International Trade and Exchange Rates Chapter 5 • The Canadian economy is a small and relatively open economy. – linked to the rest of the world through trade in goods and services, and finance. Merchandise Trade Statistics Canada, December 2009 Merchandise Trade Balance Statistics Canada, December 2009 Goods and Services Trade • In 2008, exports comprised 35% of GDP and imports comprised 34% of GDP. • In 2008, the trade balance was close to $47 billion. 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. Where do Canadian exports go? • 78% to US • 2.7% to UK • 2.3% to Japan • 2.2% to China • 1.2% to Mexico • 0.9% to Germany (Industry Canada, 2009) Where do Canadians import from? • 52.4% from US • 9.8% from China • 4.1% from Mexico • 3.5% from Japan • 2.9% from Germany • 2.9% from UK 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% 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% International Finance • Canadians can hold assets in foreign countries. • Foreigners can hold assets in Canada. 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. Current Account • 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. 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. 2. Net income from assets: net returns of financial instruments 3. Net transfers: includes items such as foreign aid, gifts between family members of different countries. Current account balance = the sum of the 3 components. Capital Account • An account of trade in existing assets The capital account consists of 2 items: 1. Capital account 2. Financial account Together they are referred to as the capital account. The capital account: includes items such as inheritances and trade in intellectual property Financial account: a record of direct investment and portfolio investment. 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. 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. The overall balance of payments must equal zero. 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. The GDP identity: Y = C + I + G + NX From chapter 2: S = I + (NX + YNR) where YNR is net investment income from non-residents. Since NX + YNR = the current account (CA) Then, S = I + CA or, S - I = CA .... how do we interpret this equation? To simplify analysis in this chapter we make the assumption that the current account equals net exports...we use the terms interchangeably. Therefore, S- I = NX ***So, in an open economy the long run equilibrium condition is that foreign investment must equal the trade balance. 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. Canada, being a small open economy, takes the world real interest rate as an exogenous variable. 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. This is called the twin deficit problem ---- budget deficit leads to a trade deficit. Twin Deficit Problem 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 The nominal exchange rate is determined by supply and demand in the foreign exchange market. 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. 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. • 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. • 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. 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. 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. 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. • Bilateral exchange rate: an exchange rate that measures the value of one currency against another currency, • Multilateral exchange rate: measurement of the value of one currency against a basket of other currencies 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. • An oversimplified example: if a pen can be purchased in US for $2US and in Canada for $2CDN, then the exchange rate is 1:1. The logic behind purchasing power parity: • Based on a principle called the law of one price. • This law asserts that a good must sell for the same price in all locations. If not, opportunities for profit would be left unexploited. • The process of taking advantage of difference in prices in different markets is called arbitrage. • The logic of the law of one price leads to the theory of purchasing power parity. 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. • Consider, for instance a Big Mac, which is almost identical regardless of which country produced it. • 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. • If PPP holds, then all Big Mac prices would be the same, if measured in US dollars. • 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. 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. • 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. • 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. Real exchange rate = Nominal exchange rate x foreign price Domestic price • 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 • 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. 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. • 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. • 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. • 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. A Monetary Union • The euro is a currency of a monetary union of many countries. • In order for countries to participate in the monetary union they were required to meet specific economic targets. 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.