Transcript Slide 1

Basics of International Finance
National income accounting
Records all the expenditures that contribute to a
country’s income and output
Balance of payments accounting
Helps us keep track of both changes in a country’s
indebtedness to foreigners and the fortunes of its
export- and import-competing industries
Gross national product (GNP)
The value of all final goods and services produced
by a country’s factors of production and sold on the
market in a given time period. It is the basic
measure of a country’s output.
7/21/2015
Econ 355, Nisha Malhotra
1
The National Income Identity
for an Open Economy

It is the sum of domestic and foreign expenditure on
the goods and services produced by domestic
factors of production:
Y = C + I + G + EX – IM
(12-1)
where:



Y is GNP
C: The amount consumed by private domestic residents
I : The amount put aside by private firms to build new plant
and equipment for future production




7/21/2015
G is government purchases
EX is exports
IM is imports
In a closed economy, EX = IM = 0.
Econ 355, Nisha Malhotra
2
The Current Account and
Foreign Indebtedness

Current account (CA) balance

The difference between exports of goods and services and
imports of goods and services




(CA = EX – IM)
A country has a CA surplus when its CA > 0.
A country has a CA deficit when its CA < 0.
CA measures the size and direction of international
borrowing.
A country’s current account balance equals the change in
its net foreign wealth.
Example: Canada imports 20 bushels of wheat and exports only


10 bushels of wheat. The current account deficit of 10 bushels is
the value of Canada’s borrowing from foreigners, which the
country will have to repay in the future.
7/21/2015
Econ 355, Nisha Malhotra
3
The Balance of Payments
Accounts (BOP)

Three types of international transactions are
recorded in the balance of payments:


Exports or imports of goods or services
Purchases or sales of financial assets


7/21/2015
Money, Stocks, government debt and purchase/sale of factories
Transfers of wealth between countries
 They are recorded in the capital account.
Econ 355, Nisha Malhotra
4
The Fundamental BOP Identity
Any international transaction automatically gives rise to two
offsetting entries in the balance of payments resulting in a
fundamental identity:
Current account + financial account + capital account = 0
**************************************************************************
Capital Inflow and Outflow

Financial inflow also called -(capital inflow)


Financial outflow also called - (capital outflow)

7/21/2015
A loan from the foreigners with a promise that they will be repaid
A transaction involving the purchase of an asset from foreigners
Econ 355, Nisha Malhotra
5
Official Reserve Transactions

Central bank-US/ (Bank of Canada)


Official international reserves


Foreign assets held by central banks as a cushion
against national economic misfortune
Official foreign exchange intervention

7/21/2015
The institution responsible for managing the supply of
money
Central banks often buy or sell international reserves
in private asset markets to affect macroeconomic
conditions in their economies.
Econ 355, Nisha Malhotra
6
Goals of “Bank of Canada”




Low and Stable Inflation
A safe and secure currency
Financial Stability
The Efficient management of Govt. funds and
Public Debt
7/21/2015
Econ 355, Nisha Malhotra
7
The Exchange Rate


THE EXCHANGE RATE refers to the value of the
Canadian dollar against the currencies of other
countries.
Depreciation: When the value (purchasing power) of
the Canadian dollar falls.
(Moving from 1.3 per US dollar to 1.5 per US dollar)
(.77 per CA dollar to .67 per CA dollar)



imported goods become more expensive, and we tend to
reduce the volume of our imports. At the same time, other
countries will pay less for some of our products and that
will tend to boost export sales.
A Depreciation lowers the relative price of export and
increases the relative price of imports.
Appreciation: The opposite
7/21/2015
Econ 355, Nisha Malhotra
8
Using the exchange rate to
calculate the price for Canon

Canon Powershot SD100 3.2
Megapixel 2x Optical/3.2x
Digital Zoom Digital Camera
www.tigredirect.com
 PRICE: US $329.99
5% tax & free shipping=346.49
www.tigerdirect.ca
 PRICE: CA $445.99
14.5% tax & free shipping=510.55
7/21/2015

Buying the camera in the
US-price in Canadian
dollars

(US $) * (CA $/US $)

us$346.49 * 1.32= ca $457.37
Econ 355, Nisha Malhotra
9
The Foreign Exchange market

Exchange rates are determined by the interaction of
buyers and sellers of foreign currencies in the
foreign exchange market.
Commercial Banks, Corporations, Nonbank financial institutions and
Central banks.


