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learning Objectives
1. Learn about the origins of the World Bank and the International Monetary Fund.
2. Understand the purpose of the International Monetary Fund both during the fixed exchange rate regime from 1945 to 1973 and after 1973.
After the Great Depression, one of the things policymakers thought was important was to return the international economy to a system of fixed exchange rates. Before the Depression (i.e., in the 1920s and before), the world mostly maintained a gold standard. Under such a system, a country establishes two rules: first, it fixes its currency value to a weight of gold; second, it establishes convertibility between the currency and gold. This means that any individual holding the national currency is allowed to cash in the currency for its equivalent in gold upon demand.
In essence, the gold standard derives from a system in which gold itself was used as a currency in exchange. Since gold was sufficiently rare and because it was inherently valuable to people, it was an ideal substance to use as a store of value and a medium of exchange (as was silver). However, once trucking gold around became more difficult, it became easier for governments to issue paper currency but to back up that currency with gold on reserve. Thus currency in circulation was just a representation of actual gold in the government’s vault, and if a person ever wished to see that actual gold, he or she could simply demand conversion.
There is much that can be said about how a gold standard operates, but that discussion is reserved for a later chapter. For our purposes here, it is sufficient to explain that the gold standard was a system of fixed exchange rates. For example, before the 1930s the United States fixed the dollar at \$20.67 per ounce of gold. During the same period, the United Kingdom fixed its currency at £4.24 per ounce. As a result of the gold-currency convertibility in both countries, this meant the dollar and pound were fixed to each other at a rate of \$4.875/£.
During the Depression years, most countries dropped off the gold standard because the loss of confidence threatened a complete conversion of currency to gold and the depletion of national gold reserves. But, as World War II drew to a close, experts were assembled in Bretton Woods, New Hampshire, in the United States in 1944 to design a set of institutions that would help establish an effective international monetary system and to prevent some of the adjustment catastrophes that occurred after World War I. One such catastrophe occurred in Germany in 1922 to 1923 when a floating German currency resulted in one of the worst hyperinflations in modern history. Photos from that period show people with wheelbarrows full of money being used to make basic purchases. One way to prevent a reoccurrence was to establish a system of fixed exchange rates. As will be shown later, an important benefit of fixed exchange rates is the potential for such a system to prevent excessive inflation.
The Bretton Woods Conference, more formally called the United Nations Monetary and Financial Conference, was held in July 1944. The purpose of the conference was to establish a set of institutions that would support international trade and investment and prevent some of the monetary instabilities that had plagued the world after World War I. The conference proposed three institutions, only two of which finally came into being.
The unsuccessful institution was the International Trade Organization (ITO), which was intended to promote the reduction of tariff barriers and to coordinate domestic policies so as to encourage a freer flow of goods between countries. Although a charter was drawn up for the ITO, the United States refused to sign onto it, fearing that it would subordinate too many of its domestic policies to international scrutiny. A subagreement of the ITO, the General Agreement on Tariffs and Trade (GATT), designed to promote multilateral tariff reductions, was established independently though.
The two successfully chartered institutions from the Bretton Woods Conference were the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF).
The IBRD is one component of a larger organization called the World Bank. Its purpose was to provide loans to countries to aid their reconstruction after World War II and to promote economic development. Much of its early efforts focused on reconstruction of the war-torn economies, but by the 1960s, its efforts were redirected to developing countries. The intent was to get countries back on their feet, economically speaking, as quickly as possible.
The second successfully chartered organization was the IMF. Its purpose was to monitor and maintain the stability of the fixed exchange rate system that was established. The system was not the revival of a gold standard but rather what is known as a gold-exchange standard. Under this system, the U.S. dollar was singled out as the international reserve currency. Forty-four of the forty-five ratifying countries agreed to have their currency fixed to the dollar. The dollar in turn was fixed to gold at \$35 per ounce. The countries also agreed not to exchange officially held gold deposits for currency as had been the practice under the gold standard. However, countries agreed that officially held gold could be exchanged between central banks.
Another important requirement designed to facilitate the expansion of international trade was that countries agreed not to put any restrictions or controls on the exchange of currencies when that exchange was intended for transactions on the current account. In other words, individuals would be free to exchange one currency for another if they wanted to import goods from another country. However, currency controls or restrictions were allowed for transactions recorded on the financial accounts. This allowed countries to prevent foreign purchases of businesses and companies or to prevent foreign banks from lending or borrowing money. These types of restrictions are commonly known as capital controls (also, currency controls and/or exchange restrictions). These controls were allowed largely because it was believed they were needed to help maintain the stability of the fixed exchange rate system.
The way a fixed exchange system operates in general, and the way the Bretton Woods gold exchange standard operated in particular, is covered in detail in Chapter 11. For now I will simply state without explanation that to maintain a credible fixed exchange rate system requires regular intervention in the foreign exchange markets by country central banks. Sometimes to maintain the fixed rate a country might need to sell a substantial amount of U.S. dollars that it is holding on reserve. These reserves are U.S. dollar holdings that had been purchased earlier, but sometimes a country can run what is called a balance of payments deficit—that is, run out of dollar reserves and threaten the stability of the fixed exchange rate system.
At the Bretton Woods Conference, participants anticipated that this scenario would be a common occurrence and decided that a “fund” be established to essentially “bail out” countries that suffered from balance of payments problems. That fund was the IMF.
The IMF was created to help stabilize exchange rates in the fixed exchange rate system. In particular, member countries contribute reserves to the IMF, which is then enabled to lend money to countries suffering balance of payments problems. With these temporary loans, countries can avoid devaluations of their currencies or other adjustments that can affect the confidence in the monetary system. Because the monies used by the IMF are contributions given by other countries in the group, it is expected that once a balance of payments problem subsides that the money will be repaid. To assure repayment the IMF typically establishes conditions, known as conditionality, for the recipients of the loans. These conditions generally involve changes in monetary and fiscal policies intended to eliminate the original problems with the balance of payments in the first place.
The role of the IMF has changed more recently though. The fixed exchange rate system, under which the IMF is designed to operate, collapsed in 1973. Since that time, most of the major currencies in the world—including the U.S. dollar, the British pound, the Japanese yen, and many others—are floating. When a currency is allowed to float, its value is determined by supply and demand in the private market and there is no longer any need for a country’s central bank to intervene. This in turn means that a country can no longer get into a balance of payments problem since that balance is automatically achieved with the adjustment in the exchange rate value. In essence the raison d’être of the IMF disappeared with the collapse of the Bretton Woods system.
Curiously, the IMF did not fall out of existence. Instead, it reinvented itself as a kind of lender of last resort to national governments. After 1973, the IMF used its “fund” to assist national governments that had international debt problems. For example, a major debt crisis developed in the early 1980s when national governments of Mexico, Brazil, Venezuela, Argentina, and eventually many other nations were unable to pay the interest on their external debt, or the money they borrowed from other countries. Many of these loans were either taken by the national governments or were guaranteed by the national governments. This crisis, known as the Third World debt crisis, threatened to bring down the international financial system as a number of major banks had significant exposure of foreign loans that were ultimately defaulted on. The IMF stepped in to provide “structural adjustment programs” in this instance. So the IMF not only loaned money for countries experiencing balance of payments crises but also now provided loans to countries that could not pay back their foreign creditors. And also, because the IMF wanted to get its money back (meaning the money contributed by the member nations), the structural adjustment loans came with strings attached: IMF conditionality.
Since that time, the IMF has lent money to many countries suffering from external debt repayment problems. It stepped in to help Brazil and Argentina several times in the 1980s and later. It helped Mexico during the peso crisis in 1994. It assisted countries during the Asian currency crisis of 1997 and helped Russia one year later when the Asian contagion swept through.
Although the IMF has come under much criticism, especially because conditionality is viewed by some as excessively onerous, it is worth remembering that the IMF makes loans, not grants. Thus it has the motivation to demand changes in policies that raise the chances of being repaid. These conditions have generally involved things like fiscal and monetary responsibility. That means reducing one’s government budget deficit and curtailing the growth of the money supply. It also prescribed privatization that involves the sale or divestiture of state-owned enterprises. The free market orientation of these conditions came to be known as the Washington Consensus.
Also mitigating the criticisms is the fact that the countries that participate in IMF programs are free to accept the loans, or not. To illustrate the alternative, Malaysia was one country that refused to participate in an IMF structural adjustment program during the Asian currency crisis and as a result did not have to succumb to any conditions. Thus it is harder to criticize the IMF’s conditions when the countries themselves have volunteered to participate. In exchange for what were often tens of billions of dollars in loans, these countries were able to maintain their good standing in the international financial community.
Although controversial, the IMF has played a significant role in maintaining the international financial system even after the collapse of fixed exchange rates. One last issue worth discussing in this introduction is the issue of moral hazard. In the past thirty years or so, almost every time a country has run into difficulty repaying its external debt, the IMF has stepped in to assure continued repayment. That behavior sends a signal to international investors that the risk of lending abroad is reduced. After all, if the country gets into trouble the IMF will lend the country money and the foreign creditors will still get their money back. The moral hazard refers to the fact that lending institutions in the developed countries may view the IMF like an insurance policy and thus make much riskier loans than they would have otherwise. In this way, the IMF could be contributing to the problem of international financial crisis rather than merely being the institution that helps clean up the mess.
Key Takeaways
• The World Bank and the IMF were proposed during the Bretton Woods Conference in 1944.
• The main purpose of the World Bank is to provide loans for postwar reconstruction and economic development for developing countries.
• The main purpose of the IMF was to monitor the international fixed exchange rate system and to provide temporary loans to countries suffering balance of payments problems.
• Since the breakup of the Bretton Woods fixed exchange rate system in 1973, the IMF has mostly assisted countries by making structural adjustment loans to those that have difficulty repaying international debts.
• The IMF conditionalities are the often-criticized conditions that the IMF places on foreign governments accepting their loans. The free-market orientation of these conditions is known as the Washington Consensus.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The name for the original division of the World Bank that describes its original purpose.
• The name for the international institution that was designed to assist countries suffering from balance of payments problems.
• The common name for the international institution whose primary function today is to make loans to countries to assist their economic development.
• In the Bretton Woods system, these types of regulations were allowed for transactions recorded on the financial account.
• This type of currency regime was implemented immediately after the collapse of the Bretton Woods system.
• The term used for the conditions the IMF places on loans it makes to countries.
• The term used for the type of loans made by the IMF to assist countries having difficulty making international debt repayments.
• The term used to describe the standard free market package of conditions typically invoked by the IMF on loans it makes to countries. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/01%3A_Introductory_Finance_Issues-_Current_Patterns_Past_History_and_International_Institutions/1.05%3A_International_Macroeconomic_Institutions-_The_IMF_and_the_Worl.txt |
The most important macroeconomic variable tracked by economists and the media is the gross domestic product (GDP). Whether it ought to be so important is another matter that is discussed in this chapter. But before that evaluation can occur, the GDP must be defined and interpreted. This chapter presents the national income identity, which defines the GDP. It also presents several other important national accounts, including the balance of payments, the twin-deficit identity, and the international investment position. These are the variables of prime concern in an international finance course.
02: National Income and the Balance of Payments Accounts
Learning objectives
1. Define GDP and understand how it is used as a measure of economic well-being.
2. Recognize the limitations of GDP as a measure of well-being.
Many of the key aggregate variables used to describe an economy are presented in a country’s National Income and Product Accounts (NIPA). National income represents the total amount of money that factors of production earn during the course of a year. This mainly includes payments of wages, rents, profits, and interest to workers and owners of capital and property. The national product refers to the value of output produced by an economy during the course of a year. National product, also called national output, represents the market value of all goods and services produced by firms in a country.
Because of the circular flow of money in exchange for goods and services in an economy, the value of aggregate output (the national product) should equal the value of aggregate income (national income). Consider the adjoining circular flow diagram, Figure 2.1.1 , describing a very simple economy. The economy is composed of two distinct groups: households and firms. Firms produce all the final goods and services in the economy using factor services (labor and capital) supplied by the households. The households, in turn, purchase the goods and services supplied by the firms. Thus goods and services move between the two groups in the counterclockwise direction. Exchanges are facilitated with the use of money for payments. Thus when firms sell goods and services, the households give the money to the firms in exchange. When the households supply labor and capital to firms, the firms give money to the households in exchange. Thus money flows between the two groups in a clockwise direction.
National product measures the monetary flow along the top part of the diagram—that is, the monetary value of goods and services produced by firms in the economy. National income measures the monetary flow along the bottom part of the diagram—that is, the monetary value of all factor services used in the production process. As long as there are no monetary leakages from the system, national income will equal national product.
The national product is commonly referred to as gross domestic product (GDP). GDP is defined as the value of all final goods and services produced within the borders of a country during some period of time, usually a year. A few things are worth emphasizing about this definition.
First, GDP is measured in terms of the monetary (or dollar) value at which the items exchange in the market. Second, it measures only final goods and services as opposed to intermediate goods. Thus wheat sold by a farmer to a flour mill will not be directly included as part of GDP since the value of the wheat will be included in the value of the flour that the mill sells to the bakery. The value of the flour will in turn be included in the value of the bread sold to the grocery store. Finally, the value of the bread will be included in the price charged by the grocery when the product is finally purchased by the consumer. Only the final bread sale should be included in GDP or else the intermediate values would overstate total production in the economy. Finally, GDP must be distinguished from another common measure of national output, gross national product (GNP).
Briefly, GDP measures all production within the borders of the country regardless of who owns the factors used in the production process. GNP measures all production achieved by domestic factors of production regardless of where that production takes place. For example, if a U.S. resident owns a factory in Malaysia and earns profits on the operation of that factory, then those profits would be counted as production by a U.S. factory owner and thus would be included in the U.S. GNP. However, since that production took place beyond U.S. borders, it would not be counted as the U.S. GDP. Alternatively, if a Dutch resident owns a factory in the United States, then the fraction of that production that accrues to the Dutch owner would be counted as part of the U.S. GDP since the production took place in the United States. It would not be counted as part of the U.S. GNP, however, since the production was done by a foreign factor owner.
GDP is probably the most widely reported and closely monitored aggregate statistic. GDP is a measure of the size of an economy. It tells us the total amount of “stuff” the economy produces. Since most of us, as individuals, prefer to have more stuff rather than less, it is straightforward to extend this to the national economy to argue that the higher the GDP, the better off the nation. For this simple reason, statisticians track the growth rate of GDP. Rapid GDP growth is a sign of growing prosperity and economic strength. Falling GDP indicates a recession, and if GDP falls significantly, we call it an economic depression.
For a variety of reasons, GDP should be used only as a rough indicator of the prosperity or welfare of a nation. Indeed, many people contend that GDP is an inadequate measure of national prosperity. Below is a list of some of the reasons why GDP falls short as an indicator of national welfare.
1. GDP only measures the amount of goods and services produced during the year. It does not measure the value of goods and services left over from previous years. For example, used cars, two-year-old computers, old furniture, old houses, and so on are all useful and provide welfare to individuals for years after they are produced. Yet the value of these items is only included in GDP in the year in which they are produced. National wealth, on the other hand, measures the value of all goods, services, and assets available in an economy at a point in time and is perhaps a better measure of national economic well-being than GDP.
2. GDP, by itself, fails to recognize the size of the population that it must support. If we want to use GDP to provide a rough estimate of the average standard of living among individuals in the economy, then we ought to divide GDP by the population to get per capita GDP. This is often the way in which cross-country comparisons are made.
3. GDP gives no account of how the goods and services produced by the economy are distributed among members of the economy. One might prefer a lower GDP with a more equitable distribution to a higher GDP in which a small percentage of the population receives most of the product.
4. Measured GDP growth may overstate the growth of the standard of living since price level increases (inflation) would raise measured GDP. Thus even if the economy produces exactly the same amount of goods and services as the year before and prices of those goods rise, then GDP will rise as well. For this reason, real GDP is typically used to measure the growth rate of GDP. Real GDP divides nominal (or measured) GDP by the price level and is designed to eliminate some of the inflationary effects.
5. Sometimes, economies with high GDPs may also produce a large amount of negative production externalities. Pollution is one such negative externality. Thus one might prefer to have a lower GDP and less pollution than a higher GDP with more pollution. Some groups also argue that rapid GDP growth may involve severe depletion of natural resources, which may be unsustainable in the long run.
6. GDP often rises in the aftermath of natural disasters. Shortly after the Kobe earthquake in Japan in the 1990s, economists predicted that Japan’s GDP would probably rise more rapidly. This is mostly because of the surge of construction activities required to rebuild the damaged buildings. This illustrates why GDP growth may not be indicative of a healthy economy in some circumstances.
7. GDP measures the value of production in the economy rather than consumption, which is more important for economic well-being. As will be shown later, national production and consumption are equal when a country’s trade balance is zero; however, if a country has a trade deficit, then its national consumption will exceed its production. Ideally, because consumption is pleasurable while production often is not, we should use the measure of national consumption to measure economic well-being rather than GDP.
Key Takeaways
• GDP is defined as the value of all final goods and services produced within the borders of a country during some period of time, usually a year.
• The following are several important weaknesses of GDP as a measure of economic well-being:
• GDP measures income, not wealth, and wealth is a better measure of economic well-being.
• GDP does not account for income distribution effects that may be important to economic well-being.
• GDP measures “bads” like pollution as well as “goods.”
• GDP measures production, not consumption, and consumption is more important to economic well-being.
exersises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term for the measure of national output occurring within the nation’s borders.
• The term for the measure of national output that includes all production by domestic factors regardless of location.
• Of income or wealth, this term better describes the gross domestic product (GDP).
• Of income or wealth, this term better describes the gross national product (GNP).
• The term used to describe the measure of GDP that takes account of price level changes or inflationary effects over time.
• The term used to describe the measure of GDP that allows better income comparisons between countries that have different population sizes.
1. Many people argue that GDP is an inadequate measure of a nation’s economic well-being. List five reasons why this may be so.
2. GDP is used widely as an indicator of the success and economic well-being of the people of a nation. However, for many reasons it is not the perfect indicator. Briefly comment on the following statements related to this issue:
• Domestic spending is a better indicator of standard of living than GDP.
• National wealth is a better indicator of standard of living than GDP. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.01%3A_National_Income_and_Product_Accounts.txt |
Learning Objectives
1. Identify the components of GDP defined in the national income identity.
2. Understand why imports are subtracted in the national income identity.
The national income or product identity describes the way in which the gross domestic product (GDP) is measured, as the sum of expenditures in various broad spending categories. The identity, shown below, says that GDP is the sum of personal consumption expenditures (C), private investment expenditures (I), government consumption expenditures (G), and expenditures on exports (EX) minus expenditures on imports (IM):
$G D P=C+I+G+E X-I M \nonumber$
Personal consumption expenditures (C), or “consumption” for short, include goods and services purchased by domestic residents. These are further subdivided into durable goods, commodities that can be stored and that have an average life of at least three years; nondurable goods, all other commodities that can be stored; and services, commodities that cannot be stored and are consumed at the place and time of purchase. Consumption also includes foreign goods and services purchased by domestic households.
Private domestic investment (I), or “investment” for short, includes expenditures by businesses on fixed investment and any changes in business inventories. Fixed investment, both residential and nonresidential, consists of expenditures on commodities that will be used in a production process for more than one year. It covers all investment by private businesses and by nonprofit institutions, regardless of whether the investment is owned by domestic residents or not. Nonresidential investment includes new construction, business purchases of new machinery, equipment, furniture, and vehicles from other domestic firms and from the rest of the world. Residential investment consists of private structures, improvements to existing units, and mobile homes. Note that this term does not include financial investments made by individuals or businesses. For example, one purchase of stock as an “investment” is not counted here.
Government expenditures include purchases of goods, services, and structures from domestic firms and from the rest of the world by federal, state, and local government. This category includes compensation paid to government employees, tuition payments for higher education, and charges for medical care. Transfer payments, such as social insurance payments, government medical insurance payments, subsidies, and government aid are not included as a part of government expenditures.
Exports consist of goods and services that are sold to nonresidents.
Imports include goods and services purchased from the rest of the world.
The difference between exports and imports (EXIM) is often referred to as net exports. Receipts and payments of factor income and transfer payments to the rest of the world (net) are excluded from net exports. Including these terms changes the trade balance definition and reclassifies national output as growth national product (GNP).
The Role of Imports in the National Income Identity
It is important to emphasize why imports are subtracted in the national income identity because it can lead to serious misinterpretations. First, one might infer (incorrectly) from the identity that imports are subtracted because they represent a cost to the economy. This argument often arises because of the typical political emphasis on jobs or employment. Thus higher imports imply that goods that might have been produced at home are now being produced abroad. This could represent an opportunity cost to the economy and justify subtracting imports in the identity. However, this argument is wrong.
The second misinterpretation that sometimes arises is to use the identity to suggest a relationship between imports and GDP growth. Thus it is common for economists to report that GDP grew at a slower than expected rate last quarter because imports rose faster than expected. The identity suggests this relationship because, obviously, if imports rise, GDP falls. However, this interpretation is also wrong.
The actual reason why imports are subtracted in the national income identity is because imports appear in the identity as hidden elements in consumption, investment, government, and exports. Thus imports must be subtracted to assure that only domestically produced goods are being counted. Consider the following details.
When consumption expenditures, investment expenditures, government expenditures, and exports are measured, they are measured without accounting for where the purchased goods were actually made. Thus consumption expenditures (C) measures domestic expenditures on both domestically produced and foreign-produced goods. For example, if a U.S. resident buys a television imported from Korea, that purchase would be included in domestic consumption expenditures. Likewise, if a business purchases a microscope made in Germany, that purchase would be included in domestic investment. When the government buys foreign goods abroad to provide supplies for its foreign embassies, those purchases are included in government expenditures. Finally, if an intermediate product is imported, used to produce another good, and then exported, the value of the original imports will be included in the value of domestic exports.
This suggests that we could rewrite the national income identity in the following way:
$G D P=\left(C_{D}+C_{F}\right)+\left(l_{D}+I_{F}\right)+\left(G_{D}+G_{F}\right)+\left(E X_{D}+E X_{F}\right)-M \nonumber$
where CD represents consumption expenditures on domestically produced goods, CF represents consumption expenditures on foreign-produced goods, ID represents investment expenditures on domestically produced goods, IF represents investment expenditures on foreign-produced goods, GD represents government expenditures on domestically produced goods, GF represents government expenditures on foreign-produced goods, EXD represents export expenditures on domestically produced goods, and EXF represents export expenditures on previously imported intermediate goods. Finally, we note that all imported goods are used in consumption, investment, or government or are ultimately exported, thus
$I M=C_{F}+I_{F}+G_{F}+E X_{F} \nonumber$
Plugging this expression into the identity above yields
$G D P=C_{D}+I_{D}+G_{D}+E X_{D} \nonumber$
and indicates that GDP does not depend on imports at all.
The reason imports are subtracted in the standard national income identity is because they have already been included as part of consumption, investment, government spending, and exports. If imports were not subtracted, GDP would be overstated. Because of the way the variables are measured, the national income identity is written such that imports are added and then subtracted again.
This exercise should also clarify why the previously described misinterpretations were indeed wrong. Since imports do not affect the value of GDP in the first place, they cannot represent an opportunity cost, nor do they directly or necessarily influence the size of GDP growth.
Key takeaways
• GDP can be decomposed into consumption expenditures, investment expenditures, government expenditures, and exports of goods and services minus imports of goods and services.
• Investment in GDP identity measures physical investment, not financial investment.
• Government includes all levels of government and only expenditures on goods and services. Transfer payments are not included in the government term in the national income identity.
• Imports are subtracted in the national income identity because imported items are already measured as a part of consumption, investment and government expenditures, and as a component of exports. This means that imports have no direct impact on the level of GDP. The national income identity does not imply that rising imports cause falling GDP.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• A measure of the value of all capital equipment and services purchased during a year.
• The term for the goods and services sold to residents of foreign countries.
• The component of GDP that includes household purchases of durable goods, nondurable goods, and services.
• The component of GDP that includes purchases by businesses for physical capital equipment used in the production process.
• The government spending in the GDP identity does not count these types of government expenditures.
• Of true or false, imported goods and services are counted once in the C, I, G, or EX terms of the GDP identity.
2. The national income identity says that gross domestic product is given by consumption expenditures, plus investment expenditures, plus government expenditures, plus exports, minus imports. In short, this is written as GDP = C + I + G + EXIM.
Consider each of the following expenditures below. Indicate in which category or categories (C, I, G, EX, or IM) the item would be accounted for in the United States.
Product Category
a. German resident purchase of a U.S.-made tennis racket
b. U.S. firm purchase of a U.S.-made office copy machine
c. Salaries to U.S. troops in Iraq
d. School spending by county government
e. U.S. household purchase of imported clothing
3. What is the gross domestic product in a country whose goods and services balance is a $300 billion deficit, consumption is$900 billion, investment is $300 billion, and government spending is$500 billion?
4. Below are the economic data for the fictional country of Sandia. Write out the national income identity. Verify whether Sandia’s data satisfy the identity.
Gross Domestic Product 400
Imports of Goods and Services 140
Investment Spending 20
Private Saving 30
Exports of Goods and Services 100
Government Transfers 40
Government Tax Revenues 140
Government Spending 140
Consumption Spending 280
Figure $1$: TABLE 2.1 SANDIA’S ECONOMIC DATA (BILLIONS OF DOLLARS) | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.02%3A_National_Income_or_Product_Identity.txt |
Learning objective
1. Learn the recent values for U.S. GDP and the relative shares of its major components.
To have a solid understanding of the international economy, it is useful to know the absolute and relative sizes of some key macroeconomic variables like the gross domestic product (GDP). For example, it is worthwhile to know that the U.S. economy is the largest in the world because its annual GDP is about \$14 trillion, not \$14 million or \$14 billion. It can also be useful to know about how much of an economy’s output each year is consumed, invested, or purchased by the government. Although knowing that the U.S. government expenditures in 2008 were about \$2.9 trillion is not so important, knowing that government expenditures made up about 20 percent of GDP can be useful to know.
Table 2.2.1 "U.S. Gross Domestic Product (in Billions of Dollars)" contains U.S. statistics for the national income and product accounts for the years 2007 and 2008. The table provides the numerical breakdown of GDP not only into its broad components (C, I, G, etc.) but also into their major subcategories. For example, consumption expenditures are broken into three main subcategories: durable goods, nondurable goods, and services. The left-hand column indicates which value corresponds to the variables used in the identity.
2007 2008 2008 (Percentage of GDP)
GDP Gross domestic product 13,807.5 14,280.7 100.0
C Personal consumption expenditures 9,710.2 10,058.5 70.4
Durable goods 1,082.8 1,022.8 7.2
Nondurable goods 2,833.0 2,966.9 20.8
Services 5,794.4 6,068.9 42.5
I Gross private domestic investment 2,134.0 2,004.1 14.0
Nonresidential 1,503.8 1,556.2 10.9
Structures 480.3 556.3 3.9
Equipment and software 1,023.5 999.9 7.0
Residential 630.2 487.8 3.4
Change in business inventories −3.6 −39.9 −0.0
G Government consumption expenditures and gross investment 2,674.8 2,883.2 20.2
Federal 979.3 1,071.2 7.5
National defense 662.2 734.3 5.1
Nondefense 317.1 336.9 2.4
State and local 1,695.5 1,812.1 12.6
EX Exports 1,662.4 1,867.8 13.1
Goods 1,149.2 1,289.6 9.0
Services 513.2 578.2 4.0
IM Imports 2,370.2 2,533.0 17.7
Goods 1,985.2 2,117.0 14.8
Services 385.1 415.9 2.9
Figure \(1\): Table 2.2 U.S. Gross Domestic Product (in Billions of Dollars)
Source: Bureau of Economic Analysis, National Economic Accounts, Gross Domestic Product (GDP), at www.bea.gov/national/nipaweb/Index.asp.
There are a number of important things to recognize and remember about these numbers.
First, it is useful to know that U.S. GDP in 2008 was just over \$14 trillion (or \$14,000 billion). This is measured in 2008 prices and is referred to as nominal GDP. This number is useful to recall, first because it can be used in to judge relative country sizes if you happen to come across another country’s GDP figure. The number will also be useful in comparison with U.S. GDP in the future. Thus if in 2020 you read that U.S. GDP is \$20 trillion, you’ll be able to recall that back in 2008 it was just \$14 trillion. Also, note that between 2007 and 2008, the United States added over \$600 billion to GDP.
The next thing to note about the numbers is that consumption expenditures are the largest component of U.S. GDP, making up about 70 percent of output in 2008. That percentage is relatively constant over time, even as the economy moves between recessions and boom times (although it is up slightly from 68 percent in 1997). Notice also that services is the largest subcategory in consumption. This category includes health care, insurance, transportation, entertainment, and so on.
Gross private domestic investment, “investment” for short, accounted for just 14 percent of GDP in 2008. This figure is down from almost 17 percent just two years before and is reflective of the slide into the economic recession. As GDP began to fall at the end of 2008, prospects for future business opportunities also turned sour, and so investment spending also fell. As the recession continued into 2009, we can expect that number to fall even further the next year.
The investment component of GDP is often the target of considerable concern in the United States. Investment represents how much the country is adding to the capital stock. Since capital is an input into production, in general the more capital equipment available, the greater will be the national output. Thus investment spending is viewed as an indicator of future GDP growth. Perhaps the higher is investment, the faster the economy will grow in the future.
One concern about the U.S. investment level is that, as a percentage of GDP, it is lower than in many countries in Europe, especially in China and other Asian economies. In many European countries, it is above 20 percent of GDP. The investment figure is closer to 30 percent in Japan and over 35 percent in China. There was a fear among some observers, especially in the 1980s and early 1990s, that lower U.S. investment relative to the rest of the world would ultimately lead to slower growth. That this projection has not been borne out should indicate that higher investment is not sufficient by itself to assure higher growth.
Government expenditures on goods and services in the United States amounted to 20 percent of GDP in 2008. Due to the recession and the large government stimulus package in 2009, we can expect this number will rise considerably next year. Recall that this figure includes state, local, and federal spending but excludes transfer payments. When transfer payments are included, government spending plus transfers as a percentage of GDP exceeds 30 percent in the United States.
Two things are worth noting. First, the state and local spending is almost twice the level of federal spending. Second, most of the federal spending is on defense-related goods and services.
Exports in the United States accounted for 13 percent of GDP in 2008 (up from 10 percent in 2003) and are closing in on the \$2 trillion level. Imports into the United States are at \$2.5 trillion, amounting to almost 18 percent of GDP. In terms of the dollar value of trade, the United States is the largest importer and exporter of goods and services in the world. However, relative to many other countries, the United States trades less as a percentage of GDP.
Key Takeaways
• U.S. GDP stands at just over \$14 trillion per year in 2008.
• U.S. consumption is about 70 percent of GDP; investment, 14 percent; government expenditures, 20 percent; exports, 13 percent; and imports, about 18 percent.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The approximate share of U.S. consumption as a share of U.S. GDP in 2008.
• The approximate share of U.S. investment as a share of U.S. GDP in 2008.
• The approximate share of U.S. government spending as a share of U.S. GDP in 2008.
• The approximate share of U.S. exports of goods and services as a share of U.S. GDP in 2008.
• The approximate share of U.S. imports of goods and services as a share of U.S. GDP in 2008.
• This main category represents the largest share of GDP spending in the U.S. economy. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.03%3A_U.S._National_Income_Statistics_%2820072008%29.txt |
Learning objectives
1. Learn the variety of ways exports and imports are classified in the balance of payments accounts.
2. Understand the distinction between GDP and GNP.
The balance of payments accounts is a record of all international transactions that are undertaken between residents of one country and residents of other countries during the year. The accounts are divided into several subaccounts, the most important being the current account and the financial account. The current account is often further subdivided into the merchandise trade account and the service account. These are each briefly defined in Table 2.3.
Current Account Record of all international transactions for goods and services, income payments and receipts, and unilateral transfers. The current account is used in the national income identity for GNP.
Merchandise Trade Account Record of all international transactions for goods only. Goods include physical items like autos, steel, food, clothes, appliances, furniture, etc.
Services Account Record of all international transactions for services only. Services include transportation, insurance, hotel, restaurant, legal, consulting, etc.
Goods and Services Account Record of all international transactions for goods and services only. The goods and services account is used in the national income identity for GDP.
Financial Account Record of all international transactions for assets. Assets include bonds, Treasury bills, bank deposits, stocks, currency, real estate, etc.
Figure $1$: Table 2.3 Balance of Payments Accounts Summary
The balance on each of these accounts is found by taking the difference between exports and imports.
Current Account
The current account (CA) balance is defined as $C A=E X^{G, S, I P R, U T}-I M^{G, S, I P R, U T}$ where the $G, S, I P R, U T$ superscript is meant to include exports and imports of goods (G), services (S), income payments and receipts (IPR), and unilateral transfers (UT). If $C A>0$, then exports of goods and services exceed imports and the country has a current account surplus. If $C A<0$, then imports exceed exports and the country has a current account deficit.
Income payments represent the money earned (i.e., income) by foreign residents on their investments in the United States. For example, if a British company owns an office building in the United States and brings back to the United Kingdom a share of the profit earned there as a part of its income, then this is classified as an income payment on the current account of the balance of payments.
Income receipts represent the money earned by domestic residents on their investments abroad. For example, if a U.S. company owns an assembly plant in Costa Rica and brings back to the United States a share of the profit earned there as a part of its income, then this is classified as an income receipt on the current account of the balance of payments.
It may be helpful to think of income payments and receipts as payments for entrepreneurial services. For example, a British company running an office building is providing the management services and taking the risks associated with operating the property. In exchange for these services, the company is entitled to a stream of the profit that is earned. Thus income payments are classified as an import, the import of a service. Similarly, the U.S. company operating the assembly plant in Costa Rica is also providing entrepreneurial services for which it receives income. Since in this case the United States is exporting a service, income receipts are classified as a U.S. export.
Unilateral transfers represent payments that are made or received that do not have an offsetting product flow in the opposite direction. Normally, when a good is exported, for example, the good is exchanged for currency such that the value of the good and the value of the currency are equal. Thus there is an outflow and an inflow of equal value. An accountant would record both sides of this transaction, as will be seen in the next section. However, with a unilateral transfer, money flows out, but nothing comes back in exchange or vice versa. The primary examples of unilateral transfers are remittances and foreign aid. Remittances occur when a person in one country transfers money to a relative in another country and receives nothing in return. Foreign aid also involves a transfer, expecting nothing in return.
Merchandise Trade Balance
The merchandise trade balance (or goods balance) can be defined as $G B=E X^{G}-I M^{G}$, where we record only the export and import of merchandise goods. If $G B>0$, the country would have a (merchandise) trade surplus. If $G B<0$, the country has a trade deficit.
Services Balance
The service balance can be defined as $S B=E X^{S}-I M^{S}$, where we record only the export and import of services. If $S B>0$, the country has a service surplus. If $S B<0$, the country has a service deficit.
Goods and Services Balance
The goods and services balance (or goods balance) can be defined as $G S B=E X^{G \& S}-I M^{G \& S}$, where we record the export and import of both merchandise goods and services. If $G S B>0$, the country would have a goods and services (G&S) surplus. If $G B<0$ the country has a G&S deficit. Note that sometimes people will refer to the difference $E X^{G \& S}-I M^{G \& S}$ as net exports. Often when this term is used the person is referencing the goods and services balance.
Here it is important to point out that when you hear a reference to a country’s trade balance, it could mean the merchandise trade balance, or it could mean the goods and services balance, or it could even mean the current account balance.
Occasionally, one will hear trade deficit figures reported in the U.S. press followed by a comment that the deficit figures refer to the “broad” measure of trade between countries. In this case, the numbers reported refer to the current account deficit rather than the merchandise trade deficit. This usage is developing for a couple of reasons. First of all, at one time, around thirty years ago or more, there was very little international trade in services. At that time, it was common to report the merchandise trade balance since that accounted for most of the international trade. In the past decade or so, service trade has been growing much more rapidly than goods trade and it is now becoming a significant component of international trade. In the United States, service trade exceeds 30 percent of total trade. Thus a more complete record of a country’s international trade is found in its current account balance rather than its merchandise trade account.
