The Balance of Payments and the Exchange Rate

Throughout most of her history Canada has been running current account deficits. Why have these deficits been occurring? Does this mean that the country is living beyond its means? Could the current account be brought to a zero balance by putting tariffs on imports as is often suggested by Canadian nationalists? Is the equilibrium level of the current account zero?

Canada has traditionally run current account deficits because the investment opportunities in the country have far exceeded the savings of Canadian residents. As a result there has been a net capital inflow which, by putting upward pressure on domestic aggregate demand, has caused the real exchange rate to be sufficiently high to create an excess of imports over exports exactly equal to the net capital inflow plus the debt service deficit. The desired surplus of imports over exports must be equal to the net capital inflow plus the debt service deficit as a condition of domestic real goods market equilibrium.

There has been a debt service deficit because a considerable fraction of the capital employed in Canada is owned either directly or indirectly by foreigners--foreigners' earnings on this capital must be repatriated abroad every year.

As long as the net capital inflow is being used to finance investment rather than consumption, Canada is not living beyond its means. Indeed, the country would only be living beyond its means if Canadian savings were negative--i.e., consumption exceed income. Aggregate savings in Canada has been positive throughout the country's history.

Any attempt to bring the current account to zero by imposing tariffs on imports in order to reduce imports relative to exports would result in a switch of world demand onto domestic goods and an increase in the aggregate demand for domestic output. If the exchange rate were fixed this would result in a rise in the domestic price level and a rise in the real exchange rate. This will switch world demand back off Canadian goods, causing imports to rise again relative to exports until the current account balance has returned to where it was before the tariff was imposed. If the monetary authority holds the domestic price level constant, the nominal value of the Canadian dollar will rise in the foreign exchange market, and the real exchange rate will appreciate, until the excess demand has been shifted off Canadian goods and the current account balance has returned to its pre-tariff level.

The current account remains unchanged in the face of the tariff because nothing has happened to change either Canadian savings or the level of investment in Canada. Because the equilibrium net capital flow has not changed, the equilibrium current account balance cannot change. This is a condition of equilibrium between domestic aggregate demand and supply. The real exchange rate must adjust until the current account balance is just sufficient to finance the net capital inflow. This determines the equilibrium real exchange rate. The equilibrium nominal exchange rate (viewed as the price of the Canadian dollar in terms of foreign currency) will equal the equilibrium real exchange rate multiplied by the ratio of the rest-of-world price level to the Canadian price level.

Let the real exchange rate be defined as

q = Pd /(pi Pf)

where pi is the Canadian dollar price of foreign currency. This equation can be manipulated into the form

1/pi = q (Pf/Pd)

where 1/pi is the foreign currency price of the Canadian dollar. At a given real exchange rate, inflation in Canada will raise Pd and lower the value of the Canadian dollar in the foreign exchange market. A tariff on Canadian imports will raise q by a sufficient amount to maintain the current account balance equal to the unchanged net capital inflow. If the nominal exchange rate is fixed, there will have to be a rise in Pd in exact proportion to the rise in q. If the exchange rate is flexible and the government follows a monetary policy that will maintain Pd constant, then pi must fall (1/pi must rise) in exact proportion to the rise in q.

The equilibrium current account deficit is that deficit that will just equal the net capital inflow. The equilibrium current account balance will only be zero if the equilibrium level of domestic savings equals the equilibrium level of domestic investment.

In the period from 1896 to 1914 there is a clear positive empirical relationship between Canada's real exchange rate and her current account deficit. During the period after World War II, no such relationship is evident. Why? What does this tell us about the effect of a devaluation on the current account balance?

During the period 1896-1914 there were substantial capital inflows into Canada associated with the settlement of the Prairie Provinces. These inflows occurred because, at the time, Canada was an excellent place to invest. The effect of the inflow of capital was to put pressure on domestic aggregate demand as domestic investment expanded. Given the fact that Canada was on the gold standard and her exchange rates with respect to other countries were fixed, the upward pressure on aggregate demand caused the Canadian price level to rise relative to price levels abroad. Canada's real exchange rate thus appreciated and a deficit in her current account sufficient to finance the inflow of capital was thereby created.

If we look at the data on the real exchange rate and the current account for the period we will observe a negative relationship between the two variables---a rise in the real exchange rate was associated with a decline in the current account surplus (increase in the current account deficit). That data would tend to confirm the notion that a devaluations "improve" the current account.

During the period after World War II there were changes in the net capital inflow in both directions from time to time. But more importantly during this period, there were shifts in world demand for Canadian exports and in Canadian demand for imports from abroad of similar magnitude to the shifts in the net capital flow. Shifts in desired exports and imports occurred in the period between 1896 and 1914 too, of course, but these were small in comparison to the enormous shift in the net capital inflow. An increase in the world demand for Canadian exports, like an increase in domestic investment, puts upward pressure on domestic aggregate demand. This will cause the price level to rise if the exchange rate is fixed. When the exchange rate is flexible and the government conducts a monetary policy that will stabilize the domestic price level, the increase in exports will create an excess demand for the Canadian dollar in world markets and an appreciation of the real exchange rate through nominal exchange rate increases rather than price level increases. This appreciation of the real exchange rate will be sufficient, under either fixed or flexible exchange rates, to eliminate the excess of desired exports over imports. Since the net capital flow has not fundamentally changed, the current account balance will return to its initial level. Recall that the real exchange rate must adjust to keep the desired current account deficit equal to the desired net capital inflow.