Demand for deposit in a currency depends on the expected rate of
return for this asset.
Choosing to hold Euro or Dollar deposit- Need to know-how the
money value of the deposit will change and how the exchange rate
will change
 Money value depend on the currency’s interest rate
 Change in exchange rate- rate of depreciation of the currency
7/21/2015
Econ 355, Nisha Malhotra
10
Demand for foreign currency
asset

The expected rate of return difference between dollar
and euro deposits is:
R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€
(13-1)
where:
R$ = interest rate on one-year dollar deposits
R€ = today’s interest rate on one-year euro deposits
E$/€ = today’s dollar/euro exchange rate (number of
dollars per euro)
Ee$/€ = dollar/euro exchange rate (number of dollars per
euro) expected to prevail a year from today
7/21/2015
Econ 355, Nisha Malhotra
11
Determination of the Equilibrium
Dollar/Euro Exchange Rate

Interest Parity: The Basic Equilibrium
Condition

The foreign exchange market is in equilibrium
when deposits of all currencies offer the same
expected rate of return.
R$= R€ + (Ee$/€ -E$/€ )/E$/€
7/21/2015
Econ 355, Nisha Malhotra
12
Equilibrium in the
Foreign Exchange Market
Determination of the Equilibrium Dollar/Euro Exchange Rate
Exchange rate, E$/€
E2$/€
E1$/€
E3
Return on
dollar deposits
2
1
3
$/€
Expected return
on euro deposits
R$
7/21/2015
Econ 355, Nisha Malhotra
Rates of return
(in dollar terms)
13
Relationships
Interest rates & Current Exchange Rate
An increase in the interest paid on deposits of a currency causes
that currency to appreciate against foreign currencies
Exchange rate, E$/€
E1$/€
Dollar return
1
E2$/€
1'
2
Expected
euro return
R1$
7/21/2015
R2$
Econ 355, Nisha Malhotra
Rates of return
(in dollar terms)
14
Relationships
Expectations about the future exchange rate
& Current Exchange Rate
A rise in the expected future exchange rate causes a rise in the current exchange rate.
Exchange rate, E$/€
Dollar return
Rise in the future
Exchange rate
E2$/€
2
E1$/€
1
Expected
euro return
R$
7/21/2015
Econ 355, Nisha Malhotra
Rates of return
(in dollar terms)
15
Relationships
Money supply and the exchange rate in the
short run

Money supply & interest rate--Increase in the level of the
nominal money supply lowers the interest rate




Since people are holding more money than they desire, they bid for
assets that pay interest. The economy as a whole cannot reduce its
money holdings, so interest rates are driven down as unwilling money
holders compete to lend their excess cash balance.
Interest rate & exchange rate (interest parity condition)-decrease in dollar interest rate depreciates the currency
Thus, an in crease in a country’s money supply causes its
currency to depreciate in the foreign exchange market.
Long Run-Price level increases and no change in the
interest rate and output. It does lead to a permanent
depreciation in the currency.
7/21/2015
Econ 355, Nisha Malhotra
16
Relationships
Money supply and the exchange rate
Money-Market/Exchange Rate Linkages
Europe
European System
of Central Banks
Canada
Bank of Canada
MSCA
(Canada
money supply)
MS E
Canada
money market
R$
(Dollar interest rate)
(European
money supply)
European
money market
Foreign
exchange
market
R€
(Euro interest rate)
E$/€
(Dollar/Euro exchange rate)
7/21/2015
Econ 355, Nisha Malhotra
17