Chapter 10B | Exchange Rates and Payments with the Rest of the World

Question 1

International Transmission Mechanisms

Answer 1

Exchange rates affect real GDP and inflation through the international transmission mechanism affecting net exports, aggregate demand, and the price level.

Question 2

International transmission mechanism

Answer 2

• how exchange rates affect real GDP and inflation

Question 3

Appreciating C$ is negative aggregate demand shock

Answer 3

Decreases net exports;

Decreases aggregate demand.

Decreasing real GDP

Increasing unemployment

Decreases inflation

Question 4

Depreciating C$ is positive aggregate demand shock

Answer 4

Increases net exports;

Increasing aggregate demand

Increasing real GDP

Decreasing unemployment

Increases inflation

Purchases the economy into expansion

Question 5

Advantages and disadvantages to both higher and lower exchange rates

Answer 5

Appreciating C$ makes imports less expensive, but is negative demand shock, hurting exporters, decreasing real GDP, increasing unemployment, decreasing inflation

Depreciating C$ makes imports more expensive, but is positive demand shock, helping exporters, increasing real GDP, decreasing unemployment, increasing inflation

Question 6

There is no socially “best” exchange rate

Answer 6

only trade-offs between winning and losing groups

Question 7

Purchasing Power Parity and Rate of Return Anchors

Answer 7

The law of one price, purchasing power parity, and rate of return parity are the best available standards for predicting where exchange rates eventually settle, despite their limitations.

Question 8

How do we predict where exchange rates settle

Answer 8

Law of one price

Question 9

Law of one price

Answer 9

profit seekers eliminate differences across markets in prices of same product

Question 10

Purchasing power parity (PPP)

Answer 10

exchange rates adjust so that money has equal real purchasing power in any country

C$15 buys exactly same products in Canada – and when converted into US$ at PPP exchange rate – and in the United States

Question 11

If $1 Canadian = 67 cents US, then PPP

Answer 11

Money, when converted to other currency buys same real goods

Question 12

If purchasing power parity does not hold, for example, Canadian $ more valuable than U.S. dollar for purchases (C$1=US$1)

Answer 12

People sell C$ for US$ = supply Canadian $ goes up

Canadian $ depreciates

Question 13

When PPP does not exist

Answer 13

profit-seeking forces and law of one price push exchange rate toward PPP rate

Question 14

What does PPP not account for

Answer 14

PPP does not account for trading limitations and the role of speculators influencing exchange rates

Question 15

Return of parity (interest rate parity)

Answer 15

rates of return on investments are equal across countries, accounting for expected depreciation or appreciation of exchange rates

Question 16

Rate of Return Formula example

Answer 16

Rate of Return In Japan = Rate of Return in Canada - expected (depreciation [-] or appreciation [+]) of yen against C$

3% = 5% - (+2%)

Japanese investor converts yen into C$ to invest at 5%. At year end, must convert C$ back to yen. Yen appreciated by 2%, so C$ depreciated by 2%.

Outcome
5% return in Canada - 2% loss converting C$ back to yen = 3% return (same as rate if invested in Japan)

Question 17

Different systems for determining exchange rates

Answer 17

Floating exchange rate

Fixed exchange rate

Question 18

Floating exchange rate

Answer 18

determined by demand and supply in foreign exchange market

Question 19

Fixed exchange rate

Answer 19

determined by governments or central banks [Earlier gold standard as fixed exchange rate]

Question 20

International Balance of Payments

Answer 20

The two main parts of the balance of payments accounts – the current account and the financial account – must add up to zero.

Question 21

Balance of payments accounts

Answer 21

measure a country’s international transactions

Current account
Financial (capital) account
Statistical discrepancy

Question 22

Flows of C$

Answer 22

Into Canada are positive numbers on balance of payments accounts
Out of Canada are negative numbers

Question 23

Current account measures flows from

Answer 23

exports, imports (and net investment/labour/transfer
income)

• Canadian exports creative positive inflow of C$; imports create negative outflow of C$
• Current account deficit
• Current account surplus

Question 24

Current account deficit

Answer 24

(negative balance) when Canadian spending on imports from R.O.W. is greater than R.O.W. spending on Canadian exports (and net investment/labour/transfers)

Question 25

Current account surplus

Answer 25

(positive balance) when R.O.W. spending on Canadian exports is greater than Canadian spending on imports from R.O.W. (and net investment/labour/transfers)

Question 26

Financial (capital) account measures

Answer 26

international investments in financial assets like bonds and direct investment in buying companies

• Canadian investments in R.O.W. are negative outflows of C$; R.O.W. investments in Canada are positive inflow of C$
• Financial account deficit
• Financial account surplus

Question 27

Financial account deficit

Answer 27

negative balance) when Canadian investments in R.O.W. greater than R.O.W. investments in Canada

Question 28

Financial account surplus

Answer 28

(positive balance) when R.O..W investments in Canada are greater than Canadian investments in R.O.W.

Question 29

Statistical discrepancy for missing data and errors is not important for balance of payments accounts

Answer 29

Statistical discrepancy for missing data and errors is not important for balance of payments accounts

Question 30

Balance of Payments Formula

Answer 30

Current Account Balance + Financial Account Balance + Statistical Discrepancy = 0

The balance of payments accounts must add to zero

Question 31

When there is a current account surplus there is financial (capital) account deficit

Answer 31

If R.O.W. spends more on Canadian exports than Canadians spend on R.O.W. imports, where does R.O.W. get extra C$?

From financial account deficit, with Canadians “loaning” R.O.W. extra C$ through investments