We’ve just seen how differences in the supply of loanable funds from savings and the demand for loanable funds for investment spending lead to international capital flows. We’ve also learned that a country’s balance of payments on current account plus its balance of payments on financial account add to zero: a country that receives net capital inflows must run a matching current account deficit, and a country that generates net capital outflows must run a matching current account surplus.

The behaviour of the financial account—reflecting inflows or outflows of capital—is best described by equilibrium in the international loanable funds market. At the same time, the balance of payments on goods and services, the main component of the current account, is determined by decisions in the international markets for goods and services. So given that the financial account reflects the movement of capital and the current account reflects the movement of goods and services, what ensures that the balance of payments really do balance? That is, what ensures that the two accounts actually offset each other?

Not surprisingly, a price is what makes these two accounts balance. Specifically, that price is the exchange rate, which is determined in the foreign exchange market.

In general, goods, services, and assets produced in a country must be paid for in that country’s currency. Canadian products must be paid for in dollars; European products must be paid for in euros; Japanese products must be paid for in yen. Occasionally, sellers will accept payment in foreign currency, but they will usually then exchange that currency for their own domestic money.

International transactions, then, require a market—the foreign exchange market—in which currencies can be exchanged for each other. This market determines exchange rates, the prices at which currencies trade. (The foreign exchange market is, in fact, not located in any one geographic spot. Rather, it is a global electronic market that traders around the world use to buy and sell currencies.)

Table 19-3 shows exchange rates among the Canadian dollar and the world’s three most important currencies, as of March 21, 2013. Each entry shows the price of the “row” currency in terms of the “column” currency. For example, at that time C$1 exchanged for €0.7553, so it took €0.7553 to buy C$1. Similarly, it took C$1.3239 to buy €1. These two numbers reflect the same rate of exchange between the euro and the Canadian dollar: 1/1.3239 = 0.7553.

There are two ways to write any given exchange rate. In this case, there were €0.7553 to C$1 and C$1.3239 to €1. Which is the correct way to write it? The answer is that there is no fixed rule. In many countries, people express the exchange rate as the price of a unit of foreign currency in terms of domestic currency. However, this rule isn’t universal, and the Canadian dollar–euro rate is commonly quoted both ways. The important thing is to be sure you know which one you are using! (See the Pitfalls section on the next page.)

When discussing movements in exchange rates, economists use specialized terms to avoid confusion. When a currency increases in value in terms of other currencies, economists say that the currency appreciates. When a currency decreases in value in terms of other currencies, it is said to depreciate. Suppose, for example, that the value of €1 went from $1 to $1.25, which means that the value of C$1 went from €1 to €0.80 (because 1/1.25 = 0.80). In this case, we would say that the euro appreciated and the Canadian dollar depreciated.

Movements in exchange rates, other things equal, affect the relative prices of goods, services, and assets in different countries. Suppose, for example, that the price of a Canadian hotel room is C$100 and the price of a French hotel room is €100. If the exchange rate were €1 = C$1, then these hotel rooms would have the same price. If the exchange rate were €1.25 = C$1, then the French hotel room would be 20% cheaper than the Canadian hotel room. If the exchange rate were €0.80 = C$1, then the French hotel room would be 25% more expensive than the Canadian hotel room.

Imagine, for the sake of simplicity, that there are only two currencies in the world: Canadian dollars and euros. Europeans wanting to purchase Canadian goods, services, and assets come to the foreign exchange market, wanting to exchange euros for Canadian dollars. That is, Europeans demand Canadian dollars from the foreign exchange market and, correspondingly, supply euros to that market. Canadians wanting to buy European goods, services, and assets come to the foreign exchange market to exchange Canadian dollars for euros. That is, Canadians supply Canadian dollars to the foreign exchange market and, correspondingly, demand euros from that market. (International transfers and payments of factor income also enter into the foreign exchange market, but to make things simple we’ll ignore these.)

Figure 19-5 shows how the foreign exchange market works. The quantity of dollars demanded and supplied at any given euro–Canadian dollar exchange rate is shown on the horizontal axis, and the euro–Canadian dollar exchange rate is shown on the vertical axis. The exchange rate plays the same role as the price of a good or service in an ordinary supply-and-demand diagram. Throughout this chapter, we will express the exchange rate as the number of units of foreign currency needed to exchange for one unit of domestic currency.

The figure shows two curves, the demand curve for Canadian dollars and the supply curve for Canadian dollars. The key to understanding the slopes of these curves is that the level of the exchange rate affects exports and imports. When a country’s currency appreciates, exports fall and imports rise. When it depreciates, exports rise and imports fall. To understand why the demand curve for Canadian dollars slopes downward, recall that the exchange rate, other things equal, determines the prices of Canadian goods, services, and assets relative to those of European goods, services, and assets. If the Canadian dollar rises against the euro (the dollar appreciates), Europeans will find Canadian products to be relatively more expensive. So, they will buy less from Canada and will acquire fewer dollars in the foreign exchange market: the quantity of Canadian dollars demanded falls as the number of euros needed to buy a Canadian dollar rises. In contrast, if the Canadian dollar falls against the euro (the dollar depreciates), Europeans will find Canadian products to be relatively cheaper. So, they will buy more from Canada and acquire more dollars in the foreign exchange market: the quantity of Canadian dollars demanded rises as the number of euros needed to buy a Canadian dollar falls.

