Chapter 16 - International Finance and the Exchange Rate

Extends the supply-and-demand framework to currency markets. The exchange rate connects domestic and international economies, linking the loanable funds market to net exports and the balance of payments.

Key Concepts

• The nominal exchange rate is determined by supply and demand for currency in the foreign exchange market
• Demand for C$comesfromexportsandfinancialinflows;\ast \ast Supply\ast \ast ofC$ comes from imports and financial outflows
• Purchasing Power Parity (PPP): in the long run, exchange rates equalize prices across countries
• Interest rate parity: capital flows equalize returns on investments across countries
• The real exchange rate measures international competitiveness; it determines net exports
• Balance of payments: current account + financial account must sum to zero
• Three exchange rate regimes: floating, fixed, and managed

1. International Trade and Global Financial Flows

Two Types of Cross-Border Flows

Trade flows (goods and services):

• Exports: Canadians sell to foreigners → foreigners pay in C$\to \ast \ast demand\ast \ast forC$ increases
• Imports: Canadians buy from foreigners → Canadians supply C$\to \ast \ast supply\ast \ast ofC$ increases

Financial flows (assets): - Financial inflows (capital inflows): foreigners buy Canadian assets → demand for C$ increases

• Financial outflows (capital outflows): Canadians buy foreign assets → supply of C$ increases

Exam Alert

Flow	Effect on C$
Exports ↑	Demand for C$ ↑
Financial inflows ↑	Demand for C$ ↑
Imports ↑	Supply of C$ ↑
Financial outflows ↑	Supply of C$ ↑

2. Exchange Rates

Nominal Exchange Rate

Nominal Exchange Rate

The price of one country’s currency in terms of another’s (e.g., ¥90 per C$). Determined by the foreign exchange market.

Appreciation: the currency becomes more valuable (buys more foreign currency). Depreciation: the currency becomes less valuable (buys less foreign currency).

Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP)

The idea that identical goods should sell for the same price in all countries when prices are converted to a common currency. In the long run, exchange rates should adjust to equalize prices.

PPP implies: if Canadian prices rise faster than Japanese prices, the C$ should depreciate to restore equality.

The Big Mac Index: a famous PPP measure comparing the price of a McDonald’s Big Mac across countries.

Interest Rate Parity

Interest Rate Parity

The idea that capital flows will equalize returns on investments across countries. If Canadian interest rates are higher than foreign rates, money flows into Canada (financial inflows) until returns are equalized.

• Higher Canadian interest rates → more financial inflows → demand for C$\uparrow \to C$ appreciates
• This appreciation offsets the higher interest rate from a foreign investor’s perspective

3. Supply and Demand of Currencies

The foreign exchange market is where currencies are bought and sold. It works like any supply-and-demand market.

Price of C$
(Exchange rate)
       |        Supply of C$
       |       /  (imports + financial outflows)
  ¥90 -|------X
       |     / \
       |    /   \
       |   /     \ Demand for C$
       |  /       (exports + financial inflows)
       +--+-------+----> Quantity of C$

Equilibrium exchange rate is set where quantity supplied = quantity demanded.

What Shifts Demand for C$?

Demand for C$ increases (rightward shift) when:

• ↑ world GDP → foreigners buy more Canadian exports
• ↑ Canadian business profitability relative to foreign
• ↑ Canadian interest rates relative to foreign (financial inflows)
• ↓ foreign political risk relative to Canada

What Shifts Supply of C$? (Two Shifters)

Shifter 1: Imports into Canada — Supply of C$ increases when:

1. ↑ Canadian GDP (more income → more spent on imports)
2. ↓ barriers protecting domestic producers (lower tariffs)
3. ↑ foreign innovation and marketing
4. ↑ domestic prices (Canadian goods become more expensive)
5. ↓ foreign prices (foreign goods become cheaper)

Shifter 2: Financial Outflows from Canada — Supply of C$ increases when:

1. ↓ Canadian interest rates relative to foreign
2. ↓ Canadian business profitability relative to foreign
3. ↓ foreign political risk (Canada looks relatively riskier)
4. ↓ expected future value of the dollar (sell now before it falls further)

Forecasting Exchange Rate Movements (3 Steps)

Exam Alert

Three-Step Framework:

1. Which curve shifts? Demand shifts due to changes in exports or financial inflows. Supply shifts due to changes in imports or financial outflows.
2. Which direction? Increase → rightward shift. Decrease → leftward shift.
3. What happens to equilibrium? Read off the new exchange rate.

Forecasting Exchange Rate

Scenario: Chinese airlines are buying more Canadian-made airplanes.

Step 1: This is an export from Canada — foreigners buying Canadian goods. Demand for C$ shifts.

Step 2: Exports increase → rightward (increase) shift in demand.

Step 3: Higher demand → higher price of C$\to \ast \ast C$ appreciates**.

(Shifter: ↑ world GDP)

4. The Real Exchange Rate and Net Exports

The nominal exchange rate tells you the price of currency. The real exchange rate tells you whether Canadian goods are competitively priced.