But there is a problem with reporting and calling it the current account deficit because most people don’t know what the current account is. There is a greater chance that people will recognize the trade deficit (although most could probably not define it either) than will recognize the current account deficit. Thus the alternative of choice among commentators is to call the current account deficit a trade deficit and then define it briefly as a “broad” measure of trade.
A simple solution would be to call the current account balance the “trade balance” since it is a record of all trade in goods and services and to call the merchandise trade balance the “merchandise goods balance,” or the “goods balance” for short. I will ascribe to this convention throughout this text in the hope that it might catch on.
GDP versus GNP
There are two well-known measures of the national income of a country: GDP and GNP. Both represent the total value of output in a country during a year, only measured in slightly different ways. It is worthwhile to understand the distinction between the two and what adjustments must be made to measure one or the other.
Conceptually, the gross domestic product (GDP) represents the value of all goods and services produced within the borders of the country. The gross national product (GNP) represents the value of all goods and services produced by domestic factors of production.
Thus production in the United States by a foreign-owned company is counted as a part of U.S. GDP since the productive activity took place within the U.S. borders, even though the income earned from that activity does not go to a U.S. citizen. Similarly, production by a U.S. company abroad will generate income for U.S. citizens, but that production does not count as a part of GDP since the productive activity generating that income occurred abroad. This production will count as a part of GNP though since the income goes to a U.S. citizen.
The way GDP versus GNP is measured is by including different items in the export and import terms. As noted above, GDP includes only exports and imports of goods and services, implying also that GDP excludes income payments and receipts and unilateral transfers. When these latter items are included in the national income identity and the current account balance is used for $E X-I M$, the national income variable becomes the GNP. Thus the GNP measure includes income payments and receipts and unilateral transfers. In so doing, GNP counts as additions to national income the profit made by U.S. citizens on its foreign operations (income receipts are added to GNP) and subtracts the profit made by foreign companies earning money on operations in the U.S. (income payments are subtracted).
To clarify, the national income identities for GDP and GNP are as follows:
$G D P=C+I+G+E^{G \& S}-I M^{G \& S} \nonumber$
and
$G N P=C+I+G+E X^{G, S, I P R, U T}-I M^{G, S, I P R, U T} \nonumber$
Financial Account Balance
Finally, the financial account balance can be defined as $K A=E X^{A}-I M^{A}$, where $E X^{A}$ and $I M^{A}$ refer to the export and import of assets, respectively. If $K A>0$, then the country is exporting more assets than it is importing and it has a financial account surplus. If $K A<0$, then the country has a financial account deficit.
The financial account records all international trade in assets. Assets represent all forms of ownership claims in things that have value. They include bonds, Treasury bills, stocks, mutual funds, bank deposits, real estate, currency, and other types of financial instruments. Perhaps a clearer way to describe exports of assets is to say that domestic assets are sold to foreigners, whereas imports of assets mean foreign assets that are purchased by domestic residents.
It is useful to differentiate between two different types of assets. First, some assets represent IOUs (i.e., I owe you). In the case of bonds, savings accounts, Treasury bills, and so on, the purchaser of the asset agrees to give money to the seller of the asset in return for an interest payment plus the return of the principal at some time in the future. These asset purchases represent borrowing and lending. When the U.S. government sells a Treasury bill (T-bill), for example, it is borrowing money from the purchaser of the T-bill and agrees to pay back the principal and interest in the future. The Treasury bill certificate, held by the purchaser of the asset, is an IOU, a promissory note to repay principal plus interest at a predetermined time in the future.
The second type of asset represents ownership shares in a business or property, which is held in the expectation that it will realize a positive rate of return in the future. Assets, such as common stock, give the purchaser an ownership share in a corporation and entitle the owner to a stream of dividend payments in the future if the company is profitable. The future sale of the stock may also generate a capital gain if the future sales price is higher than the purchase price. Similarly, real estate purchases—say, of an office building—entitle the owner to the future stream of rental payments by the tenants in the building. Owner-occupied real estate, although it does not generate a stream of rental payments, does generate a stream of housing services for the occupant-owners. In either case, if real estate is sold later at a higher price, a capital gain on the investment will accrue.
An important distinction exists between assets classified as IOUs and assets consisting of ownership shares in a business or property. First of all, IOUs involve a contractual obligation to repay principal plus interest according to the terms of the contract or agreement. Failure to do so is referred to as a default on the part of the borrower and is likely to result in legal action to force repayment. Thus international asset purchases categorized as IOUs represent international borrowing and lending.
Ownership shares, on the other hand, carry no such obligation for repayment of the original investment and no guarantee that the asset will generate a positive rate of return. The risk is borne entirely by the purchaser of the asset. If the business is profitable, if numerous tenants can be found, or if real estate values rise over time, then the purchaser of the asset will make money. If the business is unprofitable, office space cannot be leased, or real estate values fall, then the purchaser will lose money. In the case of international transactions for ownership shares, there is no resulting international obligation for repayment.
Key takeaways
• The trade balance may describe a variety of different ways to account for the difference between exports and imports.
• The current account is the broadest measure of trade flows between countries encompassing goods, services, income payments and receipts, and unilateral transfers.
• The merchandise trade balance is a more narrow measure of trade between countries encompassing only traded goods.
• Net exports often refer to the balance on goods and services alone.
• GDP is a measure of national income that includes all production that occurs within the borders of a country. It is measured by using the goods and services balance for exports and imports.
• GNP is a measure of national income that includes all production by U.S. citizens that occurs anywhere in the world. It is measured by using the current account balance for exports and imports.
• The financial account balance measures all exports and imports of assets, which means foreign purchases of domestic assets and domestic purchases of foreign assets.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• A record of all international transactions for goods and services.
• A record of all international transactions for assets.
• The name of the balance of payments account that records transactions for goods.
• The term used to describe the profit earned by domestic residents on their foreign business operations.
• The term used to describe the profit earned by foreign residents on their domestic business operations.
• The term used to describe remittances because they do not have a corresponding product flow to offset the money export or import.
• Of net importer or net exporter of services, this describes a country that has more income payments than income receipts.
• This measure of national output includes only the imports and exports of goods and services in its trade balance.
• This measure of national output includes income payments and receipts in its trade balance. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.04%3A_Balance_of_Payments_Accounts-_Definitions.txt |
Learning objectives
1. Learn how individual transactions between a foreign and domestic resident are recorded on the balance of payments accounts.
2. Learn the interrelationship between a country’s current account balance and its financial account balance and how to interpret current account deficits and surpluses in terms of the associated financial flows.
In this section, we demonstrate how international transactions are recorded on the balance of payment accounts. The balance of payments accounts can be presented in ledger form with two columns. One column is used to record credit entries. The second column is used to record debit entries.
Almost every transaction involves an exchange between two individuals of two items believed to be of equal value.An exception is the case of unilateral transfers. These transfers include pension payments to domestic citizens living abroad, foreign aid, remittances, and other types of currency transfers that do not include an item on the reverse side being traded. Thus if one person exchanges \$20 for a baseball bat with another person, then the two items of equal value are the \$20 of currency and the baseball bat. The debit and credit columns in the ledger are used to record each side of every transaction. This means that every transaction must result in a credit and debit entry of equal value.
By convention, every credit entry has a “+” placed before it, while every debit entry has a “−” placed before it. The plus on the credit side generally means that money is being received in exchange for that item, while the minus on the debit side indicates a monetary payment for that item. This interpretation in the balance of payments accounts can be misleading, however, since in many international transactions, as when currencies are exchanged, money is involved on both sides of the transaction. There are two simple rules of thumb to help classify entries on the balance of payments:
1. Any time an item (good, service, or asset) is exported from a country, the value of that item is recorded as a credit entry on the balance of payments.
2. Any time an item is imported into a country, the value of that item is recorded as a debit entry on the balance of payments.
In the following examples, we will consider entries on the U.S. balance of payments accounts. Since it is a U.S. account, the values of all entries are denominated in U.S. dollars. Note that each transaction between a U.S. resident and a foreign resident would result in an entry on both the domestic and the foreign balance of payments accounts, but we will look at only one country’s accounts.
Finally, we will classify entries in the balance of payments accounts into one of the two major subaccounts, the current account or the financial account. Any time an item in a transaction is a good or a service, the value of that item will be recorded in the current account. Any time an item in a transaction is an asset, the value of that item will be recorded in the financial account.
Note that in June 1999, what was previously called the “capital account” was renamed the “financial account” in the U.S. balance of payments. A capital account stills exists but now includes only exchanges in nonproduced, nonfinancial assets. This category is very small, including such items as debt forgiveness and transfers by migrants. However, for some time, it will be common for individuals to use the term “capital account” to refer to the present “financial account.” So be warned.
A Simple Exchange Story
Consider two individuals, one a resident of the United States, the other a resident of Japan. We will follow them through a series of hypothetical transactions and look at how each of these transactions would be recorded on the balance of payments. The exercise will provide insight into the relationship between the current account and the financial account and give us a mechanism for interpreting trade deficits and surpluses.
Step 1: We begin by assuming that each individual wishes to purchase something in the other country. The U.S. resident wants to buy something in Japan and thus needs Japanese currency (yen) to make the purchase. The Japanese resident wants to buy something in the United States and thus needs U.S. currency (dollars) to make the purchase. Therefore, the first step in the story must involve an exchange of currencies.
So let’s suppose the U.S. resident exchanges \$1,000 for ¥112,000 on the foreign exchange market at a spot exchange rate of 112 ¥/\$. The transaction can be recorded by noting the following:
1. The transaction involves an exchange of currency for currency. Since currency is an asset, both sides of the transaction are recorded on the financial account.
2. The currency exported is \$1,000 in U.S. currency. Hence, we have made a credit entry in the financial account in the table below. What matters is not whether the item leaves the country, but that the ownership changes from a U.S. resident to a foreign resident.
3. The currency imported into the country is the ¥112,000. We record this as a debit entry on the financial account and value it at the current exchange value, which is \$1,000 as noted in the table.
Step 1 U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account 0
Financial Account +1,000 (\$ currency) −1,000 (¥ currency)
Figure \(1\): Step 1
Step 2: Next, let’s assume that the U.S. resident uses his ¥112,000 to purchase a camera from a store in Japan and then brings it back to the United States. Since the transaction is between the U.S. resident and the Japanese store owner, it is an international transaction and must be recorded on the balance of payments. The item exported in this case is the Japanese currency. We’ll assume that there has been no change in the exchange rate and thus the currency is still valued at \$1,000. This is recorded as a credit entry on the financial account and labeled “¥ currency” in the table below. The item being imported into the United States is a camera. Since a camera is a merchandise good and is valued at ¥112,000 = \$1,000, the import is recorded as a debit entry on the current account in the table below.
Step 2 U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account 0
Financial Account +1,000 (¥ currency) 0
Figure \(2\): Step 2
Step 3a: Next, let’s assume that the Japanese resident uses his \$1,000 to purchase a computer from a store in the United States and then brings it back to Japan. The computer, valued at \$1,000, is being exported out of the United States and is considered a merchandise good. Therefore, a credit entry of \$1,000 is made in the following table on the current account and labeled as “computer.” The other side of the transaction is the \$1,000 of U.S. currency being given to the U.S. store owner by the Japanese resident. Since the currency, worth \$1,000, is being imported and is an asset, a \$1,000 debit entry is made in the table on the financial account and labeled “\$ currency.”
Step 3a U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account +1,000 (computer)
Financial Account 0 −1,000 (\$ currency)
Figure \(3\): Step 3a
Summary Statistics (after Steps 1, 2, and 3a)
We can construct summary statistics for the entries that have occurred so far by summing the debit and credit entries in each account and eliminating double entries. In the following table, we show all the transactions that have been recorded. The sum of credits in the current account is the \$1,000 computer. The sum of debits in the current account is the \$1,000 camera. On the financial account there are two credit entries of \$1,000, one representing U.S. currency and the other representing Japanese currency. There are two identical entries on the debit side. Since there is a U.S. currency debit and credit entry of equal value, this means that the net flow of currency is zero. The dollars that left the country came back in subsequent transactions. The same is true for Japanese currency. When reporting the summary statistics, the dollar and yen currency financial account entries would cancel, leaving a net export of assets equal to zero and the net inflow of assets equal to zero as well.
Summary 1, 2, 3a U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account +1,000 (computer)
Financial Account +1,000 (\$ currency), +1,000 (¥ currency) −1,000 (\$ currency), −1,000 (¥ currency)
Figure \(4\): Summary 1, 2, 3a
After cancellations, then, the summary balance of payments statistics would look as in the following table.
Summary 1, 2, 3a U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account +1,000 (computer)
Financial Account 0 0
Figure \(5\): Summary 1, 2, 3a
The current account balance is found by summing the credit and debit entries representing exports and imports, respectively. This corresponds to the difference between exports and imports of goods and services. In this example, the current account (or trade) balance is \( C A=\$ 1,000-\$ 1,000=0\). This means the trade account is balanced—exports equal imports.
The financial account balance is also found by summing the credit and debit entries. Since both entries are zero, the financial account balance is also zero.
Step 3b: Step 3b is meant to substitute for step 3a. In this case, we imagine that the Japanese resident decided to do something other than purchase a computer with the previously acquired \$1,000. Instead, let’s suppose that the Japanese resident decides to save his money by investing in a U.S. savings bond. In this case, \$1,000 is paid to the U.S. government in return for a U.S. savings bond certificate (an IOU) that specifies the terms of the agreement (i.e., the period of the loan, interest rate, etc.). The transaction is recorded on the financial account as a credit entry of \$1,000 representing the savings bond that is exported from the country and a debit entry of \$1,000 of U.S. currency that is imported back into the country.
Step 3b U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account 0
Financial Account +1,000 (U.S. savings bond) −1,000 (\$ currency)
Figure \(6\): Step 3b
Summary Statistics (after Steps 1, 2, and 3b)
We can construct summary statistics assuming that steps 1, 2, and 3b have taken place. This is shown in the following table. The sum of credits in the current account in this case is zero since there are no exports of goods or services. The sum of debits in the current account is the \$1,000 camera.
On the financial account, there are three credit entries of \$1,000: one representing U.S. currency, the other representing Japanese currency, and the third representing the U.S. savings bond. There are two \$1,000 entries on the debit side: one representing U.S. currency and the other representing Japanese currency. Again, the dollar and yen currency financial account entries would cancel, leaving only a net export of assets equal to the \$1,000 savings bond. The net inflow of assets is equal to zero.
Summary 1, 2, 3b U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account 0
Financial Account
+1,000 (\$ currency), +1,000 (¥ currency),
+1,000 (U.S. savings bond)
−1,000 (\$ currency), −1,000 (¥ currency)
Figure \(6\): Summary 1, 2, 3b
After cancellations, the summary balance of payments statistics would look like the following table.
Summary 1, 2, 3b U.S. Balance of Payments (\$)
Credits (+) Debits (−)
Current Account 0
Financial Account +1,000 (U.S. savings bond) 0
Figure \(6\): Summary 1, 2, 3b
The current account balance is found by summing the credit and debit entries representing exports and imports, respectively. This corresponds to the difference between exports and imports of goods and services. In this example, the current account (or trade) balance is \(C A=\$ 0-\$ 1,000=-\$ 1,000\). This means there is a trade deficit of \$1,000. Imports of goods and services exceed exports of goods and services.
The financial account balance is also found by summing the credit and debit entries. In this example, the financial account balance is \(K A=\$ 1,000-\$ 0=+\$ 1,000\). This means the financial account has a surplus of \$1,000. Exports of assets exceed imports of assets.
Important Lessons from the Exchange Story
The exercise above teaches a number of important lessons. The first lesson follows from the summary statistics, suggesting that the following relationship must hold true:
current account balance + financial account balance = 0.
In the first set of summary statistics (1, 2, 3a), both the current account and the financial account had a balance of zero. In the second example (1, 2, 3b), the current account had a deficit of \$1,000 while the financial account had a surplus of \$1,000.
This implies that anytime a country has a current account deficit, it must have a financial account surplus of equal value. When a country has a current account surplus, it must have a financial account deficit of equal value. And when a country has balanced trade (a balanced current account), then it must have balance on its financial account.
It is worth emphasizing that this relationship is not an economic theory. An economic theory could be right or it could be wrong. This relationship is an accounting identity. (That’s why an identity symbol rather than an equal sign is typically used in the formula above.) An accounting identity is true by definition.
Of course, the identity is valid only if we use the true (or actual) current account and financial account balances. What countries report as their trade statistics are only the measured values for these trade balances, not necessarily the true values.
Statisticians and accountants attempt to measure international transactions as accurately as possible. Their objective is to record the true values or to measure trade and financial flows as accurately as possible. However, a quick look at any country’s balance of payments statistics reveals that the balance on the current account plus the balance on the financial account rarely, if ever, sums to zero. The reason is not that the identity is wrong but rather that not all the international transactions on the balance of payments are accounted for properly. Measurement errors are common.
These errors are reported in a line in the balance of payments labeled “statistical discrepancy.” The statistical discrepancy represents the amount that must be added or subtracted to force the measured current account balance and the measured financial account balance to zero. In other words, in terms of the measured balances on the balance of payments accounts, the following relationship will hold:
current account balance + financial account balance + statistical discrepancy = 0.
The second lesson from this example is that imbalances (deficits and surpluses) on the balance of payments accounts arise as a result of a series of mutually voluntary transactions in which equally valued items are traded for each other. This is an important point because it is often incorrectly interpreted that a trade deficit implies that unfair trade is taking place. After all, the logic goes, when imports exceed exports, foreigners are not buying as many of our goods as we are buying of theirs. That’s unequal exchange and that’s unfair.
The story and logic are partially correct but incomplete. The logic of the argument focuses exclusively on trade in goods and services but ignores trade in assets. Thus it is true that when imports of goods exceed exports, we are buying more foreign goods and services than foreigners are buying of ours. However, at the same time, a current account deficit implies a financial account surplus. A financial account surplus, in turn, means that foreigners are buying more of our assets than we are buying of theirs. Thus when there is unequal exchange on the trade account, there must be equally opposite unequal exchange on the financial account. In the aggregate, imbalances on a current account, a trade account, or a financial account do not represent unequal exchanges between countries.
Key Takeaways
• Every transaction between a domestic and foreign resident can be recorded as a debit and credit entry of equal value on the balance of payments accounts.
• All components of transactions that involve assets, including currency flows, are recorded on the financial account; all other items are recorded on the current account.
• All trade deficits on a country’s current account implies an equally sized financial account surplus, while all trade surpluses implies an equally sized financial account deficit.
• In the aggregate, imbalances on a current account, a trade account, or a financial account do not represent unequal exchanges, or inequities, between countries.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The balance on a country’s financial account when its current account has a deficit of \$80 billion.
• A country’s financial account balance when its trade balance is −\$60 billion, its service balance is +\$25 billion, and its unilateral transfer and income account has a surplus of +\$10 billion.
• The international transactions for shares of stock in corporations (in excess of 10 percent of the company’s value) or for real estate.
• Of credit or debit, this is how exports are recorded on the balance of payments.
• Of current account or financial account, this is where an export of a clock will be recorded.
• Of current account or financial account, this is where an import of currency from your aunt in Paraguay will be recorded.
2. Use the information below from the 1997 U.S. national income accounts to calculate the following. (Assume the balance on income and unilateral transfers was zero.)
• Current account balance: __________
• Merchandise trade balance: __________
• Service balance: __________
• Net income payments and receipts: __________
• Goods and services balance: __________
Gross Domestic Product 8,080
Exports of Goods and Services 934
Merchandise Exports 678
Income Receipts 257
Imports of Goods and Services 1,043
Merchandise Imports 877
Income Payments 244
Net Unilateral Transfers −45
Figure \(7\): TABLE 2.4 U.S. NATIONAL INCOME STATISTICS, 1997 (BILLIONS OF DOLLARS) | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.05%3A_Recording_Transactions_on_the_Balance_of_Payments.txt |
Learning Objective
1. Learn the recent values for U.S. balance of payments statistics and the ways transactions are classified on both the current account and the financial account.
One of the most informative ways to learn about a country’s balance of payments statistics is to take a careful look at them for a particular year. We will do that here for the U.S. balance of payments (U.S. BoP) statistics for 2008. Below we present an abbreviated version of the U.S. BoP statistics.
The line numbers refer to the line item on the complete Bureau of Economic Analysis (BEA) report. All debit entries have a minus sign, and all credit entries have a plus sign. A brief description of each line item is provided below where all values are rounded downward for easy reference with the table. To see the entries for every line or for more recent statistics, see the U.S. Department of Commerce, Bureau of Economic Analysis Web site, located at http://www.bea.gov.
Line Number Category Value (credits [+], debits [−])
Current Account
1 Exports of goods, services, and income receipts +2,591,233
3 Goods +1,276,994
4 Services +549,602
13 Income receipts on U.S. assets abroad +761,593
14 Direct investment receipts +370,747
15 Other private receipts +385,940
16 U.S. government receipts +4,906
18 Imports of goods, services, and income −3,168,938
20 Goods −2,117,245
21 Services −405,287
30 Income payments on foreign assets in the United States −636,043
31 Direct investment payments −120,862
32 Other private payments −349,871
33 U.S. government payments −165,310
35 Unilateral transfers, net −128,363
Capital Account
39 Capital account transactions, net +953
Financial Account
40 U.S. assets abroad (increase/financial outflow [−]) −106
41 U.S. official reserve assets −4,848
46 U.S. government assets −529,615
50 U.S. private assets +534,357
51 Direct investment −332,012
52 Foreign securities +60,761
53 U.S. claims reported by U.S. nonbanks +372,229
54 U.S. claims reported by U.S. banks +433,379
55 Foreign assets in the United States (increase/financial inflow [+]) +534,071
56 Foreign official assets in the United States +487,021
63 Other foreign assets in the United States, net +47,050
64 Direct investment +319,737
65 U.S. Treasury securities +196,619
66 U.S. securities other than T-bills −126,737
67 U.S. currency +29,187
68 U.S. liabilities reported by U.S. nonbanks −45,167
69 U.S. liabilities reported by U.S. banks −326,589
71 Statistical discrepancy (sum of above with sign reversed) +200,055
Figure \(1\): Table 2.5 U.S. Balance of Payments, 2008 (Millions of Dollars Seasonally Adjusted)
Below we provide a brief description of each line item that appears on this abbreviated balance of payments record.
Current Account
Line 1, \$2.59 trillion, shows the value of all U.S. exports of goods, services, and income. This value is equal to the sum of lines 3, 4, and 13.
Line 3, \$1.27 trillion, shows exports of merchandise goods. This includes any physical items that leave the country.
Line 4, \$549 billion, shows exports of services to foreigners. This category includes travel services, passenger fares, royalties, license fees, insurance legal services, and other private services.
Line 13, \$761 billion, shows income receipts on U.S. assets abroad. This represents profits and interest earned by U.S. residents on investments in other countries. In a sense, these are payments for services rendered where the services include entrepreneurial services in the case of foreign-operated factories, or monetary services in the case of interest and dividend payments on foreign securities. This line is included in a measure of gross national product (GNP) since this income is accruing to U.S. factors of production. However, the line is excluded from a measure of gross domestic product (GDP) since production did not take place within the borders of the country. Income receipts are divided into four subcategories: direct investment receipts, other private receipts, U.S. government receipts, and compensation of employees.
Line 14, \$370 billion, shows direct investment receipts. This represents profit earned by U.S. companies on foreign direct investment (FDI), where FDI is defined as a greater than 10 percent ownership share in a foreign company. Note that this is not new investments but rather the profit and dividends earned on previous investments.
Line 15, \$385 billion, shows other private receipts. This category includes interest and profit earned by individuals, businesses, investment companies, mutual funds, pension plans, and so on. In effect, all private investment income that accrues on investments worth less than 10 percent of a company would be included here.
Line 16, \$4.9 billion, shows U.S. government income receipts. This refers to interest and other income earned by government investments abroad. Notice that this item is very small compared to the other two income categories.
Line 18, \$3.1 trillion, records imports of goods, services, and income. This value is equal to the sum of lines 20, 21, and 30.
Line 20, \$2.1 trillion, shows imports of merchandise goods. Notice that goods imports make up about two-thirds of total imports.
Line 21, \$405 billion, shows imports of services such as travel services, passenger fares, insurance, and so on.
Line 30, \$636 billion, shows income payments on foreign assets in the United States. This corresponds to income earned by foreigners who operate companies in the United States or income earned on other U.S.-based assets held by foreigners. This entry is further divided into four components: direct investment payments, other private payments, U.S. government payments, and compensation of employees.
Line 31, \$120 billion, records direct investment payments to foreigners in the United States. This represents profit earned on foreign direct investment by foreign residents’ companies, where FDI is defined as a greater than 10 percent ownership share in a U.S. company. Note that this is not new investments but rather the profit and dividends earned on previous investments.
Line 32, \$349 billion, reports other private payments. This category includes interest and profit earned by individuals, businesses, investment companies, mutual funds, pension plans, and so on. In effect, all private investment income that accrues on investments worth less than 10 percent of a company would be included here.
Line 33, \$165 billion, records payments made by the U.S. government to foreigners. This item represents mostly interest payments on U.S. Treasury bills owned by foreigners.
Line 35, \$128 billion, records net unilateral transfers. These transfers refer to government grants to foreign nations, government pension payments, and private remittances to family and friends abroad. A debit entry here means that the net transfers are outbound, that is, more transfers are made from the U.S. to individuals abroad than are made in the reverse direction.
Capital Account
Line 39, \$953 million, represents net capital account transactions.
Financial Account
Line 40, \$106 million, shows the value of purchases of foreign assets by U.S. residents, hence it is referred to as a capital outflow. The line is the sum of U.S. official reserve assets (line 41), U.S. government assets (line 46), and U.S. private assets (line 50).
Line 41, \$4.8 billion, represents net U.S. official reserve transactions. Any purchases or sales of foreign currency in a foreign exchange intervention by the central bank would be recorded here. Since the item is a debit entry, it means that the U.S. central bank made net purchases of foreign assets (currencies) in 2008.
It is worth noting that this line is more important for a country maintaining a fixed exchange rate. To maintain a credible fixed exchange rate, central banks must periodically participate in the foreign exchange market. This line measures the extent of that participation and is sometimes referred to as the “balance of payments” in a fixed exchange rate system.
Line 46, \$529 billion, represents net purchases of assets by the U.S. government, though not by the Federal Reserve.
Line 50, \$534 billion, shows private purchases of foreign assets by U.S. residents. It is the primary component of total U.S. assets abroad. The item is composed of direct investment (line 51), foreign securities (line 52), U.S. claims reported by U.S. nonbanks (line 53), and U.S. claims reported by U.S. banks (line 54).
Line 51, \$332 billion, shows direct investment by U.S. residents abroad. It would include purchases of factories, stocks, and so on by U.S. businesses and affiliates in foreign countries as long as there is a controlling interest in excess of 10 percent voting share.
Line 52, \$60 billion, shows net purchases of foreign stocks and bonds by U.S. individuals and businesses when there is no controlling interest in the foreign company. Most purchases by U.S. mutual funds, pension funds, and insurance companies would be classified here.
Line 53, \$372 billion, shows U.S. resident purchases of foreign assets reported by nonbanks.
Line 54, \$433 billion, reports U.S. resident purchases of foreign assets reported by U.S. banks. This may include items like foreign currency denominated demand deposits held by U.S. businesses and individuals in U.S. banks.
Line 55, \$534 billion, shows the sum total of foreign assets in the United States. This item refers to all purchases of U.S. assets by foreign residents, thus, it is listed as a capital inflow. This line is composed of the sum of foreign official assets in the United States (line 56), and other foreign assets in the United States (line 63).
Line 56, \$487 billion, refers to purchases of U.S. assets by foreign governments or foreign central banks.
Line 63, \$47 billion, refers to all other foreign assets purchases of U.S. assets and is the main component of capital inflows. It is composed of direct investment (line 64), U.S. Treasury securities (line 65), U.S. securities other than T-bills (line 66), U.S. currency (line 67), U.S. liabilities reported by U.S. nonbanks (line 68), and U.S. liabilities reported by U.S. banks (line 69).
Line 64, \$319 billion, refers to purchases of U.S. factories and stocks when there is a greater than 10 percent ownership share.
Line 65, \$196 billion, shows total purchases of U.S. Treasury bills by foreigners. This corresponds to foreign loans to the U.S. government.
Line 66, \$126 billion, shows non-U.S. Treasury bill and nondirect investment purchases of stocks and bonds by foreigners.
Line 67, \$29 billion, a credit entry, represents U.S. currency that has been repatriated (net). Typically, this flow is a credit indicating an outflow of U.S. currency. Because of the expectation that the U.S. dollar will remain stable in value, it is often held by residents in inflationary countries to prevent the deterioration of purchasing power. It is estimated that over \$270 billion of U.S. currency circulates abroad and is used in exchange for foreign goods and services or simply held to store value. The value on line 67 represents only the amount that flowed back in 2007.
Line 68, \$45 billion, shows deposits and purchases of U.S. assets by foreigners reported by U.S. nonbanks.
Line 69, \$326 billion, reports deposits and purchases of U.S. assets by foreigners reported by U.S. banks. Thus if a foreign resident opens a checking account in a U.S. bank denominated in U.S. dollars, that value would be recorded here.
Line 71, \$200 billion, represents the statistical discrepancy. It is the sum of all the above items with the sign reversed. It is included to satisfy the accounting requirement that all debit entries be balanced by credit entries of equal value. Thus when the statistical discrepancy is included, the balance on the complete balance of payments is zero.
Summary Balances on the U.S. Balance of Payments (2008)
Table 2.6 reports a number of noteworthy balance of payments “balances” for 2008. In effect these subaccount balances allow us to identify net inflows or outflows of specific categories of goods, services, income, and assets.
Lines 1 + 18 + 35 Current account balance −706, 068
Lines 3 + 20 Trade (goods) balance −840, 251
Lines 4 + 21 Services balance +144, 315
Lines 3 + 4 + 20 + 21 Goods and services balance −695, 936
Lines 12 + 29 (not listed) Investment income balance +118, 231
Lines 40 + 55 Financial account balance +533, 965
Line 71 Statistical discrepancy +200,055
Figure \(2\): Table 2.6 Balances on the U.S. Balance of Payments, 2008 (Millions of Dollars Seasonally Adjusted) (Credits [+], Debits [−])
The sum of lines 1, 18, and 35 (i.e., exports of goods, services, and income; imports of goods, services, and income; and unilateral transfers [maintaining signs]) represents the current account (CA) balance. In 2008 in the United States, the CA balance was −706 billion dollars where the minus sign indicates a deficit. Thus the United States recorded a current account deficit of \$706 billion. Note that the current account balance is often reported as the “trade balance using a broad measure of international trade.”
Because unilateral transfers are relatively small and because investment income can be interpreted as payments for a service, it is common to say that a current account deficit means that imports of goods and services exceed exports of goods and services.
The sum of lines 3 and 20 (i.e., exports of goods and imports of goods) is known as the merchandise trade balance, or just trade balance for short. In 2008, the United States recorded a trade deficit of over \$840 billion. This means that the United States imported more physical goods than it exported.
The sum of lines 4 and 21, service exports and service imports, represents the service trade balance or just service balance. The table shows that the United States recorded a service surplus of over \$144 billion in 2008. In other words, the U.S. exports more services than it imports from the rest of the world.
The sum of lines 2 and 19 (not listed), exports of goods and services and imports of goods and services, is a noteworthy trade balance because this difference is used in the national income identity for GDP. In contrast, the national income identity for GNP includes the current account balance instead. In 2008, the United States recorded a goods and services trade deficit of over \$695 billion.
The sum of lines 12 and 29 (not listed), income receipts on U.S. assets abroad and income payments on foreign assets in the United States, represents the balance on investment income. In 2008, there was a recorded investment income surplus of over \$118 billion in the United States. This means that U.S. residents earned more on their investments abroad than foreigners earned on their investments in the United States.
The sum of lines 40 and 55, U.S. assets abroad and foreign assets in the United States, represents the financial account balance. In 2008, the United States recorded a financial account surplus of over \$533 billion. A surplus on capital account means that foreigners are buying more U.S. assets than U.S. residents are buying of foreign assets. These asset purchases, in part, represent international borrowing and lending. In this regard, a capital account surplus implies that the United States is borrowing money from the rest of the world.
Finally, line 71 records the 2008 U.S. statistical discrepancy as a \$200 billion credit entry. This implies that recorded debit entries on the balance of payments exceeded recorded credit entries. Thus an additional \$200 billion credit entry is needed to make the accounts balance. This is the largest statistical discrepancy recorded since the BEA records began in 1960.
The presence of a statistical discrepancy means that there are international transactions that have taken place but have not been recorded or accounted for properly. One might conclude that the size of the errors is \$200 billion, but this does not follow. The discrepancy only records the net effect. It is conceivable that \$400 billion of credit entries and \$200 billion of debit entries were missed. Or possibly, \$800 billion of debit entries and \$600 billion of credit entries were missed. In each case, the difference is \$200 billion dollars, but clearly the amount of error is substantially more in the latter case.
Based on the way the balance of payments data are collected, it seems likely that the primary source of the statistical discrepancy is on the capital account side rather than the current account side. This is because trade in goods, the primary component of the current account, is measured directly and completely by customs officials, while capital account data are acquired through surveys completed by major banks and financial institutions. This does not mean that errors cannot occur, however. Goods trade is tangible and thus is easier to monitor. Capital transactions, in contrast, can be accomplished electronically and invisibly and thus are more prone to measurement errors. Service and income transactions on the current account are also likely to exhibit the same difficulty in monitoring, implying that errors in the current account are more likely to arise in these subcategories.
Key Takeaways
• The U.S. balance of payments records transactions on both the current and financial accounts concluding with several important balances.
• The United States had a current account deficit of \$706 billion in 2008.
• The U.S. had a merchandise trade deficit that was larger than its current account deficit at over \$840 billion in 2008.
• The U.S. had a financial account surplus of over \$533 billion.
• The statistical discrepancy at \$200 billion in 2008 demonstrates that all international transactions are not being recorded since the sum of the balance on the current account and the financial accounts does not equal zero.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The value of the statistical discrepancy if a country has a current account deficit of \$250 billion and a financial account surplus of \$230 billion.
• The approximate value of the U.S. current account deficit in 2008.
• The approximate value of the U.S. merchandise trade deficit in 2008.
• Of U.S. domestic residents or foreign residents, this group profited more on its foreign investments because the United States ran a surplus on its investment income balance.
• The approximate value of the U.S. financial account surplus in 2008.
• The approximate value of the statistical discrepancy in the U.S. balance of payments in 2008. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.06%3A_U.S._Balance_of_Payments_Statistics_%282008%29.txt |
Learning Objectives
1. Learn the interrelationship between a country’s government budget balance (deficit) and its current account balance (deficit).
2. Interpret the interrelationships of trade balances and budget balances in terms of the sources and uses of funds in the financial system.
One of the important relationships among aggregate economic variables is the so-called twin-deficit identity, a term in reference to a country’s government budget deficit and a simultaneous current account deficit. The name for this identity became commonplace during the 1980s and 1990s because at that time the United States experienced deficits in both of these accounts. Now, as we will see later, the identity will be a misnomer in many circumstances since there is no reason that “twin” deficits need to always appear together on these two national accounts. In fact, some countries will, at times, experience a deficit on one account and a surplus on the other. Also, at times, a country will experience a surplus on both accounts.
Thus a better title to this section would be “The Relationship between a Country’s Government Budget Deficit and Its Current Account Deficit.” However, since 2004, the United States finds itself back in the twin-deficit scenario, and since “twin-deficit identity” rolls off the tongue much more easily, we will stick to this title.