A similar argument explains why the supply curve of Canadian dollars in Figure 19-5 slopes upward: the more euros required to buy a Canadian dollar, the more dollars Canadians will supply. Again, the reason is the effect of the exchange rate on relative prices. If the Canadian dollar rises against the euro, European products look cheaper to Canadians—who will demand more of them. This will require Canadians to convert more dollars into euros.

The equilibrium exchange rate is the exchange rate at which the quantity of Canadian dollars demanded in the foreign exchange market is equal to the quantity of Canadian dollars supplied. In Figure 19-5, the equilibrium is at point E, and the equilibrium exchange rate is 0.76. That is, at an exchange rate of 30.76 per C$1, the quantity of Canadian dollars supplied to the foreign exchange market is equal to the quantity of Canadian dollars demanded.

To understand the significance of the equilibrium exchange rate, it’s helpful to consider a numerical example of what equilibrium in the foreign exchange market looks like. A hypothetical example is shown in Table 19-4. The first row shows European purchases of Canadian dollars, either to buy Canadian goods and services or to buy Canadian assets. The second row shows Canadian sales of Canadian dollars, either to buy European goods and services or to buy European assets. At the equilibrium exchange rate, the total quantity of Canadian dollars Europeans want to buy is equal to the total quantity of Canadian dollars Canadians want to sell.

Remember that the balance of payments accounts divide international transactions into two types. Purchases and sales of goods and services are counted in the current account. (Again, we’re leaving out transfers and factor income to keep things simple.) Purchases and sales of assets are counted in the financial account. At the equilibrium exchange rate, then, we have the situation shown in Table 19-4: the sum of the balance of payments on current account plus the balance of payments on financial account is zero.

Now let’s briefly consider how a shift in the demand for Canadian dollars affects equilibrium in the foreign exchange market. Suppose that for some reason capital flows from Europe to Canada increase—say, due to a change in the preferences of European investors. The effects are shown in Figure 19-6. The demand for Canadian dollars in the foreign exchange market increases as European investors convert euros into dollars to fund their new investments in Canada. This is shown by the shift of the demand curve from D₁ to D₂. As a result, the Canadian dollar appreciates against the euro: the number of euros per Canadian dollar at the equilibrium exchange rate rises from XR₁ to XR₂.

What are the consequences of this increased capital inflow for the balance of payments? The total quantity of Canadian dollars supplied to the foreign exchange market still must equal the total quantity of Canadian dollars demanded. So the increased capital inflow to Canada—an increase in the balance of payments on financial account—must be matched by a decline in the balance of payments on current account. What causes the balance of payments on current account to decline? The appreciation of the Canadian dollar. A rise in the number of euros per Canadian dollar leads Canadians to buy more European goods and services and Europeans to buy fewer Canadian goods and services.

Table 19-5 shows a hypothetical example of how this might work. Europeans are buying more Canadian assets, increasing the balance of payments on financial account from 0.5 to 1.0. This is offset by a reduction in European purchases of Canadian goods and services and a rise in Canadian purchases of European goods and services, both the result of the dollar’s appreciation. So, any change in the Canadian balance of payments on financial account generates an equal and opposite reaction in the balance of payments on current account. Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other.

Let’s briefly run this process in reverse. Suppose there is a reduction in capital flows from Europe to Canada—again due to a change in the preferences of European investors. The demand for Canadian dollars in the foreign exchange market falls, and the dollar depreciates: the number of euros per Canadian dollar at the equilibrium exchange rate falls. This leads Canadians to buy fewer European products and Europeans to buy more Canadian products. Ultimately, this generates an increase in the Canadian balance of payments on current account. So, a fall in capital flows into Canada leads to a weaker dollar, which in turn generates an increase in Canadian net exports.

In 1993, one Canadian dollar exchanged, on average, for 2.35 Mexican pesos. By 2012, the peso had fallen against the Canadian dollar by almost 82%, with an average exchange rate in 2012 of 13.16 pesos per Canadian dollar. Did Mexican products also become much cheaper relative to Canadian products over that 19-year period? That is, did Mexican products also fall in price by almost 82%, in terms of Canadian dollars? The answer is no, because Mexico had much higher inflation than Canada did over that period. So, although the exchange rate changed considerably, the relative price of Canadian and Mexican products changed little between 1993 and 2012.

