International Trade and Exchange Rates

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International Trade and Exchange Rates

• Chapter 5

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• The Canadian economy is linked to the rest of the
  world through trade in goods and services, and
  finance.

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Goods and Services Trade

• The Canadian economy is a small and relatively
  open economy.
• In 2005, exports comprised 37.6 of GDP and
  imports comprised 34.1 of GDP.
• In 2006, the trade balance was 51 billion.

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In contrast, the US economy is a large and
relatively closed economy.

• In 2006, exports comprised 11.1 of GDP and
  imports comprised 16.6 of GDP.
• As of 2007 the trade balance is -226 (US)
  billion.

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Where do Canadian exports go?

• 81 to US
• 6 to EU
• 2 to Japan

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Where do Canadians import from?

• 67 from US
• 10 from EU
• 3 from Japan

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What does Canada export?

• Machinery and equipment 21
• Auto parts 19
• Industrial goods 19
• Energy 19
• Forestry products 8
• Agriculture fish 7
• Consumer goods 4

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What does Canada import?

• Machinery and equipment 28
• Auto parts 20
• Industrial goods 20
• Consumer goods 13
• Energy 9
• Agriculture and fish 6
• Forestry products 1

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International Finance

• Canadians can hold assets in foreign countries.
• Foreigners can hold assets in Canada.

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• I. The Balance of Payments Accounts
• A record of the transactions of a country with
  the rest of the world.
• It is comprised of 2 majors accounts the current
  account and the capital account.

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• Current Account an account of trade in currently
  produced goods and services.
• Consists of 3 major components net exports, net
  income from assets and net transfers.

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• 1. Net Exports exports - imports
• the merchandise trade balance refers to net
  exports of goods only.
• trade in services consists of items such as
  tourism and education.

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• 2. Net income from assets net returns of
  financial instruments

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• 3. Net transfers includes items such as foreign
  aid, gifts between family members of different
  countries.

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• Current account balance the sum of the 3
  components.

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1. Capital Account

• An account of trade in existing assets

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• The capital account consists of 2 items
• Capital account
• Financial account
• Together they are referred to as the capital
  account.

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• The capital account includes items such as
  inheritances and trade in intellectual property

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• Financial account a record of direct investment
  and portfolio investment.

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• One final item in the capital account is
  official reserves, which are assets held by
  central banks that can be used to make
  international payments.

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Official reserves are assets

• If the amount is positive then the Bank of Canada
  has sold foreign reserves.
• If the amount is negative then the Bank of Canada
  has bought foreign reserves.
• The amount of official reserves equals the
  balance of payments deficit.

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• The overall balance of payments must equal zero.

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• II. Savings and Investment in a small open
  economy
• In previous chapters we stated that in long run
  equilibrium, savings equals investment. This
  statement was made in the context of a closed
  economy.

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• The GDP identity Y C I G NX
• From chapter 2 S I (NX YNR),
• where YNR is net investment income from
  non-residents.

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• Since NX YNR the current account (CA)
• Then, S I CA
• or, S - I CA .... how do we interpret this
  equation?

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• To simplify analysis in this chapter we make the
  assumption that the current account equals net
  exports...we use the terms interchangeably.

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• Therefore, S- I NX

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• So, in an open economy the long run
  equilibrium condition is that foreign investment
  must equal the trade balance.

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• III. The Importance of the World Real Interest
  Rate
• The world real interest rate is the real rate of
  interest that prevails in international capital
  markets.
• It is assumed that individuals, businesses and
  governments can borrow or lend at this rate.

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• Canada, being a small open economy, takes the
  world real interest rate as an exogenous
  variable.

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Fiscal Policy and Twin Deficits

• Expansionary fiscal policy results in a shift of
  the savings curve to the left.
• The leftward shift results in a higher domestic
  real interest rate and thus there is an excess of
  domestic investment over savings......we have a
  trade deficit and negative net foreign lending.

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• This is called the twin deficit problem ----
  budget deficit leads to a trade deficit.

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Twin Deficit Problem
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IV. Exchange Rates

• Exchange rate determination
• A nominal exchange rate indicates the number of
  Canadian dollars that must be given up in order
  to purchase a unit of foreign currency.
• For instance, on January 28, 2008 the Canada -
  US exchange rate was 0.99

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• The nominal exchange rate is determined by
  supply and demand in the foreign exchange market.

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• Flexible exchange rate system exchange rate is
  determined in the foreign exchange market.
• A change in nominal exchange rate is referred to
  as a currency appreciation or depreciation.
• If the Cdn-US exchange rate changes from 1.11 to
  1.01, then Canadian currency has appreciated and
  US currency has depreciated.

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• Fixed exchange rate system central banks buy
  and sell currency at a fixed rate in terms of
  foreign exchange. This system is an example of a
  price support.