To understand this identity it will be helpful to take a much more careful look at the national income identity. This time I will build up the identity in a stepwise fashion using a circular flow diagram to better visualize the flows of money within an economy. A circular flow diagram is typically one of the first principles shown to students in an introductory macroeconomics class. Its purpose is to show the flow of money between the major players (or agents) within an economy. Circular flow diagrams can be either simple or complex depending on how many agents one introduces into the system and how finely one wishes to break down the monetary flows.
Circular Flow: Version 1
The simplest version of a circular flow diagram considers an economy consisting of two agents: households and firms. We imagine that firms produce goods and services using labor as an input.
The flow of money is shown in Figure $1$. The C arrow represents the dollar value of consumption expenditures made by households to purchase the goods and services produced and sold by firms. (The goods and services flow could be represented by an arrow in the opposite direction to C, but we leave that out for simplicity.) Since we assume in this case that there are only households buying goods, all GNP consists of C. The money that flows to firms from sales of consumption goods is given to the workers in exchange for their labor services. This monetary flow is represented by the arrow labeled “disposable income.” Disposable income is all the money households have to spend, which in this case is equal to the national income (NI).
Note especially that we use GNP rather than GDP as our measure of national income so that flows with the rest of the world later are properly defined.
Circular Flow: Version 2
The circular flow can be extended one step by adding financial institutions in Figure $2$. Financial institutions represent any company that facilitates borrowing and lending; the prime example is a bank. However, they may also include investment companies, pension funds, and mutual funds. The presence of financial institutions allows some money to be diverted from the consumption flow.
In Figure $2$, these diversions are represented by $S_{H H}$, representing household savings and $S_{B}$, representing business saving. Some of the revenue earned by firms is not actually given out to workers in the form of wages. Instead some money is “retained” in the form of profit and excess earnings. These retained earnings are generally used to purchase investment goods to help an industry replace worn-out capital equipment and to add new capital. Much of these retained earnings may be used directly to purchase new capital equipment, although some of it will be saved by depositing it in a financial institution. For simplicity we will imagine that all such business saving flows through the financial system, hence the $S_{B}$ arrow. In addition, households generally hold back some of their income from spending and deposit it into pension plans, savings accounts, and so on. Thus we include the arrow from households. The easiest way to think of the diagram is to imagine that financial institutions take deposits from firms and households and then lend out the money to finance investment spending, $S_{H H}$. With some exceptions, this is the way it will often work. One notable exception is that some of the money lent by banks is often used to finance consumption rather than investment. This occurs whenever households finance consumption spending using a credit card. However, we can avoid this complication by defining $S_{H H}$ as being “net” savings, where the net means “after subtracting household borrowing.” With this definition in mind, it should be clear that $S_{H H}$ can be negative—that is, its flow reversed—if household borrowing exceeds household saving.
We can now identify several important relationships. The first one relates to an important decision made by households. They choose how much of their disposable income should be spent on consumption and how much should be saved. You may recall from previous courses that the fraction of income spent on consumption goods (from an extra dollar of income) is called the marginal propensity to consume, while the fraction of income saved is called the marginal propensity to save.
A second relationship is shown on the left side of the Firms box. This indicates that GNP is equal to the sum of $C$ and $I$. This version of the national income identity would only be valid if there were no government sector and no trade with the rest of the world.
A third important relationship is shown by noting the flow of money in and out of the financial sector. There we see two arrows flowing in (i.e., $S_{H H}$ and $S_{B}$) and one flow outward (i.e., $I$). This leads to the identity
$S_{H H}+S_{B}=I , \nonumber$
indicating that the sum of household and business saving equals investment. A more common simplification of this relationship is shown by noting the following:
$S_{P}=S_{H H}+S_{B}, \nonumber$
where $S_{P}$ is called private saving. Thus private saving equals the sum of household saving and business saving. This will simplify the above identity to
$S_{P}=1, \nonumber$
or simply, private saving equals investment. Note that the term “private” is used here to distinguish it from government (or public sector) saving, which we’ll include next.
Circular Flow: Version 3
Next, let’s add in the government sector in Figure $3$. The government is shown both to take money out of the circular flow and to inject money back in. Money is withdrawn first in the form of taxes ($T$. In the adjoining diagram, taxes are represented as a flow of money directly from firms, as if it is entirely a tax on income. This is a simplification since in reality taxes are collected in many forms from many different agents. For example, governments collect profit taxes from firms and financial institutions, sales and property taxes from households, and tariffs on traded goods (not included yet). All of these taxes are assumed to be lumped together in the $T$ flow and withdrawn directly from national income.
Tax revenues ($T R$) can be spent in two separate ways. The $T R$ flow represents transfer payments injected into the household income stream. Transfer payments include social security paid to retired workers, Medicaid and welfare payments, unemployment, and so on. These are government expenditures that do not exchange for a particular good or service. The second type of expenditure is $G$. $G$ represents spending by government for the purchase of goods and services produced by firms. It includes defense spending, education, police and fire protection, and so on.
The final monetary flow, shown flowing out of the government, is labeled $S_{G}$ and refers to government saving. It should be obvious that the money collected by government in the form of taxes need not always equal government expenditures. In the event that tax revenues exceed expenditures, the government would have extra money left over. We imagine that this money would be saved in the financial sector since it is always better to collect interest when possible. Hence we draw the flow of excess funds, government saving ($S_{G}$), flowing from government into the financial sector.
We can now represent the flow of funds in and out of the government sector with the following identity:
$S_{G}=T-T R-G. \nonumber$
When $T$ exceeds the sum of $T R$ and $G$ the government has extra saving that flows into the financial sector. These funds would then be available to lend out and finance additional investment.
Of course, what is more typical of many governments is for the sum of $T R$ and $G$ to exceed tax revenue, $T$. In this case, the flow of government saving ($S_{G}$) would be negative and would be represented in the diagram as a flow in the opposite direction. In this case, the government would be borrowing money from the financial sector to finance its excess expenditures. We would also say that the government is running a budget deficit.
In short, negative government saving, that is, $S_{G}<0$, implies a government budget deficit, which the government finances by borrowing from the financial sector.
Otherwise, positive government saving, that is, $S_{G}>0$, implies a government budget surplus, which results either in additions to saving or a repayment of previous debt.
Next, in this version of the circular flow, we can represent the national income identity as the flow of money into firms. In this case, GNP equals the sum of $C$, $I$, and $G$. This version would only be Accurate when there is no trade with the rest of the world.
Lastly, with government included, we must rewrite the relationship representing the flows in and out of the financial sector. This now becomes
$S_{H H}+S_{B}+S_{G}=1. \nonumber$
This identity says that the sum of household, business, and government saving must equal private investment expenditures.
Circular Flow: Version 4
The final circular flow diagram shown in Figure $4$ extends the previous version to include trade flows with the rest of the world. The rest of the world (RoW) is shown at the very bottom of the adjoining diagram, below the dotted line, which represents the border. Trade with the RoW consists first of exports of goods, services, income and transfers, and expenditures on exports (EX), represented by a flow into firms since money is being used by foreigners to purchase the exported products. Second, imports of goods, services, income and transfers, and imports (IM) are subtracted from firms, resulting in an arrow from firms to the RoW. This adjustment accounts for the fact that measured expenditures made by households, the government, and firms in a open economy will consist of purchases of both domestic and imported goods. Thus the C, I, and G flows will include their purchases of imports, and these should not be included as part of GNP. In essence, the money used to buy imported products is redirected to the foreign firms, hence we have the outflow of money.
This completes the national income identity with all major sectors included and now becomes
$G N P=C+I+G+E X-I M, \nonumber$
which is represented by the flow of money into (and away from) firms on the left side of the diagram. However, as noted elsewhere, $E X-I M$, the balance on the current account, need not be equal to zero. If $E X-I M>0$, then the country would have a current account ($C A$) surplus, whereas if $E X-I M<0$ the country would have a $C A$ deficit.
Consider when $E X-I M<0$. In this case, more money flows out to purchase imports than flows back in to purchase exports. Essentially, there is a loss of money to the RoW despite some exceptions; however, this money does not remain outside the country. Instead, it is brought right back in and deposited into financial institutions (shown as the $S_{F}$ flow on the diagram). In other words, it is saved. This saving represents the country’s financial account surplus, which is equal and opposite to the CA deficit (see Chapter 2, Section 2.5 for a more complete explanation).
The key point is that foreign saving offsets the $C A$ deficit. This can be represented by the relationship showing the inflows and outflows from the RoW, namely,
$S_{F}=I M-E X. \nonumber$
This says that foreign saving equals the $C A$ deficit. From the perspective of the foreigners, we would refer to $S_{F}$ as money saved or lent to the domestic country. From the perspective of the domestic country, $S_{F}$ would be considered money borrowed from the RoW.
Clearly, since a country may run a surplus on trade (i.e., $E X-I M>0$), $S_{F}$ could also be negative. In this case, the RoW would either be dissaving, meaning it is withdrawing previously accumulated saving from the domestic country, or the RoW would be borrowing money from the domestic country. This would occur if a domestic bank makes a loan to someone abroad. Alternatively, from the perspective of the domestic country, we can say it is lending money to the RoW when $S_{F}<0$.
Finally, the Twin-Deficit Identity
The twin-deficit identity is derived by accounting for the monetary flows in and out of the financial sector in version four of the circular flow. This results in the following identity:
$S_{H H}+S_{B}+S_{G}+S_{F}=I. \nonumber$
This says that the sum of household saving, business saving, government saving, and foreign saving must equal private investment spending. An equivalent version can be written by recalling that household plus business saving equals private saving to get
$S_{p}+S_{G}+S_{F}=I. \nonumber$
The identity is best interpreted by noting that there are four key sources for funds in the financial sector that are not part of the consumption stream. The pool of funds to finance investment can be drawn from households, businesses, the government, or from the RoW. Also, the sum of all funds not used for consumption must be equal to the amount spent on investment goods.
It is important to note that this relationship is an accounting identity. This means that the relationship must be true as long as all variables are measured properly. This is not an economic theory, which is a proposition that may or may not be true. In practice, this identity rarely adds up, however, because the variables are not typically measured accurately.
To turn this identity into the “twin-deficit” identity, we must merely take note of several previous definitions. Recall that
$S_{G}=T-T R-G, S_{F}=I M-E X, \nonumber$
and
$S_{P}=S_{H H}+S_{B}. \nonumber$
Plugging these into identity 1 above yields
$S_{P}+T-T R-G+I M-E X=I. \nonumber$
Reorder these to get the following twin-deficit identity:
$\left(S_{P}-I\right)+(I M-E X)=(G+T R-T). \nonumber$
This is a popular way of writing the twin-deficit identity since it explicitly indicates two deficits. If the second expression $(I M-E X)>0$, then the country has a current account deficit (i.e., a trade deficit). If the right-hand-side expression $(G + T R − T)>0$, then the country has a government budget deficit. The expression in total, then, demonstrates that these two deficits are related to each other according to this accounting identity. Indeed, the difference between the government budget deficit and the trade deficit must equal the difference between private saving and investment as shown here:
$(S_{P} − I) = (G + T R − T) − (I M − E X). \nonumber$
The Twin-Deficit Relationship in the United States and China
Perhaps the best way to get a feel for the twin-deficit relationship in a country is to look at the numbers. Table 2.7 and Table 2.8 show values for the twin-deficit identity in the United States and in China over the past ten years or so. All values are presented as a percentage of GDP. Also, because the data on the balance of payments never add up, which results in a statistical discrepancy term, the twin-deficit identity numbers do not add up. To avoid that problem, the private saving numbers presented are not the actual reported values but the values saving would have to be to assure the twin-deficit identity adds up—that is, it is derived as a residual value.
Figure $5$: U.S. Twin-Deficit Figures (GDP), 1997–2008. Source: U.S. Bureau of Economic Analysis, National Economic Accounts, Frequently Requested NIPA Tables. See U.S. BEA interactive tables for the years indicated at www.bea.gov/national/nipaweb/SelectTable.asp?Popular=Y.
(SpI) + Current Account Deficit = Govt. Budget Deficit
Year Private Saving* (%) Investment (%) Current Account Deficit (%) Govt. Budget Deficit (%)
2008 13.5 14.0 4.7 4.2
2007 11.7 15.4 5.3 1.6
2006 12.1 16.7 6.1 1.5
2005 12.9 16.5 6.1 2.5
2004 14.0 16.1 5.5 3.4
2003 14.0 15.2 4.8 3.6
2002 13.4 15.1 4.4 2.7
2001 11.6 15.9 3.8 −0.5
2000 11.0 17.7 4.2 −2.4
1999 12.6 17.5 3.2 −1.7
1998 13.8 17.3 2.4 −1.0
1997 15.2 16.7 1.7 0.2
* Private saving is calculated as a residual.
Figure $6$: Table 2.8 China Twin-Deficit Figures (GDP), 1997–2007. Source: China Data Online, China Statistical Yearbook. See China Statistical Yearbooks located at chinadataonline.org/member/yearbooksp/default.asp?StartYear=1981&EndYear=2009&IFFirst=yes&page=2.
(SpI) + Current Account Deficit = Govt. Budget Deficit
Year Private Saving* (%) Investment (%) Current Account Deficit (%) Govt. Budget Deficit (%)
2007 53.0 42.3 −11.3 −0.6
2006 52.8 42.6 −9.4 0.8
2005 51.1 42.7 −7.2 1.2
2004 48.1 43.2 −3.6 1.3
2003 46.0 41.0 −2.8 2.2
2002 43.0 37.9 −2.4 2.6
2001 40.1 36.5 −1.3 2.3
2000 39.5 35.3 −1.7 2.5
1999 39.6 36.2 −1.4 1.9
1998 40.2 36.2 −2.9 1.1
1997 40.6 36.7 −3.1 0.7
* Private saving is calculated as a residual.
The twin-deficit numbers reveal some interesting patterns. As of the most recent data (2008), the United States has twin deficits, with a CA deficit of 4.7 percent of GDP and a government budget deficit of 4.2 percent. Since these numbers are almost equal, it is as if the U.S. government deficit, which must be financed with borrowing, is being financed by borrowed funds from abroad. In the previous year, 2007, government borrowing requirements were much lower, at 1.6 percent, but borrowing from foreigners was higher at 5.3 percent. The extra borrowing allowed the U.S. savings rate to remain much lower than the private investment requirement. We can interpret this year as one in which private investment was mostly financed with borrowings from abroad.
The United States has had twin deficits since 2001, when it finished a four-year run with a trade deficit and a government budget surplus. This demonstrates that twin “deficits” do not always arise despite the label used to describe the identity. During the budget surplus years the government was able to retire some of its outstanding debt, but the country also ran CA deficits implying, essentially, borrowings from foreigners. As in 2007, these years also describe periods in which foreign borrowings are used to maintain a higher investment level than can be sustained with the lower national savings rate.
In contrast, consider the twin-deficit numbers calculated in the same way for China during the same period. The differences with the U.S. numbers are striking. The two things that stand out immediately are the significantly higher values for private saving and investment. Instead of numbers in the midteens in the United States, China’s percentages are in the midforties to low fifties. Again, the savings terms are calculated as residuals, so there may be some error there, but nonetheless it is clear that China both saves and invests about three times more than the United States as a percentage of GDP. Because it invests so much more, the implication from the national income identity is that China consumes much less than the United States as a percentage. Indeed, China’s consumption figures (not shown) are usually less than 50 percent of GDP.
Indeed, this is why China and many other Asian economies are described as high-saving and low-consuming countries. The United States in comparison is described as a high-consumption country and low-saving country.
The negative number on China’s CA deficit in all the years means that China has run a trade surplus. A surplus means it is lending money abroad and forgoing consumption, by another 11 percent in 2007. (This will be explained in more detail in Chapter 3.) Also, the negative number for China’s budget balance means that it was running a government budget surplus in 2007. So in 2007, China had twin surpluses—a much rarer occurrence—rather than twin deficits. In previous years China didn’t have twin anything: running trade surpluses that were increasing through the past decade, and government budget deficits.
It is worth reflecting briefly on the large investment and trade surpluses in China in comparison with the United States. The U.S. per capita GDP is about $47,000. Comprising that per person production is about 15 percent that goes into investment. That still leaves a considerable percentage left for the consumption and government spending that enhance Americans’ standard of living. In contrast, China’s per capita GDP, in purchasing power parity (PPP) terms, is about$6,000. Per person, it produces much less than in the United States. But curiously, despite being a much poorer country, the high investment rate means that it consumes and spends on government programs a much smaller percentage of its income than the United States; perhaps as little as $3,000 per person. This seems to fly in the face of simple logic. One might expect that a richer country like the United States would save more and consume less since it can do so while still maintaining a high standard of living. For a poorer country like China, we might expect it would save less and try to consume a larger proportion of its income in order to catch up (i.e., in terms of its standard of living) with the rest of the world. Instead, it is the exact opposite. Key Takeaways • Twin deficits occur when a country has both a current account deficit and a government budget deficit at the same time. • When twin deficits occur, the sum of net private saving $(S_{P} − I)$ and the current account deficit must equal the government budget deficit. • A government budget deficit represents a use of funds drawn from the financial sector. • A trade deficit represents a source of funds for the financial sector. • Private saving represents a source of funds for the financial sector. • Private investment represents a use of funds drawn from the financial sector. • The United States has run twin deficits for the past seven years. It can be reasonably described as a low-investment, low-saving, and high-consumption country. • China has mostly run trade surpluses and budget deficits in the past decade. It can be reasonably described as a high-investment, high-saving, and low-consumption country. Exercises 1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?” • An excess of government receipts over expenditures. • National income minus taxes plus transfer payments. • The level of government spending when the government deficit is$100 billion, transfer payments are $800 billion, and tax revenues are$1,300 billion.
• The four different sources of saving described in this chapter.
• Of deficit, surplus, or balance, the balance on the current account if the expression $I M − E X$ in the twin-deficit identity is positive.
• Of deficit, surplus, or balance, the balance on the government budget if the expression $(G + T R − T)$ in the twin-deficit identity is positive.
2. What is the government’s budget balance if government spending is $40 billion, private saving is$60 billion, government transfer payments are $10 billion, private investment is$80 billion, and tax revenues are $50 billion? Show your work. 3. Below are the economic data for the fictional country of Sandia. Write out the twin-deficit identity. Verify whether Sandia’s data satisfy the identity. Figure $7$: TABLE 2.9 SANDIA’S ECONOMIC DATA (BILLIONS OF DOLLARS) Gross Domestic Product 400 Imports of Goods and Services 140 Investment Spending 20 Private Saving 30 Exports of Goods and Services 100 Government Transfers 40 Government Tax Revenues 140 Government Spending 140 Consumption Spending 280 4. Japan once argued that the main reason the United States had large trade deficits during the 1980s and 1990s was because of its large federal government budget deficit. If the United States wanted to reduce its trade deficit, Japan said, then the United States should reduce its budget deficit. Use the twin-deficit identity to answer the following questions: • Explain what also would have to hold for there to be a direct relationship between budget deficit changes and trade deficit changes. • Is it possible to account for a reduction in the federal government budget deficit and a simultaneous increase in the current account deficit? Explain. • Is it possible to reduce the federal government budget deficit, maintain the same level of net private saving (i.e., $S_{P} − I$), and still experience an increase in the current account deficit? Explain. 5. Explain whether the following economic changes are consistent with the twin-deficit identity. Assume ceteris paribus, meaning all other variables in the identity remain fixed. • A$10 billion increase in the government budget deficit and a $10 billion increase in the current account deficit. • A$50 billion decrease in the government budget deficit and a $50 billion increase in private investment. • A$10 billion increase each in the government budget surplus, the current account deficit, private saving, and private investment.
• A $30 billion increase in the current account surplus and a$30 billion increase in the government budget deficit.
6. Refer to the table below to answer the following questions:
• Use the twin-deficit identity to fill in the blank values in the table below for the three fictitious countries.
Private Saving (Sp) Investment Current Account Deficit Government Budget Deficit
Metis 500 500 200
Thebe 150 0 300
Leda 75 100 0
• Which country is best described as financing its government budget deficit with domestic saving?
• Which country is best described as financing its government budget deficit with foreign saving?
• Which country is best described as financing extra domestic investment with government saving? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.07%3A_The_Twin-Deficit_Identity.txt |
Learning objectives
1. Learn how to define and interpret a country’s international investment position.
2. Understand how the international investment position is updated from year to year.
A country’s international investment position (IIP) is like a balance sheet in that it shows the total holdings of foreign assets by domestic residents and the total holdings of domestic assets by foreign residents at a point in time. In the International Monetary Fund’s (IMF) financial statistics, these are listed as domestic assets (foreign assets held by domestic residents) and domestic liabilities (domestic assets owned by foreign residents). The financial account balance, whose counterpart is the current account balance, is more like an income statement that shows the changes in asset holdings during the past year. In other words, the financial account balance consists of flow variables since it records changes in the country’s asset holdings during the year, while the international asset position of a country consists of stock variables since it records the total value of assets at a point in time.
A country’s net international asset position may be in surplus, deficit, or balance. If in surplus, then the value of foreign assets (debt and equity) held by domestic residents exceeds the value of domestic assets held by foreigners. Alternatively, we could say that domestic assets exceed domestic liabilities. This country would then be referred to as a creditor country. If the reverse is true, so that domestic liabilities to foreigners exceed domestic assets, then the country would be called a debtor country.
Asset holdings may consist of either debt obligations or equity claims. Debt consists of IOUs (i.e., I owe you) in which two parties sign a contract agreeing to an initial transfer of money from the lender to the borrower followed by a repayment according to an agreed schedule. The debt contract establishes an obligation for the borrower to repay principal and interest in the future. Equity claims represent ownership shares in potentially productive assets. Equity holdings do not establish obligations between parties, at least not in the form of guaranteed repayments. Once ownership in an asset is transferred from seller to buyer, all advantages and disadvantages of the asset are transferred as well.
Debt and equity obligations always pose several risks. The first risk with debt obligations is the risk of possible default (either total or partial). To the lender, default risk means that the IOU will not be repaid at all, that it will be repaid only in part, or that it is repaid over a much longer period of time than originally contracted. The risk of default to the borrower is that future borrowing will likely become unavailable. The advantage of default to the borrower, of course, is that not all the borrowed money is repaid. The second risk posed by debt is that the real value of the repayments may be different than expected. This can arise because of unexpected inflation or unexpected currency changes. Consider inflation first. If inflation is higher than expected, then the real value of debt repayment (if the nominal interest rate is fixed) will be lower than originally expected. This will be an advantage to the borrower, who repays less in real terms, and a disadvantage to the lender, who receives less in real terms. If inflation turns out to be less than expected, then the advantages are reversed. Next, consider currency fluctuations. Suppose a domestic resident, who receives income in the domestic currency, borrows foreign currency in the international market. If the domestic currency depreciates, then the value of the repayments in domestic currency terms will rise even though the foreign currency repayment value remains the same. Thus currency depreciations can be harmful to borrowers of foreign currency. A similar problem can arise for a lender. Suppose a domestic resident purchases foreign currency and then lends it to a foreign resident (note that this is the equivalent of saving money abroad). If the domestic currency appreciates, then foreign savings, once cashed in, will purchase fewer domestic goods and the lender will lose.
The risk of equity purchases arises whenever the asset’s rate of return is less than expected. This can happen for a number of different reasons. First, if the equity purchases are direct investment in a business, then the return on that investment will depend on how well the business performs. If the market is vibrant and management is good, then the investment will be profitable. Otherwise, the rate of return on the investment could be negative. All the risk, however, is borne by the investor. The same holds true for stock purchases. Returns on stocks may be positive or negative, but it is the purchaser who bears full responsibility for the return on the investment. Equity purchases can suffer from exchange rate risk as well. When foreign equities are purchased, their rate of return in terms of domestic currency will depend on the currency value. If the foreign currency in which assets are denominated falls substantially in value, then the value of those assets falls along with it.
The U.S. International Investment Position
The United States is the largest debtor nation in the world. This means that its international investment position is in deficit and the monetary value of that deficit is larger than that of any other country in the world. The data for the U.S. international investment position in 2008 are available in this U.S. BEA international investment position spreadsheet.The data for the U.S. international investment position are available from the Bureau of Economic Analysis, International Economic Accounts, International Investment Position, at www.bea.gov/international/xls/intinv08_t1.xls. At market values the preliminary estimate for 2008 is that the U.S. was in debt to the rest of the world in the amount of \$3.469 trillion. (Refer to cell I22 in spreadsheet.) Excluding financial derivatives that refer to interest rate and foreign exchange contracts, the United States was in debt in the amount −\$3.628 trillion (cell I24).
Note that this valuation is the U.S. “net” investment position, meaning that it is the difference between the sum total value of foreign assets owned by U.S. residents (U.S. assets abroad) minus U.S. assets owned by foreigners (foreign-owned assets in the United States). The first of these, U.S. assets abroad, represents our purchases of foreign equities and money we have lent to foreigners. The total value stood at \$19.888 trillion in 2008 using market value methods (cell I26). The second, foreign-owned assets in the United States, represents foreign purchases of U.S. equities and money foreigners have lent to us or, equivalently, that we have borrowed. The total in 2008 stood at \$23.357 trillion (cell I50).
The size of the U.S. debt position causes worry for some. Thirty years ago the United States had a sizable creditor position. However, as a result of trade deficits run throughout the 1980s and 1990s, the United States quickly turned from a net creditor to a net debtor. The changeover occurred in 1989. In the early 1990s, the size of this debt position was not too large compared to the size of the economy; however, by the late 1990s and early 2000s, the debt ballooned. In 2008, the U.S. debt position stood at 24.6 percent of GDP, which interestingly is down slightly from 24.9 percent of GDP in 2002 despite annual current account deficits since then. The reason for these changes is changes in the valuations of assets, as reflected in stock market prices, real estate price changes, and changes in the exchange rate.
Notice in the 2008 BEA IIP spreadsheet that the investment position is derived from the 2007 position in the following way. First, the current account deficit caused an addition to U.S. external debt of \$505 billion (cell D22). Changes in asset prices both here and abroad further increased U.S. external debt by \$720 billion (cell E22). This could be because either real estate prices abroad fell by more than in the United States or security prices abroad fell by more than in the United States. Next, there was another increase of \$583 billion in external U.S. debt because of changes in exchange rates. In this case, an appreciation of the U.S. dollar increased the values of foreign-held U.S. assets and reduced the value of U.S.-held foreign assets. Finally, U.S. external debt decreased by \$479 billion due to other factors that don’t neatly fit into the first two categories. (See footnote 2 in the BEA IIP spreadsheet.)
For several reasons, the debt is not a cause for great worry, although it is growing quickly. First, despite its large numerical size, the U.S. international debt position is still less than 25 percent of its annual GDP. Although this is large enough to be worrisome, especially with a trend toward a future increase, it is not nearly as large as some other countries have experienced in the past. In Argentina and Brazil, international debt positions exceeded 60 percent of their GDPs. For some less-developed countries, international debt at times has exceeded 100 percent of their annual GDP.
A second important point is that much of our international obligations are denominated in our own home currency. This means that when international debts (principal + interest) are paid to foreigners, they will be paid in U.S. currency rather than foreign currency. This relieves the U.S. from the requirement to sell products abroad to acquire sufficient foreign currency to repay its debts. Many other countries that have experienced international debt crises have had great problems financing interest and principal repayments especially when bad economic times make it difficult to maintain foreign sales.
Finally, it is worth noting that, despite the name applied to it, our international “debt” position does not correspond entirely to “debt” in the term’s common usage. Recall that debt commonly refers to obligations that must be repaid with interest in the future. Although a sizable share of our outstanding obligations is in the form of debt, another component is in equities. That means some of the money “owed” to foreigners is simply the value of their shares of stock in U.S. companies. These equities either will make money or will not be based on the success of the business, but they do not require a formal obligation for repayment in the future.
key Takeaways
• The IIP measures the difference between the total value of domestic holdings of foreign assets and the value of foreign assets held in the domestic country. If the IIP is negative, we say the country is a debtor country. If the IIP is positive, we say the country is a creditor country.
• Asset holdings include both debt and equities. Debt involves an obligation to repay principal and interest, whereas equities involve either profit or loss to the foreign asset holder.
• The U.S. IIP stands at \$3.5 trillion in 2008, making the United States the largest debtor nation in the world.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• A complete record of a country’s holdings of foreign assets and foreigners’ holdings of domestic assets at a point in time.
• The term describing a country whose total domestic assets held abroad exceed total domestic liabilities held by foreigners.
• The term describing a country whose total domestic liabilities held by foreigners exceed total domestic assets held abroad.
• The name for the type of asset that establishes an obligation for the borrower to repay principal and interest in the future.
• The name for the type of asset that represents ownership shares in potentially productive assets. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/02%3A_National_Income_and_the_Balance_of_Payments_Accounts/2.08%3A_International_Investment_Position.txt |
One of the most misinterpreted and misunderstood concepts in international finance is the implication of a country’s trade deficit or surplus. Often it is incorrectly presumed that a trade deficit is problematic while a trade surplus is a sign of economic strength. This chapter walks the reader through a thorough investigation of trade imbalances—what they mean and how to interpret them. The chapter concludes that trade deficits can indeed be a big problem for a country, but not always. Trade surpluses can also be a sign of strength, but again, not always. Whether a trade imbalance for a particular country should be viewed as good, bad, or benign depends on many other economic circumstances. This chapter spells out what those circumstances are.
03: The Whole Truth about Trade Imbalances
Learning Objective
1. Recognize that trade deficits are not inherently bad and trade surpluses are not inherently good for a country.
There is a popular and pervasive myth about international trade. The myth, simply stated, is that trade deficits are bad and trade surpluses are good. Good or bad for whom, one might ask? Well, for the entire country.
The presence of a trade deficit, or an increase in the trade deficit in a previous month or quarter, is commonly reported as a sign of distress. Similarly, a decrease in a trade deficit, or the presence of or increase in a trade surplus, is commonly viewed as a sign of strength in an economy.
Unfortunately, these perceptions and beliefs are somewhat misguided. In general, it is simply not true that a trade deficit is a sign of a weak economy and a trade surplus is a sign of a strong economy. Merely knowing that a country has a trade deficit, or that a trade deficit is rising, is not enough information to say anything about the current or future prospects for a country—and yet that is precisely how the statistics are often reported.
The truth about trade deficits is that sometimes they are good, sometimes they are bad, but most times, they are benign (i.e., they just don’t matter). There are situations in which trade deficits could be interpreted as a sign of a strong thriving economy. There are other situations in which trade deficits could be indicative of economic problems. In most situations, however, trade deficits are not large enough to warrant a positive or negative interpretation. In this case, they should be viewed without interest. These same points apply to trade surpluses as well.
The purpose of this chapter is to explain, clearly and intuitively, the circumstances in which trade imbalances should be interpreted as good and the circumstances in which they are bad. The section will show situations in which trade deficits can indeed lead to long-term harm for an economy. However, it will also show cases in which trade deficits significantly improve a country’s long-term economic prospects. We will highlight cases in which trade surpluses are appropriate and a sign of strength for a country, and we will show other cases in which trade surpluses may correspond to current demise or even an eventual collapse of an economy.
Most important, one should realize after reading this chapter that merely knowing that a country has a trade deficit or surplus is not enough information to say anything substantive about the strength of a country or its economic prospects.
KEY TAKEAWAY
• Trade deficits or trade surpluses can be good, bad, or benign depending on the underlying economic circumstances.
EXERCISE
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of good, bad, or benign, this is what the common myth is about the nature of trade deficits.
• Of good, bad, or benign, this is what the common myth is about the nature of trade surpluses.
• Of good, bad, benign, or all of the above, in general, this is what trade deficits can be.
• Of good, bad, benign, or all of the above, in general, this is what trade surpluses can be.
• Of good, bad, benign, or all of the above, perhaps most of the time, this is what trade deficits are.
• Of good, bad, benign, or all of the above, perhaps most of the time, this is what trade surpluses are. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/03%3A_The_Whole_Truth_about_Trade_Imbalances/3.01%3A_Overview_of_Trade_Imbalances.txt |
LEARNING Objective
1. Learn why trade deficits may not be related to job losses in a country.
One of the main reasons trade deficits are considered deleterious is because of a common argument that trade deficits result in job losses. The rationale behind this argument is simple and convincing. There are two parts to the story that begin with the definition of a trade deficit.
First, a trade deficit arises whenever imports exceed exports. One simple reason for an imbalance of this kind is that imports are too large or at least larger than they would be under balanced trade. The most common reason offered in developed countries for why imports are too large is that low import prices arise because less-developed countries have exceedingly low wages paid to workers, lax health and safety standards, or more lenient environmental policies, all of which contribute to a veritable flood of imports.
The effect of excessive imports is said to be the purchase of cheaper foreign goods by domestic consumers rather than purchasing the slightly more expensive domestic varieties. As demand for domestic firms’ products falls, these firms are forced to downsize, resulting in the layoff of domestic workers. Thus it is said that trade deficits cause the loss of domestic jobs.
The second story argues that the reason imports exceed exports is because exports are too low; they are smaller than they should be. The most common reason given for low exports, especially in the developed countries, is the relatively high barriers to trade in developing countries. Although many countries participate in the World Trade Organization (WTO), the average applied tariffs still remain considerably higher in developing countries.
The effect of insufficient exports is that products that could be produced and sold abroad are not produced and sold abroad because of the barriers to trade. If the barriers were only removed, then exports would expand and jobs would be created in the country.
Thus since both of these stories can operate simultaneously, most observers are convinced that trade deficits indeed will cause job losses. Turn the deficit around, perhaps so much so as to induce a trade surplus, and this logic suggests that more jobs will be created.
This argument is very convincing because there is an element of truth to it. Changes in import and export patterns will certainly have competitive impacts on some industries and could produce temporary job losses. However, this doesn’t mean that a country with a trade deficit generates fewer overall jobs than a country with a trade surplus. Nor does it mean that increases in a country’s trade deficit will necessarily lead to economy-wide job losses.
One reason job losses may not occur has to do with the deceptive nature of the previous job loss stories. The stories are convincing as far as they go, but unfortunately, they don’t go far enough. In other words, the job loss stories have some validity, but they are incomplete; they don’t tell the full story, and as a result they tend to mislead.
The rest of the story (as Paul Harvey would have said) is to recognize that when trade deficits arise on the current account, there is an equal and opposite trade surplus on the financial account of the balance of payments. A financial account surplus means that foreigners are purchasing domestic assets. Some of these purchases consist of equities such as stocks and real estate, while other asset purchases involve the lending of money as when foreigners purchase a government bond. In any case, that money flows back into the deficit country and ultimately is spent by someone. That someone could be the previous holder of the real estate or it could be the domestic government. When it is spent, it creates demands for goods and services that in turn create jobs in those industries.
Now consider for a moment the following thought experiment. Suppose we could instantly change the behavior of the foreign lenders generating the financial account surplus (and the related trade deficit). Suppose they decide at once not to lend the money to the government or not to purchase real estate but instead decide to purchase domestic goods. The increase in goods purchases by foreigners would imply that export demand and hence exports will rise. Indeed, they will rise sufficiently to eliminate the trade deficit. And because of the increase in exports, jobs will be created in the export industries. However, at the same time export jobs are created, other jobs in the economy are being lost. That’s because now less money is there to purchase the real estate or to lend to the government. Thus the elimination of the trade deficit doesn’t create jobs in the aggregate, but it will change which sectors have more and less demand for its products. In other words, changes in the trade deficit will ultimately affect only where the jobs are in the economy (i.e., in which industries), not how many jobs there are.
The one exception to this, and one of the main reasons the job loss stories remain so convincing, is when there are rapid changes in the trade deficit or surplus. Rapid changes, like the thought experiment above, would require adjustments of workers between industries. During that adjustment process, some workers will be temporarily unemployed. If that adjustment involves an increase in the trade deficit or a decrease in the trade surplus, the temporary jobs effect will be very noticeable in the tradable products industries. However, if the adjustment involves a decrease in the deficit or an increase in the surplus, then the job losses will more likely occur in the nontradable products sectors and it will be difficult to connect those job losses to the changes in the trade balance.