To take account of the effects of differences in inflation rates, economists calculate real exchange rates, exchange rates adjusted for international differ ences in aggregate price levels. Suppose that the exchange rate we are looking at is the number of Mexican pesos per Canadian dollar. Let P_Can and P_Mex be indexes of the aggregate price levels in Canada and Mexico, respectively. Then the real exchange rate between the Mexican peso and the Canadian dollar is defined as:

To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate. To understand the significance of the difference between the real and nominal exchange rates, let’s consider the following example. Suppose that the Mexican peso depreciates against the Canadian dollar, with the exchange rate going from 10 pesos per Canadian dollar to 15 pesos per Canadian dollar, a 50% change. But suppose that the price of everything in Mexico, measured in pesos, simultaneously increases by 50%, so that the Mexican price index rises from 100 to 150. Further suppose that at the same time, Canadian prices do not change, so that the Canadian price index remains at 100. Then the initial real exchange rate is:

After the peso depreciates and the Mexican price level increases, the real exchange rate is:

In this example, the peso has depreciated substantially in terms of the Canadian dollar, but the real exchange rate between the peso and the Canadian dollar hasn’t changed at all. And because the real peso–Canadian dollar exchange rate hasn’t changed, the nominal depreciation of the peso against the Canadian dollar will have no effect, either on the real quantity of goods and services exported by Mexico to Canada or on the real quantity of goods and services imported by Mexico from Canada.

To see why, consider again the example of a hotel room. Suppose that this room initially costs 1000 pesos per night, which is $100 at an exchange rate of 10 pesos per dollar. After both Mexican prices and the number of pesos per dollar rise by 50%, the hotel room costs 1500 pesos per night—but 1500 pesos divided by 15 pesos per dollar is $100, so the Mexican hotel room still costs $100. As a result, a Canadian tourist considering a trip to Mexico will have no reason to change plans.

The same is true for all goods and services that enter into trade: the current account responds only to changes in the real exchange rate, not the nominal exchange rate. A country’s products become cheaper to foreigners only when that country’s currency depreciates in real terms, and those products become more expensive to foreigners only when the currency appreciates in real terms. As a consequence, economists who analyze movements in exports and imports of goods and services focus on the real exchange rate, not the nominal exchange rate.

Figure 19-7 illustrates just how important it can be to distinguish between nominal and real exchange rates. The line labelled “Nominal exchange rate” shows the number of pesos it took to buy a Canadian dollar from July 1993 to December 2012. As you can see, in nominal terms, the peso depreciated massively over that period. But the line labelled “Real exchange rate” shows the real exchange rate: it was calculated using Equation 19-4, with price indexes for both Mexico and Canada set so that 1993 = 100. In real terms, the peso depreciated between 1994 and 1995, but not by nearly as much as the nominal depreciation. By the end of 2012, the real peso–Canadian dollar exchange rate was just about back where it started.

A useful tool for analyzing exchange rates, closely connected to the concept of the real exchange rate, is known as purchasing power parity. The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Purchasing power parity is an example of the economic concept of the Law of One Price, the idea that perfectly substitutable goods, in this case baskets, must sell for the same price in equilibrium. Suppose, for example, that a basket of goods and services that costs C$100 in Canada and the same basket costs US$97.55 in the United States. Then the implied purchasing power parity exchange rate is 0.9755 U.S. dollars per Canadian dollar: at that exchange rate, US$97.55 = C$100, the market basket costs the same amount in both countries. In other words, if purchasing power parity holds, the nominal exchange rate is given by the relative price ratio between two countries. In this case:

Calculations of purchasing power parities are usually made by estimating the cost of buying broad market baskets containing many goods and services—everything from automobiles and groceries to housing and telephone calls. But as the For Inquiring Minds below explains, once a year the magazine The Economist publishes a list of purchasing power parities based on the cost of buying a market basket that contains only one item—a McDonald’s Big Mac.

Nominal exchange rates almost always differ from purchasing power parities. Some of these differences are systematic: in general, aggregrate price levels are lower in poor countries than in rich countries because services tend to be cheaper in poor countries. But even among countries at roughly the same level of economic development, nominal exchange rates vary quite a lot from purchasing power parity. Figure 19-8 shows the nominal exchange rate between the U.S. dollar and the Canadian dollar, measured as the number of U.S. dollars per Canadian dollar, from 1990 to 2012, together with an estimate of the purchasing power parity exchange rate between Canada and the United States over the same period. The purchasing power parity didn’t change much over the whole period because Canada and the United States had about the same rate of inflation. At the beginning of the period the nominal exchange rate was above purchasing power parity, so a given market basket cost more in Canada than in the United States. But in 2002, the nominal exchange rate was below the purchasing power parity, so a market basket cost less in Canada than in the United States.

Over the long run, however, purchasing power parities are pretty good at predicting actual changes in nominal exchange rates. In particular, nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket. In fact, by 2005 the nominal exchange rate between Canada and the United States was US$0.824 per C$1, just about the purchasing power parity. And in recent years the cost of living was higher in Canada than in the United States.