Macroeconomics 10b

depreciation

A fall in the value of the Canadian dollar is a

appreciation of the dollar

A rise in the value of the Canadian dollar

Managed Flexible Exchange Rate Regime "Managed Float"

A third type of exchange rate regime is called a Managed Float. In this regime, the exchange rate is flexible, but the central bank will intervene occasionally to prevent speculators from creating exaggerated short-term fluctuations in the exchange rate. The bank intervenes by buying or selling official reserves versus its own currency.

EXCHANGE RATES

An exchange rate is simply the value of one currency in terms of another. It is always calculated as a ratio. The ratio is usually the Canadian dollar price of one unit of foreign currency.

Fixed or Pegged Exchange Rates

Fixed or Pegged Exchange Rates We have seen in a flexible exchange rate regime that it is the forces of demand and supply in the foreign exchange market that determine exchange rates. In contrast, in a regime of fixed exchange rates, the central bank fixes or pegs the exchange rate at a given level. Although Canada has a flexible exchange rate, we can illustrate the workings of a fixed exchange rate regime by imagining that the Bank of Canada has pegged the exchange rate between the C$ and the US$. Suppose the Bank of Canada has fixed the exchange rate at C$1.10 to the US$. Now suppose that there is a drop in demand for the C$. Instead of allowing the C$ to depreciate, the Bank would intervene in the market and offer to buy Canadian dollars and sell some of its reserves of US dollars. This would prevent the depreciation of the C$. Conversely, if there was a rise in demand for C$, the Bank of Canada would offer to sell C$ and buy US$. In this way it would prevent the appreciation of the Canadian dollar. When a central bank manages the exchange rate in this way, its foreign exchange reserves will rise or fall each time it intervenes in the market. The balance of these transactions will appear in the Capital Account of the Balance of Payments. In a fixed exchange rate regime, if the central bank wishes to increase the value of its currency, it will revalue the currency. E.g. The Bank of Canada could revalue the C$ to 1.05 US$. (This is an increase in the value of the Canadian dollar because it now takes fewer C$ to buy one US$). If the central bank wishes to decrease the value of its currency, it will devalue its exchange rate. E.g. The Bank of Canada could devalue the C$ to 1.15 US$. (This is a decrease in the value of the Canadian dollar because it now takes more C$ to buy one US$.)

Floating or Flexible Exchange Rates:

In a floating or flexible regime, the exchange rate of a currency is determined by the forces of global demand and supply for that currency. We can show the determination of the exchange rate between the C$ and the US$ in a diagram using demand and supply curves for the Canadian dollar. This is shown in the diagram below. The vertical axis measures the price of one Canadian dollar in U.S. dollars. That price is US$.78. The horizontal axis measures the Quantity of C$.

The Demand for Canadian Dollars

In the preceding diagram we can see that the Demand curve (D) for Canadian dollars has a negative slope. This means that as the (US$) price of Canadian dollars increases, the quantity demanded of C$ decreases. The demand curve for Canadian dollars is therefore like the demand curve for most goods.

The Supply of Canadian Dollars

In the preceding diagram we can see that the Supply curve (S) for C$ has a positive slope. This means that as the (US$) price of Canadian dollars increases, the quantity supplied of C$ also increases. In general, people are more willing to sell their C$ at a higher price than at a lower price.

Equilibrium

The equilibrium exchange rate occurs where the quantity demanded of Canadian dollars equals the quantity supplied. This equilibrium occurs where the D and S curves intersect at an exchange rate of US$.78. The exchange rate between the C$ and the US$ fluctuates a great deal, even over the course of a single day. These fluctuations occur as a result of changes in the demand for or supply of Canadian dollars.

an appreciation of the C$ against the US$ means

a depreciation of the US$ against the C$.

Exchange rates can be

fixed or floating.

What determines the position of the Demand Curve for C$?

• Exports: If foreigners want to buy Canadian goods and services, they need to buy Canadian dollars to pay for those goods and services. Therefore the amount of C$ demanded depends on the amount of goods and services we export. • Sales of Canadian assets such as stocks, bonds, real estate, and businesses. If foreigners want to buy these assets, they will demand C$ to pay for them. o The demand for some of these assets, such as bonds, will depend on relative interest rates. If Canadian interest rates increase relative to foreign interest rates, there will be a greater demand for Canadian bonds. It is important to recognize that the Demand for one currency is the Supply of another currency. For example, when Americans want to buy Canadian dollars, they will pay for these Canadian dollars using US$, thereby supplying US$. Therefore, the events listed above that will affect the demand for C$ will also affect the supply of US$ or other foreign currencies.

What Determines the Position of the Supply Curve for C$?

• Imports: If Canadians import goods and services from other countries they will need foreign currencies to pay for these imports. Foreign currencies will be paid for with Canadian dollars which will increase the supply of C$ on the foreign exchange market. • Sales of Canadian assets. The effect on the supply of Canadian dollars is the opposite of the effect on the demand for Canadian dollars. o If Canadian interest rates rise, relative to foreign rates, people will buy or keep Canadian bonds, and will buy fewer foreign assets. Therefore they will sell or supply a lower quantity of C$.