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 Chapter 14
The Foreign Sector

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Learning Objectives
After this chapter you will be able to:
 explain the balance-of-payments
accounts, which include the current
account and the capital and financial
accounts
 understand exchange rates and how
they are determined
 summarize exchange rate systems and
their evolution
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The Balance of Payments
Accounts
The balance of payments accounts provide a
summary of all transactions between
Canadian residents and foreigners that
involve exchanging Canadian dollars for
some other currency.
 Receipts (shown by a + sign) represent
monetary inflows to the Canadian economy.
 Payments (shown by a - sign) represent
monetary outflows from the Canadian
economy.

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The Current Account
The current account (which summarizes
all foreign transactions associated with
current economic activity in Canada and
involving Canadian dollars) includes four
types of transactions:
 trade in merchandise
 trade in services
 flows of investment income
 transfers

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Current Account Surplus and
Deficit
A current account surplus occurs when this
account’s receipts outweigh payments, while
a current account deficit occurs when
payments outweigh receipts.
 The merchandise balance of trade equals
merchandise export receipts minus
merchandise import payments.
 The balance of trade represents export
receipts minus import payments for both
goods and services.

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Canada’s Current Account
Figure 14.1

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The Capital and Financial
Accounts
 The capital account summarizes transfer of
ownership of savings and intangible assets.
 The financial account, which summarizes all
foreign transactions of financial assets
involving Canadian dollars, includes three
types of transactions:
 Portfolio investment is financial investment that
does not give the buyer controlling interest.
 Direct investment is financial investment that
gives the buyer controlling interest.
 Other financial investments are linked to day-
to-day fluctuations in bank deposits.
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Capital and Financial
Surpluses/Deficits
 A capital and financial accounts surplus
occurs when these accounts’ receipts
outweigh payments so that Canadians make
less foreign investments than foreigners
make in Canada.
 A capital and financial accounts deficit occurs
when these account’s payments outweigh
receipts so that Canadians make more
foreign investments than foreigners make in
Canada.
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Canada’s Capital and Financial
Accounts

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Balance-of-Payments Surpluses/Deficits
 A balance-of-payments surplus is a positive
net balance showing that receipts outweigh
payments on the current account and capital
and financial accounts combined.
 A balance-of-payments deficit is a negative
balance showing that payments outweigh
receipts on the current account and capital
and financial accounts combined.

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Canada’s Balance of Payments

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Changes in Official Reserves (a)
The change in official reserves account:
 shows the effect of the Bank of Canada’s
buying and selling of foreign currency on
the flow of Canadian dollars
 is equal in value (and opposite in sign) to
the surplus or deficit noted in the balance
of payments

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Changes in Official Reserves (b)
 A negative change in official reserves
indicates that the Bank of Canada sold
Canadian dollars (creating an outflow) by
buying foreign currency.
 A positive change in official reserves
indicates that the Bank of Canada bought
Canadian dollars (creating an inflow) by
selling foreign currency.

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Exchange Rates
The exchange rate is the value of one
nation’s currency in terms of another
currency.
 Two exchange rates can be used to
compare any two currencies (e.g. the
Canadian and U.S. dollars).
 For example, Canadian dollars to buy US$1
= (1/U.S. dollars to buy CDN$1).

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Exchange Rates and Prices
The impact of exchange rates on prices
can be illustrated using Canadian and
U.S. dollars.
 A product’s U.S. dollar price = the Canadian
dollar price x U.S. dollars to buy CDN$1.00.
 A product’s Canadian dollar price = the U.S.
dollar price x Canadian dollars to buy
US$1.00.

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The Demand for Canadian Dollars
 The demand for Canadian dollars is the
relationship between the price of a Canadian
dollar and the quantity demanded in
exchange for another currency (e.g. the U.S.
dollar).
 The demand curve’s negative slope is
determined by foreign export buyers, since
the higher Canadian dollar means that
Americans find Canadian products more
expensive and so they buy fewer of them.
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The Supply of Canadian Dollars
 The supply of Canadian dollars is the
relationship between the price of a Canadian
dollar and the quantity supplied in exchange
for another currency (e.g. the U.S. dollar).
 The supply curve’s positive slope is
determined by Canadian import buyers, since
a higher Canadian dollar means that
Canadians find American products cheaper
and so they buy more of them.
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A Foreign Exchange Market
FIGURE 14.4

Canadian Dollar Demand and Supply Curves

Surplus S
0.92
a a

Price of Canadian Dollar (in $US)