In the above example, we would observe no relationship between the real exchange rate and the current account balance. On the basis of this observation, one might be tempted to include that devaluations do not lead to "improvements" in the current account. Such a conclusion would be erroneous, of course, because the observed appreciation was necessary to remove what would have otherwise been an "improvement" in the current account.

This illustrates that we cannot test the proposition that devaluations "improve" the current account by looking at observed relationships between the current account balance and the real exchange rate. If the current account balance has to adjust to an exogenous change in the net capital flow, then a devaluation will be associated with an increase in the current account surplus. If there is a shock to exports and imports, on the other hand, the real exchange rate will have to adjust to offset the effect of that shock on the current account, and no relationship between the movement of the real exchange rate and the current account will be observed.

In normal periods, when there are not huge shifts in investment between countries, major shocks in desired exports and imports and saving and investment will all be occurring simultaneously. The effects of all these simultaneous shocks on the current account balance will be sometimes positive and sometimes negative. And the effects on the real exchange rate will be sometimes positive and sometimes negative. Overall, there is no particular reason why we should observe the positive effects of these shocks on the real exchange rate to be associated with negative effects on the current account balance. Sometimes the real exchange rate and the current account balance will be positively related, sometimes they will be negatively related and sometimes there will be no apparent relationship---it will depend on the magnitudes of the underlying shocks to saving and investment in comparison to the magnitudes of the shocks to desired exports and imports.

It is clearly true that a desire to import more from abroad at a given level of desired exports will put downward pressure on the currency. It is not true, however, that an observed current account deficit is an indication of a future decline in the dollar. Indeed, if desired exports and imports have not exogenously shifted, a current account deficit will be the result of an appreciation of the exchange rate that brings the current account into line with an exogenous increase in the net capital inflow. This increased net inflow of capital could be the result of either a shift of world investment into the domestic economy or a decline in domestic savings. The dollar will appreciate to create a current account deficit equal to the increase in the net capital flow, not devalue because of the observed deterioration of the current account. The analyst is incorrectly associating an observed deterioration of the current account with a desired increase in imports relative to exports. Current account changes associated with shocks to desired exports and imports never actually appear. The exchange rate will adjust to eliminate them and we will have no way of observing whether they have occurred.

To answer the first part of the question we can refer to what was demonstrated in the answer to the immediately preceding question---the observed combinations of the exchange rate and the current account balance tell us nothing about the underlying theoretical relationship between the real exchange rate and the current account. A devaluation of the dollar can be associated with either an increase in the current account balance or a decline---it depends upon what was happening to desired exports and imports and desired savings and investment.

With regard to the second part of the question, there is no reason why an observed deterioration of the current account should lead to a devaluation of the domestic currency in the immediate future. If the increased deficit in the current account resulted from and appreciation of the the currency to maintain goods market equilibrium in the face of a shift of world investment into the domestic economy and there is reason to believe that the increase in domestic investment will be temporary, then a future devaluation may occur when the domestic investment boom dissipates. But that assumes that a positive shock to desired exports or negative shock to desired imports does not occur at the same time in sufficient magnitude to cause the real and nominal exchange rate to appreciate at the same time that investment declines.

Note also that in an environment of flexible exchange rates like the present Canadian one, the nominal value of the Canadian dollar can appreciate when the real value of the dollar is falling if Canada's price level is rising at a sufficiently slower rate than the U.S. price level.

Why do analysts make such statements? This is a matter of speculation, beyond the purview of economic analysis. Writers of popular articles rely on the appreciation of their readers. Readers can be expected to like financial analysts whose conclusions seem reasonable to them and regard arguments they don't understand with suspicion. It would perhaps seem obvious to the uninformed that an expansion of (desired) imports relative to exports would cause the currency to deteriorate in value and that evidence from Statistics Canada that the current account has deteriorated is an indication that (desired) imports have increased relative to (desired) exports. An attempt to show the fallacy of this view by arguing about real goods market equilibrium would probably cause typical readers' eyes to gloss over! Those who write articles for financial newspapers for a living and want to eat and live well are well advised to keep this in mind.

One also often hears "nonsense" arguments from business economists who have formal training in economics and "should know better". There is the same pressure on these economists as there is on financial writers. Listeners of TV clips or readers of quotes in the financial papers think highly of arguments that seem cogent to them, and view the type of logical argument we are engaging in here, which they don't understand, as theoretical speculation. Business economists who want listeners to think that the firm they represent engages in "good" economic analysis will be wise to say things that conform to the conventional "wisdom". The firms whose services they are advertizing will, one would suspect, accept nothing less. This gives us reason to regard very highly those business economists who have the expositional skills to entertain their listeners and get the argument right at the same time.