CHAPTER 14. Copyright 2010 by McGraw-Hill Ryerson Limited. All rights reserved. Chapter

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1 CHAPTER 14 1a. A boom in the American economy creates additional demand for Canadian exports, increasing Canada s merchandise and nonmerchandise trade receipts. This has a positive effect on Canada s balance of trade. b. A higher value of the Canadian dollar in terms of the U.S. dollar makes Canadian products more expensive relative to those from the U.S. Canadian exports therefore become less attractive in the U.S., pushing down Canada s merchandise and nonmerchandise trade receipts, and American imports become more attractive in Canada, pushing up Canada s merchandise and nonmerchandise trade payments. Both trends have a negative effect on Canada s balance of trade. c. As more goods and services are produced in Canada, Canadian exports rise, pushing up Canada s merchandise and nonmerchandise trade receipts, and foreign imports fall, pushing down Canada s merchandise and nonmerchandise trade payments. Both trends have a positive effect on Canada s balance of trade. d. A "made in Canada" recession reduces Canadian demand for foreign imports, pushing down Canada s merchandise and nonmerchandise trade payments. This has a positive effect on Canada s balance of trade. 2. In this increasingly common situation, Canada s merchandise trade surplus is so high (due to factors such as an American boom, a Canadian recession, or a low Canadian dollar) that the current account shows a surplus. As a result, it is likely that the capital and financial accounts will be pushed into a deficit, meaning that there are more investments by Canadians in foreign markets that by foreigners in the Canadian market. 3a. merchandise trade, payment b. investment income, payment c. investment income, receipt d. trade in services, payment e. trade in services, receipt f. transfers, payment g. merchandise trade, receipt 4a. financial account, direct investment, receipt b. financial account, portfolio investment, payment c. financial account, other financial investments, receipt d. financial account, portfolio investment, receipt e. financial account, direct investment, payment f. financial account, other financial investments, payment g. capital account, receipt h. capital account, payment i. capital account, receipt 5a. - b. Delphi s merchandise balance of trade is -$140.2 million (= +$183.4 m. - $323.6 m.), and its balance of trade is -$49.7 million (= -$140.2 m. + $90.5 m.). c. Given an investment income balance of +$34.4 million, Delphi has a current account surplus of (+)$17.0 million (= -$140.2 m. + $90.5 m. + $34.4 m. + $32.3 m.), and, given a capital account balance of $1.2 m., and a portfolio investment balance of -$13.1 million, the capital and financial accounts have a deficit of (-)$9.2 million (= $1.2m. -$20.2 m. - $13.1 m. + $22.9 m.). Chapter

2 d. Delphi has a balance of payments surplus of (+)$12.3 million (= +$17.0 m. - $9.2 m. + $4.5 m.), which is the sum of the current and capital and financial account balances as well as the statistical discrepancy. e. Delphi s "change in official reserves" has a value of -$12.3 million, which matches the (+)$12.3 million balance of payments surplus, so that Delphi s balance of payments accounts sum to zero. This means that Delphi s central bank sold $12.3 million of its out currency and bought foreign currency in order to keep down the value of Delphi s currency. 6a. U.S. dollar price = Canadian dollar price x U.S. dollars to buy CDN $1.00 = $520 x $0.81 = $ b. Canadian dollar price = U.S. dollar price x Canadian dollars to buy U.S. $1.00 = $ x $1.22 = $ c. U.S. dollar price = Canadian dollar price x U.S. dollars to buy CDN $1.00 = $3.00 x (1/$1.25) = $2.40 d. Canadian dollar price = U.S. dollar price x Canadian dollars to buy U.S. $1.00 = $82 x (1/.80) = $ a. FIGURE 14A-1 Canadian Dollar Demand And Supply Curves b. With a flexible exchange rate, the Canadian dollar has its equilibrium value of US$0.79. Chapter