Canadian Dollar Demand and 0.91
Supply Schedules b
Price of Quantity of Quantity of 0.90
Cdn. Cdn. Dollars - Cdn. Dollars
Dollar Supplied Supplied
c c
0.89
(in $US) ($ billions)
(surplus (+) or shortage (-)) Shortage

US$0.92 60 – 40 = +20
D
US$0.90 50 – 50 = 0
US$0.89 45 – 55 = -10

0 40 45 50 55 60
Quantity of Canadian Dollars (billions)

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Appreciation and Depreciation
 When an exchange rate is allowed to vary,
foreign exchange markets will reach
equilibrium where demand and supply are
equal.
 A currency appreciates when its price rises
relative to the price of another currency.
 A currency depreciates when its price falls
relative to the price of another currency.

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Changes in Exchange Rates (a)
Four factors affect exchange rates:
 price differences: A rise in A’s prices
relative to B’s reduces demand and raises
supply of A’s currency and lowers its price
in terms of B’s currency (and vice versa).
 product demand: A rise in demand for A’s
products raises demand and reduces
supply of A’s currency and raises its price in
terms of other currencies (and vice versa).
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Changes in Exchange Rates (b)
Factors affecting exchange rates (cont’d)
 interest rates: A rise in A’s interest rate relative
to B’s increases demand and decreases supply
of A’s currency, raising its price in terms of B’s
currency (and vice versa).
 Speculation: Signs that A’s currency will
increase relative to B’s currency mean an
immediate increase in demand and decrease
in supply of A’s currency and raise its price in
terms of B’s currency (and vice versa).
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Exchange Rate Changes
FIGURE 14.5

S3
d

Price of Canadian Dollar (in $US)

S2
Price of Canadian Dollar (in $US)

0.95 S0 0.95
a S1 D3
0.90 0.90
c
0.85 D0 0.85 D2
b
D1

0 50 60 0 60 70
Quantity of Canadian Quantity of Canadian
Dollars (billions) Dollars (billions)

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Flexible Exchange Rates (a)
 Flexible exchange rates are allowed to move
freely to their equilibrium levels.
 Fixed exchange rates are set or “pegged” to
a certain value by each country’s
government.
 A target exchange rate below equilibrium
creates an excess demand for the currency
and a balance-of-payments surplus.
 A target exchange rate above equilibrium
creates an excess supply for the currency and
a balance-of-payments deficit.

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Flexible Exchange Rates (b)
 A low fixed exchange rate stimulates
exports, but brings the danger of
inflation.
 A high fixed exchange rate puts
downward pressure on inflation as well
as on real output and employment.

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Fixed Exchange Rates
FIGURE 14.6

Canadian Dollar Demand and Supply Curves

Balance-of-
Payments Deficit
S

Price of Canadian Dollar (in $US)

a a
0.92
Canadian Dollar Demand and
b
Supply Schedules
0.91
Price of Quantity Quantity
-
Canadian Supplied Supplied
Dollar ($ billions) 0.90
(in $US) (surplus (+) or shortage (-))
c c
0.89
US$0.92 75 – 65 = +10
US$0.91 70 – 70 = 0 Balance-of-
US$0.89 60 – 80 = -20 Payments Surplus D

0 60 65 70 75 80
Quantity of Canadian Dollars (billions)

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Evolution of Exchange Rate
Systems
There have been three major exchange rate
systems used by industrialized countries during
the past century:
 the gold standard (1879-1934), which meant that
each country set the value of its currency in terms
of an amount of gold
 the Bretton Woods System (1945-1971), which was
based on adjustable fixed exchange rates
 the managed float (1971-the present), which is a
flexible exchange rate system that sometimes
involves short-term government intervention

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Canadian Exchange Rates

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Cities, Creativity and Diversity
According to economic thinker Jane Jacobs,
“poverty has no causes… Only prosperity has
causes.” In her view, small-scale creativity and
productive efficiency are the main drivers of
growth.
 these factors are inextricably tied to cities whose
inhabitants find ways to produce previously
imported items
 this theory also means that the main way a country
gains long-term wealth is by fostering vigorous
import-replacing cities within its borders, as in the
case of Japan, South Korea, and more recently
China

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Systems of Survival
 Jacobs devised a model of social and economic
ethics, in which diversity is again key.
 Societies thrive only if rules underlying
commerce and politics are distinct.
 Those in business must be honest, show
initiative and inventiveness, recognize the
benefits of efficiency and contracts, know when
to collaborate and compete, understand the
costs of ostentation, and forsake pessimism
about the future.
 Rulers must honour loyalty and discipline and
respect hierarchy.
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