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Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

Compiler Press

h.h.chartrand@compilerpress.ca

215 Lake Crescent

Saskatoon, Saskatchewan

Canada, S7H 3A1
 

Curriculum Vitae

 

Launched  1998

 

 

Macroeconomics

5.0 Global Economy (cont'd)

 

5.2 Balance of Payments

1. Balance of Payments
2. Exchange Rate

3. Trade & the Domestic Economy

1. Fiscal Policy

2. Monetary Policy

1. Balance of Payments                                      

The balance of payments is the score sheet for all economic transactions during a given period between  one country and its residents (including the governments) and all other countries. Transactions  are reported using double entry bookkeeping with credit entries balanced on the debit side, and vice versa. The balance of payments thus necessarily balances. There can be no surplus or deficit in a country's balance of payments as a whole.

A country's balance of payments is divided into two major sections: the current account and the capital account.

The current account, in turn, is subdivided into goods and services and transfer payments.

 The capital account is subdivided into non-monetary and monetary sectors.

The overall balance of payments comprises the current account (merchandise and services), unilateral transfers (gifts, grants, remittances, and so on), and the capital account (long-term and short-term capital movements). If payments due in exceed those due out, a country is said to be in overall surplus; and when payments due out exceed payments due in, it is in overall deficit. The surplus or deficit must be balanced by a monetary movement in the opposite direction, and consequently the overall balance including monetary movements must always be equal.

It is important not to confuse the 'trade balance' and the balance of payments.  The trade balance refers to trade in goods.  An export surplus or deficit in goods may be matched by net sales of services. There would then be no deficit in goods and services as a whole.  Thus the balance of payments is a broader and more significant measure than is the balance of trade in goods alone.

Often the balance of goods and services is confused with the current account balance. The current account as a whole has always had a basic importance.  A nation with a deficit on total current account is ipso facto decreasing its capital assets abroad (including gold) or increasing its capital liabilities to foreigners.  A nation with a current-account surplus is gaining foreign assets or reducing its foreign liabilities.

A deficit in the balance of goods and services does not necessarily affect a country's exchange rate.  There may be a matching inflow of investment capital that strengthens the immediate exchange position and builds up a country's future exporting capacity.  Similarly, a surplus in the balance of goods and services may not assure a strong exchange rate.

For another explanation see: The Economist Glossary - Balance of Payments; Government of Canada Balance of Payments (a) & (b);  Wikipedia Balance of Payments;

 

2. Exchange Rate

The 'exchange rate' is  the price of a country's money in relation to another country's money. An exchange rate is "fixed" when countries use gold or another agreed-upon standard, and each currency is worth a specific measure of the metal or other standard.  An exchange rate is "floating" when supply and demand (including speculation) sets exchange rates.

Generally when Canada's exports increase, the exchange rate increases (i.e. fewer Canadian dollars buy a unit of foreign currency).  Increased foreign demand for Canadian currency makes Canadian goods more expensive.  As Canadian goods become more expensive, exports decline.  Decreased demand for the Canadian dollar then tends to lower the exchange rate making Canadian goods cheaper and so on and so on in a floating exchange rate system.  It important to note that the foreign exchange market is, in the main, binary, i.e., there is market for the $Cdn and the $US and a separate market for the $Cdn and the British and yet another for the $Cdn and the Europeann .

Demand for Dollars (P&B 7th Ed Fig. 25.2)

Change in Demand for Dollars (P&B 7th Ed Fig. 25.5; R&L 13th Ed Fig. 35-3)

Supply of Dollars (P&B 7th Ed Fig. 25.3; R&L 13th Ed Fig. 35-3)

Change in Supply of Dollars (P&B 7th Ed Fig. 25.6)

Equilibrium Exchange Rate (P&B 7th Ed Fig. 25.4; R&L 13th Ed Fig. 35-1)

Foreign Exchange Market Intervention (P&B 7th Ed Fig. 25.7)

World trade now depends on a managed floating exchange system. Governments act to stabilize their countries' exchange rates by limiting imports, stimulating exports, or devaluing currencies.