Real Exchange Rate Formula

$\text{Real exchange rate}=\frac{\text{Domestic price in dollars}}{\text{Foreign price converted to dollars}}$

Equivalently:

$\text{Real exchange rate}=\frac{\text{Domestic price in dollars}}{\text{Foreign price in foreign currency}÷\text{Nominal exchange rate}}$

Real Exchange Rate Calculation

• Canadian pork: C$4 per kg
• Japanese pork: ¥450 per kg
• Nominal exchange rate: ¥90 per C$

Foreign price converted to dollars = ¥450 ÷ ¥90/C$=C$5

$\text{Real exchange rate}=\frac{C\$4}{C\$5}=\frac{4}{5}=0.8$

Interpretation: Canadian pork is 4/5 (80%) the price of Japanese pork → Canada is internationally competitive in pork.

Real Exchange Rate and Competitiveness

Internationally         Internationally
  Competitive           Uncompetitive
  (Canadian prices       (Canadian prices
   low relative to        high relative to
   foreign prices)        foreign prices)
       |                       |
  -----+-------+-------+------->  Real exchange rate
               Low           High

  Low real exchange rate:      High real exchange rate:
  • Canadians import few        • Canadians import a lot
    foreign goods               of foreign goods
  • Foreigners buy a lot        • Foreigners buy few
    of Canadian exports          Canadian exports

Exam Alert

• Real depreciation (real exchange rate ↓) → Canada more competitive → exports ↑, imports ↓ → net exports ↑
• Real appreciation (real exchange rate ↑) → Canada less competitive → exports ↓, imports ↑ → net exports ↓

Economy-wide: real depreciation leads to an increase in total exports and a decrease in total imports. The real exchange rate is strongly correlated with net exports as a share of GDP.

5. Exchange Rate Regimes

Governments choose how much to intervene in the foreign exchange market:

Regime	Description	Example
Floating	Exchange rate fluctuates freely in response to supply and demand	Canada today (since 1970)
Fixed	Government sets the rate and never (or rarely) changes it	Canada 1962–1970 at US$0.925
Managed	Government buys/sells currency to reduce volatility and/or keep currency cheap	Canada 1952–1960

Policy Implication

A managed or fixed exchange rate requires the government to intervene in the forex market — buying its own currency when it depreciates, selling when it appreciates. This depletes (or builds) foreign exchange reserves.

6. The Balance of Payments

Balance of Payments

A summary of a country’s transactions with the rest of the world. It tracks two accounts that must sum to zero.

Current Account

Tracks income crossing national borders each year:

• Exports of goods and services (inflow)
• Imports of goods and services (outflow)
• Investment income received from abroad (inflow)
• Investment income paid to foreigners (outflow)
• Other transfers

$\text{Current Account Balance}=\text{Income received from abroad}-\text{Income paid abroad}$

• Current account surplus: receives more income from abroad than it pays
• Current account deficit: pays more income abroad than it receives

Canada's Current Account (2019)

• Income received from abroad: $900billion(exports$735B + investment income $150B+other$15B)
• Income paid abroad: $950billion(imports$775B + investment income $150B+other$25B)
• Current account deficit: −$50 billion
• On average, each Canadian received ~$1,250 less from abroad than they paid to foreigners

Financial Account

Tracks financial flows across borders (changes in asset ownership):

• Foreign direct investment (FDI): buying/selling whole companies or large stakes
• Portfolio investment: buying/selling stocks and bonds
• Deposits and loans

$\text{Financial Account Balance}=\text{Financial inflows}-\text{Financial outflows}$

Canada's Financial Account (2019)

• Financial inflows: $315billion(FDI$60B + portfolio $35B+deposits/loans$210B + other $10B)
• Financial outflows: $265billion(FDI$100B + portfolio $35B+deposits/loans$90B + other $40B)
• Financial account surplus: +$50 billion
• Foreigners bought $50 billion more Canadian assets than Canadians bought foreign assets

The Balance of Payments Identity

Exam Alert

$\text{Current Account}+\text{Financial Account}=0$ A current account deficit must be financed by a financial account surplus (foreigners invest in Canada to fund the gap). They are two sides of the same coin.

Canada’s 2019 current account deficit (−$50B)wasexactlyoffsetbyitsfinancialaccountsurplus(+$50B).

Definitions

Nominal Exchange Rate The price of one currency in terms of another (e.g., ¥90 per C$), determined by the foreign exchange market.

Foreign Exchange Market A market where one currency can be exchanged for another; equilibrium determines the nominal exchange rate.

Appreciation An increase in a currency’s value relative to other currencies (it buys more foreign currency).

Depreciation A decrease in a currency’s value relative to other currencies (it buys less foreign currency).

Purchasing Power Parity (PPP) The theory that exchange rates adjust in the long run so that identical goods cost the same in all countries.

Interest Rate Parity The theory that capital flows equalize investment returns across countries, linking interest rates to exchange rates.

Real Exchange Rate The price of domestic goods relative to foreign goods: Domestic price / (Foreign price / Nominal exchange rate). Measures international competitiveness.

Floating Exchange Rate An exchange rate that fluctuates freely in response to market supply and demand.

Fixed Exchange Rate An exchange rate set by the government that rarely or never changes.

Managed Exchange Rate An exchange rate where the government intervenes by buying/selling currency to reduce volatility or influence the rate.

Balance of Payments A record of all transactions between a country and the rest of the world; consists of the current account and financial account.

Current Account Tracks income flows across borders: exports minus imports, plus net investment income and transfers.

Financial Account Tracks financial flows across borders: foreign direct investment, portfolio investment, and loans/deposits.

Current Account Deficit When a country pays more income abroad than it receives (imports + outflows exceed exports + inflows).

Financial Account Surplus When foreigners invest more in a country than that country invests abroad (financial inflows > financial outflows).