3 c. A target exchange rate of US$.0.81 contributes to a balance of payments deficit of (-)$40 billion and a value of +$40 billion for Canada s "changes in official reserves" (since the combined effect of the balance of payments accounts must be zero). To maintain the value of the Canadian dollar above its equilibrium value, the Bank of Canada must be buying Canadian dollars and selling foreign currency. d. A target exchange rate of US$0.78 leads to a balance of payments surplus of (+)$20 billion and a value of -$20 billion for "changes in official reserves" (since the combined effect of the balance of payments accounts must be zero). To maintain the value of the Canadian dollar below its equilibrium value, the Bank of Canada must be selling Canadian dollars and buying foreign currency. 8a. A rise in Canadian interest rates makes Canadian bonds more appealing to financial investors in both Canada and the United States. With more American purchases of Canadian bonds, the demand for Canadian dollars in this foreign exchange market increases, as from D 2 to D 3 in the right-hand graph of Figure 14.5 in the chapter. Similarly, Canadians are more likely to buy Canadian rather than American bonds, decreasing the supply of Canadian dollars, as from S 2 to S 3 in the same graph. The result, as shown in the graph, is a rise in the price of the Canadian dollar in terms of U.S. dollars. b. Falling real output in the United States means a drop in American spending on Canadian exports. This decreases the demand for Canadian dollars in this foreign exchange market, as from D 0 to D 1 in the left-hand graph of Figure 14.5 in the chapter. At the same time, a rise in Canada s real output causes more Canadian spending on American imports, increasing the supply of Canadian dollars, as from S 0 to S 1 in the same graph. The result, as shown in the graph, is a fall in the price of the Canadian dollar in terms of U.S. dollars. c. As American make more financial investments in Canada, the demand for Canadian dollars in this foreign exchange market increases, as from D 2 to D 3 in the right-hand graph of Figure 14.5 in the chapter. In this case, there is no effect on the supply curve for Canadian dollars. The result as shown by a movement from the intersection of S 2 and D 2 to S 2 and D 3 in the same graph, is a rise in the price of the Canadian dollars in terms of U.S. dollars. d. As "snowbirds" become more likely to travel outside Canada, the supply of Canadian dollars in this foreign exchange market increases, as from S 0 to S 1 in the left-hand graph of Figure In this case, there is no effect on the demand curve for Canadian dollars. The result, as shown by a movement from the intersection of S 0 and D 0 to S 1 and D 0 in the same graph, is a fall in the price of the Canadian dollars in terms of U.S. dollars. e. As Americans choose make more financial investments in Canada, the demand for Canadian dollars in this foreign exchange market increases, as from D 2 to D 3 in the right-hand graph of Figure 14.5 in the chapter. Meanwhile, Canadians will also choose to make more financial investments in Canada. Therefore the supply for Canadian dollars in this market decreases, as from S 2 to S 3 in the same graph. The result, as shown in the graph, is a rise in the price of the Canadian dollars in terms of U.S. dollars. 9. When the US$ exchange rate of the Canadian dollar rises, the Canadian dollar buys more in terms of US$, which increases the incentive for Canadians to engage in cross-border shopping. In contrast, a fall in the Canadian dollar s US$ value reduces cross-border shopping. 10. The main advantages of a fixed exchange rate in terms of the U.S. dollar is that this policy would eliminate the uncertainty that currency fluctuations Chapter