To provide some validation of this point—that is, that changes in the trade balances do not have effects on the aggregate number of jobs in an economy—consider Figure 3.1.1 , showing two U.S. macroeconomic variables plotted over the past twenty years: the current account balance and the national unemployment rate. Now if the jobs stories suggesting that trade deficits cause job losses were true, we might expect to see an inverse relationship between the trade balance and the unemployment rate. Alternatively, if an increase in a country’s trade deficit causes job losses in the economy, we might expect an increase in the unemployment rate to occur as well. Similarly, a decrease in the trade deficit should create jobs and lead to a decrease in the unemployment rate.
Interestingly, what Figure 3.1.1 shows is that during the periods when the U.S. trade deficit is rising (i.e., the trade balance is falling), the unemployment rate is falling; whereas when the trade deficit is falling, the unemployment rate is rising. This is precisely the opposite effect one would expect if the job-loss stories of trade deficits were true.
Of course this evidence does not prove that trade deficits will reduce unemployment in every country in all circumstances. However, the evidence does suggest that it is inappropriate to jump to the popular conclusion that trade deficits are bad for jobs and thus bad for the economy.
Key Takeaways
• Trade deficits are often incorrectly presumed to cause job losses in an economy.
• The job-loss stories suggest that trade deficits arise due to excessive imports or insufficient exports and that by eliminating a deficit a country can create jobs in the economy.
• The job-loss story is incomplete though because it ignores the demand and jobs caused by the financial account surplus.
• When all effects of trade imbalances are accounted for, trade deficits may cause no more than temporary job losses in transition but not affect the aggregate level of jobs in an economy.
• Evidence from the United States over the past twenty years is used to show that the relationship between trade deficits and the unemployment rate is the opposite from what the popular “trade deficits cause job losses” stories would suggest.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of too large, too small, or just right, concerns about trade deficits sometimes suggest this about imports.
• The import effect on trade deficits is sometimes said to be caused by this wage phenomenon in foreign countries.
• The import effect on trade deficits is sometimes said to be caused by this environmental legal phenomenon in foreign countries.
• Of too large, too small, or just right, concerns about trade deficits sometimes suggest this about exports.
• The export effect on trade deficits is sometimes said to be caused by this trade barrier phenomenon in foreign countries.
• The “trade deficits cause job losses” story ignores the effects of international transactions recorded on this balance of payments account.
• Of increase, decrease, or stay the same, this has been the typical corresponding change in the U.S. unemployment rate whenever the U.S. trade deficit was rising since 1980. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/03%3A_The_Whole_Truth_about_Trade_Imbalances/3.02%3A_Trade_Imbalances_and_Jobs.txt |
Learning objectives
1. Understand the long-term implications of trade imbalances.
2. Identify conditions under which trade imbalances are detrimental, beneficial, or benign.
In this section, a series of simple scenarios (or stories) are presented to demonstrate how the well-being of a country may be affected when it runs a trade imbalance. The scenarios compare national output with domestic spending over two periods of time under alternative assumptions about the country’s trade imbalance and its economic growth rate between the two periods. After each aggregate scenario is presented, we also provide an analogous situation from the point of view of an individual. Finally we present an evaluation of each scenario and indicate countries that may be displaying similar trade patterns.
Two periods are used as a simple way to introduce the dynamic characteristics of trade imbalances. The amount of time between the two periods can be varied to provide alternative interpretations. Thus the two periods could be labeled as today and tomorrow, this year and next year, or this generation and next generation.
We assume that all trade imbalances correspond to debt obligations or IOUs (i.e., I owe you). In other words, the financial account imbalances that offset the trade imbalances will be interpreted as international borrowing and lending rather than, say, foreign direct investment flows or real estate purchases.
Afterward, we will comment on how the interpretations of these scenarios may change with the alternative type of asset flow.
National welfare is best measured by the amount of goods and services that are “consumed” by households. What we care about, ultimately, is the standard of living obtainable by the average citizen, which is affected not by how much the nation produces but by how much it consumes. Although gross domestic product (GDP) is often used as a proxy for national welfare, it is an inadequate indicator for many reasons, especially when a country runs trade imbalances. To quickly see why, consider the extreme situation in which a country runs the largest trade surplus possible. This would arise if a country exports all of its GDP and imports nothing. The country’s trade surplus would then equal its GDP, but the citizens in the country would have no food, clothing, or anything else to consume. The standard of living would be nonexistent.
To avoid this problem we use domestic spending (DS), or the sum of domestic consumption, investment, and government spending, as a proxy for national welfare. More formally, let
$D S = C + I + G \nonumber$,
where C, I, and G are defined as in the national income accounts. Recall from Chapter 2 that C, I, and G each can be segmented into spending on domestically produced goods and services and spending on imported goods and services. Thus domestic spending includes imported goods in the measure of national welfare. This is appropriate since imported goods are consumed by domestic citizens and add to their well-being and standard of living.
One problem with using domestic spending as a proxy for average living standards is the inclusion of investment (note that this problem would also arise using GDP as a proxy). Investment spending measures the value of goods and services used as inputs into the productive process. As such, these items do not directly raise the well-being of citizens, at least not in the present period. To clarify this point, consider an isolated, self-sufficient corn farmer. Each year the farmer harvests corn, using part of it to sustain the family during the year, while allocating some of the kernels to use as seed corn for the following year. Clearly, the more kernels the farmer saves for next year’s crop, the less corn the family will have to consume this year. As with the farmer, the same goes for the nation: the more that is invested today, the lower will be today’s standard of living, ceteris paribus. Thus we must use domestic spending cautiously as a measure of national welfare and take note of changes in investment spending if it occurs.
The analysis below will focus on the interpretation of differences between national income (GDP) and domestic spending under different scenarios concerning the trade imbalance. The relationship between them can be shown by rewriting the national income identity.
The national income identity is written as
$G D P = C + I + G + E X - I M \nonumber$
Substituting the term for domestic spending yields
$G D P = D S + E X − I M \nonumber$
and rearranging it gives
$E X − I M = G D P − D S \nonumber$
The last expression implies that when a country has a current account (or trade) surplus, GDP must exceed domestic spending by the equivalent amount. Similarly, when a country has a trade deficit, domestic spending exceeds GDP.
Note that to be completely accurate, we should use growth national product (GNP) rather than GDP in the analysis. This is because we are interpreting EXIM as the current account balance that includes income payments and receipts. With income flows included on the trade side, the measure of national output we get is GNP not GDP. Because conceptually both are measures of national output, we will use GNP in everything that follows in this section.
Case 1: No Trade Imbalances; No GNP Growth between Periods
Case one, what we will call the base case, is used to demonstrate how GNP compares with domestic spending in the simplest scenario. Here we assume that the country does not run a trade deficit or surplus in either of the two periods and that no GNP growth occurs between periods. No trade imbalance implies that no net international borrowing or lending occurs on the financial account. The case mimics how things would look if the country were in autarky and did not trade with the rest of the world.
Note from Figure 3.3.1 that domestic spending is exactly equal to GNP in both periods. Since domestic spending is used to measure national welfare, we see that the average standard of living remains unchanged between the two periods. Overall, nothing very interesting happens in this case, but it will be useful for comparison purposes.
The Individual Analogy
Consider an individual named Rajiv. For an individual, GNP is analogous to Rajiv’s annual income since his income represents the value of goods and services produced with his labor services. Domestic spending is analogous to the value of the goods and services purchased by Rajiv during the year. It corresponds to Rajiv’s consumption of goods and services that serves as a proxy for his welfare level. Trade for an individual occurs whenever a transaction occurs with someone outside his household.
In the second period, Rajiv must pay back the $5,000 in loans plus the interest charges, which, at a 10 percent interest rate, would amount to$500. Thus $5,500 of Rajiv’s$30,000 income would go toward debt repayment, leaving him with only $24,500 to spend on consumption. In this case, extra consumption, or a higher living standard in period one, is achieved by sacrificing a lower living standard in the future. Note that in the first period Rajiv imports more goods and services in consumption than he exports in terms of labor services. Hence, this corresponds to a trade deficit. In the second period, Rajiv imports fewer goods and services in consumption than the labor services he exports; hence, this corresponds to a trade surplus. Evaluation Case two reflects legitimate concerns about countries that run large or persistent trade deficits. The case highlights the fact that trade deficits, which arise from international borrowing, may require a reduced average standard of living for the country in the future when the loans must be repaid. An example of this situation would be Mexico during the 1970s and 1980s. Mexico ran sizeable current account deficits in the 1970s as it borrowed liberally in international markets. In the early 1980s, higher interest rates reduced its ability to fulfill its obligations to repay principal and interest on its outstanding loans. Their effective default precipitated the third world debt crisis of the 1980s. During the 1980s, as arrangements were made for an orderly, though incomplete, repayment of Mexico’s loans, the country ran sizeable current account surpluses. As in case two here, Mexico’s current account deficits in the 1970s allowed it to raise its average living standards, above what would have been possible otherwise, while its current account surpluses in the 1980s forced a substantial reduction in living standards. It is worth emphasizing that current account deficits are not detrimental in the periods in which the deficits are occurring. In fact, current account deficits correspond to higher consumption, investment, and government spending levels than would be possible under balanced trade. Instead, current account deficits pose a problem only when the debt repayment occurs, which is when the country is running current account surpluses. Trade deficits raise national welfare in the periods in which they occur, while trade surpluses reduce welfare in the periods in which they occur. In other words, in terms of the national welfare effects, the problem here isn’t large or persistent trade deficits but rather the large and persistent trade surpluses that might arise in the future as a result. It is also worth noting that trade deficits in this case need not be a problem in the long run if they are not too large. Just as an individual may make a choice to substitute future consumption for present consumption, so might a nation. For example, an individual may reasonably decide while young to take exotic vacations, engage in daredevilish activities, or maybe purchase a fast car, even if it means taking out sizeable loans. Better to enjoy life while healthy, he may reason, even if it means that he will have to forgo similar vacations or activities when he is older. Similarly, a nation, through an aggregation of similar individual decisions, may “choose” to consume above its income today even though it requires reduced consumption tomorrow. As long as the future reduced consumption “costs” are borne by the individuals who choose to overconsume today, deficits for a nation need not be a problem. However, if the decision to overconsume is made through excessive government spending, then the burden of reduced consumption could fall on the future generation of taxpayers, in which case there would be an intergenerational welfare transfer. Case 3: Current Account Deficit Period 1; Positive GDP Growth between Periods In the third case, we assume, as in case two, that the country runs a trade deficit in the first period, that the trade deficit corresponds to borrowing from the rest of the world, and that in period two all the loans are repaid with interest. What differs here is that we will assume GNP growth occurs between the first and second periods. As we’ll see, growth can significantly affect the long-term effects of trade deficits. In Figure 3.3.3 , note that the first period domestic spending (DS1) lies above GNP in the first period (GNP1). This arises because a trade deficit implies that the country is borrowing from the rest of the world, allowing it to spend (and consume) more than it produces. In the second period, we assume that GNP has grown to GNP2 as shown in the graph. The principal and interest from first period loans are repaid, which lowers domestic spending to DS2. Note that since domestic spending is less than GNP2, the country must be running a trade surplus. Also note that the trade surplus implies that consumption and the average standard of living are reduced below the level that is obtainable with balanced trade in that period. In a sense, the trade deficit has a similar long-term detrimental effect as in case two. However, it is possible that the first period trade deficit, in this case, may actually be generating a long-term benefit. Suppose for a moment that this country’s balanced trade outcome over two periods would look like the base case. In that case, balanced trade prevails but no GDP growth occurs, leaving the country with the same standard of living in both periods. Such a country may be able to achieve an outcome like case three if it borrows money from the rest of the world in period one—thus running a current account deficit—and uses those funds to purchase investment goods, which may in turn stimulate GNP growth. If GNP rises sufficiently, the country will achieve a level of domestic spending that exceeds the level that would have been obtained in the base case. Indeed, it is even possible for a country’s standard of living to be increased in the long term entirely because it runs a trade deficit. In case three, imagine that all the borrowed funds in period one are used for investment. This means that even though domestic spending rises, the average standard of living would remain unchanged relative to the base case because investment goods generate no immediate consumption pleasures. In period two, the higher level of domestic spending may be used for increased consumption that would cause an increase in the country’s average living standards. Thus the country is better off in both the short term and long term with the unbalanced trade scenario compared to the balanced trade case. The Individual Analogy The third case is analogous to our individual Rajiv with, say, a$30,000 income in period one. The trade deficit in the first period means that he borrows money using his credit card to purchase an additional, say, $5,000 worth of “imported” consumption goods. Thus in period one the person’s consumption and standard of living are higher than reflected by his income. In the second period, the GNP rises, corresponding to an increase in Rajiv’s income. Let say that his income rises to$40,000 in the second period. We’ll also assume that all credit card loans must be repaid along with 10 percent interest charges in the second period. Consumption spending for Rajiv is now below his income. Subtracting the $5,000 principal repayment and the$500 interest payment from his $40,000 income yields consumption of$34,500.
The investment story above is similar to the case in which an individual takes out $5,000 in student loans in period one and earns an advanced degree that allows him to acquire a better-paying job. Assuming the educational investment does not add to his consumption pleasures (a seemingly reasonable assumption for many students), his welfare is unaffected by the additional spending that occurs in period one. However, his welfare is increased in period two since he is able to consume an additional$4,500 worth of goods and services even after paying back the student loans with interest.
Evaluation
The lesson of case three is that trade deficits, even if large or persistent, will not cause long-term harm to a nation’s average standard of living if the country grows rapidly enough. Rapid economic growth is often a cure-all for problems associated with trade deficits.
In some cases, it is possible for growth to be induced by investment spending made possible by borrowing money in international markets. A trade deficit that arises in this circumstance could represent economic salvation for a country rather than a sign of economic weakness.
Consider a less-developed country. Countries are classified as less developed because their average incomes are very low. Indeed, although many less-developed countries, or LDCs, have a small, wealthy upper class, most of the population lives in relative poverty. Individuals who are poor rarely save very much of their incomes, therefore, LDCs generally have relatively small pools of funds at home that can be used to finance domestic investment. If investment is necessary to fuel industrialization and economic growth, as is often the case especially in early stages of development, an LDC might be forced to a slow or nonexistent growth path if it restricts itself to balanced trade and limits its international borrowing.
On the other hand, if an LDC borrows money in international financial markets, it will run a trade deficit by default. If these borrowed funds are used for productive investment, which in turn stimulates sufficient GDP growth, then the country may be able to raise average living standards even after repaying the principal and interest on international loans. Thus trade deficits can be a good thing for less-developed countries.
The same lesson can be applied to the economies in transition in the former Soviet bloc. These countries suffered from a lack of infrastructure and a dilapidated industrial base after the collapse of the Soviet Union. One obvious way to spur economic growth in the transition is to replace the capital stock with new investment: build new factories, install modern equipment, improve the roads, improve telecommunications, and so on. However, with income falling rapidly after the collapse, there were few internal sources to fund this replacement investment. It was also not obvious which sectors were the best to invest in. Nevertheless, one potential option was for these countries to borrow funds on international financial markets. Trade deficits that would occur under this scenario could be justified as an appropriate way to stimulate rapid economic growth.
Of course, just because trade deficits can induce economic growth and generate long-term benefits for a country doesn’t mean that a trade deficit will spur long-term economic growth. Sometimes investments are made in inappropriate industries. Sometimes external shocks cause once profitable industries to collapse. Sometimes borrowed international funds are squandered by government officials and used to purchase large estates and big cars. For many reasons good intentions, and good theory, do not always produce good results. Thus a country that runs large and persistent trade deficits, hoping to produce the favorable outcome shown in case three, might find itself with the unfavorable outcome shown in case two.
Finally, a country running trade deficits could find itself with the favorable outcome even if it doesn’t use borrowed international funds to raise domestic investment. The United States, for example, has had rather large trade deficits since 1982. By the late 1980s, the United States achieved the status of the largest debtor nation in the world. During the same period, domestic investment remained relatively low especially in comparison to other developed nations in the world. One may quickly conclude that since investment was not noticeably increased during the period, the United States may be heading for the detrimental outcome. However, the United States maintained steady GNP growth during the 1980s and 1990s, except during the recession year in 1992. As long as growth proceeds rapidly enough, for whatever reason, even a country with persistent deficits can wind up with the beneficial outcome.
Case 4: Current Account Surplus Period 1; No GDP Growth between Periods
In this case, we assume that the country runs a trade surplus in the first period and that no GDP growth occurs between periods. A surplus implies that exports exceed imports of goods and services and that the country has a financial account deficit. We will assume that the financial account deficit corresponds entirely to loans made to the rest of the world. We can also refer to these loans as savings, since the loans imply that someone in the country is forgoing current consumption. In the future, these savings will be redeemed along with the interest collected in the interim. We shall assume that all of these loans are repaid to the country with interest in the second period.
In Figure 3.3.4 , we see that in the first period, when the trade surplus is run, domestic spending (DS1) is less than national income or GDP. This occurs because the country is lending rather than consuming some of the money available from production. The excess of exports over imports represents goods that could have been used for domestic consumption, investment, and government spending but are instead being consumed by foreigners. This means that a current account surplus reduces a country’s potential for consumption and investment below what is achievable in balanced trade. If the trade surplus substitutes for domestic consumption and government spending, then the trade surplus will reduce the country’s average standard of living. If the trade surplus substitutes for domestic investment, average living standards would not be affected, but the potential for future growth can be reduced. In this sense, trade surpluses can be viewed as a sign of weakness for an economy, especially in the short run during the periods when surpluses are run. Surpluses can reduce living standards and the potential for future growth.
Nevertheless, this does not mean that countries should not run trade surpluses or that trade surpluses are necessarily detrimental over a longer period. As shown in the diagram, when period two arrives the country redeems its past loans with interest. This will force the country to run a trade deficit, and domestic spending (DS2) will exceed GDP. The trade deficit implies imports exceed exports, and these additional imports can be used to raise domestic consumption, investment, and government spending. If the deficit leads to greater consumption and government spending, then the country’s average standard of living will rise above what is achievable in balanced trade. If the deficit leads to greater investment, then the country’s potential for GDP growth in the third period (not shown) is enhanced.
Briefly, this case describes the situation in which a country forgoes first period consumption and investment so that in period two it can enjoy even greater consumption and investment.
The Individual Analogy
Consider our individual, Rajiv, who has an annual income of $30,000 over two periods. This corresponds to the constant GDP in the above example. Rajiv would run a trade surplus in period one if he lends money to others. One way to achieve this is simply to put money into a savings account in the local bank. Suppose Rajiv deposits$5,000 into a savings account. That money is then used by the bank to make loans to other individuals and businesses. Thus in essence Rajiv is making loans to them with the bank acting as an intermediary. The $5,000 also represents money that Rajiv does not use to buy goods and services. Thus in period one Rajiv exports$30,000 of labor services, but imports only $25,000 of consumption goods. The excess is loaned to others so that they may be consumed instead in the first period. It is clear that Rajiv’s standard of living at$25,000 is lower in the first period than the $30,000 he could have achieved had he not deposited money into savings. In the second period, we imagine that Rajiv again earns$30,000 and withdraws all the money plus interest from the savings account. Suppose he had earned 10 percent interest between the periods. In this case, his withdrawal would amount to $5,500. This means that in period two Rajiv can consume$35,500 worth of goods and services. This outcome also implies that Rajiv’s domestic spending capability exceeds his income and so he must be running a trade deficit. In this case, Rajiv’s imports of goods and services at $35,500 exceed his exports of$30,000 worth of labor services; thus he has a trade deficit.
Is this outcome good or bad for Rajiv? Most would consider this a good outcome. One might argue that Rajiv has prudently saved some of his income for a later time when he may have a greater need. The story may seem even more prudent if Rajiv suffered a significant drop in income in the second period to, say, $20,000. In this case, the savings would allow Rajiv to maintain his consumption at nearly the same level in both periods despite the shock to his income stream. This corresponds to the words of wisdom that one should save for a rainy day. Savings can certainly allow an individual to smooth his consumption stream over time. Alternatively, one might consider the two periods of the story to be middle age and retirement. In this case, it would make sense to save money out of one’s income in middle age so that one can draw on those savings and their accumulated earnings during retirement when one’s income has fallen to zero. On the other hand, excessive saving in the first period might make Rajiv seem miserly. Few people would advise that one save so much as to put oneself into poverty or to reduce one’s living standard below some reasonable norm. Excessive prudence can seem inappropriate as well. Evaluation The prime example of a country that mimics the first period of case four is Japan during the 1980s and 1990s. Japan ran sizeable trade surpluses during those two decades. As this story suggests, the flip side of the trade surplus is a financial account deficit that implied a considerable increase in the amount of loans that Japan made to the rest of the world. Although Japan’s trade surplus has often been touted as a sign of strength, an important thing to keep in mind is that Japan’s trade surpluses implied lower consumption and government purchases, and thus a lower standard of living than would have been possible with balanced trade. Although trade surpluses can also result in lower investment, this effect was not apparent for Japan. During those two decades of investment, spending as a percentage of GDP always exceeded 25 percent, higher than most other developed countries. These surpluses may turn out to be especially advantageous for Japan as it progresses in the twenty-first century. First of all, it is clear that Japan’s surpluses did not usher in an era of continual and rapid GDP growth. By the early 1990s, Japan’s economy had become stagnant and finally began to contract by 1998. However, rather than allowing a decline in GDP to cause a reduction in living standards, Japan could use its sizeable external savings surplus to maintain consumption at the level achieved previously. Of course, this would require that Japan increase its domestic consumption and begin to run a trade deficit, two things that did not occur even by 2009. In another respect, Japan’s trade surpluses may be advantageous over the longer run. Japan, along with most other developed nations, will experience a dramatic demographic shift over the next three decades. Its retired population will continue to grow as a percentage of the total population of the baby boomers reach retirement and people continue to live longer. The size of the Japan’s working population will consequently decline as a percentage of the population. This implies an increasing burden on Japan’s pay-as-you-go social retirement system as a smaller number of workers will be available per retiree to fund retiree benefits. If at that time Japan draws down its accumulated foreign savings and runs trade deficits, it will be able to boost the average consumption level of its population while reducing the need to raise tax burdens to fund its social programs. Of course, this outcome may never be realized if Japan’s economy does not rebound strongly from its recent stagnant condition. Overall, regardless of the outcome, Japan’s economy today, faced with a potentially severe recession, is certainly in a stronger position by virtue of its accumulated foreign savings than it would be if it had run trade deficits during the past two decades. Summary These stories suggest that trade imbalances, when evaluated in terms of their momentary effects and their long-term economic consequences, can be either good, bad, or benign, depending on the circumstances. Trade deficits may signal excessive borrowing that could in the future lead to possible default, or worse, an excessive reduction in living standards needed to repay the accumulated debt. In this case, the trade deficit is clearly bad for the nation. Alternatively, trade deficits may represent a country that is merely drawing down previously accumulated foreign savings or selling other productive assets, in which case there is no potential for default or reduced living standards in the future. Here, the trade deficit is either immaterial or even beneficial in that the nation is able to achieve a higher current living standard because of the deficit. Trade deficits might also make an expansion of domestic investment possible, which could spur future economic growth sufficiently to make repayment consistent with growing living standards. In this case, trade deficits are clearly good as they stimulate future economic prosperity. Finally, in a free market economy, trade deficits may simply reflect the aggregated choices of many individuals to forgo future consumption to achieve more current consumption. In this case, the trade deficit should be viewed as immaterial since it merely reflects the free choices of the nation’s people. On the other hand, a trade surplus may correspond to prudent foreign saving and purchases of foreign productive assets, which may be used to support a growing retired population in the future. In this case, the trade surplus is a good thing for the nation. The trade surplus might also represent a period of repayment of past debt. This outcome may be acceptable if achieved together with growing living standards. However, if the surplus arises in a period of slow growth or falling GDP, then the surplus would correspond to painful reductions in living standards, which is clearly a bad outcome for the country. Finally, the trade surplus may occur as a result of the aggregated choices of many individuals who have acquired greater past consumption by forgoing current consumption. In this case, the surplus should be viewed as immaterial to the nation as a whole. Key Takeaways • Domestic spending measures the total value of purchases of goods and services in a country regardless of where the goods and services were produced. As such, it is a better way to measure the “consumption” in an economy affecting the nation’s standard of living as compared to “production” or GDP. • When a country has a current account deficit, its national consumption exceeds its national production. When a country has a current account surplus, its national production exceeds its national consumption. • Trade deficits become a problem over time if accumulated borrowings result in a substantial reduction in consumption and standard of living for its citizens during the repayment periods. • The problems associated with a deficit occur not when the trade deficit is being run but in later periods when a trade surplus becomes necessary. • Trade deficit problems are mitigated with GNP growth. The faster GNP grows, the lesser the decline in future consumption during the repayment period. Exercises 1. Consider the Japanese economy over two periods of time: first period (today) and second period (the future). Suppose Japanese GDP today is$2,000 billion (we’ll use the U.S. dollar rather than the yen). Suppose Japan runs a current account surplus of 5 percent of GDP in the first period and lends money at the market interest rate of 5 percent.
• What is the value of domestic spending on C, I, and G in the first period?
• What would be the value of domestic spending in Japan in the second period if all the first period loans are repaid with interest and no economic growth occurs between periods?
2. Consider the following situations describing the actions of an individual household. Explain whether each situation is analogous to a country running a trade deficit, a trade surplus, or neither. Briefly explain why.
• A student takes out a bank loan to finance a spring break vacation.
• A family sells an antique watch to finance a purchase of 100 shares of a “hot” stock.
• A retired couple cashes in a portion of their savings to finance their daily living expenses.
• A carpenter builds a deck for a dentist in exchange for dental checkups for his kids.
• A family pays off the last \$3,000 of its student loans.
3. Suppose that each situation listed is the dominant effect on a country’s balance of payments. Indicate by filling in the blank spaces whether the current account and capital account will be in surplus or deficit.
Current Account Balance Financial Account Balance
a. A country is a net borrower from the rest of the world
b. A country is repaying past debts
c. A country exports more goods and services than it imports
d. A country sells foreign assets and repatriates the proceeds
e. A country is a net lender to the rest of the world
f. A country earns more income on foreign assets than foreigners earn in its country | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/03%3A_The_Whole_Truth_about_Trade_Imbalances/3.03%3A_The_National_Welfare_Effects_of_Trade_Imbalances.txt |
Learning objective
1. Recognize how the long-term consequences of trade deficits change when they are financed by equity rather than debt.
The analysis of trade imbalances is further complicated by the fact that not all financial flows are debt obligations or IOUs (i.e., I owe you). In the previous stories, we assumed that all financial account transactions corresponded to international lending or borrowing. In actuality, many international asset transactions involve sales or purchases of productive assets. For example, if a foreigner purchases shares of Microsoft stock in the U.S. market, the transaction would be recorded as a credit entry on the financial account and would add to a financial account surplus. However, in this case we could not claim that someone in the United States borrowed money from the rest of the world because there is no obligation to repay principal and interest in the future. Instead the foreign purchaser of the U.S. asset has purchased an ownership claim in a U.S. corporation that entitles him to the future stream of dividends plus capital gains if he sells the stock later at a higher price. If the company is profitable in the future, then the investors will earn a positive return. However, if the company suffers economic losses in the future, then the dividends may be discontinued and the stock’s price may fall. Alternatively, the U.S. dollar could experience a significant depreciation. The end result could be losses for the foreign investor and a negative rate of return. In either case the foreign investor is not “entitled” to a return of his original investment or any additional return beyond. This same type of relationship arises for international real estate transactions and for foreign direct investment, which occurs when a foreign firm substantially owns and operates a company in another country.
To the extent that financial account flows correspond to asset purchases without repayment obligations, the stories above change somewhat. For example, suppose a country runs a trade deficit in period one and suppose further that the resulting financial account surplus corresponds to foreign purchases of U.S. real estate and businesses. In the first period, a country’s standard of living could be raised above what is possible with balanced trade—not by borrowing money but by selling ownership claims on productive assets. In the second period, the country’s standard of living need not be reduced since there is no repayment obligation.
This case is analogous to an individual who sells his watch at a pawnshop. In that period he is able to buy more than his income because he has divested some of his previously accumulated wealth. In the following period, he can once again make purchases equal to his income and thus need not suffer a reduction in his living standards.
The implication here is that nondebt asset flows may be less problematic than international loans because they do not require a reduction in living standards in the future. Of course, in this case, there is an additional concern that the country that sells off its assets may also be losing control of its productive assets and thus its citizens will not be the ones to earn positive returns on these domestic activities. This concern should be tempered for a few reasons. First, foreign-owned firms remain subject to the laws of the domestic country. Countries can prevent exorbitant profit taking by applying profit taxes. What’s more, the foreign owners do not enjoy voting privileges and thus have less say over laws that might affect them. Second, foreign-owned firms generate employment opportunities for domestic citizens, and that serves to benefit the country. Finally, owners of firms, whether foreign or domestic, are generally motivated by similar desires—namely, to make the business successful— and successful businesses generally benefit the owners, the employees, and the consumers of the product.
As an example, consider the purchase in the 1980s of Rockefeller Center in New York City by a group of Japanese investors. Rockefeller Center is a centrally located building in New York City whose owners lease office space to businesses that wish to locate their offices there. Any owner of the building must compete with other businesses leasing office space throughout the city and thus must provide as high a quality and as low a price as possible. If the owners manage the property well and provide quality services, then they will have a lot of tenants and they will make a profit. If they provide poor services, then businesses will move out and the owners will lose money. Thus it really shouldn’t matter to the tenants whether the owners are American or Japanese, only whether they are good managers of the office space. Similarly, the owners, regardless of nationality, will hire workers to maintain the facilities. These workers will benefit if the management is good and will suffer if it is poor, regardless of the owners’ nationality. Finally, if the owners of the building are successful, then they deserve to earn a profit or return on their investment. If they provide poor services at high prices, then they will deserve to make a loss. Indeed, it shouldn’t matter to anyone whether the owners are American or Japanese nationals.
Key Takeaways
• A trade deficit financed by sales of equity rather than debt does not require a repayment in the future or a subsequent decline in consumption. However, it does imply that a flow of the profits from domestic activities will accrue to foreigners rather than domestic residents.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The full form of the abbreviation “IOU.”
• The terms representing the two broad types of assets; one is related to borrowing and lending and the other is related to ownership.
• The type of asset represented by a bank certificate of deposit.
• The type of asset represented by a common or preferred share of stock.
• The type of asset represented by a checking account deposit.
• The type of asset represented by the deed to a private golf course.
• International purchases of this type of asset require repayment of principal and interest in the future.
• International purchases of this type of asset do not require repayment of principal and interest. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/03%3A_The_Whole_Truth_about_Trade_Imbalances/3.04%3A_Some_Further_Complications.txt |
Learning Objective
1. Identify the conditions determining when a nation’s trade imbalance is good, bad, or benign.
Review of Trade Imbalance Interpretations
A quick reading of business and financial newspapers and magazines often reveals a number of misunderstandings about economic relationships. One of the most notable is the widespread conviction that trade deficits are a troubling economic condition that indicates weakness in an economy, while trade surpluses are a sign of strength for an economy. Although these beliefs are well founded in some circumstances, they are not valid as a general principle. A careful look at the implications of trade imbalances reveals that trade deficits can, at times, be an indicator of rising economic stature, while trade surpluses can be associated with economic disaster. In many other cases, perhaps most, trade imbalances are simply benign—that is, they do not represent a serious threat or imply a notable benefit.
There are several reasons why misunderstandings about trade imbalances persist. The first problem relates to the terminology. A deficit, regardless of the context, sounds bad. To say that a business’s books are in deficit, that a government’s budget is in deficit, or that a country’s trade balance is in deficit, simply sounds bad. A surplus, in contrast, sounds pretty good. For a business, clearly we’d prefer a surplus, to be in the black, to make a profit. Likewise, a budget surplus or a trade surplus must be good as well. Lastly, balance seems either neutral or possibly the ideal condition worth striving for. From an accountant’s perspective, balance is often the goal. Debits must equal credits, and the books must balance. Surely, this terminology must contribute to the confusion, at least in a small way, but it is not accurate in describing trade imbalances in general.
A second reason for misunderstandings, especially with regard to deficits, may be a sense of injustice or inequity because foreigners are unwilling to buy as many of our goods as we buy of theirs. Fairness would seem to require reciprocity in international exchanges and therefore balanced trade. This misunderstanding could be easily corrected if only observers were aware that a country’s balance of payments, which includes trade in goods, services, and assets, is always in balance. There are no unequal exchanges even when a country runs a trade deficit.
A third reason for the misunderstanding is that trade deficits are indeed bad for some countries in some situations while surpluses are sometimes associated with good economic outcomes. One needs only to note the many international debt crises experienced by countries after they had run persistent and very large trade deficits. One could also look at the very high growth rates of Japan in the 1980s and China in the last few decades for examples of countries with large trade surpluses that have seemingly fared very well.
However, despite these examples, one should not conclude that any country that has a trade deficit or whose trade deficit is rising is necessarily in a potentially dangerous situation; nor should we think that just because a country has a trade surplus that it is necessarily economically healthy. To see why, we must recognize that trade imbalances represent more than just an imbalance in goods and services trade.
Any imbalance in goods and services trade implies an equal and opposite imbalance in asset trade. When a country runs a trade deficit (more exhaustively labeled a current account deficit), it is also running a financial account surplus; similarly, a trade surplus corresponds to a financial account deficit. Imbalances on the financial account mean that a country is a net seller of international assets (if a financial account surplus) or a net buyer of international assets (if a financial account deficit).
One way to distinguish among good, bad, or benign trade imbalances is to recognize the circumstances in which it is good, bad, or benign to be a net international borrower or lender, a net purchaser, or seller of ownership shares in businesses and properties.
The International Investment Position
An evaluation of a country’s trade imbalance should begin by identifying the country’s net international asset or investment position. The investment position is like a balance sheet in that it shows the total holdings of foreign assets by domestic residents and the total holdings of domestic assets by foreign residents at a point in time. In the International Monetary Fund’s (IMF) financial statistics, these are listed as domestic assets (foreign assets held by domestic residents) and domestic liabilities (domestic assets owned by foreign residents). In contrast, the financial account balance is more like an income statement that shows the changes in asset holdings during the past year. In other words, the international asset position of a country consists of stock variables while the financial account balance consists of flow variables.
A country’s net international investment balance may either be in a debtor position, a creditor position, or in balance. If in a creditor position, then the value of foreign assets (debt and equity) held by domestic residents exceeds the value of domestic assets held by foreigners. Alternatively, we could say that domestic assets exceed domestic liabilities. If the reverse is true, so that domestic liabilities to foreigners exceed domestic assets, then the country would be called a debtor nation.
Asset holdings may consist of either debt obligations or equity claims. Debt consists of IOUs in which two parties sign a contract agreeing to an initial transfer of money from the lender to the borrower followed by a repayment according to an agreed schedule. The debt contract establishes an obligation for the borrower to repay principal and interest in the future. Equity claims represent ownership shares in potentially productive assets. Equity holdings do not establish obligations between parties, at least not in the form of guaranteed repayments. Once ownership in an asset is transferred from seller to buyer, all advantages and disadvantages of the asset are transferred as well.
Debt and equity obligations always pose several risks. The first risk with debt obligations is the risk of possible default (either total or partial). To the lender, default risk means that the IOU will not be repaid at all, that it will be repaid only in part, or that it is repaid over a much longer period than originally contracted. To the borrower, the risk of default is that future borrowing will likely become unavailable. In contrast, the advantage of default to the borrower is that not all the borrowed money is repaid.
