS

  17. FLEXIBLE EXCHANGE RATES Exchange rates determined by supply & demand

  18. The Market for Foreign Currency (Pounds) Figure 16-2 P S Dollar price of 1 pound 2 D Q1 Q Quantity of pounds

  19. The Market for Foreign Currency (Pounds) D Figure 16-2 P S Pound appreciates Dollar price of 1 pound 2 D Q1 Q Quantity of pounds

  20. The Market for Foreign Currency (Pounds) Pound depreciates D Figure 16-2 P S Dollar price of 1 pound 2 D Q1 Q Quantity of pounds

  21. Flexible Exchange Advantages: • Automatic adjustment • Can eliminate balance of payments deficits or surpluses Disadvantages: • Risk of constantly changing exchange rates • Worsening terms of trade with large depreciation • Complicates domestic macroeconomic policies

  22. FIXED EXCHANGE RATES Currency exchange rates are set by government

  23. The Market for Foreign Currency (Pounds) D Figure 16-2 P S BUT governmentwants to maintainexchange rate… Pressure on Pound Dollar price of 1 pound 2 D Q1 Q Quantity of pounds

  24. The Market for Foreign Currency (Pounds) D Figure 16-2 P S Sell foreign currency reserves Dollar price of 1 pound 2 D Q1 Q Q2 Quantity of pounds

  25. The Market for Foreign Currency (Pounds) D Figure 16-2 P S S1 Dollar price of 1 pound 2 D Q1 Q Q2 Quantity of pounds

  26. Fixed Exchange Advantages: • Avoids risk, uncertainty of fluctuations Disadvantages: • Requires intervention to maintain rate • “Currency intervention”: buy/sell currency • Other options: exchange controls, domestic macroeconomic policies

  27. Managed Float • Used by most nations since 1971 • Rates set by market forces • Governments occasionally intervene

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