No economy is self-contained.  Central banks must therefore pay attention to trading and financial relationships with other countries. If goods are bought abroad, there is a demand for foreign currency to pay for them. Alternatively, if goods are sold abroad, foreign currency is acquired that the seller ordinarily wishes to convert into the home currency. These two sets of transactions usually pass through the banking system, but there is no necessary reason why in the short-term they should balance. Sometimes there is a surplus of purchases and sometimes a surplus of sales. Short-term disequilibrium is not usually significant, but it is important that there be a tendency to balance in the long term.  It is difficult for a country to be a permanent borrower or to continue building up a command over goods and services that it does not exercise.

Short-term disequilibrium can be handled by increasing or decreasing balances of foreign exchange. If a country has no balances to diminish, it may borrow, but normally it carries working balances. If the commercial banks find it unprofitable to hold such balances, the central bank will usually carry them; indeed, it may insist on concentrating the bulk of the country's foreign-exchange resources in its hands or in those of an associated agency.

Long-term equilibrium is more difficult. It may be achieved  in three ways: price movements, exchange revaluation (appreciation or depreciation of the currency), or exchange controls.

Price levels may be influenced by expanding or contracting the money supply.  If the central bank wants to stimulate imports, for example, it can induce a a rise in domestic prices by increasing the money supply. If additional exports are required, the central bank can force down domestic prices by decreasing the money supply.

The objective may be achieved directly by revaluing a country's exchange rate. Depending on the circumstances, the rate may be increased or decreased, or allowed to "float." Appreciation means that the domestic  currency becomes more valuable in terms of the currencies of other countries and exports consequently become more expensive for foreigners. Depreciation involves decreasing the value of the domestic currency thus lowering the price of export goods in the world's markets. In both cases, however, the effects are usually only temporary, and for this reason the central bank usually  prefers relative stability in exchange rates even at the cost of fluctuation in domestic prices.

Sometimes governments resort to exchange controls (sometimes combined with import licensing) to allocate foreign exchange more or less directly in payment for specific imports. At times, a considerable apparatus has been assembled for this purpose, and, despite "leakages" of various kinds, the system has proved reasonably efficient in achieving balance on external payments account. Its chief disadvantage is that it interferes with normal market processes, thereby encouraging rigidities in the economy, reinforcing vested interests, and restricting the growth of world trade.  On the other hand, some countries, e.g., Argentina, will impose an export tax to keep domestic prices low.

Whatever method is chosen, the process of adjustment is generally supervised by some central authority -- the central bank or some institution closely associated with it -- that can assemble the information necessary to ensure that the proper responses are made to changing conditions.

Also see: The Economist Glossary - Exchange Rate; Wikipedia - Exchange Rate;

 

3. Trade & The Domestic Economy

So far in the AD/AS model for an open economy we have employed an implicit assumption: Sd = Id but in open economy some domestic savings are invested abroad and some investment at home is financed from abroad.  This opens up the question of loanable funds, a disputed alternative to Keynesian theory.  Loanable funds are not testable in this course. 

How does such short and long run capital flows affect the AD/AS short- and long-run equilibrium, the exchange rate, the interest rate, the inflation rate ?   What are the effects on the national factor endowment and LAS?  What tools are available to a national government and its central bank?

 P&B 7th edition

Fiscal Policy

export support policies, inter alia.

 

Monetary Policy

domestic money and foreign currency market interventions, inter alia.

in defense of the domestic and foreign exchange value of the $Cdn

 

Net Capital Outflows is the relationship between foreign assets bought by Canadians and Canadian assets bought by foreign citizens in a given time period.  If we buy more foreign assets than we sell Canadian assets then net capital outflow is positive and vice versa.  This means, in the binary exchange market, if Canadian net capital outflow to country A is positive then country A's net capital outflow to Canada is reduced in a given time period.

To buy foreign assets we sell Canadian dollars to buy the appropriate foreign currency in which the foreign asset is valued.  To buy Canadian assets foreigners must by Canadian dollars.  Effects?

Real Interest Rate: nominal rate, e.g., 6% minus the inflation rate, e.g., 3% equals a real rate of 3%.  Monetary transmission mechanism.  Effects?

 

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