The second risk posed by debt is that the real value of the repayments may be different than expected. This can arise because of unexpected inflation or unexpected currency value changes. Consider inflation first. If inflation is higher than expected, then the real value of debt repayment (if the nominal interest rate is fixed) will be lower than originally expected. This will be an advantage to the borrower (debtor), who repays less in real terms, and a disadvantage to the lender (creditor), who receives less in real terms. If inflation turns out to be less than expected, then the advantages are reversed.
Next, consider currency fluctuations. Suppose a domestic resident, who receives income in the domestic currency, borrows foreign currency in the international market. If the domestic currency depreciates, then the value of the repayments in domestic currency terms will rise even though the foreign currency repayment value remains the same. Thus currency depreciations can be harmful to borrowers of foreign currency. A similar problem can arise for a lender. Suppose a domestic resident purchases foreign currency and then lends it to a foreign resident (note in this case the domestic resident is saving money abroad). Afterward, if the domestic currency appreciates, then foreign savings, once cashed in, will purchase fewer domestic goods and the lender will lose.
Similarly, various risks arise with equity purchases internationally because the asset’s rate of return may turn out to be less than expected. This can happen for a number of different reasons. First, if the equity purchases are direct investment in a business, then the return on that investment will depend on how well the business performs. If the market is vibrant and management is good, then the investment will be profitable. Otherwise, the rate of return on the investment could be negative; the foreign investor could lose money. In this case, all the risk is borne by the investor, however. The same holds for stock purchases. Returns on stocks may be positive or negative, but it is the purchaser who bears full responsibility for the return on the investment. As with debt, equity purchases can suffer from exchange rate risk as well. When foreign equities are purchased, their rate of return in terms of domestic currency will depend on the currency value. If the foreign currency in which assets are denominated falls substantially in value, then the value of those assets falls along with it.
Four Trade Imbalance Scenarios
There are four possible situations that a country might face. It may be
1. a debtor nation with a trade deficit,
2. a debtor nation with a trade surplus,
3. a creditor nation with a trade deficit,
4. a creditor nation with a trade surplus.
Figure 3.5.1 depicts a range of possible international investment positions. On the far left of the image, a country would be a net debtor nation, while on the far right, it would be a net creditor nation. A trade deficit or surplus run in a particular year will cause a change in the nation’s asset position assuming there are no capital gains or losses on net foreign investments. A trade deficit would generally cause a leftward movement in the nation’s investment position implying either a reduction in its net creditor position or an increase in its net debtor position. A trade surplus would cause a rightward shift in a country’s investment position implying either an increase in its net creditor position or a decrease in its net debtor position.
An exception to this rule occurs whenever there are changes in the market value of foreign assets and when the investment position is calculated using current market values rather than original cost. For example, suppose a country has balanced trade in a particular year and is a net creditor nation. If the investment position is evaluated using original cost, then since the current account is balanced, there would be no change in the investment position. However, if the investment position is evaluated at current market values, then the position can change even with balanced trade. In this case, changes in the investment position arise due to capital gains or losses. Real estate or property valuations may change, portfolio investments in stock markets may rise or fall, and currency value changes may also affect the values of national assets and liabilities.
The pros and cons of a national trade imbalance will depend on which of the four situations describes the current condition of the country. We’ll consider each case in turn next.
Case 1: Net Debtor Nation Running a Current Account Deficit
This is perhaps the most common situation in the world, or at least this type of case gets the most attention. The main reason is that large trade deficits run persistently by countries, which are also large debtor nations, can eventually be unsustainable. Examples of international debt crises are widespread. They include the third world debt crisis of the early 1980s, the Mexican crisis in 1994, and the Asian crisis in 1997.
However, not all trade deficits nor all debtor countries face eventual default or severe economic adjustment. Indeed, for some countries, a net debtor position with current account deficits may be an ideal economic situation. To distinguish the good cases from the bad requires us to think about situations in which debt is good or bad.
As mentioned earlier, a current account deficit means that a country is able to spend more on goods and services than it produces during the year. The additional spending can result in increases in consumption, investment, and/or government spending. The country accomplishes this as a net debtor country by borrowing from the rest of the world (incurring debt), or by selling some of its productive assets (equities).
Let’s consider a few scenarios.
First, suppose the current account deficit is financed by borrowing money from the rest of the world (i.e., incurring debt). Suppose the additional spending over income is on consumption and government goods and services. In this case, the advantage of the deficit is that the country is able to consume more private and public goods while it is running the deficit. This would enhance the nation’s average standard of living during the period the deficit is being run. The disadvantage is that the loans that finance the increase in the standard of living must be repaid in the future. During the repayment period, the country would run a current account surplus, resulting in national spending below national income. This might require a reduction in the country’s average standard of living in the future.
This scenario is less worrisome if the choices are being made by private citizens. In this case, individuals are freely choosing to trade off future consumption for current consumption. However, if the additional spending is primarily on government goods and services, then it will be the nation’s taxpayers who will be forced to repay government debt in the future by reducing their average living standards. In other words, the future taxpayers’ well-being will be reduced to pay for the extra benefits accruing to today’s taxpayers.
Possible reductions in future living standards can be mitigated or eliminated if the economy grows sufficiently fast. If national income is high enough in the future, then average living standards could still rise even after subtracting repayment of principal and interest. Thus trade deficits are less worrisome when both current and future economic growth are more rapid.
One way to stimulate economic growth is by increasing spending on domestic investment. If the borrowed funds that result when a country runs a current account deficit are used for investment rather than consumption or if the government spending is on infrastructure, education, or other types of human and physical capital, then the prospects for economic growth are enhanced.
Indeed, for many less-developed countries and countries in transition from a socialist to capitalist market, current account deficits represent potential salvation rather than a curse. Most poor countries suffer from low national savings rates (due to low income) and inadequate tax collection systems. One obvious way to finance investment in these countries is by borrowing from developed countries that have much higher national savings rates. As long as the investments prove to be effective, much more rapid economic growth may be possible.
Thus trade deficits for transitional and less-developed economies are not necessarily worrisome and may even be a sign of strength if they are accompanied by rising domestic investment and/or rising government expenditures on infrastructure.
The main problem with trade deficits arises when they result in a very large international debt position. (Arguably, one could claim that international debt greater than 50 percent of GDP is very large.) In this circumstance, it can lead to a crisis in the form of a default on international obligations. However, the international debt position figures include both debt and equities, and only the debt can be defaulted on. Equities, or ownership shares, may yield positive or negative returns but do not represent the same type of contractual obligations. A country would never be forced to repay foreign security holders for its losses simply because its value on the market dropped. Thus a proper evaluation of the potential for default should only look at the net international “debt” position after excluding the net position on equities.
Default becomes more likely the larger the external debt relative to the countries’ ability to repay. Ability to repay can be measured in several ways. First, one can look at net debt relative to GDP. Since it measures annual national income, GDP represents the size of the pool from which repayment of principal and interest is drawn—the larger the pool, the greater the ability of the country to repay. Alternatively, the lower the country’s net debt to GDP ratio, the greater the country’s ability to repay.
A second method to evaluate ability to repay is to consider net debt as a percentage of exports of goods and services. This is especially relevant when international debt is denominated in foreign currencies. In this case, the primary method to acquire foreign currencies to make repayment of debt is through the export of goods and services. (The alternative method is to sell domestic assets.) Thus the potential for default may rise if the country’s ratio of net external debt to exports is larger.
Notice, though, that the variable to look at to evaluate the risk of default is the net debt position, not the trade deficit. The trade deficit merely reveals the change in the net debt position during the past year and does not record total outstanding obligations. In addition, a trade deficit can be run even while the net “debt” position falls. This could occur if the trade deficit is financed primarily with net equity sales rather than net debt obligations. Thus the trade deficit, by itself, does not reveal a complete picture regarding the potential for default.
Next, we should consider what problems are associated with default. Interestingly, it is not really default itself that is immediately problematic but the actions taken to avoid default. If default on international debt does occur, international relationships with creditor countries would generally suffer. Foreign banks that are not repaid on past loans will be reluctant to provide loans in the future. For a less-developed country that needs foreign loans to finance productive investment, these funds may be cut off for a long period and thus negatively affect the country’s prospects for economic growth. On the positive side, default is a benefit for the defaulting country in the short-run since it means that borrowed funds are not repaid. Thus the country enjoys the benefits of greater spending during the previous periods when trade deficits are run but does not have to suffer the consequences of debt repayment. With regard to the country’s international debt position, default would cause an immediate discrete reduction in the country’s debt position.
The real problem arises when economic shocks suddenly raise external obligations on principal and interest, making a debt that was once sustainable suddenly unsustainable. In these cases, it is the effort made to avoid default that is the true source of the problem.
Inability to repay foreign debt arises either if the value of payments suddenly increases or if the income used to finance those payments suddenly falls. Currency depreciations are a common way in which the value of repayments can suddenly rise. If foreign debt is denominated in foreign currency, then domestic currency depreciation implies an appreciation in the value of external debt. If the currency depreciation is large enough, a country may become suddenly unable to make interest and principal repayments. Note, however, that if external debt were denominated in domestic currency, then the depreciation would have no effect on the value of interest and principal repayments. This implies that countries with large external debts are in greater danger of default if (1) their currency value is highly volatile and (2) the external debt is largely denominated in foreign currency.
A second way in which foreign interest obligations can suddenly rise is if the obligations have variable interest rates and if the interest rates suddenly rise. This was one of the problems faced by third world countries during the debt crisis in the early 1980s. Loans received from the U.S. and European banks carried variable interest rates to reduce the risk to the banks from unexpected inflation. When restrictive monetary policy in the United States pushed up U.S. interest rates, interest obligations by foreign countries also suddenly rose. Thus international debt with variable interest rates potentially raises the likelihood of default.
Default can also occur if a country’s ability to repay suddenly falls. This can occur if the country enters into a recession. Recessions imply falling GDP, which reduces the pool of funds available for repayment. If the recession is induced by a reduction in exports, perhaps because of recessions in major trading partner countries, then the ability to finance foreign interest and principal repayments is reduced. Thus a recession in the midst of a large international debt position can risk potential default on international obligations.
But what are the problems associated with a sudden increase in debt repayment if default on the debt does not occur? The problem, really, is that the country might suddenly have to begin running current account surpluses to maintain repayments of its international obligations. Remember that trade deficits mean that the country can spend more than its income. By itself, that’s a good thing. Current account surpluses, though, mean that the country must spend less than its income. That’s the bad thing, especially if it occurs in the face of an economic recession.
Indeed, this is one of the problems the U.S. economy is facing in the midst of the current recession. As the U.S. GDP began to fall in the fall of 2008, the U.S. trade deficit also fell. For the “trade deficits are bad” folks, this would seem to be a good thing. However, it really indicated that not only was U.S. production falling but, because its trade deficit was also falling, its consumption was falling even faster. In terms of standard of living, the drop in the U.S. trade deficit implied a worsening of the economic conditions of its citizens.
However, since this problem arises only when a net debtor country runs a current account surplus, we’ll take up this case in the next section. Note well though that the problems associated with a trade deficit run by a net debtor country are generally not visible during the period in which the trade deficit is run. It is more likely that a large international debt will pose problems in the future if or when substantial repayment begins.
In summary, the problem of trade deficits run by a net debtor country is more worrisome
1. the larger the net debtor position,
2. the larger the net debt (rather than equity) position,
3. the larger the CA deficit (greater than 5 percent of GDP is large according to some, although large deficit with small net debtor position is less worrisome),
4. the more net debt is government obligations or government backed,
5. the larger the government deficit,
6. if a high percentage of debt is denominated in foreign currency and if the exchange rate has or will depreciate substantially,
7. if rising net debt precedes slower GDP growth,
8. if rising net debt correlates with falling investment,
9. if deficits correspond to “excessive” increase in (\(C + G\)) per capita (especially if G is not capital investment),
10. if interest rate on external debt is variable,
11. if a large recession is imminent.
The situation is benign or beneficial if the reverse occurs.
Case 2: Net Debtor Nation Running a Current Account Surplus
This case generally corresponds to a country in the process of repaying past debt. Alternatively, foreigners may be divesting themselves of domestic equity assets (i.e., selling previously purchased equities, like stocks and real estate, back to domestic residents). In either case, the trade surplus will reduce the country’s net debtor position and will require that domestic spending is less than national income. This case is especially problematic if it arises because currency depreciation has forced a sudden change in the country’s required repayments on international debt. This is the outcome when a series of trade deficits proves to be unsustainable. What unsustainability means is that the deficits can no longer be continued. Once external financing is no longer available, the country would not have the option to roll over past obligations. In this case, in the absence of default, the country’s net repayment on current debt would rise and push the financial account into deficit and hence the trade account into surplus.
When this turnaround occurs rapidly, the country suddenly changes from a state in which it spends more on consumption, investment, and government than its income to a state in which it spends less on these items than its income. Even if GDP stayed the same, the country would suffer severe reductions in its standard of living and reductions in its investment spending. The rapid reduction in domestic demands is generally sufficient to plunge the economy into a recession as well. This reduction in GDP further exacerbates the problem.
This problematic outcome is made worse nationally when most of the debt repayment obligations are by the domestic government or if the external obligations are government-backed. A government that must suddenly make larger than expected repayments of debt must finance it either by raising taxes or by reducing government benefits. The burden of the repayment is then borne by the general population because it must all come from taxpayers. Exactly who suffers more or less will depend on the nature of the budget adjustments, although it often seems that poorer segments of the population bear the brunt of the adjustment costs.
If the sudden increase in debt repayment were primarily by private firms, then the burdens would fall on the associates of those firms rather than the general population. If this occurs on a small scale, we can view this as normal adjustments in a free market system: some firms always go bust, forcing dislocations of labor and capital. The general population in this case would not bear the burden of adjustment unless they are affiliated with the affected firms.
However, even if the debt repayment burden is private and even if the government had not previously guaranteed that debt, the government may feel compelled to intervene with assistance if many private firms are negatively affected. This will perhaps be even more likely if the affected private debt is held by major national banks. Default by enough banks can threaten the integrity of the banking system. Government intervention to save the banks would mean that the general population would essentially bear the burdens of private mistakes.
This kind of rapid reversal is precisely what happened to Indonesia, Thailand, Malaysia, and South Korea in the aftermath of the Asian currency crisis in 1997. Afterward, these countries recorded substantial current account surpluses. These surpluses should not be viewed as a sign of strong vibrant economies; rather, they reflect countries that are in the midst of recessions, struggling to repay their past obligations, and that are now suffering a reduction in average living standards as a consequence.
The most severe consequences of a current account surplus as described above arise when the change from trade deficit to surplus is abrupt. If, on the other hand, the transition is smooth and gradual, then the economy may not suffer noticeably at all. For example, consider a country that has financed a period of extra spending on infrastructure and private investment by running trade deficits and has become a net international debtor nation. However, once the investments begin to take off, fueling rapid economic growth, the country begins to repay more past debt than the new debt that it incurs each period. In this case, the country could make a smooth transition from a trade deficit to a trade surplus. As long as GDP growth continued sufficiently fast, the nation might not even need to suffer reductions in its average living standards even though it is spending less than its income during the repayment period.
In summary, the situation of a net debtor nation running current account surpluses is more worrisome if
1. surpluses follow default,
2. GDP growth rate is low or negative,
3. the investment rate is low or falling,
4. real \(C + G\) per capita is falling,
5. surplus corresponds to rising net debt and larger equity sales.
The situation is benign or beneficial if the reverse occurs.
Case 3: Net Creditor Nation Running a Current Account Surplus
A net creditor country with trade surpluses is channeling savings to the rest of the world either through lending or through the purchase of foreign productive assets. The situation is generally viewed as prudent but may have some unpleasant consequences. Recall that a country with a trade surplus is spending less on consumption, investment, and government combined than its national income. The excess is being saved abroad. Net creditor status means that the country has more total savings abroad than foreigners have in their country.
The first problem may arise if the surplus corresponds to the substitution of foreign investment for domestic investment. In an era of relatively free capital mobility, countries may decide that the rate of return is higher and the risk is lower on foreign investments compared to domestic investments. If domestic investment falls as a result, future growth prospects for the country are reduced as well. This situation has been a problem in Russia and other transition economies. As these economies increased their private ownership of assets, a small number of people became extremely wealthy. In a well-functioning economy with good future business prospects, wealth is often invested internally helping to fuel domestic growth. However, in many transition economies, wealth holders decided that it was too risky to invest domestically because uncertainty about future growth potential was very low. So instead, they saved their money abroad, essentially financing investment in much healthier and less risky economies.
China is another creditor country running a trade surplus today. It is, however, in a different situation than Russia or the transition economies in the 1990s. China’s internal investment rate is very high and its growth rate has been phenomenal over the past twenty years or more. The fact that it has a trade surplus means that as a nation it is saving even more than necessary to finance its already high investment levels. The excess it is lending abroad, thereby raising its international creditor position. (See Chapter 1 for more details.) If it was to redirect that saving domestically, it may not be able to fuel additional growth since their investment spending is already so high. Their trade surplus also means that its average standard of living is well below what is possible because it is saving the surplus abroad rather than spending it on consumption or government goods at home.
A second problem arises even if domestic investment remains high. With domestic investment kept high, the cost of the large surpluses must be felt as a reduction in consumption and government spending. In this case, a large trade surplus leads to a reduction in average living standards for the country. This is a point worth emphasizing. Countries that run trade surpluses suffer a reduction in living standards, not an increase, relative to the case of balanced trade.
Another potential problem with being a net creditor country is the risk associated with international lending and asset purchases. First of all, foreign direct investments may not pay off as hoped or expected. Portfolio investments in foreign stock markets can suddenly be reduced in value if the foreign stock market crashes. On international loans, foreign nations may default on all or part of the outstanding loans, may defer payments, or may be forced to reschedule payments. This is a more likely event if the outstanding loans are to foreign countries with national external debts that may prove unsustainable. If the foreign country suffers rapid currency depreciation and if the foreign loans are denominated in domestic currency, then the foreign country may be forced to default. Defaults may also occur if the foreign debtor countries suffer severe recessions. The creditor nation in these cases is the one that must suffer the losses.
It was this situation that was especially serious for the United States at the onset of the third world debt crisis in the early 1980s. At that time, a number of large U.S. banks had a considerable proportion of their asset portfolios as loans to third world countries. Had these countries defaulted en masse, it would have threatened the solvency of these banks and could have led to a serious banking crisis in the U.S. economy.
Alternatively, suppose the surplus country has made external loans in the foreign countries’ currency. If the foreign currency depreciates, even if only gradually, then the value of the foreign assets falls in terms of the domestic currency. The realized rates of return on these assets could then become negative, falling far short of returns on comparable domestic assets.
This is the dilemma that China faces today. The Chinese government has accumulated almost \$1 trillion of U.S. Treasury bonds as a result of its persistent current account surpluses over the past decade. All of this debt is denominated in U.S. dollars, making it subject to exchange rate risk. If the Chinese relent to U.S. pressure to allow their fixed currency value appreciate to the U.S. dollar, then the value of these U.S. assets falls in value and reduces their future returns. The Chinese are also worried about the potential for future U.S. inflation due to the expansionary monetary policy used during the current economic crisis. If inflation does arise in the future, the value of the trillion dollars of foreign debt would also be reduced. This situation is epitomized with a popular parable that says, “If you owe me a thousand dollars, then you have a problem, but if you owe me a million dollars, then I have a problem.” Even though the United States is the debtor and the Chinese the creditor, the Chinese now have a problem because they may have lent too much to the United States.
In summary, the situation of a net creditor nation running current account surpluses is worrisome if the
1. net credit position is very large,
2. current account surplus is very large,
3. GDP growth rate is low,
4. investment rate is low or falling,
5. C + G per capita is low or falling,
6. surplus involves lending denominated in a foreign currency that may afterward depreciate,
7. domestic currency has appreciated substantially,
8. foreign asset values have fallen substantially.
The situation is benign or beneficial if the reverse occurs.
Case 4: Net Creditor Nation Running a Current Account Deficit
In general, a deficit run by a country that is a net creditor is least likely to be problematic. Essentially, this describes a country that is drawing down previously accumulated savings. The deficit also implies that the country is spending more than its income. This situation is especially good if it allows the country to maintain living standards during a recession. This case would also be good if a country with a rapidly aging population is drawing down previous savings to maintain average living standards.
The current account deficit can cause problems if as in case one, the deficit corresponds to falling investment and increases in consumption and government expenditures. If these changes occur while the economy continues to grow, then it may indicate potential problems for future economic growth. However, if the same changes occur while the economy is in a recession, then the effect would be to maintain average living standards by drawing down external savings. If this occurs only during the recession, then the long-term effect on growth would be mitigated.
This case can be a problem if the net creditor position is extremely large. A large amount of foreign savings can always potentially drop in value given currency fluctuations as described above in case three. However, the current account deficit only serves to reduce this potential problem since it reduces the country’s net creditor position.
In summary, the situation of a net creditor nation running current account deficits is worrisome if
1. the net creditor status is smaller and the deficit is larger (although this is generally less worrisome than if the country were a net debtor),
2. investment is falling (although a temporary drop in investment is likely in a recession),
3. \(C + G\) per capita is rising rapidly.
The situation is benign or beneficial if the reverse occurs.
Key Takeaways
• Since trade deficits are not always bad and trade surpluses not always good, it is important to know how to judge a country’s trade imbalance.
• Trade deficits are more worrisome when a country is a large international debtor and when growth or prospective growth is low.
• Trade deficits are less worrisome if international debt is low or if the country is a creditor nation.
• Trade deficits are less worrisome if they accompany increased investment and other stimuli to economic growth.
• Trade surpluses are more worrisome when the foreign credits reduce domestic investment sufficiently to reduce growth.
• Trade surpluses are more worrisome when future repayments will likely be lower than anticipated. This can occur if the credits are exceedingly large or denominated in foreign currency.
• Trade surpluses are more worrisome when they arise suddenly in association with a large international debtor position.
Exercises
1. Suppose the hypothetical country of Avalon has a current account deficit of \$20 billion this year. From the two scenarios listed in each part below, identify which scenario would make this deficit more worrisome to an economic analyst and which scenario would be less worrisome. Briefly explain why.
• Scenario 1: Avalon’s GDP is \$80 billion dollars per year.
Scenario 2: Avalon’s GDP is \$800 billion per year.
• Scenario 1: Avalon is a net debtor country.
Scenario 2: Avalon is a net creditor country.
• Scenario 1: Avalon’s annual consumption spending is 50 percent of GDP.
Scenario 2: Avalon’s annual consumption spending is 90 percent of GDP.
• Scenario 1: Avalon’s GDP grew 1 percent last year.
Scenario 2: Avalon’s GDP grew 10 percent last year.
2. Below are the economic data for five fictitious countries running trade deficits. Dollar amounts are in billions, and percentages are relative to GDP.
Alpha (%) Beta (%) Gamma (%) Delta (%) Epsilon (%)
GDP \$260 \$340 \$135 \$400 \$840
Trade Deficit (TD) 9.1 9.7 2.5 5.7 6.0
Projected GDP Growth +2.0 +10.2 +3.0 +1.0 +5.5
Net International Investment Position (IIP) 75 debtor 30 creditor 20 debtor 60 debtor 5 debtor
Domestic Investment (I) 18 35 16 13 27
Suppose you work for the International Monetary Fund, and it has asked you to assess which two of these five countries’ trade deficits are most likely to pose future repayment problems. Provide a brief explanation justifying your assessment.
3. Consider the fictitious country of Malamar. Economic data for Malamar are presented in the table below. Note that Malamar is currently running a trade deficit of \$60 billion.
Trade Deficit (TD) \$60 billion
GDP \$1,000 billion
GDP Growth—Past 3 Years (Growth −) −1.2%
Projected GDP Growth—Next 3 Years (Growth +) 8.5%
Net International Investment Position (IIP) −\$800 billion (debtor)
Domestic Investment (I) \$350 billion
In the table below, reference the above data (either directly or in combination) in the first column and indicate in the second column whether this information tends to make Malamar’s deficit more worrisome or less worrisome. One example is provided to illustrate.
1. Data More or Less Worrisome
TD/GDP = 6 percent More
4. Consider the following statements concerning current account balances. Explain in what sense, if any, the statements are valid. In what sense, if any, are the statements misguided?
• A current account deficit implies that our nation is giving away money to the rest of the world.
• A current account deficit indicates that a country has exported jobs to the rest of the world.
• A current account deficit implies that the nation must have a reduced standard of living in the future. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/03%3A_The_Whole_Truth_about_Trade_Imbalances/3.05%3A_How_to_Evaluate_Trade_Imbalances.txt |
People trade one national currency for another for one reason: they want to do something with the other currency. What they might do consists of one of two things: either they wish to spend the money, acquiring goods and services, or they wish to invest the money.
This chapter introduces the foreign exchange market for currency trades. It highlights some of the more obvious, although sometimes confusing, features and then turns attention to the motivations of foreign investors. One of the prime motivations for investing in another country is because one hopes to make more money on an investment abroad. How an investor calculates and compares those rates of returns are explored in this chapter.
04: Foreign Exchange Markets and Rates of Return
Learning objective
1. Learn who participates in foreign exchange markets and why.
The foreign exchange market (Forex) is not a market like the New York Stock Exchange, where daily trades of stock are conducted in a central location. Instead, the Forex refers to the activities of major international banks that engage in currency trading. These banks act as intermediaries between the true buyers and sellers of currencies (i.e., governments, businesses, and individuals). These banks will hold foreign currency deposits and stand ready to exchange these for domestic currency upon demand. The exchange rate (ER) will be determined independently by each bank but will essentially be determined by supply and demand in the market. In other words, the bank sets the exchange rate at each moment to equalize its supply of foreign currency with the market demand. Each bank makes money by collecting a transactions fee for its “exchange services.”
It is useful to categorize two distinct groups of participants in the Forex, those whose transactions are recorded on the current account (importers and exporters) and those whose transactions are recorded on the financial account (investors).
Importers and Exporters
Anyone who imports or exports goods and services will need to exchange currencies to make the transactions. This includes tourists who travel abroad; their transactions would appear as services in the current account. These businesses and individuals will engage in currency trades daily; however, these transactions are small in comparison to those made by investors.
International Investors, Banks, Arbitrageurs, and Others
Most of the daily currencies transactions are made by investors. These investors, be they investment companies, insurance companies, banks, or others, are making currency transactions to realize a greater return on their investments or holdings. Many of these companies are responsible for managing the savings of others. Pension plans and mutual funds buy and sell billions of dollars worth of assets daily. Banks, in the temporary possession of the deposits of others, do the same. Insurance companies manage large portfolios that act as their capital to be used to pay off claims on accidents, casualties, and deaths. More and more of these companies look internationally to make the most of their investments.
It is estimated by the Bank of International Settlements that over \$3 trillion (or \$3,000 billion) worth of currency is traded every day. Only about \$60 to \$100 billion of trade in goods and services takes place daily worldwide. This suggests that many of the currency exchanges are done by international investors rather than importers and exporters.
Investment Objectives
Investors generally have three broad concerns when an investment is made. They care about how much money the investment will earn over time, they care about how risky the investment is, and they care about how liquid, or convertible, the asset is.
1. Rate of return (RoR). The percentage change in the value of an asset over some period.
Investors purchase assets as a way of saving for the future. Anytime an asset is purchased, the purchaser is forgoing current consumption for future consumption. To make such a transaction worthwhile the investors hope (sometimes expect) to have more money for future consumption than the amount they give up in the present. Thus investors would like to have as high a rate of return on their investments as possible.
Example 1: Suppose a Picasso painting is purchased in 1996 for \$500,000. One year later, the painting is resold for \$600,000. The rate of return is calculated as
Example 2: \$1,000 is placed in a savings account for one year at an annual interest rate of 10 percent. The interest earned after one year is \$1,000 × 0.10 = \$100. Thus the value of the account after one year is \$1,100. The rate of return is
This means that the rate of return on a domestic interest-bearing account is merely the interest rate.
2. Risk. The second primary concern of investors is the riskiness of the assets. Generally, the greater the expected rate of return, the greater the risk. Invest in an oil wildcat endeavor and you might get a 1,000 percent return on your investment—that is, if you strike oil. The chances of doing so are likely to be very low, however. Thus a key concern of investors is how to manage the trade-off between risk and return.
3. Liquidity. Liquidity essentially means the speed with which assets can be converted to cash. Insurance companies need to have assets that are fairly liquid in the event that they need to pay out a large number of claims. Banks also need to be able to make payouts to their depositors, who may request their money back at any time.
Key takeaways
• Participants in the foreign exchange markets can be classified into traders and investors.
• Traders export or import goods and services whose transactions appear on the current account of the balance of payments.
• Investors purchase or sell assets whose transactions appear on the financial account of the balance of payments.
• The three main concerns for any investor are first to obtain a high rate of return, second to minimize the risk of default, and third to maintain an acceptable degree of liquidity.
• The rate of return on an asset is the percentage change in its value over a period.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This group enters the foreign exchange market to make transactions that will be recorded on the current account.
• This group enters the foreign exchange market to make transactions that will be recorded on the financial account.
• The percentage change in the value of an asset over some period.
• The term used to describe the ease with which an asset can be converted to cash.
• The term used to describe the possibility that an asset will not return what is originally expected.
• A list of three main objectives for international investors.
• The rate of return on a share of stock whose value rises during the year from \$5.50 per share to \$6.50 per share.
• The rate of return on a commercial office building that was purchased one year ago for \$650,000 and sold today for \$600,000. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/04%3A_Foreign_Exchange_Markets_and_Rates_of_Return/4.01%3A_The_Forex-_Participants_and_Objectives.txt |
Learning objective
1. Learn some of the basic definitions regarding currency markets and exchange rates.
Anyone who has ever traveled to another country has probably had to deal with an exchange rate between two currencies. (I say “probably” because a person who travels from, say, Italy to Spain continues to use euros.) In a sense, exchange rates are very simple. However, despite their simplicity they never fail to generate confusion. To overcome that confusion this chapter begins by offering straightforward definitions and several rules of thumb that can help with these problems.
The exchange rate (ER) represents the number of units of one currency that exchanges for a unit of another. There are two ways to express an exchange rate between two currencies (e.g., between the U.S. dollar [\$] and the British pound [£]). One can either write \(\$ / £\) or \(£/\$\). These are reciprocals of each other. Thus if \(E\) is the \(\$ / £\) exchange rate and \(V\) is the \(£/\$\) exchange rate, then \(E = 1/V\).
For example, on January 6, 2010, the following exchange rates prevailed:
\(E_{\$ /£}= 1.59\), which implies \(E_{£/\$} = 0.63\),
and
\(V_{¥/\$} = 92.7\), which implies \(E_{\$/¥} = 0.0108\).
Currency Value
It is important to note that the value of a currency is always given in terms of another currency. Thus the value of a U.S. dollar in terms of British pounds is the \(£/\$\) exchange rate. The value of the Japanese yen in terms of dollar is the \(\$/¥\) exchange rate.
Note that we always express the value of all items in terms of something else. Thus the value of a quart of milk is given in dollars, not in quarts of milk. The value of car is also given in dollar terms, not in terms of cars. Similarly, the value of a dollar is given in terms of something else, usually another currency. Hence, the rupee/dollar exchange rate gives us the value of the dollar in terms of rupees.
This definition is especially useful to remember when one is dealing with unfamiliar currencies. Thus the value of the euro \((€)\) in terms of British pounds is given as the \(£/€\) exchange rate.
Similarly, the peso/euro exchange rate refers to the value of the euro in terms of pesos.
Currency appreciation means that a currency appreciates with respect to another when its value rises in terms of the other. The dollar appreciates with respect to the yen if the \(¥/\$)\ exchange rate rises.
Currency depreciation, on the other hand, means that a currency depreciates with respect to another when its value falls in terms of the other. The dollar depreciates with respect to the yen if the \(¥/\$)\ exchange rate falls.
Note that if the \(¥/\$)\ rate rises, then its reciprocal, the \(\$/¥)\ rate, falls. Since the \(\$/¥)\ rate represents the value of the yen in terms of dollars, this means that when the dollar appreciates with respect to the yen, the yen must depreciate with respect to the dollar.
The rate of appreciation (or depreciation) is the percentage change in the value of a currency over some period.
Example 1: U.S. dollar (US\$) to the Canadian dollar (C\$)
On January 6, 2010, \(E_{C\$/US\$} = 1.03\). On January 6, 2009, \(E_{C\$/US\$} = 1.19\).
Use the percentage change formula, (new value − old value)/old value:
Multiply by 100 to write as a percentage to get
−0.134 × 100 = −13.4%.
Since we have calculated the change in the value of the U.S. dollar in terms of Canadian dollar, and since the percentage change is negative, this means that the dollar has depreciated by 13.4 percent with respect to the C\$ during the previous year.
Example 2: U.S. dollar (\$) to the Pakistani rupee (R)
On January 6, 2010, ER/\$ = 84.7.On January 6, 2010, ER/\$ = 79.1.
Use the percentage change formula, (new value − old value)/old value:
Multiply by 100 to write as a percentage to get
+0.071 × 100 = +7.1%.
Since we have calculated the change in the value of the U.S. dollar, in terms of rupees, and since the percentage change is positive, this means that the dollar has appreciated by 7.1 percent with respect to the Pakistani rupee during the past year.
Other Exchange Rate Terms
Arbitrage generally means buying a product when its price is low and then reselling it after its price rises in order to make a profit. Currency arbitrage means buying a currency in one market (e.g., New York) at a low price and reselling, moments later, in another market (e.g., London) at a higher price.
The spot exchange rate refers to the exchange rate that prevails on the spot, that is, for trades to take place immediately. (Technically, it is for trades that occur within two days.)
The forward exchange rate refers to the rate that appears on a contract to exchange currencies either 30, 60, 90, or 180 days in the future.
For example, a corporation might sign a contract with a bank to buy euros for U.S. dollars sixty days from now at a predetermined ER. The predetermined rate is called the sixty-day forward rate. Forward contracts can be used to reduce exchange rate risk.
For example, suppose an importer of BMWs is expecting a shipment in sixty days. Suppose that upon arrival the importer must pay €1,000,000 and the current spot ER is 1.20 \$/€.
Thus if the payment were made today it would cost \$1,200,000. Suppose further that the importer is fearful of a U.S. dollar depreciation. He doesn’t currently have the \$1,200,000 but expects to earn more than enough in sales over the next two months. If the U.S. dollar falls in value to, say, 1.30 \$/€ within sixty days, how much would it cost the importer in dollars to purchase the BMW shipment?
The shipment would still cost €1,000,000. To find out how much this is in dollars, multiply €1,000,000 by 1.30 \$/€ to get \$1,300,000.
Note that this is \$100,000 more for the cars simply because the U.S. dollar value changed.
One way the importer could protect himself against this potential loss is to purchase a forward contract to buy euros for U.S. dollars in sixty days. The ER on the forward contract will likely be different from the current spot ER. In part, its value will reflect market expectations about the degree to which currency values will change in the next two months. Suppose the current sixty-day forward ER is 1.25 \$/€, reflecting the expectation that the U.S. dollar value will fall. If the importer purchases a sixty-day contract to buy €1,000,000, it will cost him \$1,250,000 (i.e., \$1,000,000 × 1.25 \$/€). Although this is higher than what it would cost if the exchange were made today, the importer does not have the cash available to make the trade today, and the forward contract would protect the importer from an even greater U.S. dollar depreciation.
When the forward ER is such that a forward trade costs more than a spot trade today costs, there is said to be a forward premium. If the reverse were true, such that the forward trade were cheaper than a spot trade, then there is a forward discount.
A currency trader is hedging if he or she enters into a forward contract to protect oneself from a downside loss. However, by hedging the trader also forfeits the potential for an upside gain. Suppose in the story above that the spot ER falls rather than rises. Suppose the ER fell to 1.10 \$/€. In this case, had the importer waited, the €1,000,000 would only have cost \$1,100,000 (i.e., \$1,000,000 × 1.10 \$/€). Thus hedging protects against loss but at the same time eliminates potential unexpected gain.