4 cause in Canada-U.S. trade as well as in financial investment between the two countries. The main disadvantages of this policy are (i) the Bank of Canada would have to use monetary policy to maintain the Canadian dollar at its target value rather than using monetary policy as a stabilization tool, and (ii) it would be impossible to shield the Canadian economy from American inflation. 11.With the gradual growth in the net flow of direct and portfolio investment to emerging economies, the demand for the emerging economies currencies will increase, gradually pushing up the exchange rates of these currencies. 12a. When the Bank of Canada raises its target range for the overnight rate, other interest rates rise as well. Investment and consumption spending on durables decrease, shifting the AD curve leftward and reducing inflationary pressures. At the same time, the rise in interest rates heightens the value of the Canadian dollar, decreasing net exports and adding to the AD curve s leftward shift, while also cutting the inflation rate due to the fall in import prices. b. The exchange rate adjustment reinforces Bank policy and makes monetary policy more effective than it would otherwise be. c. Given the reinforcing nature of exchange rate adjustments, with flexible exchange rates, this system makes monetary policy more effective than would be the case with fixed exchange rates. 13. With time, lenders in global financial markets began to view the public debts of high-borrowing euro-zone countries as unsustainable. Without the huge loan guarantees provided by other European nations (Germany in particular) these high-borrowing countries would have been forced into default, as interest rates on their newly issued public debt rose to crushingly high levels. Even with the guarantees of their euro-zone partners, interest rates on these countries debt have remained high, imposing significant future burdens on their taxpayers. Internet Application Questions 1. Answers are found by accessing 'Exchange Rates', 'Average Rates', 'Annual Averages present'. 2a. Answer found in links to 'Economy', 'Trade', 'Data', 'Trade', and 926 (Exchange Rates, in Canadian Dollars, Monthly, Unadjusted). Click on 'Mthly B3400 USA Noon Spot Rate (Dollar) in Canadian Dollars' and then press down the control key and click on 'Mthly B3404 France Noon Spot Rate (Franc) in Canadian Dollars', 'Mthly B3405 Germany Noon Spot Rate (Deutsche mark) in Canadian Dollars', and 'Mthly B3412 UK (Pound) Noon Spot Rate in Canadian Dollars'. Then click on 'Go' and 'Go'. Under 'Output Format' click on '2D Line Graph'. Then press 'Go'. You can print out the resulting graph. b. The US dollar, French franc, and Deutsche mark have all risen against the Canadian dollar, while the British pound has fallen against the Canadian dollar. ANSWERS TO QUESTIONS AT THE END OF 'CITIES, CREATIVITY and DIVERSITY' 1. Often cost-reducing changes apply in more than one sector. If various sectors are clustered in a local area, it is more likely innovations will Chapter

5 spread from one sector to another. A wide variety of examples could be used to show such a link. To take an historical illustration, the introduction of railways in British cities during the latter part of the Industrial Revolution reduced transportation costs in a raft of these cities industries, from steel to textiles. 2. According to both Jane Jacobs and John Kenneth Galbraith, corporate managers can all too easily act in ways that go against the interest of their shareholders. For example, when the desire to gain personal glory leads managers to take over competitors, they often misuse shareholders funds by overpaying for the rival companies shares. ANSWERS TO QUESTIONS AT THE END OF 'A NEW CAPITALIST MANIFESTO (at the Online Learning Centre) 1. The main problem faced by those living in the extralegal sector is a lack of defined property rights, which means minimal access to borrowed funds, and a significant risk that assets considered to be personally owned could be taken away without legal protection. 2. Because those living in the extralegal sector already have already built up complex systems of property relations, any successful incorporation of this sector into formal property systems will require that these informal relations be analyzed and recognized, de Soto contends. ANSWERS TO QUESTIONS AT THE END OF GOING GLOBAL (at the Online Learning Centre) 1a. If Canada is seen as a less attractive location for direct investment, the drop in foreign direct investment will reduce Canada s foreign liabilities, raising the country s net foreign assets - in other words, leading to a smaller negative value. b. If Canadian governments borrow more, foreign portfolio investment will rise, which raises Canada s foreign liabilities and reduces its net foreign assets, leading to a larger negative value. c. A fall in Canadian interest rates relative to other countries leads to a decline in foreign portfolio investment, which reduces Canada s foreign liabilities and raises its net foreign assets, leading to a smaller negative value. 2. Answers may differ depending on how the benefits and costs of foreign direct investment are weighted. The benefits of higher Canadian living standards and lower prices for both Canadian and foreign consumers must be compared with the costs associated with higher foreign liabilities, decreased economic sovereignty, and lower domestic R&D expenditures. In practice, supporters of foreign direct investment tend to place most emphasis on its positive effect on productivity, while critics focus most attention on the diminution of national economic sovereignty. Chapter