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• A change in the price of foreign exchange under
  the fixed system is referred to as currency
  devaluation or revaluation.
• A devaluation (revaluation) occurs when the
  value of the currency in terms of foreign
  exchange is reduced (increased) by official
  action.

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• In the fixed system, the central bank uses
  exchange market intervention to make up any
  excess supply or demand arising form private
  transactions.
• In order to carry out such intervention the
  central bank must hold an inventory of foreign
  exchange that can be sold in exchange for
  domestic currency when necessary.

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• If a country has an exchange rate crisis and
  their central bank does not have enough foreign
  currency to maintain the fixed rate, the central
  bank will likely resort to a devaluation.

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• A managed or dirty system is one in which
  exchange rates are typically determined in the
  foreign exchange market, but the central bank may
  use intervention to smooth out large fluctuations
  in exchange rates.

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History of the Canadian exchange rate system

• Throughout history Canada s exchange rate has
  intermittently been fixed and flexible.
• Since 1973, the exchange rate has been managed.
• In the early 1970s Canadian currency
  appreciated and then started to depreciate slowly
  until 2003, when a sharp appreciation occurred.

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• Bilateral exchange rate an exchange rate that
  measures the value of one currency against
  another currency,

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• Multilateral exchange rate measurement of the
  value of one currency against a basket of other
  currencies

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Exchange rate in the long run

• The purchasing power parity (PPP) theory states
  that in the long run the nominal exchange rate
  moves primarily as a result of difference in
  price level behaviour between two countries.

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• An oversimplified example if a pen can be
  purchased in US for 2US and in Canada for 2CDN,
  then the exchange rate is 11.

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The logic behind purchasing power parity

• Based on a principle called the law of one price.

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• This law asserts that a good must sell for the
  same price in all locations. If not,
  opportunities for profit would be left
  unexploited.

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• The process of taking advantage of difference in
  prices in different markets is called arbitrage.

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• The logic of the law of one price leads to the
  theory of purchasing power parity.

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Limitations of the model

• 1. Many goods are not easily traded.
• 2. Tradable goods are not always perfect
  substitutes.
• 3. The existence of barriers to the movement of
  goods.

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• Consider, for instance a Big Mac, which is almost
  identical regardless of which country produced
  it.

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• The Economist magazine gathers information every
  year on the price of a Big Mac in local
  currencies around the world, and puts the
  information together with exchange rates to test
  the theory of PPP.

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• If PPP holds, then all Big Mac prices would be
  the same, if measured in US dollars.

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• Purchasing power parity is not a precise theory
  of exchange rates, but it often is a reasonable
  first approximation.
• It is supposed to indicate which direction the
  currency will move in the long run.

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Real Exchange Rates

• The rate at which a person can trade the goods
  and services of one country for the goods and
  services of another.

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• Suppose that you go shopping and find that a pair
  of Canadian blue jeans is twice as expensive as a
  pair of US blue jeans.
• We say that the real exchange rate is ½ pair of
  Canadian blue jeans per pair of US blue jeans.

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• Similar to the nominal exchange rate, we express
  the real exchange rate as units of the domestic
  item per unit of the foreign item.
• Real and nominal exchange rates are closely
  related.

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• Real exchange rate
• Nominal exchange rate x foreign price
• Domestic price

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• The real exchange rate is a key determinant of
  how much a country exports and imports.
• For instance, when Five Roses Inc. Is deciding
  whether to buy French or Canadian wheat to make
  flour, it will ask which wheat is cheaper

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• As macroeconomists, we focus on the overall price
  rather than the prices of individual items.
• We use price indexes to measure the real exchange
  rate.

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• Real exchange rate e x (Pf/P)
• e is the nominal exchange rate between the
  Canadian dollar and foreign currencies.
• P is the price index for a Canadian basket.
• Pf is the price index for a foreign basket.

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• The real exchange rate measures the price of a
  basket of goods and services available
  domestically relative to a basket of goods and
  services available abroad.

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• If the real exchange rate is greater than 1, then
  we expect demand for domestic produced goods to
  rise.
• Eventually the price will be driven up or the
  exchange rate will be driven down.
• In other words, we will move towards PPP over
  time.

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• Since P and Pf refer to different baskets, we do
  not expect the real exchange rate to equal 1.
• In the long run, we expect the real exchange rate
  to return to its average level.

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A Monetary Union

• The euro is a currency of a monetary union of
  many countries.

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• In order for countries to participate in the
  monetary union they were required to meet
  specific economic targets.

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• Referred to as the Maastrict criteria
• 1. 2 maximum inflation rate
• 2. Budget deficit of less than 2 of GDP
• 3. Debt ratio less than 60 of GDP
• As well, there were to be no restrictions of
  capital flows and no devaluation in the two
  preceding periods.