Key takeaways
• An exchange rate denominated x/y gives the value of y in terms of x. When an exchange rate denominated x/y rises, then y has appreciated in value in terms of x, while x has depreciated in terms of y.
• Spot exchange rates represent the exchange rate prevailing for currency trades today. Forward, or future, exchange rates represent the exchange values on trades that will take place in the future to fulfill a predetermined contract.
• Currency arbitrage occurs when someone buys a currency at a low price and sells shortly afterward at a higher price to make a profit.
• Hedging refers to actions taken to reduce the risk associated with currency trades.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used to describe an increase in the value of the yen.
• This currency value is expressed by the euro/peso exchange rate.
• This has happened to the value of the U.S. dollar if the dollar/euro exchange rate rises from 1.10 \$/€ to 1.20 \$/€.
• The term used to describe the process of buying low and selling high to make a profit.
• The term used to describe the exchange rate that appears on a contract to exchange currencies either 30, 60, 90, or 180 days in the future.
• The term used to describe the exchange rate that prevails for (almost) immediate trades.
• The term used to describe process of protecting oneself from the riskiness of exchange rate movements.
2. Use the exchange rate data in the table to answer the following questions. The first two exchange rates are the spot rates on those dates. The third exchange rate is the one-year forward exchange rate as of February 2004.
February 4, 2003 February 4, 2004 Forward February 4, 2005
United States–Europe 1.08 \$/€ 1.25 \$/€ 1.24 \$/€
South Africa–United States 8.55 rand/\$ 6.95 rand/\$ 7.42 rand/\$
• Calculate the rate of change in the euro value relative to the dollar between 2003 and 2004.
• Calculate the rate of change in the dollar value relative to the euro between 2003 and 2004.
• Calculate the rate of change in the dollar value relative to the South African rand between 2003 and 2004.
• Calculate the expected change in the dollar value relative to the euro between 2004 and 2005.
• Calculate the expected change in the dollar value relative to the rand between 2004 and 2005. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/04%3A_Foreign_Exchange_Markets_and_Rates_of_Return/4.02%3A_Exchange_Rate-_Definitions.txt |
Learning Objective
1. Learn how to calculate the rate of return (RoR) for a domestic deposit and a foreign deposit.
Suppose that an investor holding U.S. dollars must decide between two investments of equal risk and liquidity. Suppose one potential investment is a one-year certificate of deposit (CD) issued by a U.S. bank while a second potential investment is a one-year CD issued by a British bank. For simplicity we’ll assume that interest is calculated on both CDs using a simple interest rather than with a compounding formula. A CD is a type of deposit that provides a higher rate of interest to the depositor in return for a promise to keep the money deposited for a fixed amount of time. The time period could be six months, one year, two years, or any other period decided by the bank. If the depositor wants to withdraw the money earlier, she must pay a penalty.
Since we imagine that an investor wants to obtain the highest rate of return (RoR) possible, given acceptable risk and liquidity characteristics, that investor will choose the investment with the highest rate of return. If the investor acted naively, she might simply compare interest rates between the two investments and choose the one that is higher. However, this would not necessarily be the best choice. To see why, we need to walk through the calculation of rates of return on these two investments.
First, we need to collect some data, which we will do in general terms rather than use specific values. Examples with actual values are presented in a later section.
Let \(E_{\$/£} \)= the spot ER.
\(E_{\$/£}^e\) = the expected ER one year from now.
\(i_{\$}\) = the one-year interest rate on a CD in the United States (in decimal form).
\(i_{£}\) = the one-year interest rate on a CD in Britain (in decimal form).
U.S. Rate of Return
The rate of return on the U.S. CD is simply the interest rate on that deposit. More formally,
\(R_{0}R_{\$} = i_{\$}\).
This is because the interest rate describes the percentage increase in the value of the deposit over the course of the year. It is also simple because there is no need to convert currencies.
British Rate of Return
The rate of return on the British CD is more difficult to determine. If a U.S. investor, with dollars, wants to invest in the British CD, she must first exchange dollars for pounds on the spot market and then use the British pound (£) to purchase the British CD. After one year, she must convert pounds back to dollars at the exchange rate that prevails then. The rate of return on that investment is the percentage change in dollar value during the year. To calculate this we can follow the procedure below.
Suppose the investor has P dollars to invest (P for principal).
Step 1: Convert the dollars to pounds.
is the number of pounds the investor will have at the beginning of the year.
Step 2: Purchase the British CD and earn interest in pounds during the year.
is the number of pounds the investor will have at the end of the year. The first term in parentheses returns the principal. The second term is the interest payment.
Step 3: Convert the principal plus interest back into dollars in one year.
is the number of dollars the investor can expect to have at the end of the year.
The rate of return in dollar terms from this British investment can be found by calculating the expected percentage change in the value of the investor’s dollar assets over the year, as shown below:
After factoring out the P, this reduces to
Thus the rate of return on the foreign investment is more complicated because the set of transactions is more complicated. For the U.S. investment, the depositor simply deposits the dollars and earns dollar interest at the rate given by the interest rate. However, for the foreign deposit, the investor must first convert currency, then deposit the money abroad earning interest in foreign currency units, and finally reconvert the currency back to dollars. The rate of return depends not only on the foreign interest rate but also on the spot exchange rate and the expected exchange rate one year in the future.
Note that according to the formula, the rate of return on the foreign deposit is positively related to changes in the foreign interest rate and the expected foreign currency value and negatively related to the spot foreign currency value.
Key Takeaways
• For a dollar investor, the rate of return on a U.S. deposit is equal to the interest rate: \(R_{0}R_{\$} = i_{\$}\).
• For a dollar investor, the rate of return on a foreign deposit depends on the foreign interest rate, the spot exchange rate, and the exchange rate expected to prevail at the time the deposit is redeemed: In particular, .
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• These three variables influence the rate of return on a foreign deposit.
• For a U.S. dollar investor, this is the rate of return on a U.S. dollar deposit yielding 3 percent per year.
• The term used to describe the exchange rate predicted to prevail at some point in the future.
• The term for the type of bank deposit that offers a higher yield on a deposit that is maintained for a predetermined period of time. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/04%3A_Foreign_Exchange_Markets_and_Rates_of_Return/4.03%3A_Calculating_Rate_of_Returns_on_International_Investments.txt |
Learning objective
1. Break down the rate of return on foreign deposits into three distinct components.
Although the derivation of the rate of return formula is fairly straightforward, it does not lend itself easily to interpretation or intuition. By applying some algebraic “tricks,” it is possible to rewrite the British rate of return formula in a form that is much more intuitive.
Step 1: Begin with the British rate of return formula derived in Chapter 4, Section 4.3:
Step 2: Factor out the term in parentheses. Add $i_{£}$ and then subtract it as well. Mathematically, a term does not change in value if you add and subtract the same value:
Step 3: Change the (−1) in the expression to its equivalent, . Also change $-i_{£}$ to its equivalent, . Since, these changes do not change the value of the rate of return expression:
Step 4: Rearrange the expression:
Step 5: Simplify by combining terms with common denominators:
Step 6: Factor out the percentage change in the exchange rate term:
This formula shows that the expected rate of return on the British asset depends on two things, the British interest rate and the expected percentage change in the value of the pound. Notice that if is a positive number, then the expected $/£$ ER is greater than the current spot ER, which means that one expects a pound appreciation in the future. Furthermore, represents the expected rate of appreciation of the pound during the following year. Similarly, if were negative, then it corresponds to the expected rate of depreciation of the pound during the subsequent year.
The expected rate of change in the pound value is multiplied by $(1 + i_{£})$, which generally corresponds to a principal and interest component in a rate of return calculation.
To make sense of this expression, it is useful to consider a series of simple numerical examples.
Suppose the following values prevail,
5% per year
1.1 $/£ 1.0$/£
Plugging these into the rate of return formula yields
which simplifies to
$R_{0}R_{£} = 0.05 + (1 + 0.05) × 0.10 =.155 or 15.5%. \nonumber$
Note that because of the exchange rate change, the rate of return on the British asset is considerably higher than the 5 percent interest rate.
To decompose these effects suppose that the British asset yielded no interest whatsoever.
This would occur if the individual held pound currency for the year rather than purchasing a CD. In this case, the rate of return formula reduces to
$R_{0}R_{£} = 0.0 + (1 + 0.0) × 0.10 =.10 or 10% \nonumber$.
This means that 10 percent of the rate of return arises solely because of the pound appreciation. Essentially an investor in this case gains because of currency arbitrage over time. Remember that arbitrage means buying something when its price is low, selling it when its price is high, and thus making a profit on the series of transactions. In this case, the investor buys pounds at the start of the year, when their price (in terms of dollars) is low, and then resells them at the end of the year when their price is higher.
Next, suppose that there was no exchange rate change during the year, but there was a 5 percent interest rate on the British asset. In this case, the rate of return becomes
$R_{0}R_{£} = 0.05 + (1 + 0.05) × 0.0 =.05 or 5% \nonumber$.
Thus with no change in the exchange rate, the rate of return reduces to the interest rate on the asset.
Finally, let’s look back at the rate of return formula:
The first term simply gives the contribution to the total rate of return that derives solely from the interest rate on the foreign asset. The second set of terms has the percentage change in the exchange rate times one plus the interest rate. It corresponds to the contribution to the rate of return that arises solely due to the exchange rate change. The one plus interest rate term means that the exchange rate return can be separated into two components, a principal component and an interest component.
Suppose the exchange rate change is positive. In this case, the principal that is originally deposited will grow in value by the percentage exchange rate change. But the principal also accrues interest and as the £ value rises, the interest value, in dollar terms, also rises.
Thus the second set of terms represents the percentage increase in the value of one’s principal and interest that arises solely from the change in the exchange rate.
Key Takeaways
• The rate of return on a foreign deposit consists of three components: the interest rate itself, the change in the value of the principal due to the exchange rate change, and the change in the value of the interest due to the exchange rate change.
• Another formula, but one that is equivalent to the one in the previous section, for the rate of return on a foreign deposit is .
exercise
1. Consider the following data. Suppose the expected exchange rates are the average expectations by investors for exchange rates in one year. Imagine that the interest rates are for equally risky assets and are annual rates.
United States Australia Singapore
Current Exchange Rate 1.80 A$/US$ 1.75 S$/US$
Expected Exchange Rate 1.90 A$/US$ 1.65 S$/US$
Current Interest Rate (%) 2.0 4.0 1.0
• Calculate the rate of return for a U.S. dollar investor investing in the Australian deposit for one year.
• Calculate the rate of return for a U.S. dollar investor investing in the Singapore deposit for one year.
• Among these three options (United States, Australia, and Singapore), which is the best place for the investor to invest? Which is the worst place?
2. The covered interest parity condition substitutes the forward exchange rate for the expected exchange rate. The condition is labeled “covered” because the forward contract assures a certain rate of return (i.e., without risk) on foreign deposits. The table below lists a spot exchange rate, a ninety-day forward rate, and a ninety-day money market interest rate in Germany and Canada. Use this information to answer the following questions.
Germany Canada
Spot Exchange Rate 0.5841 $/DM 0.7451 US$/C$90-Day Forward Exchange Rate 0.5807$/DM 0.7446 US$/C$
90-Day Interest Rate (%) 1.442 0.875
What would the U.S. ninety-day interest rate have to be for the United States to have the highest rate of return for a U.S. investor? (Use the exact formulas to calculate the rates of return.) | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/04%3A_Foreign_Exchange_Markets_and_Rates_of_Return/4.04%3A__Interpretation_of_the_Rate_of_Return_Formula.txt |
Learning Objectives
1. Learn how to apply numerical values for exchange rates and interest rates to the rate of return formulas to determine the best international investment.
Use the data in the tables below to calculate in which country it would have been best to purchase a one-year interest-bearing asset. These numbers were taken from the Economist, Weekly Indicators, December 17, 2005, p. 90, http://www.economist.com.
Example 1
Consider the following data for interest rates and exchange rates in the United States and Britain:
2.37% per year
4.83% per year
1.96 $/£ 1.75$/£
We imagine that the decision is to be made in 2004, looking forward into 2005. However, we calculate this in hindsight after we know what the 2005 exchange rate is. Thus we plug in the 2005 rate for the expected exchange rate and use the 2004 rate as the current spot rate. Thus the ex-post (i.e., after the fact) rate of return on British deposits is given by
which simplifies to
$R_{0}R_{£} = 0.0483 + (1 + 0.0483)(−0.1071) = 0.064 \ or −6.4 \% \nonumber$.
A negative rate of return means that the investor would have lost money (in dollar terms) by purchasing the British asset.
Since $R_{0}R_{} = 2.37$ > $R_{0}R_{£} = −6.4\%$, the investor seeking the highest rate of return should have deposited her money in the U.S. account.
Example 2
Consider the following data for interest rates and exchange rates in the United States and Japan.
2.37% per year
0.02% per year
104 ¥/$120 ¥/$
Again, imagine that the decision is to be made in 2004, looking forward into 2005. However, we calculate this in hindsight after we know what the 2005 exchange is. Thus we plug in the 2005 rate for the expected exchange rate and use the 2004 rate as the current spot rate. Note also that the interest rate in Japan really was 0.02 percent. It was virtually zero.
Before calculating the rate of return, it is necessary to convert the exchange rate to the yen equivalent rather than the dollar equivalent. Thus
Now, the ex-post (i.e., after the fact) rate of return on Japanese deposits is given by
which simplifies to
$R_{0}R_{¥} − 0.0002 + (1 + 0.0002)(−0.1354) = −0.1352 \ or -13.52 \%. \nonumber$
A negative rate of return means that the investor would have lost money (in dollar terms) by purchasing the Japanese asset.
Since $R_{0}R_{} = 2.37$ > $R_{0}R_{¥} = −13.52 \%$, the investor seeking the highest rate of return should have deposited his money in the U.S. account.
Example 3
Consider the following data for interest rates and exchange rates in the United States and South Korea. Note that South Korean currency is in won (W).
2.37% per year
4.04% per year
1,059 W/$1,026 W/$
As in the preceding examples, the decision is to be made in 2004, looking forward to 2005. However, since the previous year interest rate is not listed, we use the current short-term interest rate. Before calculating the rate of return, it is necessary to convert the exchange rate to the won equivalent rather than the dollar equivalent. Thus
Now, the ex-post (i.e., after the fact) rate of return on Italian deposits is given by
which simplifies to
$R_{0}R_{W} = 0.0404 + (1 + 0.0404)(0.0328) = 0.0746 \ or +7.46\%. \nonumber$.
In this case, the positive rate of return means an investor would have made money (in dollar terms) by purchasing the South Korean asset.
Also, since $R_{0}R_{} = 2.37 \ > R_{0}R_{W} = 7.46\%$, the investor seeking the highest rate of return should have deposited his money in the South Korean account.
key takeaway
• An investor should choose the deposit or asset that promises the highest expected rate of return assuming equivalent risk and liquidity characteristics.
Exercises
1. Consider the following data collected on February 9, 2004. The interest rate given is for a one-year money market deposit. The spot exchange rate is the rate for February 9. The expected exchange rate is the one-year forward rate. Express each answer as a percentage.
2.5%
0.7541 US$/C$
0[0].7468 US$/C$
• Use both RoR formulas (one from Chapter 4, Section 4.3, the other from Chapter 4, Section 4.4, Step 5) to calculate the expected rate of return on the Canadian money market deposit and show that both formulas generate the same answer.
• What part of the rate of return arises only due to the interest earned on the deposit?
• What part of the rate of return arises from the percentage change in the value of the principal due to the change in the exchange rate?
• What component of the rate of return arises from the percentage change in the value of the interest payments due to the change in the exchange rate?
2. Consider the following data collected on February 9, 2004. The interest rate given is for a one-year money market deposit. The spot exchange rate is the rate for February 9. The expected exchange rate is the one-year forward rate. Express each answer as a percentage.
4.5%
1.8574 $/£ 1.7956$/£
• Use both RoR formulas (one from Chapter 4, Section 4.3, the other from Chapter 4, Section 4.4, Step 5) to calculate the expected rate of return on the British money market deposit and show that both formulas generate the same answer.
• What part of the rate of return arises only due to the interest earned on the deposit?
• What part of the rate of return arises from the percentage change in the value of the principal due to the change in the exchange rate?
• What component of the rate of return arises from the percentage change in the value of the interest payments due to the change in the exchange rate? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/04%3A_Foreign_Exchange_Markets_and_Rates_of_Return/4.05%3A_Applying_the_Rate_of_Return_Formulas.txt |
Interest rate parity is one of the most important theories in international finance because it is probably the best way to explain how exchange rate values are determined and why they fluctuate as they do. Most of the international currency exchanges occur for investment purposes, and therefore understanding the prime motivations for international investment is critical.
The chapter applies the rate of return formula developed in Chapter 4 and shows how changes in the determinants of the rate of return on assets affect investor behavior on the foreign exchange market, which in turn affects the value of the exchange rate. The model is described in two different ways: first, using simple supply and demand curves; and second, using a rate of return diagram that will be used later with the development of a more elaborate macro model of the economy.
05: Interest Rate Parity
Learning Objectives
1. Define the interest rate parity condition.
2. Learn the asset approach to exchange rate determination.
Interest rate parity (IRP) is a theory used to explain the value and movements of exchange rates. It is also known as the asset approach to exchange rate determination. The interest rate parity theory assumes that the actions of international investors—motivated by cross-country differences in rates of return on comparable assets—induce changes in the spot exchange rate. In another vein, IRP suggests that transactions on a country’s financial account affect the value of the exchange rate on the foreign exchange (Forex) market. This contrasts with the purchasing power parity theory, which assumes that the actions of importers and exporters, whose transactions are recorded on the current account, induce changes in the exchange rate.
Interest Rate Parity Condition
Interest rate parity refers to a condition of equality between the rates of return on comparable assets between two countries. The term is somewhat of a misnomer on the basis of how it is being described here, as it should really be called rate of return parity. The term developed in an era when the world was in a system of fixed exchange rates. Under those circumstances, and as will be demonstrated in a later chapter, rate of return parity did mean the equalization of interest rates. However, when exchange rates can fluctuate, interest rate parity becomes rate of return parity, but the name was never changed.
In terms of the rates of return formulas developed in Chapter 4, interest rate parity holds when the rate of return on dollar deposits is just equal to the expected rate of return on British deposits, that is, when
$R_{0}R_{} = R_{0}R_{£}. \nonumber$
Plugging in the above formula yields
This condition is often simplified in many textbooks by dropping the final term in which the British interest rate is multiplied by the exchange rate change. The logic is that the final term is usually very small especially when interest rates are low. The approximate version of the IRP condition then is
One should be careful, however. The approximate version would not be a good approximation when interest rates in a country are high. For example, back in 1997, short-term interest rates were 60 percent per year in Russia and 75 percent per year in Turkey. With these interest rates, the approximate formula would not give an accurate representation of rates of return.
Interest Rate Parity Theory
Investor behavior in asset markets that results in interest parity can also explain why the exchange rate may rise and fall in response to market changes. In other words, interest parity can be used to develop a model of exchange rate determination. This is known as the asset approach, or the interest rate parity model.
The first step is to reinterpret the rate of return calculations described previously in more general (aggregate) terms. Thus instead of using the interest rate on a one-year certificate of deposit (CD), we will interpret the interest rates in the two countries as the average interest rates that currently prevail. Similarly, we will imagine that the expected exchange rate is the average expectation across many different individual investors. The rates of return then are the average expected rates of return on a wide variety of assets between two countries.
Next, we imagine that investors trade currencies in the foreign exchange (Forex) market. Each day, some investors come to a market ready to supply a currency in exchange for another, while others come to demand currency in exchange for another.
Consider the market for British pounds (£) in New York depicted in Figure 5.1 . We measure the supply and demand of pounds along the horizontal axis and the price of pounds (i.e., the exchange rate $E_{/£}$ on the vertical axis. Let $S_{£}$ represent the supply of pounds in exchange for dollars at all different exchange rates that might prevail. The supply is generally by British investors who demand dollars to purchase dollar denominated assets. However, supply of pounds might also come from U.S. investors who decide to convert previously acquired pound currency. Let $D_{£}$ the demand for pounds in exchange for dollars at all different exchange rates that might prevail. The demand is generally by U.S. investors who supply dollars to purchase pound-denominated assets. Of course, demand may also come from British investors who decide to convert previously purchased dollars. Recall that
which implies that as $E_{/£}$ rises, $R_{0}R_{£}$ falls. This means that British investors would seek to supply more pounds at higher pound values but U.S. investors would demand fewer pounds at higher pound values. This explains why the supply curve slopes upward and the demand curve slopes downward.
The intersection of supply and demand specifies the equilibrium exchange rate (E1) and the quantity of pounds (Q1) traded in the market. When the Forex is at equilibrium, it must be that interest rate parity is satisfied. This is true because the violation of interest rate parity will cause investors to shift funds from one country to another, thereby causing a change in the exchange rate. This process is described in more detail in Chapter 5, Section 5.2.
Key Takeaways
• Interest rate parity in a floating exchange system means the equalization of rates of return on comparable assets between two different countries.
• Interest rate parity is satisfied when the foreign exchange market is in equilibrium, or in other words, IRP holds when the supply of currency is equal to the demand in the Forex.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This theory of exchange rate determination is also known as the asset approach.
• The name of the condition in which rates of return on comparable assets in different countries are equal.
• Of greater, less, or equal, this is how the supply of pounds compares to the demand for pounds in the foreign exchange market when interest rate parity holds. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.01%3A_Overview_of_Interest_Rate_Parity.txt |
Learning Objective
1. Learn how changes in interest rates and expected exchange rates can influence international investment decisions and affect the exchange rate value.
Comparative statics refers to an exercise in a model that assesses how changes in an exogenous variable will affect the values of the endogenous variables. The endogenous variables are those whose values are determined in the equilibrium. In the IRP model, the endogenous variables are the exchange rate value and—of lesser importance—the quantity of currencies exchanged on the Forex market. The exogenous variables are those whose values are given beforehand and are known by the model’s decision makers. In the IRP model, the exogenous variables are those that influence the positions of the rate of return curves, including the U.S. interest rate, the British interest rate, and the expected future exchange rate. Another way to describe this is that the endogenous variable values are determined within the model, while the exogenous variable values are determined outside of the model.
Comparative statics exercises enable one to answer a question like “What would happen to the exchange rate if there were an increase in U.S. interest rates?” When assessing a question like this, economists will invariably invoke the ceteris paribus assumption. Ceteris paribus means that we assume all other exogenous variables are maintained at their original values when we change the variable of interest. Thus if we assess what would happen to the exchange rate (an endogenous variable) if there were an increase in the U.S. interest rate (an exogenous variable) while invoking ceteris paribus, then ceteris paribus means keeping the original values for the other exogenous variables (in this case, the British interest rate and the expected future exchange rate) fixed.
It is useful to think of a comparative statics exercise as a controlled economic experiment. In the sciences, one can test propositions by controlling the environment of a physical system in such a way that one can isolate the particular cause-and-effect relationship. Thus, to test whether a ball and a feather will fall at the same rate in a frictionless vacuum, experimenters could create a vacuum environment and measure the rate of descent of the ball versus the feather. In economic systems, such experiments are virtually impossible because one can never eliminate all the “frictions.”
However, by creating mathematical economic systems (i.e., an economic model), it becomes possible to conduct similar types of “experiments.” A comparative statics exercise allows one to isolate how a change in one exogenous variable affects the value of the equilibrium variable while controlling for changes in other variables that might also affect the outcome.
The Effect of Changes in U.S. Interest Rates on the Spot Exchange Rate
Suppose that the Forex is initially in equilibrium such that \(S_{£} = D_{£}\) at the exchange rate E1. Now let average U.S. interest rates (\(i_{\$}\)) rise, ceteris paribus. The increase in interest rates raises the rate of return on U.S. assets (\(R_{0}R_{\$}\) ), which at the original exchange rate causes the rate of return on U.S. assets to exceed the rate of return on British assets (\(R_{0}R_{\$} \ > R_{0}R_{£}\) ). This will raise the supply of pounds on the Forex as British investors seek the higher average return on U.S. assets. It will also lower the demand for British pounds (£) by U.S. investors who decide to invest at home rather than abroad.
This will raise the demand for pounds on the Forex as U.S. investors seek the higher average return on British assets. It will also lower the supply of British pounds by British investors who decide to invest at home rather than abroad. Thus in terms of the graph, \(D_{£}\) shifts right (black to red) while \(S_{£}\) shifts left (black to red). The equilibrium exchange rate rises to \(E_{2}\) . This means that the increase in British interest rates causes a pound appreciation and a dollar depreciation. As the exchange rate rises, \(R_{0}R_{\$}\) falls since . \(R_{0}R_{\$}\) continues to fall until the interest parity condition, (\(R_{0}R_{\$} \ = R_{0}R_{£}\)), again holds.
The Effect of Changes in the Expected Exchange Rate on the Spot Exchange Rate
Suppose that the Forex is initially in equilibrium such that \(S_{£} \ = D_{£}\) at the exchange rate \(E_{1}\). Now suppose investors suddenly raise their expected future exchange rate (\(E_{\$/£}^e\)), ceteris paribus. This means that if investors had expected the pound to appreciate, they now expect it to appreciate more. Likewise, if investors had expected the dollar to depreciate, they now expect it to depreciate more. Also, if they had expected the pound to depreciate, they now expect it to depreciate less. Likewise, if they had expected the dollar to appreciate, they now expect it to appreciate less.
This change might occur because new information is released. For example, the British Central Bank might release information that suggests an increased chance that the pound will rise in value in the future.
The increase in the expected exchange rate raises the rate of return on British assets (\(R_{0}R_{£}\)), which at the original exchange rate causes the rate of return on British assets to exceed the rate of return on U.S. assets (\(R_{0}R_{£} \ > R_{0}R_{\$}\)). This will raise the demand for the pound on the Forex as U.S. investors seek the higher average return on British assets. It will also lower the supply of British pounds by British investors who decide to invest at home rather than abroad. Thus, as depicted in Figure 5.4 , \(D_{£}\) shifts right (black to red) while \(S_{£}\) shifts left (black to red). The equilibrium exchange rate rises to \(E_{2}\). This means that the increase in the expected exchange rate (\(E_{\$/£}^e\)) causes a pound appreciation and a dollar depreciation
This is a case of self-fulfilling expectations. If investors suddenly think the pound will appreciate more in the future and if they act on that belief, then the pound will begin to rise in the present, hence fulfilling their expectations.
As the exchange rate rises, \(R_{0}R_{£}\) falls since \(R_{0}R_{£}\) continues to fall until the interest parity condition, (\(R_{0}R_{\$} \ = R_{0}R_{£}\)), again holds.
Key Takeaways
• An increase in U.S. interest rates causes a pound depreciation and a dollar appreciation.
• An increase in British interest rates causes a pound appreciation and a dollar depreciation.
• An increase in the expected exchange rate (\(E_{\$/£}^e\)) causes a pound appreciation and a dollar depreciation.
Exercises
1. Consider the economic changes listed along the left column of the following table. Indicate the effect of each change on the variables listed in the first row. Use insights from the interest rate parity model to determine the answers. Assume floating exchange rates. You do not need to show your work. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
U.S. Dollar Value E\$/€
a. A decrease in U.S. interest rates
b. An increase in expected U.S. economic growth that raises expected asset values
c. An expected increase in European stock values
2. On February 5, 2004, the Wall Street Journal reported that Asian central banks were considering selling a significant share of their U.S. government bond holdings. It was estimated at the time that foreign central banks owned over \$800 billion in U.S. Treasury bonds, or one-fifth of all U.S. federal government debt. Taiwan was considering using some of its foreign reserves to help its businesses purchase U.S. machinery.
• What is the likely effect on the U.S. dollar value if Taiwan implements its plan? Explain.
• What effect would this transaction have on the U.S. trade deficit? Explain.
• How would the answer to part a change if the Taiwanese government used sales of its foreign reserves to help its businesses purchase Taiwanese-produced machinery? Explain. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.02%3A_Comparative_Statics_in_the_IRP_Theory.txt |
Learning Objective
1. Use the rate of return plots to represent the interest rate parity equilibrium in the foreign exchange market.
An alternative graphical approach is sometimes used to depict the equilibrium exchange rate in the foreign exchange (Forex) market. The graph is called the rate of return diagram since it depicts rates of return for assets in two separate countries as functions of the exchange rate. The equilibrium condition depicted in the diagram represents the interest rate parity condition. In effect, the diagram identifies the equilibrium exchange rate that must prevail to satisfy the interest rate parity condition.
Recall the rate of return formulas for deposits in two separate countries. Consider an investor, holding U.S. dollars, comparing the purchase of a one-year certificate of deposit (CD) at a U.S. bank with a one-year CD issued by a British bank. The rate of return on the U.S. deposit works out simply to be the U.S. interest rate shown below:
$R_{0}R_{} = i_{} \nonumber$.
The rate of return on the British asset, however, is a more complicated formula that depends on the British interest rate ($i_{£}$), the spot exchange rate ($E_{/£}$), and the expected exchange rate ($E_{/£}^e$). In its simplest form it is written as follows:
In Figure 5.5 , we plot both $R_{0}R$ equations with respect to the exchange rate ($E_{/£}$). Since $R_{0}R_{}$ is not a function (i.e., not dependent) on the exchange rate, it is drawn as a vertical line at the level of the U.S. interest rate ($i_{£}$). This simply means that as the exchange rate rises or falls, the $R_{0}R_{}$ always remains immutably fixed at the U.S. interest rate.
The $R_{0}R_{}$, however, is a function of the exchange rate. Indeed, the relationship is negative since $E_{/£}$ is in the denominator of the equation. This means that as $E_{/£}$ rises, $R_{0}R_{}$ falls, and vice versa.
The intuition behind this negative relationship is obtained by looking at the alternative (equivalent) formula for $R_{0}R_{£}$:
Recall that the exchange rate ratio represents the expected percentage change in the value of the pound. Suppose, as an example, that this term were positive. That would mean the investor believes the pound will appreciate during the term of the investment. Furthermore, since it is an expected appreciation of the pound, it will add to the total rate of return on the British investment. Next, suppose the spot exchange rate ($E_{/£}$) rises today. Assuming ceteris paribus, as we always do in these exercises, the expected exchange rate remains fixed. That will mean the numerator of the exchange rate expression will fall in value, as will the value of the entire expression. The interpretation of this change is that the investor’s expected appreciation of the pound falls, which in turn lowers the overall rate of return. Hence, we get the negative relationship between the $/£$ exchange rate and $R_{0}R_{£}$.
The intersection of the two RoR curves in the diagram identifies the unique exchange rate $E_{/£}'$ that equalizes rates of return between the two countries. This exchange rate is in equilibrium because any deviations away from interest rate parity (IRP) will motivate changes in investor behavior and force the exchange back to the level necessary to achieve IRP. The equilibrium adjustment story is next.
Key Takeaways
• The rates of return are plotted with respect to the exchange rate. The domestic rate of return does not depend on the exchange rate and hence is drawn as a vertical line. The foreign rate of return is negatively related to the value of the foreign currency.
• The intersection of the rates of return identifies the exchange rate that satisfies the interest rate parity condition.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of positive, negative, or zero, the relationship between the U.S. interest rate and the rate of return on U.S. assets.
• Of positive, negative, or zero, the relationship between the exchange rate (E$/£) and the rate of return on U.S. assets. • Of positive, negative, or zero, the relationship between the exchange rate (E$/£) and the rate of return on British assets.
• The name of the endogenous variable whose value is determined at the intersection of two rate of return curves. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.03%3A_Forex_Equilibrium_with_the_Rate_of_Return_Diagram.txt |
Learning objective
1. Learn how adjustment to equilibrium is described in the interest rate parity model.
Any equilibrium in economics has an associated behavioral story to explain the forces that will move the endogenous variable to the equilibrium value. In the foreign exchange (Forex) model, the endogenous variable is the exchange rate. This is the variable that is determined as a solution in the model and will change to achieve the equilibrium. Variables that do not change in the adjustment to the equilibrium are the exogenous variables. In this model, the exogenous variables are \(E_{\$/£}^e\), \(i_{\$}\), and \(i_{£}\). Changes in the exogenous variables are necessary to cause an adjustment to a new equilibrium. However, in telling an equilibrium story, it is typical to simply assume that the endogenous variable is not at the equilibrium (for some unstated reason) and then explain how and why the variable will adjust to the equilibrium value.
Exchange Rate Too High
Suppose, for some unspecified reason, the exchange rate is currently at \(E_{\$/£}^″\) as shown in Figure 5.6 . The equilibrium exchange rate is at \(E_{\$/£}'\) since at this rate, rates of return are equal and interest rate parity (IRP) is satisfied. Thus at \(E_{\$/£}^″\) the exchange rate is too high. Since the exchange rate, as written, is the value of the pound, we can also say that the pound value is too high relative to the dollar to satisfy IRP.
With the exchange rate at \(E_{\$/£}^″\), the rate of return on the dollar, \(R_{0}R_{\$}\), is given by the value A along the horizontal axis. This will be the value of the U.S. interest rate. The rate of return on the pound, \(R_{0}R_{£}\) is given by the value B, however. This means that \(R_{0}R_{£} \ < R_{0}R_{\$}\) and IRP does not hold. Under this circumstance, higher returns on deposits in the United States will motivate investors to invest funds in the United States rather than Britain. This will raise the supply of pounds on the Forex as British investors seek the higher average return on U.S. assets. It will also lower the demand for British pounds (£) by U.S. investors who decide to invest at home rather than abroad. Both changes in the Forex market will lower the value of the pound and raise the U.S. dollar value, reflected as a reduction in \(E_{\$/£}\).
In more straightforward terms, when the rate of return on dollar deposits is higher than on British deposits, investors will increase demand for the higher RoR currency and reduce demand for the other. The change in demand on the Forex raises the value of the currency whose RoR was initially higher (the U.S. dollar in this case) and lowers the other currency value (the British pound).
As the exchange rate falls from \(E_{\$/£}^″\) to \(E_{\$/£}'\), \(R_{0}R_{£}\) begins to rise up, from B to A. This occurs because \(R_{0}R_{£}\) is negatively related to changes in the exchange rate. Once the exchange rate falls to \(E_{\$/£}'\), \(R_{0}R_{£}\) will become equal to \(R_{0}R_{\$}\) at A and IRP will hold. At this point there are no further pressures in the Forex for the exchange rate to change, hence the Forex is in equilibrium at \(E_{\$/£}'\).
Exchange Rate Too Low
If the exchange rate is lower than the equilibrium rate, then the adjustment will proceed in the opposite direction. At any exchange rate below \(E_{\$/£}'\) in the diagram, \(R_{0}R_{£} \ > R_{0}R_{\$}\). This condition will inspire investors to move their funds to Britain with the higher rate of return. The subsequent increase in the demand for pounds will raise the value of the pound on the Forex and \(E_{\$/£}'\) will rise (consequently, the dollar value will fall). The exchange rate will continue to rise and the rate of return on pounds will fall until \(R_{0}R_{£} \ = R_{0}R_{\$}\) (IRP holds again) at \(E_{\$/£}'\).
Key Takeaways
• In the interest rate parity model, when the \$/£ exchange rate is less than the equilibrium rate, the rate of return on British deposits exceeds the RoR on U.S. deposits. That inspires investors to demand more pounds on the Forex to take advantage of the higher RoR. Thus the \$/£ exchange rate rises (i.e., the pound appreciates) until the equilibrium is reached when interest rate parity holds.
• In the interest rate parity model, when the \$/£ exchange rate is greater than the equilibrium rate, the rate of return on U.S. deposits exceeds the RoR on British deposits. That inspires investors to demand more U.S. dollars on the Forex to take advantage of the higher RoR. Thus the \$/£ exchange rate falls (i.e., the dollar appreciates) until the equilibrium is reached when interest rate parity holds.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the expected effect on the exchange rate (E\$/£) if the rate of return on pound assets is greater than the rate of return on dollar assets.
