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• 

The figure below shows that the quantity of Canadian dollars that people plan to buy depends

on the exchange rate.

• 

The quantity of Canadian dollars supplied in the foreign exchange market is the amount that

traders plan to sell during a given time period at a given exchange rate.

•  The quantity depends on many factors but the main ones are:

o  The exchange rate

o  Canadian demand for imports

o  Interest rates in Canada and other countries

o 

The expected future exchange rate

•  The law of supply of foreign exchange states that other things remaining the same, the higher

the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign

exchange market.

•  The exchange rate influences the quantity of dollars supplied for two reasons:

o  Imports effect

o  Expected profit effect

•  Imports effect:

o 

The higher the exchange rate, the cheaper are foreign-produced goods to Canadians,

and the greater the level of imports, the greater the quantity of Canadian dollars

supplied on the foreign exchange market.

•  Expected profit effect:

o 

The higher the exchange rate, the larger the expected profit from selling Canadian

dollars, and the greater the quantity of dollars supplied on the foreign exchange market.

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Exchange Rate Fluctuations 

• 

A change in any influence other than the exchange rate on the quantity of Canadian dollars that

people plan to buy brings a change in the demand for dollars and a shift in the demand curve for

dollars.

• 

These other influences are:

o  Interest rates in Canada and other countries.

o  World demand for Canadian exports.

o 

The expected future exchange rate.

•  The Canadian interest rate minus the foreign interest rate is called the Canadian interest rate

differential.

•  In the figure below, the demand for dollars increases and the demand curve shifts rightward if

world demand for Canadian exports increases, the Canadian interest rate differential increases

or the expected future exchange rate rises.

•  The demand for dollars decreases and the demand curve shifts leftward if world demand for

Canadian exports decreases, the Canadian interest rate differential decreases or the expected

future exchange rate falls.

• 

A change in any influence other than the exchange rate on the quantity of Canadian dollars that

people plan to sell brings a change in the supply dollars and a shift in the supply curve of dollars.

•  These other influences are:

o  Interest rates in Canada and other countries

o  Canadian demand for imports

o 

The expected future exchange rate

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• 

In the figure below, the supply of dollars increases and the supply curve shifts rightward if

Canadian import demand increases, the Canadian interest rate differential decreases or the

expected future exchange rate falls.

•  The supply of dollars decreases and the supply curve shifts leftward if Canadian import demand

decreases, the Canadian interest rate differential increases or the expected future exchange

rate rises.

•  The exchange rate can fluctuate a great deal, even over a day, and certainly over weeks and

months.

•  What makes the exchange rate volatile?

• 

The main reason is that demand and supply are interdependent  – they are influenced by the

same factors.•  Purchasing power parity means equal value of money.

•  If all (or most) prices have increased in the United States and have not increased in Canada, then

people will generally expect that the value of the Canadian dollar on the foreign exchange

market must rise.

•  Interest rate parity means equal interest rates.

•  Adjusted for risk, interest rate parity always prevails.

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Exchange Rate Policy 

• 

A flexible exchange rate policy is one that permits the exchange rate to be determined by

demand and supply with no direct intervention in the foreign exchange market by the central

bank.

• 

A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the

government or central bank and that blocks the unregulated forces of demand and supply by

direct intervention in the foreign exchange market.

•  A crawling peg exchange rate policy is one that selects a target path for the exchange rate with

intervention in the foreign exchange market to achieve that path.

Financing International Trade 

•  A country’s balance of payments accounts record its international trading, borrowing and

lending in three accounts: 

o 

Current account 

o  Capital and financial account 

o  Official settlements account 

•  The current account records payments for imports of goods and services from abroad, receipts

from exports of goods and services sold abroad, net interest paid abroad, and net transfers

(such as foreign aid payments). 

•  The capital and financial account records foreign investment in Canada minus Canadian

investment abroad. 

•  The official settlements account records the change in official Canadian reserves. 

•  Official reserves are the government’s holdings of foreign currency. 

• 

If Canadian official reserves increase, the official settlements account balance is negative and if

official Canadian reserves decrease, the official settlements account balance is positive. 

•  The sum of the balances of the three accounts always equals zero. 

•  A country that has a current account deficit and that borrows more from the rest of the world

than it lends to it is called a net borrower. 

•  A net lender is a country that lends more to the rest of the world than it borrows from it. 

•  A debtor nation is a country that during its entire history has borrowed more from the rest of

the world than is has lent to it. 

• 

A creditor nation is a country that has invested more in the rest of the world than other

countries have invested in it. •  Net exports is the value of exports of goods and services minus the value of imports of goods

and services. 

•  The government sector balance is equal to net taxes minus government expenditures on goods

and services. 

•  The private sector balance is equal to saving minus investment. 

•  Net exports is equal to the sum of the government sector surplus and the private sector surplus.