• Of increase, decrease, or stay the same, the expected effect on the exchange rate (E\$/£) if the rate of return on U.S. assets is greater than the rate of return on British assets.
• Of increase, decrease, or stay the same, the expected effect on the value of the dollar if the rate of return on pound assets is greater than the rate of return on dollar assets.
• Of increase, decrease, or stay the same, the expected effect on the value of the dollar if the rate of return on U.S. assets is greater than the rate of return on British assets.
• Of increase, decrease, or stay the same, the expected effect on the value of the dollar if the rate of return on U.S. assets is equal to the rate of return on British assets. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.04%3A_Exchange_Rate_Equilibrium_Stories_with_the_RoR_Diagram.txt |
Learning Objective
1. Learn the effects of changes in the foreign interest rate on the value of the domestic and foreign currency using the interest rate parity model.
Suppose that the foreign exchange market (Forex) is initially in equilibrium such that \(R_{0}R_{£} = R_{0}R_{\$}\) (i.e., interest rate parity holds) at an initial equilibrium exchange rate given by \(E_{\$/£}’\). The initial equilibrium is depicted in Figure 5.7 . Next, suppose U.S. interest rates rise, ceteris paribus. Ceteris paribus means we assume all other exogenous variables remain fixed at their original values. In this model, the British interest rate (\(i_{£}\)) and the expected exchange rate (\(E_{\$/£}^e\)) both remain fixed as U.S. interest rates rise.
The increase in U.S. interest rates will shift the U.S. RoR line to the right from \(R_{0}R_{\$}’\) to \(R_{0}R_{\$}^″\) as indicated by step 1 in Figure 5.7 . Immediately after the increase and before the exchange rate changes, \(R_{0}R_{\$} \ > R_{0}R_{£}\). The adjustment to the new equilibrium will follow the “exchange rate too high” equilibrium story earlier. Accordingly, higher U.S. interest rates will make U.S. dollar investments more attractive to investors, leading to an increase in demand for dollars on the Forex resulting in an appreciation of the dollar, a depreciation of the pound, and a decrease in \(E_{\$/£}\). The exchange rate will fall to the new equilibrium rate \(E_{\$/£}^”\) as indicated by step 2 in the figure.
In summary, an increase in the U.S. interest rate will raise the rate of return on dollars above the rate of return on pounds, lead investors to shift investments to U.S. assets, and result in a decrease in the \(\$/£\) exchange rate (i.e., an appreciation of the U.S. dollar and a depreciation of the British pound).
In contrast, a decrease in U.S. interest rates will lower the rate of return on dollars below the rate of return on pounds, lead investors to shift investments to British assets, and result in an increase in the \(\$/£\) exchange rate (i.e., a depreciation of the U.S. dollar and an appreciation of the British pound).
Key takeaways
• An increase in U.S. interest rates will result in a decrease in the \(\$/£\) exchange rate (i.e., an appreciation of the U.S. dollar and a depreciation of the British pound).
• A decrease in U.S. interest rates will result in an increase in the \(\$/£\) exchange rate (i.e., a depreciation of the U.S. dollar and an appreciation of the British pound).
exercise
1. Consider the economic change listed along the top row of the following table. In the empty boxes, indicate the effect of each change, sequentially, on the variables listed in the first column. For example, a decrease in U.S. interest rates will cause a decrease in the rate of return (RoR) on U.S. assets. Therefore a “−” is placed in the first cell under the “A Decrease in U.S. Interest Rates” column of the table. Next in sequence, answer how the RoR on euro assets will be affected. Use the interest rate parity model to determine the answers. You do not need to show your work. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
A Decrease in U.S. Interest Rates
RoR on U.S. Assets
RoR on Euro Assets
Demand for U.S. Dollars on the Forex
Demand for Euros on the Forex
U.S. Dollar Value
Euro Value
E\$/€ | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.05%3A_Exchange_Rate_Effects_of_Changes_in_U.S._Interest_Rates_Using_the_RoR_Diagram.txt |
Learning Objective
1. Learn the effects of changes in the foreign interest rate on the value of the domestic and foreign currency using the interest rate parity model.
Suppose that the foreign exchange market (Forex) is initially in equilibrium such that \(R_{0}R_{£} = R_{0}R_{\$}\) (i.e., interest rate parity holds) at an initial equilibrium exchange rate given by \(E_{\$/£}’\). The initial equilibrium is depicted in Figure 5.8 . Next, suppose British interest rates rise, ceteris paribus. Ceteris paribus means we assume all other exogenous variables remain fixed at their original values. In this model, the U.S. interest rate (\(i_{\$}\)) and the expected exchange rate (\(E_{\$/£}^e\)) both remain fixed as British interest rates rise.
The increase in British interest rates (\(i_{£}\)) will shift the British RoR line to the right from \(R_{0}R_{£}’\) to \(R_{0}R_{£}^”\) as indicated by step 1 in the figure.
The reason for the shift can be seen by looking at the simple rate of return formula:
Suppose one is at the original equilibrium with exchange rate \(E_{\$/£}’\). Looking at the formula, an increase in \(i_{£}\) clearly raises the value of \(R_{0}R_{£}\) for any fixed values of \(E_{\$/£}^e\). This could be represented as a shift to the right on the diagram, as from A to B. Once at B with a new interest rate, one could perform the exercise used to plot out the downward sloping RoR curve (see Chapter 5, Section 5.3). The result would be a curve, like the original, but shifted entirely to the right.
Immediately after the increase and before the exchange rate changes, \(R_{0}R_{£} \ > R_{0}R_{\$}\). The adjustment to the new equilibrium will follow the “exchange rate too low” equilibrium story presented in Chapter 5, Section 5.4. Accordingly, higher British interest rates will make British pound investments more attractive to investors, leading to an increase in demand for pounds on the Forex, and resulting in an appreciation of the pound, a depreciation of the dollar, and an increase in \(E_{\$/£}\). The exchange rate will rise to the new equilibrium rate \(E_{\$/£}^"\) as indicated by step 2.
In summary, an increase in British interest rates will raise the rate of return on pounds above the rate of return on dollars, lead investors to shift investments to British assets, and result in an increase in the \(\$/£\) exchange rate (i.e., an appreciation of the British pound and a depreciation of the U.S. dollar).
In contrast, a decrease in British interest rates will lower the rate of return on British pounds below the rate of return on dollars, lead investors to shift investments to U.S. assets, and result in a decrease in the \(\$/£\) exchange rate (i.e., a depreciation of the British pound and an appreciation of the U.S. dollar.
Key Takeaways
• An increase in British interest rates will result in an increase in the \$/£ exchange rate (i.e., an appreciation of the British pound and a depreciation of the U.S. dollar).
• A decrease in British interest rates will result in a decrease in the \$/£ exchange rate (i.e., a depreciation of the British pound and an appreciation of the U.S. dollar).
exercise
1. Consider the economic change listed along the top row of the following table. In the empty boxes, indicate the effect of each change, sequentially, on the variables listed in the first column. For example, a decrease in U.S. interest rates will cause a decrease in the rate of return (RoR) on U.S. assets. Therefore a “−” is placed in the first box of the table. Next in sequence, answer how the RoR on euro assets will be affected. Use the interest rate parity model to determine the answers. You do not need to show your work. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
A Decrease in Euro Interest Rates
RoR on U.S. Assets
RoR on Euro Assets
Demand for U.S. Dollars on the Forex
Demand for Euros on the Forex
U.S. Dollar Value
Euro Value
E\$/€ | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.06%3A_Exchange_Rate_Effects_of_Changes_in_Foreign_Interest_Rates_Using_the_RoR_Diagram.txt |
Learning Objective
1. Learn the effects of changes in the expected future currency value on the spot value of the domestic and foreign currency using the interest rate parity model.
Suppose that the foreign exchange market (Forex) is initially in equilibrium such that \(R_{0}R_{£} = R_{0}R_{\$}\) (i.e., interest rate parity holds) at an initial equilibrium exchange rate given by \(E_{\$/£}’\). The initial equilibrium is depicted in Figure 5.9 . Next, suppose investors’ beliefs shift so that \(E_{\$/£}^e\) rises, ceteris paribus. Ceteris paribus means we assume all other exogenous variables remain fixed at their original values. In this model, the U.S. interest rate (\(i_{\$}\)) and the British interest rate (\(i_{£}\)) both remain fixed as the expected exchange rate rises.
An expected exchange rate increase means that if investors had expected the pound to appreciate, they now expect it to appreciate even more. Likewise, if investors had expected the dollar to depreciate, they now expect it to depreciate more. Alternatively, if they had expected the pound to depreciate, they now expect it to depreciate less. Likewise, if they had expected the dollar to appreciate, they now expect it to appreciate less.
This change might occur because new information is released. For example, the British Central Bank might release information that suggests an increased chance that the pound will rise in value in the future.
The increase in the expected exchange rate (\(E_{\$/£}^e\)) will shift the British \(R_{0}R\) line to the right from \(R_{0}R_{£}’\) to \(R_{0}R_{£}^”\) as indicated by step 1 in the figure.
The reason for the shift can be seen by looking at the simple rate of return formula:
Suppose one is at the original equilibrium with exchange rate \(E_{\$/£}'\). Looking at the formula, an increase in \(E_{\$/£}^e\) clearly raises the value of \(R_{0}R_{£}\) for any fixed values of \(i_{£}\). This could be represented as a shift to the right on the diagram from A to B. Once at B with a new expected exchange rate, one could perform the exercise used to plot out the downward sloping \(R_{0}R\) curve. The result would be a curve, like the original, but shifted entirely to the right.
Immediately after the increase and before the exchange rate changes, \(R_{0}R_{£} \ > R_{0}R_{\$}\). The adjustment to the new equilibrium will follow the “exchange rate too low” equilibrium story presented in Chapter 5, Section 5.4. Accordingly, higher expected British rates of return will make British pound investments more attractive to investors, leading to an increase in demand for pounds on the Forex and resulting in an appreciation of the pound, a depreciation of the dollar, and an increase in \(E_{\$/£}\). The exchange rate will rise to the new equilibrium rate \(E_{\$/£}^”\) as indicated by step 2.
In summary, an increase in the expected future \(\$/£\) exchange rate will raise the rate of return on pounds above the rate of return on dollars, lead investors to shift investments to British assets, and result in an increase in the \(\$/£\) exchange rate (i.e., an appreciation of the British pound and a depreciation of the U.S. dollar).
In contrast, a decrease in the expected future \(\$/£\) exchange rate will lower the rate of return on British pounds below the rate of return on dollars, lead investors to shift investments to U.S. assets, and result in a decrease in the \(\$/£\) exchange rate (i.e., a depreciation of the British pound and an appreciation of the U.S. dollar).
Key takeaways
• An increase in the expected future pound value (with respect to the U.S. dollar) will result in an increase in the spot \(\$/£\) exchange rate (i.e., an appreciation of the British pound and a depreciation of the U.S. dollar).
• A decrease in the expected future pound value (with respect to the U.S. dollar) will result in a decrease in the spot \(\$/£\) exchange rate (i.e., a depreciation of the British pound and an appreciation of the U.S. dollar).
exercise
1. Consider the economic change listed along the top row of the following table. In the empty boxes, indicate the effect of the change, sequentially, on the variables listed in the first column. For example, a decrease in U.S. interest rates will cause a decrease in the rate of return (RoR) on U.S. assets. Therefore a “−” is placed in the first box of the table. Next in sequence, answer how the RoR on euro assets will be affected. Use the interest rate parity model to determine the answers. You do not need to show your work. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
A Reduction in Next Year’s Expected Dollar Value
\(R_{0}R\) on U.S. Assets
\(R_{0}R\) on Euro Assets
Demand for U.S. Dollars on the Forex
Demand for Euros on the Forex
U.S. Dollar Value
Euro Value
\(E_{\$/€}\) | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/05%3A_Interest_Rate_Parity/5.07%3A_Exchange_Rate_Effects_of_Changes_in_the_Expected_Exchange_Rate_Using_the_RoR_Diagram.txt |
Purchasing power parity is both a theory about exchange rate determination and a tool to make more accurate comparisons of data between countries. It is probably more important in its latter role since as a theory it performs pretty poorly. Its poor performance arises largely because its simple form depends on several assumptions that are not likely to hold in the real world and because the amount of foreign exchange activity due to importer and exporter demands is much less than the amount of activity due to investor demands. Nonetheless, the theory remains important to provide the background for its use as a tool for cross-country comparisons of income and wages, which is used by international organizations like the World Bank in presenting much of their international data.
06: Purchasing Power Parity
Learning objectives
1. Identify the conditions under which the law of one price holds.
2. Identify the conditions under which purchasing power parity holds.
Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. The theory assumes that the actions of importers and exporters (motivated by cross-country price differences) induce changes in the spot exchange rate. In another vein, PPP suggests that transactions on a country’s current account affect the value of the exchange rate on the foreign exchange (Forex) market. This is in contrast with the interest rate parity theory, which assumes that the actions of investors (whose transactions are recorded on the capital account) induce changes in the exchange rate.
PPP theory is based on an extension and variation of the “law of one price” as applied to the aggregate economy. To explain the theory it is best to first review the idea behind the law of one price.
The Law of One Price (LoOP)
The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Consider the following information about movie video tapes sold in the U.S. and Mexican markets.
Price of videos in U.S. market () \$20
Price of videos in Mexican market () p150
Spot exchange rate () 10 p/\$
The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by the spot exchange rate as shown:
To see why the peso price is divided by the exchange rate rather than multiplied, notice the conversion of units shown in the brackets. If the law of one price held, then the dollar price in Mexico should match the price in the United States. Since the dollar price of the video is less than the dollar price in the United States, the law of one price does not hold in this circumstance.
The next question to ask is what might happen as a result of the discrepancy in prices. Well, as long as there are no costs incurred to transport the goods, there is a profit-making opportunity through trade. For example, U.S. travelers in Mexico who recognize that identical video titles are selling there for 25 percent less might buy videos in Mexico and bring them back to the United States to sell. This is an example of “goods arbitrage.” An arbitrage opportunity arises whenever one can buy something at a low price in one location, resell it at a higher price, and thus make a profit.
Using basic supply and demand theory, the increase in demand for videos in Mexico would push up the price of videos. The increase in supply of videos on the U.S. market would force the price down in the United States. In the end, the price of videos in Mexico may rise to, say, p180 while the price of videos in the United States may fall to \$18. At these new prices the law of one price holds since
The idea in the law of one price is that identical goods selling in an integrated market in which there are no transportation costs, no differential taxes or subsidies, and no tariffs or other trade barriers should sell at identical prices. If different prices prevailed, then there would be profit-making opportunities by buying the good in the low price market and reselling it in the high price market. If entrepreneurs took advantage of this arbitrage opportunity, then the prices would converge to equality.
Of course, for many reasons the law of one price does not hold even between markets within a country. The price of beer, gasoline, and stereos will likely be different in New York City and in Los Angeles. The price of these items will also be different in other countries when converted at current exchange rates. The simple reason for the discrepancies is that there are costs to transport goods between locations, there are different taxes applied in different states and different countries, nontradable input prices may vary, and people do not have perfect information about the prices of goods in all markets at all times. Thus to refer to this as an economic “law” does seem to exaggerate its validity.
From LoOP to PPP
The purchasing power parity theory is really just the law of one price applied in the aggregate but with a slight twist added. If it makes sense from the law of one price that identical goods should sell for identical prices in different markets, then the law ought to hold for all identical goods sold in both markets.
First, let’s define the variable \(CB_{\$}\) to represent the cost of a basket of goods in the United States denominated in dollars. For simplicity we could imagine using the same basket of goods used in the construction of the U.S. consumer price index (\(CPI_{\$}\)). The consumer price index (CPI) uses a market basket of goods that are purchased by an average household during a specified period. The basket is determined by surveying the quantity of different items purchased by many different households. One can then determine, on average, how many units of bread, milk, cheese, rent, electricity, and so on are purchased by the typical household. You might imagine it’s as if all products are purchased in a grocery store with items being placed in a basket before the purchase is made. \(CB_{\$}\) then represents the dollar cost of purchasing all the items in the market basket. We will similarly define \(CB_{P}\) to be the cost of a market basket of goods in Mexico denominated in pesos.
Now if the law of one price holds for each individual item in the market basket, then it should hold for the market baskets as well. In other words,
Rewriting the right-hand side equation allows us to put the relationship in the form commonly used to describe absolute purchasing power parity, which is
If this condition holds between two countries, then we would say PPP is satisfied. The condition says that the PPP exchange rate (pesos per dollar) will equal the ratio of the costs of the two market baskets of goods denominated in local currency units. Note that the reciprocal relationship is also valid.
Because the cost of a market basket of goods is used in the construction of the country’s consumer price index, PPP is often written as a relationship between the exchange rate and the country’s price indices. However, it is not possible merely to substitute the price index directly for the cost of the market basket used above. To see why, we will review the construction of the CPI in Chapter 6, Section 6.2.
KEy takeaways
• The law of one price says that identical goods should sell for identical prices in two different markets when converted at the current exchange rate and when there are no transportation costs and no differential taxes applied.
• The purchasing power parity theory is an aggregated version of the law of one price.
• The purchasing power parity condition says that identical market baskets should sell for identical prices in two different markets when converted at the current exchange rate and when there are no transportation costs and no differential taxes applied.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The exchange rate value if toothpaste costs \$2.50 in the United States and 30 pesos in Mexico and the law of one price holds.
• The exchange rate value if a market basket costs \$450 in the United States and 5,400 pesos in Mexico and purchasing power parity holds.
• The term used to describe a collection of goods and services consumed by a typical consumer.
• The term used to distinguish PPP based on price levels rather than inflation rates.
• The term used to describe the economic principle that identical goods should sell at identical prices in different markets.
2. Use the information in the table below to answer the following question. Show your work.
The Economist Price per Issue Exchange Rate (December 2, 1999)
United States \$3.95
Canada C\$ 4.95 1.47 C\$/\$
Japan ¥920 102 ¥/\$
• Calculate the implied purchasing power parity exchange rates between Canada and the United States and between Japan and the United States based on the price of the Economist magazine. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.01%3A_Overview_of_Purchasing_Power_Parity_%28PPP%29.txt |
Learning Objective
1. Learn the relationship between the consumer price index and the PPP exchange rate.
The consumer price index (CPI) is an index that measures the average level of prices of goods and services in an economy relative to a base year. To track only what happens to prices, the quantities of goods purchased is assumed to remain fixed from year to year. This is accomplished by determining—with survey methods—the average quantities of all goods and services purchased by a typical household during some period. The quantities of all of these goods together are referred to as the average market basket. For example, the survey might find that the average household in one month purchases 10 gallons of gas, 15 cans of beer, 3.2 gallons of milk, 2.6 pounds of butter, and so on. The basket of goods would also contain items like health and auto insurance, housing services, utility services, and many other items. We can describe the market basket easily as a collection or set of quantities (\(Q_{1}, Q_{2}, Q_{3},…, Q_{n}\)). Here \(Q_{1}\) may be the quantity of gasoline, \(Q_{2}\) the quantity of beer, and so on. The set has n different quantity entries, implying that there are n different items in the market basket.
The cost of the market basket is found by surveying the average prices for each of the n products in the market in question. This survey would yield a collection or set of prices (\(P_{1}, P_{2}, P_{3},…, P_{n}\)). The cost of the market basket is then found by summing the product of the price and quantity for each item. That is, \(CB = P_{1}Q_{1} + P_{2}Q_{2} + P_{3}Q_{3} +…+ P_{n}Q_{n}\), or
The first year in which the index is constructed is called the base year. Suppose 1982 is the base year for the United States. Let \(CB_{YY}\) represent the cost of the market basket evaluated at the prices that prevail in the year (YY) (e.g., \(CB_{09}\) is the cost of a market basket evaluated in 2009 prices). The CPI is derived according to the following formula:
where \(CPI_{YY}\) is the CPI in the year (YY). The term is multiplied by 100 by convention, probably because it reduces the need to use digits after a decimal point. Notice that the CPI in the base year is equal to 100—that is, \(CPI_{82} = 100\)—because \(CB_{82}/CB_{82}=1\). This is true for all indices—they are by convention set to 100 in the base year.
The CPI in a different year (either earlier or later) represents the ratio of the cost of the market basket in that year relative to the cost of the same basket in the base year. If in 1982 the cost of the market basket rises, then the CPI will rise above 100. If the cost of the market basket falls, then the CPI would fall below 100.
If the CPI rises, it does not mean that the prices of all the goods in the market basket have risen. Some prices may rise more or less. Some prices may even fall. The CPI measures the average price change of goods and services in the basket.
The inflation rate for an economy is the percentage change in the CPI during a year. Thus if \(CPI_{08}\) on January 1, 2008, and \(CPI_{09}\) on January 1, 2009, are the price indices, then the inflation rate during 2008 is given by
PPP Using the CPI
The purchasing power parity relationship can be written using the CPI with some small adjustments. First, consider the following ratio of 2009 consumer price indices between Mexico and the United States:
Given that the base year is 2008, the ratio is written in terms of the market basket costs on the right-hand side and then rewritten into another form. The far right-hand side expression now reflects the purchasing power parity exchange rates in 2009 divided by the PPP exchange rate in 2008, the base year. In other words,
So, in general, if you want to use the consumer price indices for two countries to derive the PPP exchange rate for 2009, you must apply the following formula, derived by rewriting the above as
where represents the PPP exchange rate that prevails in the base year between the two countries. Note that in order for this formula to work correctly, the CPIs in both countries must share the same base year. If they did not, a more complex formula would need to be derived.
Key Takeaways
• A country’s consumer price index in year (YY) is derived as the ratio of the market basket cost in year (YY) and the market basket cost in the base year.
• The PPP exchange rate between two countries can be written as the ratio of the their consumer price indices in that year multiplied by an adjustment factor given by the PPP exchange rate in the base year of the countries’ CPIs.
exercise
1. Suppose a consumer purchases the following products each week: ten gallons of gas, fifteen cans of beer, three gallons of milk, and two pounds of butter. Suppose in the initial week the prices of the products are \$3 per gallon of gas, \$2 per can of beer, \$4 per gallon of milk, and \$4 per pound of butter. Suppose one year later the prices of the same products are \$2 per gallon of gas, \$3 per can of beer, \$5 per gallon of milk, and \$5 per pound of butter.
• Calculate the cost of a weekly market basket in the initial base period.
• Calculate the cost of a market basket one year later.
• Construct the price index value for both years.
• What is the inflation rate between the two years? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.02%3A_The_Consumer_Price_Index_%28CPI%29_and_PPP.txt |
Learning Objective
1. Learn how adjustment to equilibrium occurs in the PPP model.
The purchasing power parity (PPP) relationship becomes a theory of exchange rate determination by introducing assumptions about the behavior of importers and exporters in response to changes in the relative costs of national market baskets. Recall the story of the law of one price, when the price of a good differed between two countries’ markets and there was an incentive for profit-seeking individuals to buy the good in the low price market and resell it in the high price market. Similarly, if a market basket containing many different goods and services costs more in one market than another, we should likewise expect profit-seeking individuals to buy the relatively cheaper goods in the low-cost market and resell them in the higher-priced market. If the law of one price leads to the equalization of the prices of a good between two markets, then it seems reasonable to conclude that PPP, describing the equality of market baskets across countries, should also hold.
However, adjustment within the PPP theory occurs with a twist compared to adjustment in the law of one price story. In the law of one price story, goods arbitrage in a particular product was expected to affect the prices of the goods in the two markets. The twist that’s included in the PPP theory is that arbitrage, occurring across a range of goods and services in the market basket, will affect the exchange rate rather than the market prices.
PPP Equilibrium Story
To see why the PPP relationship represents an equilibrium, we need to tell an equilibrium story. An equilibrium story in an economic model is an explanation of how the behavior of individuals will cause the equilibrium condition to be satisfied. The equilibrium condition is the PPP equation written as
The endogenous variable in the PPP theory is the exchange rate. Thus we need to explain why the exchange rate will change if it is not in equilibrium. In general there are always two versions of an equilibrium story, one in which the endogenous variable (\(E_{p/\$}\) here) is too high and one in which it is too low.
PPP equilibrium story 1. Let’s consider the case in which the exchange rate is too low to be in equilibrium. This means that
where \(E_{p/\$}\) is the exchange rate that prevails on the spot market. Since it is less than the ratio of the market basket costs in Mexico and the United States, it is also less than the PPP exchange rate. The right side of the expression is rewritten to show that the cost of a market basket in the United States evaluated in pesos (i.e., \(CB_{\$}E_{p/\$}\)) is less than the cost of the market basket in Mexico also evaluated in pesos. Thus it is cheaper to buy the basket in the United States, or in other words, it is more profitable to sell items in the market basket in Mexico.
The PPP theory now suggests that the cheaper basket in the United States will lead to an increase in demand for goods in the U.S. market basket by Mexico. As a consequence, it will increase the demand for U.S. dollars on the foreign exchange (Forex) market. Dollars are needed because purchases of U.S. goods require U.S. dollars. Alternatively, U.S. exporters will realize that goods sold in the United States can be sold at a higher price in Mexico. If these goods are sold in pesos, the U.S. exporters will want to convert the proceeds back to dollars. Thus there is an increase in U.S. dollar demand (by Mexican importers) and an increase in peso supply (by U.S. exporters) on the Forex. This effect is represented by a rightward shift in the U.S. dollar demand curve in Figure 6.1 . At the same time, U.S. consumers will reduce their demand for the pricier Mexican goods. This will reduce the supply of dollars (in exchange for pesos) on the Forex, which is represented by a leftward shift in the U.S. dollar supply curve in the Forex market.
Both the shift in demand and supply will cause an increase in the value of the dollar and thus the exchange rate (\(E_{p/\$}\)) will rise. As long as the U.S. market basket remains cheaper, excess demand for the dollar will persist and the exchange rate will continue to rise. The pressure for change ceases once the exchange rate rises enough to equalize the cost of market baskets between the two countries and PPP holds.
PPP equilibrium story 2. Now let’s consider the other equilibrium story (i.e., the case in which the exchange rate is too high to be in equilibrium). This implies that
The left-side expression says that the spot exchange rate is greater than the ratio of the costs of market baskets between Mexico and the United States. In other words, the exchange rate is above the PPP exchange rate. The right-side expression says that the cost of a U.S. market basket, converted to pesos at the current exchange rate, is greater than the cost of a Mexican market basket in pesos. Thus, on average, U.S. goods are relatively more expensive while Mexican goods are relatively cheaper.
The price discrepancies should lead consumers in the United States or importing firms to purchase less expensive goods in Mexico. To do so, they will raise the supply of dollars in the Forex in exchange for pesos. Thus the supply curve of dollars will shift to the right as shown in Figure 6.2 . At the same time, Mexican consumers would refrain from purchasing the more expensive U.S. goods. This would lead to a reduction in demand for dollars in exchange for pesos on the Forex. Hence, the demand curve for dollars shifts to the left. Due to the demand decrease and the supply increase, the exchange rate (\(E_{p/\$}\)) falls. This means that the dollar depreciates and the peso appreciates.
Extra demand for pesos will continue as long as goods and services remain cheaper in Mexico. However, as the peso appreciates (the dollar depreciates), the cost of Mexican goods rises relative to U.S. goods. The process ceases once the PPP exchange rate is reached and market baskets cost the same in both markets.
Adjustment to Price Level Changes under PPP
In the PPP theory, exchange rate changes are induced by changes in relative price levels between two countries. This is true because the quantities of the goods are always presumed to remain fixed in the market baskets. Therefore, the only way that the cost of the basket can change is if the goods’ prices change. Since price level changes represent inflation rates, this means that differential inflation rates will induce exchange rate changes according to the theory.
If we imagine that a country begins with PPP, then the inequality given in equilibrium story 1, can arise if the price level rises in Mexico (peso inflation), if the price level falls in the United States (dollar deflation), or if Mexican inflation is more rapid than U.S. inflation. According to the theory, the behavior of importers and exporters would now induce a dollar appreciation and a peso depreciation. In summary, an increase in Mexican prices relative to the change in U.S. prices (i.e., more rapid inflation in Mexico than in the United States) will cause the dollar to appreciate and the peso to depreciate according to the purchasing power parity theory.
Similarly, if a country begins with PPP, then the inequality given in equilibrium story 2, can arise if the price level rises in the United States (dollar inflation), the price level falls in Mexico (peso deflation), or if U.S. inflation is more rapid than Mexican inflation. In this case, the inequality would affect the behavior of importers and exporters and induce a dollar depreciation and peso appreciation. In summary, more rapid inflation in the United States would cause the dollar to depreciate while the peso would appreciate.
Key Takeaways
• An increase in Mexican prices relative to the change in U.S. prices (i.e., more rapid inflation in Mexico than in the United States) will cause the dollar to appreciate and the peso to depreciate according to the purchasing power parity theory.
• More rapid inflation in the United States would cause the dollar to depreciate while the peso would appreciate.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or no change, the effect on the demand for euros in the foreign exchange market if a market basket costs more in the United States than it does in Germany.
• Of increase, decrease, or no change, the effect on the supply of dollars in the foreign exchange market if a market basket costs more in the United States than it does in Germany.
• Of increase, decrease, or no change, the effect on the U.S. dollar value according to the PPP theory if a market basket costs \$300 in the United States and €200 in Germany and the exchange rate is \(E_{\$/€}\) = 1.30.
• Of increase, decrease, or no change, the effect on the euro value according to the PPP theory if a market basket costs €200 in Germany and ¥22,000 in Japan and the exchange rate is \(E_{¥/€}\) = 115.
• Of increase, decrease, or no change, the effect on the euro value according to the PPP theory if a market basket costs €200 in Germany and ¥22,000 in Japan and the exchange rate is \(E_{¥/€}\) = 100. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.03%3A_PPP_as_a_Theory_of_Exchange_Rate_Determination.txt |
Learning objectives
1. Identify the reasons why the PPP condition is rarely satisfied between two countries.
2. Learn the dynamic version of PPP.
The main problem with the purchasing power parity (PPP) theory is that the PPP condition is rarely satisfied within a country. There are quite a few reasons that can explain this and so, given the logic of the theory, which makes sense, economists have been reluctant to discard the theory on the basis of lack of supporting evidence. Below we consider some of the reasons PPP may not hold.
Transportation costs and trade restrictions. Since the PPP theory is derived from the law of one price, the same assumptions are needed for both theories. The law of one price assumes that there are no transportation costs and no differential taxes applied between the two markets. These mean that there can be no tariffs on imports or other types of restrictions on trade. Since transport costs and trade restrictions do exist in the real world, this would tend to drive prices for similar goods apart. Transport costs should make a good cheaper in the exporting market and more expensive in the importing market. Similarly, an import tariff would drive a wedge between the prices of an identical good in two trading countries’ markets, raising it in the import market relative to the export market price. Thus the greater transportation costs and trade restrictions are between countries, the less likely for the costs of market baskets to be equalized.
Costs of nontradable inputs. Many items that are homogeneous nevertheless sell for different prices because they require a nontradable input in the production process. As an example, consider why the price of a McDonald’s Big Mac hamburger sold in downtown New York City is higher than the price of the same product in the New York suburbs. Because the rent for restaurant space is much higher in the city center, the restaurant will pass along its higher costs in the form of higher prices. Substitute products in the city center (other fast food restaurants) will face the same high rental costs and thus will charge higher prices as well. Because it would be impractical (i.e., costly) to produce the burgers at a cheaper suburban location and then transport them for sale in the city, competition would not drive the prices together in the two locations.
Perfect information. The law of one price assumes that individuals have good, even perfect, information about the prices of goods in other markets. Only with this knowledge will profit seekers begin to export goods to the high price market and import goods from the low-priced market. Consider a case in which there is imperfect information. Perhaps some price deviations are known to traders but other deviations are not known, or maybe only a small group of traders know about a price discrepancy and that group is unable to achieve the scale of trade needed to equalize the prices for that product. (Perhaps they face capital constraints and can’t borrow enough money to finance the scale of trade needed to equalize prices.) In either case, traders without information about price differences will not respond to the profit opportunities and thus prices will not be equalized. Thus the law of one price may not hold for some products, which would imply that PPP would not hold either.
Other market participants. Notice that in the PPP equilibrium stories, it is the behavior of profit-seeking importers and exporters that forces the exchange rate to adjust to the PPP level. These activities would be recorded on the current account of a country’s balance of payments. Thus it is reasonable to say that the PPP theory is based on current account transactions. This contrasts with the interest rate parity theory in which the behavior of investors seeking the highest rates of return on investments motivates adjustments in the exchange rate. Since investors are trading assets, these transactions would appear on a country’s capital account of its balance of payments. Thus the interest rate parity theory is based on capital account transactions.
It is estimated that there are approximately \$1–2 trillion dollars worth of currency exchanged every day on international foreign exchange (Forex) markets. That’s one-eighth of U.S. GDP, which is the value of production in the United States in an entire year. In addition, the \$1–2 trillion estimate is made by counting only one side of each currency trade. Thus that’s an enormous amount of trade. If one considers the total amount of world trade each year and then divides by 365, one can get the average amount of goods and services traded daily. This number is less than \$100 billion dollars. This means that the amount of daily currency transactions is more than ten times the amount of daily trade. This fact would seem to suggest that the primary effect on the daily exchange rate must be caused by the actions of investors rather than importers and exporters. Thus the participation of other traders in the Forex market, who are motivated by other concerns, may lead the exchange rate to a value that is not consistent with PPP.
Relative PPP
There is an alternative version of the PPP theory called the “relative PPP theory.” In essence this is a dynamic version of the absolute PPP theory. Since absolute PPP suggests that the exchange rate may respond to inflation, we can imagine that the exchange rate would change in a systematic way given that a continual change in the price level (inflation) is occurring.
In the relative PPP theory, exchange rate changes over time are assumed to be dependent on inflation rate differentials between countries according to the following formula:
Here the percentage change in the dollar value between the first period and the second period is given on the left side. The right side gives the differences in the inflation rates between Mexico and the United States that were evaluated over the same time period. The implication of relative PPP is that if the Mexican inflation rate exceeds the U.S. inflation rate, then the dollar will appreciate by that differential over the same period. The logic of this theory is the same as in absolute PPP. Importers and exporters respond to variations in the relative costs of market baskets so as to maintain the law of one price, at least on average. If prices continue to rise faster in Mexico than in the United States, for example, price differences between the two countries would grow and the only way to keep up with PPP is for the dollar to appreciate continually versus the peso.
Key takeaways
• Purchasing power parity (PPP) will not be satisfied between countries when there are transportation costs, trade barriers (e.g., tariffs), differences in prices of nontradable inputs (e.g., rental space), imperfect information about current market conditions, and when other Forex market participants, such as investors, trade currencies for other reasons.
• Relative PPP is a dynamic version of the theory that relates currency appreciation or depreciation to differences in country inflation rates.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The name for the PPP theory based on relative inflation rates between countries.
• A type of trade cost whose presence is likely to cause deviations in the law of one price and PPP.
• The term used to describe a kind of production input, of which office rental is one type.
• Traders need to have information about this in other markets in order to take advantage of arbitrage opportunities. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.04%3A_Problems_and_Extensions_of_PPP.txt |
Learning Objective
1. Interpret the PPP theory as a projection of long-term tendencies in exchange rate values.
In general, the purchasing power parity (PPP) theory works miserably when applied to real-world data. In other words, it is rare for the PPP relationship to hold true between any two countries at any particular point in time. In most scientific disciplines, the failure of a theory to be supported by the data means the theory is refuted and should be thrown out or tossed away. However, economists have been reluctant to do that with the PPP theory. In part this is because the logic of the theory seems particularly sound. In part it’s because there are so many “frictions” in the real world, such as tariffs, nontariff barriers, transportation costs, measurement problems, and so on that it would actually be surprising for the theory to work when applied directly to the data. (It is much like expecting an object to follow Newton’s laws of motion while sitting on the ground.)
In addition, economists have conceived of an alternative way to interpret or apply the PPP theory to overcome the empirical testing problem. The trick is to think of PPP as a “long-run” theory of exchange rate determination rather than a short-run theory. Under such an interpretation, it is no longer necessary for PPP to hold at any point in time. Instead, the PPP exchange rate is thought to represent a target toward which the spot exchange rate is slowly drawn.
This long-run interpretation requires an assumption that importers and exporters cannot respond quickly to deviations in the cost of market baskets between countries. Instead of immediate responses to price differences between countries by engaging in arbitrage—buying at the low price and selling high—traders respond slowly to these price signals. Some reasons for the delay include imperfect information (traders are not aware of the price differences), long-term contracts (traders must wait till current contractual arrangements expire), and/or marketing costs (entry to new markets requires research and setup costs). In addition, we recognize that the exchange rate is not solely determined by trader behavior. Investors, who respond to different incentives, might cause persistent deviations from the PPP exchange rate even if traders continue to respond to the price differences.
When there is a delayed response, PPP no longer needs to hold at a particular point in time. However, the theory does imagine that traders eventually will adjust to the price differences (buying low and selling high), causing an eventual adjustment of the spot exchange rate toward the PPP rate. However, as adjustment occurs, it is quite possible that the PPP exchange rate also continues to change. In this case, the spot exchange rate is adjusting toward a moving target.
How long will this adjustment take? In other words, how long is the long run? The term itself is generally used by economists to represent some “unspecified” long period of time; it might be several months, years, or even decades. Also, since the target, the PPP exchange rate, is constantly changing, it is quite possible that it is never reached. The adjustment process may never allow the exchange rate to catch up to the target even though it is constantly chasing it.
Perhaps the best way to see what the long-run PPP theory suggests is to consider Figure 6.3 . The figure presents constructed data (i.e., made up) between two countries, A and B. The dotted black line shows the ratio of the costs of market baskets between the two countries over a long period, a century between 1904 and 2004. It displays a steady increase, indicating that prices have risen faster in country A relative to country B. The solid blue line shows a plot of the exchange rate between the two countries during the same period. If PPP were to hold at every point in time, then the exchange rate plot would lie directly on top of the market basket ratio plot. The fact that it does not means PPP did not hold all the time. In fact, PPP held only at times when the exchange rate plot crosses the market basket ratio plot; on the diagram this happened only twice during the century—not a very good record.
Nonetheless, despite performing poorly with respect to moment-by-moment PPP, the figure displays an obvious regularity. The trend of the exchange rate between the countries is almost precisely the trend in the market basket ratio; both move upward at about the same “average” rate. Sometimes the exchange rate is below the market basket ratio, even for a long period of time, but at other times, the exchange rate rises up above the market basket ratio.
The idea here is that lengthy exchange rate deviations from the market basket ratio (i.e., the PPP exchange rate) mean long periods of time in which the cost of goods is cheaper in one country than in another. Eventually, traders will respond to these price discrepancies and begin to import more from the less expensive country. This will lead to the increase in demand for that country’s currency and cause the exchange rate to move back toward the market basket ratio. However, in the long-run version of the theory, this will take time, sometimes a considerable amount of time, even years or more.
To see how this relationship works in one real-world example, consider Figure 6.4 . It plots the exchange rate (\(E_{\$/£}\)) between the U.S. dollar and the British pound between 1913 and 2004 together with an adjusted ratio of the countries’ consumer price indices (CPIs) during the same period.A technical point: The ratio of CPIs is adjusted because the ratio of CPIs must be multiplied by the PPP exchange rate that prevailed in the base year for the two countries. However, the CPI series used has 1967 as the base year in the United Kingdom and 1974 as the base year in the United States. This would mean the CPI ratio should be multiplied by the ratio of the cost of a market basket in the United States in 1974 divided by the market basket cost in the United Kingdom in 1967. Unsurprisingly, I don’t have that information. Thus I’ll assume a number (1.75) that is somewhat greater than the actual exchange rate that prevailed at the time. The higher number may account for the fact that prices rose considerably between 1967 and 1974. In any case, it remains a guess. The adjusted ratio represents an estimate of the ratio of the costs of market baskets between the two countries.
In the diagram, the dotted black line represents the estimated ratio of market basket costs and the solid blue line is the exchange rate (\(E_{\$/£}\)). Note how closely the exchange rate tracks the trend in the market basket ratio. This remains true even though the exchange rate remained fixed during some lengthy periods of time, as in the 1950s and 1960s. While this depiction is just two countries over a long period, it is suggestive that the long-run version of PPP may have some validity.
More sophisticated empirical tests of the long-run version of PPP have shown mixed results, as some studies support the hypothesis while others tend to reject it. Regardless, there is much more support for this version of the theory than for the much more simplistic short-run version.
Key Takeaways
• Under the long-run purchasing power parity (PPP) theory, the PPP exchange rate is thought to represent a target toward which the spot exchange rate is slowly drawn over time. The empirical evidence for this theory is mixed.
• Long-run data showing the trend in consumer price index (CPI) ratios between the United States and the United Kingdom relative to the \$/£ exchange rate suggest some validity to the theory.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used by economists to denote an unspecified point in time in the distant future.
• The term used by economists to denote an unspecified point in time in the near future.
• The term used to describe the general path along which a variable is changing.
• Under this version of the PPP theory, the PPP exchange rate represents a target toward which the spot exchange rate is slowly drawn over time. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.05%3A_PPP_in_the_Long_Run.txt |
learning goal
1. Recognize how the terms overvalued and undervalued exchange rates are defined, applied, and interpreted.
It is quite common to hear people claim that a country’s exchange rate is overvalued or undervalued. The first question one should ask when someone claims the exchange rate is overvalued is “overvalued with respect to what?” There are two common reference exchange rates often considered. The person may mean the exchange rate is overvalued with respect to purchasing power parity (PPP), or he may mean the exchange rate is overvalued relative to the rate presumed Needed to balance the current account (CA).
The mere use of these terms suggests immediately that there is some “proper” value for the exchange rate. However, one should refrain from accepting this implication. As was previously discussed, PPP is unlikely to hold, even over very long periods, for a variety of very good reasons. Also, there is no reason to think that current account balance represents some equilibrium or goal for an economy: countries can run trade deficits or surpluses for an extended period and suffer no ill effects. Thus overvaluation or undervaluation of an exchange rate, for either reason (PPP or current account balance) should be thought of simply as something that happens. Of more interest is what it means when it happens.
Over- and Undervaluation with Respect to PPP
First let’s consider over- and undervaluation with respect to PPP. The PPP exchange rate is defined as the rate that equalizes the cost of a market basket of goods between two countries. The PPP exchange rate between the Mexican peso and the U.S. dollar would be written as
which represents the PPP value of the U.S. dollar in terms of pesos.
If the U.S. dollar is overvalued with respect to the Mexican peso, then the spot exchange rate exceeds the PPP exchange rate:
This will also mean the exchange rate exceeds the ratio of market basket costs:
therefore, the following will hold:
The left side (LS) of this expression represents the cost of a U.S. market basket converted to pesos at the current spot exchange rate. The right side (RS) is the cost of the basket in Mexico also evaluated in pesos. Since LS > RS, goods and services cost more on average in the United States than in Mexico at the current exchange rate. Thus for the U.S. dollar to be overvalued with respect to the peso means that goods and services are relatively more expensive in the United States than in Mexico. Of course, it also implies that goods and services are relatively cheaper in Mexico.
A simple guide to judge whether a currency is overvalued is to consider it from the perspective of a tourist. When the U.S. dollar is overvalued, a U.S. tourist traveling to Mexico will find that many products seem cheaper than in the United States, after converting at the spot exchange rate. Thus an overvalued currency will buy more in other countries.
An undervalued currency works in the opposite direction. When the U.S. dollar is undervalued, the cost of a basket of goods in the United States is lower than the cost in Mexico when evaluated at the current exchange rate. To a U.S. tourist, Mexican goods and services would seem more expensive on average. Thus an undervalued currency will buy less in other countries.
Finally, if the U.S. dollar is overvalued with respect to the Mexican peso, it follows that the peso is undervalued with respect to the dollar. In this case, since the U.S. tourists would find Mexican goods comparatively cheap, Mexican tourists would find U.S. goods to be comparatively expensive. If the U.S. dollar were undervalued, then the peso would be overvalued.
Is overvaluation or undervaluation good or bad? That depends on what a person is trying to achieve. For example, if the U.S. dollar is overvalued with respect to the peso, then a U.S. tourist traveling to Mexico will be very happy. In fact, the more overvalued the dollar is, the better. However, for an exporter of U.S. goods to Mexico, its price in peso terms will be higher the more overvalued is the dollar. Thus an overvalued dollar will likely reduce sales and profits for these U.S. firms.
Over- and Undervaluation with Respect to Current Account Balance
The second way over- and undervaluation is sometimes applied is in comparison to an exchange rate presumed necessary to induce trade balance, or balance on the current account. If one imagines that a trade deficit, for example, arises primarily because a country imports too much or exports too little (rather than being driven by financial decisions tending to cause a financial account surplus), then one may also look for ways to either reduce imports or raise exports. A change in the exchange rate offers one viable method to affect trade flows.
Suppose the United States has a trade deficit (which it indeed has had for more than thirty years prior to 2010). If the U.S. dollar value were to fall—a dollar depreciation—then foreign goods would all become relatively more expensive to U.S. residents, tending to reduce U.S. imports. At the same time, a dollar depreciation would also cause U.S. goods to become relatively cheaper to foreign residents tending to raise U.S. exports.
Sometimes economists make numerical estimations as to how much the dollar value would have to fall to bring trade into balance. These estimations are enormously difficult to make for several reasons and should be interpreted and used with great caution, if at all. The primary reason is that many different factors on both the trade side and the financial side influence a country’s trade imbalance besides just the exchange rate. The exchange rate that balances trade would depend on the values taken by all the other factors that also influence the trade balance. Different values for all the other variables would mean a different exchange rate needed to balance trade. Thus there isn’t one exchange rate value that will balance trade. Instead, there is a different exchange rate value that will balance trade in each and every alternative circumstance. Indeed, even the current exchange rate—whatever that is—can balance trade if other factors change appropriately.
Despite these cautions, many observers will still contend that a country’s currency needs to depreciate by some percentage to eliminate a trade deficit, or needs to appreciate to eliminate a trade surplus. When it is believed a depreciation of the currency is needed to balance trade, they will say the currency is overvalued. When it is believed an appreciation of the currency is needed to balance trade, they will say the currency is undervalued. However, in a floating exchange rate system, it is hard to argue that the exchange rate is at the “wrong” value since—with competition in the market—it will always be at the rate that equalizes supply and demand. In other words, the “proper” value for the exchange rate can be said to be not the one that will satisfy PPP or not the one that will generate trade balance but rather whatever rate currently prevails. Under this notion, a currency can never be over- or undervalued in a floating exchange rate system. Instead, the spot exchange rate is always at the “proper” value.
In a fixed exchange rate system, a government can sometimes intervene to maintain an exchange rate that is very different from what would arise if allowed to float. In these cases, large trade surpluses can arise because the government maintains an artificially low value for its currency. Calls for a revaluation (appreciation) of the currency, to promote a reduction in a trade surplus, are somewhat more appropriate in these cases since the market does not determine the exchange rate. Similarly, large deficits could be reduced with a devaluation (depreciation) of the currency.
Key takeaways
• A currency can be overvalued or undervalued with respect to two reference values: (1) the value that would satisfy purchasing power parity (PPP) or (2) the value that would generate current account balance.
• Use of the terms overvaluation and undervaluation suggests that there is a “proper” value for the exchange rate. However, there are often valid reasons why exchange rates will not conform to PPP or why trade imbalances will persist.
• In a floating exchange rate system, the “proper” exchange rate can be said to be the rate that equalizes supply and demand for currencies in exchange. Under this notion, there can never be an over- or undervalued exchange rate.
Exercises
1. Use the information in the table below to answer the question, “Is the U.S. dollar overvalued or undervalued with respect to the Canadian dollar and the Japanese yen in terms of purchases of the Economist?” State why it is overvalued or undervalued. Show your work.
The Economist Price per Issue Exchange Rate (December 2, 1999)
United States \$3.95
Canada C\$4.95 1.47\(C\$/\$\)
Japan ¥920 102 \(¥/\$\)
2. Use the information in the table below to answer the following questions:
Big Mac Price Exchange Rate (June 4, 1998)
United States (dollar) \$2.53
South Korea (won) W 2,600 1,475 \(W/\$\)
Israel (shekel) sh 12.50 3.70 \(sh/\$\)
Poland (zloty) zl 5.30 3.46 \(zl/\$\)
1. Calculate whether the won, shekel, and zloty are overvalued or undervalued with respect to the U.S. dollar in terms of Big Mac purchases. Explain what it means to be overvalued or undervalued.
2. What would the exchange rates have to be in order to equalize Big Mac prices between South Korea and the United States, Israel and the United States, and Poland and the United States?
3. If in the long run the exchange rate moves to satisfy Big Mac purchasing power parity (PPP), will the won, shekel, and zloty appreciate or depreciate in terms of dollars? Explain the logic.
3. Use the information about the hourly wage for a high school principal and exchange rates to answer the following questions:
Wage Actual Exchange Rate PPP Exchange Rate
United States \$25/hour
Mexico P220/hour 10.9 \(p/\$\) 7.5 \(p/\$\)
Japan ¥3,000/hour 110 \(¥/\$\) 132 \(¥/\$\)
1. Calculate the hourly wage rate in dollars in Mexico and Japan using the actual exchange rates.
2. Calculate the hourly wage rate in dollars in Mexico and Japan using the PPP exchange rates.
3. Based on the information above, in which country is it best to be a high school principal? Which country is second best? Which is third best?
4. In terms of PPP, is the U.S. dollar overvalued or undervalued with respect to the peso and with respect to the yen?
5. According to the PPP theory, given the conditions above, would the dollar be expected to appreciate or depreciate with respect to the peso and with respect to the yen? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.06%3A_Overvaluation_and_Undervaluation.txt |
Learning objective
1. Learn why using PPP exchange rates to convert income data to a common currency is a better method for making cross-country comparisons.
Probably the most important application of purchasing power parity (PPP) exchange rates is in making cross-country comparisons of income, wages, or gross domestic product (GDP). Suppose that we would like to compare per capita GDP between two countries—say, the United States and China. In 2004, GDP in the United States was approximately \$12 trillion; in China GDP was about ¥16 trillion. With a population in the United States of 290 million people, per capita U.S. GDP works out to \$41,400 per person. China’s population was approximately 1.3 billion people in 2004, so its GDP per capita works out to 11,500 yuan (¥) per person. However, we can’t compare these two per capita figures since they are in different units—dollars and yuan. Thus we need to convert units, either turn dollars into yuan or yuan into dollars.
The simplest approach to make this conversion is to use the spot exchange rate that prevailed in 2004, which was 8.28 yuan per dollar. Converting yuan to dollars yields a per capita GDP for China of \$1,390. Note that at \$41,400 per person, U.S. per capita GDP was almost thirty times higher than China’s.
However, there is a problem using this method. One thing that is quickly recognized by Americans when they travel in and around China is that many goods and services seem considerably cheaper than they are in the United States. From a Chinese traveler’s perspective, many U.S. goods would seem considerably more expensive. The implication is that although U.S. GDP per person is thirty times higher, that income may not purchase thirty times more goods and services in the U.S. because the prices of U.S. goods and services are so much higher when converted at the current exchange rate. Since presumably we are comparing per capita GDPs to compare how “well-off” people are in one country relative to another, these per capita figures will not accurately reflect these differences.
A solution is found in the purchasing power parity theory (PPP). When prices for similar goods differ as described in the previous paragraph, we would say the U.S. dollar is overvalued with respect to the yuan and with respect to PPP. At the same time, we would say the yuan is undervalued vis-à-vis the dollar. One way to reach comparable (or equalized) values of goods and services between the countries is to apply the PPP exchange rate in the conversion. The PPP exchange rate is that exchange rate that would equalize the value of comparable market baskets of goods and services between two countries.
For example, the estimated PPP exchange rate between the U.S. dollar and yuan in 2004 was 1.85 \(¥/\$\). If this exchange rate had prevailed between the countries, the prices of U.S. goods would seem, on average, to be approximately equal to the prices that prevailed in China. Now, if we use this exchange rate to make the conversion to dollars of GDP per capita in China, then we will get a number that reflects the purchasing power of Chinese income in terms of the prices that prevail in the United States—that is, in terms of prices that are equalized between the countries.
Thus if we take China’s GDP per capita of ¥11,500 and convert to dollars with the PPP exchange rate, we get \$6,250 per person. The units derived in this expression would typically be called “international dollars.” What this means is that ¥11,500 will buy a bundle of goods and services in China that would cost \$6,250 if purchased in the United States at U.S. prices. In other words, ¥11,500 is equal to \$6,250 when the prices of goods and services are equalized between countries.
The PPP method of conversion is a much more accurate way of making cross-country comparisons of values between countries. In this example, although China’s per capita GDP was still considerably lower than in the United States (\$6,250 vs. \$41,400), it is nonetheless four and a half times higher than using the spot exchange rate (\$6,250 vs. \$1,390). The higher value takes account of the differences in prices between the countries and thus better reflects the differences in purchasing power of per capita GDP.
The PPP conversion method has become the standard method used by the World Bank and others in making cross-country comparisons of GDP, GDP per capita, and average incomes and wages. For most comparisons concerning the size of economies or standards of living, using PPP is a more accurate method and can fundamentally change our perception of how countries compare. To see how, consider Table 6.1, constructed from World Bank data. It shows a ranking of the top ten countries in total GDP converting to dollars using both the current exchange rate method and the PPP method.
Rank Country Using Current Exchange Rate (\$) Country Using PPP Exchange Rate (\$)
1 United States 14,204 United States 14,204
2 Japan 4,909 China 7,903
3 China 4,326 Japan 4,355
4 Germany 3,653 India 3,338
5 France 2,853 Germany 2,925
6 United Kingdom 2,646 Russia 2,288
7 Italy 2,293 United Kingdom 2,176
8 Brazil 1,613 France 2,112
9 Russia 1,608 Brazil 1,977
10 Spain 1,604 Italy 1,841
11 Canada 1,400 Mexico 1,542
12 India 1,217 Spain 1,456
Figure \(1\): Table 6.1 GDP Rankings (in Billions of Dollars), 2008
The United States remains at the top of the list using both methods. However, several countries rise up in the rankings. China rises from the third largest economy using current exchange rates to the second largest using PPP. This means that in terms of the physical goods and services produced by the economies, China really does produce more than Japan. PPP conversion gives a better representation of the relative sizes of these countries.
Similarly, India rises from twelfth rank to fourth. Russia also moves up into sixth place from ninth. At the same time, Japan, Germany, the United Kingdom, France, Italy, Brazil, and Spain all move down in the rankings. Canada moves out of the top twelve, being replaced by Mexico, which rises up to eleventh.
For those countries whose GDP rises in value when converting by PPP (i.e., China, India, and Russia), their currencies are undervalued with respect to the U.S. dollar. So using the current exchange rate method underestimates the true size of their economies. For the other countries, their currencies are overvalued to the dollar, so converting their GDPs at current exchange rates gives an overestimate of the true size of their economies.
Key takeaways
• Using purchasing power parity (PPP) exchange rates to convert income data to a common currency is a better way to make international comparisons because it compensates for the differential costs of living.
• “International dollars” is the term used for the units for data converted to U.S. dollars using the PPP exchange rate.
• International rankings can vary significantly between data converted using actual versus PPP exchange rates.
Exercises
1. In February 2004, the Mexican peso–U.S. dollar exchange rate was 11 \(p/\$\). The price of a hotel room in Mexico City was 1,000 pesos. The price of a hotel room in New York City was \$200.
• Calculate the price of the Mexican hotel room in terms of U.S. dollars.
• Calculate the price of the U.S. hotel room in terms of Mexican pesos.
• Now suppose the exchange rate rises to 12 \(p/\$\). What does the exchange rate change indicate has happened to the value of the U.S. dollar relative to the value of the Mexican peso?
1. Does the currency change benefit the U.S. tourist traveling to Mexico City or the Mexican tourist traveling to New York City? Explain why.
2. In 2008, Brazil’s per capita income in nominal terms was \$8,295 while its per capita income in purchasing power parity (PPP) terms was \$10,466. Based on this information, if you were an American traveling in Brazil, would Brazilian products seem expensive or inexpensive relative to U.S. products?
3. In 2008, Germany’s per capita income in nominal terms was \$44,729 while its per capita income in PPP terms was \$35,539. Based on this information, if you were a German traveling in the United States, would U.S. products seem expensive or inexpensive relative to German products? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/06%3A_Purchasing_Power_Parity/6.07%3A_PPP_and_Cross-Country_Comparisons.txt |
Money is a critical component of a modern economy because it facilitates voluntary exchanges. What exactly money is and how it fulfills this role is not widely understood. This chapter defines money and explains how a country’s central bank determines the amount of money available in an economy. It also shows how changes in the amount of money in a country influence two very important macroeconomic variables: the interest rate and the inflation rate.
07: Interest Rate Determination
Learning Objective
1. Learn how a money market model, combining money supply and demand, influences the equilibrium interest rate in an economy.
This chapter describes how the supply of money and the demand for money combine to affect the equilibrium interest rate in an economy. The model is called the money market model.
A country’s money supply is mostly the amount of coin and currency in circulation and the total value of all checking accounts in banks. These two types of assets are the most liquid (i.e., most easily used to buy goods and services). The amount of money available to spend in an economy is mostly determined by the country’s central bank. The bank can control the total amount of money in circulation by using several levers (or tools), the most important of which is the sale or purchase of U.S. government Treasury bonds. Central bank sales or purchases of Treasury bonds are called “open market operations.”
Money demand refers to the demand by households, businesses, and the government, for highly liquid assets such as currency and checking account deposits. Money demand is affected by the desire to buy things soon, but it is also affected by the opportunity cost of holding money. The opportunity cost is the interest earnings one gives up on other assets to hold money.
If interest rates rise, households and businesses will likely allocate more of their asset holdings into interest-bearing accounts (these are usually not classified as money) and will hold less in the form of money. Since interest-bearing deposits are the primary source of funds used to lend in the financial sector, changes in total money demand affect the supply of loanable funds and in turn affect the interest rates on loans.
Money supply and money demand will equalize only at one average interest rate. Also, at this interest rate, the supply of loanable funds financial institutions wish to lend equalizes the amount that borrowers wish to borrow. Thus the equilibrium interest rate in the economy is the rate that equalizes money supply and money demand.
Using the money market model, several important relationships between key economic variables are shown:
• When the money supply rises (falls), the equilibrium interest rate falls (rises).
• When the price level increases (decreases), the equilibrium interest rate rises (falls).
• When real GDP rises (falls), the equilibrium interest rate rises (falls).
Connections
The money market model connects with the foreign exchange (Forex) market because the interest rate in the economy, which is determined in the money market, determines the rate of return on domestic assets. In the Forex market, interest rates are given exogenously, which means they are determined through some process not specified in the model. However, that process of interest rate determination is described in the money market. Economists will sometimes say that once the money market model and Forex model are combined, interest rates have been “endogenized.” In other words, interest rates are now conceived as being determined by more fundamental factors (gross domestic product [GDP] and money supply) that are not given as exogenous.
The money market model also connects with the goods market model in that GDP, which is determined in the goods market, influences money demand and hence the interest rate in the money market model.
key takeaway
• The key results from the money market model are the following:
• When the money supply rises (falls), the equilibrium interest rate falls (rises).
• When the price level increases (decreases), the equilibrium interest rate rises (falls).
• When real gross domestic product (GDP) rises (falls), the equilibrium interest rate rises (falls).
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term describing what is mostly composed of coin and currency in circulation and checking account deposits in a country.
• The term describing the amount of money that households, businesses, and government want to hold or have available.
• Of increase, decrease, or stay the same, this happens to the interest rate when the money supply falls.
• Of increase, decrease, or stay the same, this happens to the interest rate when the domestic price level falls.
• Of increase, decrease, or stay the same, this happens to the interest rate when real GDP falls. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.01%3A_Overview_of_Interest_Rate_Determination.txt |
Learning Objectives
1. Recognize how casual uses of the term money differ from the more formal definition used in the money market model.
2. Learn how to interpret the equilibrium interest rate in a world in which there are many different interest rates applied and different types of loans and deposits.
There are several sources of confusion that can affect complete understanding of this basic model.
The first source of confusion concerns the use of the term “money.” In casual conversation, money is sometimes used more narrowly and sometimes more broadly than the formal definition. For example, someone might say, “I want to be a doctor so I will make a lot of money.” In this case, the person is really referring to income, not money, per se. Since income is typically paid using money, the everyday substitution of the term money for income does make sense, but it can lead to confusion in interpreting the forthcoming model. In general, people use the term money whenever they want to refer to a country’s coin and currency and anything these items are used for in payment. However, our formal definition of money also includes items that are not coin and currency. Checking account deposits are an example of a type of money included in the formal definition but not more casually thought of as money. Thus pay attention to the definition and description below and be sure to recognize that one’s common conception of money may or may not overlap precisely with the formal definition.
A second source of confusion involves our usage of the term interest rate. The model that will be developed will derive an equilibrium interest rate for the economy. However, everyone knows that there are many interest rates in the economy, and each of these rates is different. There are different rates for your checking and savings account, different rates on a car loan and mortgage, different rates on credit cards and government bonds. Thus it is typical to wonder what interest rate we are talking about when we describe the equilibrium interest rate.
It is important to note that financial institutions make money (here I really should say “make a profit”) by lending to one group at a higher rate than it borrows. In other words, financial institutions accept deposits from one group of people (savers) and lend it to another group of people (borrowers.) If they charge a higher interest rate on their loans than they do on deposits, the bank will make a profit.
This implies that, in general, interest rates on deposits to financial institutions are lower than interest rates on their loans. When we talk about the equilibrium interest rate in the forthcoming model, it will mostly apply to the interest rates on deposits rather than loans. However, we also have a small problem in interpretation since different deposits have different interest rates. Thus which interest rate are we really talking about?
The best way to interpret the equilibrium interest rate in the model is as a kind of average interest rate on deposits. At the end of this chapter, we will discuss economic changes that lead to an increase or decrease in the equilibrium interest rate. We should take these changes to mean several things. First, that average interest rates on deposits will rise. Now, some of these rates may rise and a few may fall, but there will be pressure for the average to increase. Second, since banks may be expected to maintain their rate of profit (if possible) when average deposit interest rates do increase, average interest rates on loans will also increase. Again, some loan rates may rise and some fall, but the market pressure will tend to push them upward.
The implication is that when the equilibrium interest rate changes we should expect most interest rates to move in the same direction. Thus the equilibrium interest rate really is referring to an average interest rate across the entire economy, for deposits and for loans.
Key Takeaways
• The term money is used causally in a different ways than we define it in the model: here money is defined as total value of coin and currency in circulation and checking account deposits at a point in time.
• The equilibrium interest rate in the money market model should be interpreted as an average interest rate across the entire economy, for deposits and for loans.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of higher, lower, or the same, this is how average interest rates on bank deposits compare with average interest rates on bank loans.
• The term used to describe the amount of money a person earns as wages.
• When a person is asked how much money he has, he typically doesn’t think to include the current balance in this type of bank deposit.
2. Since there are many different interest rates on many types of loans and deposits, how do we interpret the equilibrium interest rate in the model? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.02%3A_Some_Preliminaries.txt |
Learning Objective
1. Learn why money exists and what purpose it serves.
The money supply in a country refers to a stock of assets that can be readily used to purchase goods and services. An asset is anything that has value. Anything that has value could potentially be used in exchange for other goods, services, or assets. However, some assets are more easily exchangeable than other assets.
Examples of assets include currency, checking account balances, stocks, bonds, whole life insurance policies, real estate, and automobiles. Currency—dollar bills in the United States, pounds sterling in Britain, and pesos in Mexico—is an asset that is readily exchangeable for goods and services within its respective countries. In contrast, real estate is an asset that is very difficult to use to buy goods. For example, no grocery store would accept ownership of a few square feet of your house in exchange for your weekly groceries. The idea of this transaction is unimaginable. Yet these two extreme cases can help us understand the distinction we make between assets classified as money and those not considered money. Most textbook definitions of money begin by defining several of money’s key features.
Money as a Unit of Account
One of the most important features of money is its application as a unit of account. In other words, we choose to measure the value of goods, services, and assets in terms of currency or money. In ancient societies, shells, shovels, hoes, knives, cattle, and grain were used as money. In these cases, it would have been common to define the value of an item in terms of how many shells, or knives, or cows, and so on the item exchanges for. The standard unit of account in a country is its currency: dollars in the United States, yen in Japan, and euros in the European Union.
Money as a Medium of Exchange
The key distinguishing feature of money, as compared with other nonmoney assets, is its role as a medium of exchange. Coin, and later currency, came into existence primarily to serve as a vehicle for the exchange of goods and services. Rather than hauling around items that you might hope to barter exchange for other goods you need, it is easier and more efficient to carry coin and currency to purchase goods. However, in order for money to function in this role, it must have widespread acceptability. Anyone selling something you want must be willing to accept the coin or currency you have. Their willingness to accept will in turn depend on the expectation that they’ll be able to use that coin later to buy the goods they want.
Other types of assets are often not acceptable as a medium of exchange. For example, if I own a \$1,000 U.S. savings bond, I am unlikely to be able to use the bond to purchase items in a store. Bonds can be traded at a bank or a bond market, where exchanges of this sort are common, but not anywhere else. Thus bonds do not function as a medium of exchange.
Liquidity is a term used to describe the distinction made here between bonds and currency. An asset is said to be liquid if it is readily exchangeable for goods and services. An asset is illiquid if it is not easily exchangeable. Thus coin and currency are very liquid assets, while bonds are more illiquid. Real estate is an example of a very illiquid asset since it could take a considerable amount of time to convert the ownership share of a home into a spendable form.
Money as a Store of Value
Perhaps the least important characteristic of money is an ability to serve as a store of value. This is less important because it does not distinguish money from other assets. All assets serve as a store of value. As an example, if I want to save some income from each paycheck so that I can go on a vacation next year, I need to hold that income in a form that will maintain its purchasing power. One simple way to hold it is by cashing my paycheck and putting currency into an envelope. That money accumulating in the envelope will be easily used to purchase plane tickets and a hotel room when I take my vacation next year. In this way, holding currency will allow me to store value over time. On the other hand, I could cash each paycheck and deposit some of the money I want to save into my online stock trading account. With these funds I can purchase stocks, another form of asset. Next year, I can sell the stocks and use the money to take my vacation. Thus stocks represent a store of value as well.
Key Takeaways
• Money is any asset that serves as a unit of account and can be used as a medium of exchange for economic transactions. It is all assets that have a high degree of liquidity. Money also serves as a store of value, but it is not unique in this role.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The three characteristics that are used to define money.
• This characteristic of money is shared by real estate assets.
• This characteristic of money allows us to compare the values of different products.
• Without this characteristic of money, individuals would be forced to trade by barter. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.03%3A_What_Is_Money.txt |
Learning Objective
1. Learn the various definitions of money supply and their approximate values in the U.S. economy.
In the United States, the Federal Reserve Bank (or “Federal Reserve,” and more informally, “the Fed”) reports several distinct measures of the aggregate money supply. The narrowest measure, M1, includes only the most liquid assets. Higher numbers following an “M” reflect broader measures of money that include less liquid assets. Below is a description of M1–M3. However, unless otherwise specified, all later references to the money supply will relate to the M1 definition.
Money Supply Measure “M1”
M1 consists of the most highly liquid assets. That is, M1 includes all forms of assets that are easily exchangeable as payment for goods and services. It consists of coin and currency in circulation, traveler’s checks, demand deposits, and other checkable deposits.
The first item in M1 is currency and coin in circulation. In the United States, “currency” refers to \$1, \$5, \$10, \$20, \$50, and \$100 bills. U.S. “coin,” meanwhile, refers to pennies, nickels, dimes, and quarters. “In circulation” means that it has to be outside of banks, in people’s wallets or purses and businesses’ cash registers. Once the currency or coin is deposited in a bank, it is no longer considered to be in circulation, thus it is no longer a part of the M1 money supply.
The second item of M1 is traveler’s checks. Traveler’s checks are like currency, except that they have a form of insurance tied to them. If a traveler’s check is lost or stolen, the issuer will reimburse you for the loss.
The third item in M1 is demand deposits or checking account balances in banks. These consist of money individuals and businesses have deposited into an account in which a check can be written to pay for goods and services. When a check is presented to the bank, it represents a demand for transfer of funds from the check writer to the agent receiving the check. Since the funds must be disbursed on demand, we also refer to these as demand deposits.
The final category in M1 is labeled “other checkable deposits.” This consists of two items; NOW accounts and ATS accounts. NOW stands for “negotiable orders of withdrawal.” A NOW account is exactly like a checking account except for one thing: it can earn interest. Thus checking accounts without interest are demand deposits and those with interest are NOW accounts. ATS stands for “automatic transfer service.” ATS accounts are savings accounts (also called time deposits) with one special feature. They can be drawn automatically to cover overdrafts from one’s checking account. Thus if an individual has a checking account with “overdraft protection” tied to their savings account, then the savings account is an ATS account.
Table 7.1 shows the M1 money supply for the U.S. economy as of November 2009. Notice that the largest component of M1, just over half, is the coin and currency in circulation. Traveler’s checks are an insignificant share at \$7.5 billion. Demand deposits and other checkable deposits almost equally split the remaining shares of M1 at close to 25 percent each. The total value of the M1 money supply is \$1,688 billion, which is over 10 percent of annual U.S. GDP.
Billions (\$) Total M1 (%)
Currency in Circulation 859.1 51
Traveler’s Checks 5.1 < 1
Demand Deposits 439.0 26
Other Checkable Deposits 385.4 23
Total M1 Money Supply 1,688.7 100
Figure \(1\): Table 7.1 Components of U.S. M1 Money Supply, November 2009. Source: Federal Reserve Statistical Release, Money Stock Measures, January 14, 2010. http://www.federalreserve.gov/releases/h6/Current.
Money Supply Measure “M2”
M2 is a broader measure of money than M1. It includes all of M1, the most liquid assets, and a collection of additional assets that are slightly less liquid. These additional assets include savings accounts, money market deposit accounts, small time deposits (less than \$100,000) and retail money market mutual funds. Excluded are IRA and Keogh deposits in money market accounts. (These are excluded since they are retirement funds and hence are unlikely to be used as payment for goods and services anytime soon.)
Money Supply Measure “M3”
M3 is an even broader definition of the money supply, including M2 and other assets even less liquid than M2. As the number gets larger (i.e., “1, 2, 3…”), the assets included become less and less liquid. The additional assets include large-denomination time deposits (amounts greater than \$100,000), balances in institutional money funds (these include pension funds deposits), responsible party (RP) liabilities issued by depository institutions (refers to repurchase agreements), and eurodollars held by U.S. residents at foreign branches of U.S. banks worldwide and all banking offices in Canada and the United Kingdom (eurodollars are any U.S. dollar deposits made in a depository institution outside the United States). M3 excludes assets held by depository institutions, the U.S. government, money funds, and foreign banks and official institutions.
The United States values of all three major money supply definitions are given in Table 7.2. Note that the M1 definition of money is just under one-tenth of the value of the annual GDP in the United States. The M2 money supply is almost six times larger, indicating substantial deposits in savings and time deposits and money market funds. M3 was last reported by the U.S. Fed in February 2006. But at that time, it was almost 90 percent of the U.S. annual GDP.
M1 1,688.7
M2 8,391.9
M3 (February 2006) 10,298.7
Figure \(2\): Table 7.2 U.S. Money Supply Measures (in Billions of Dollars), November 2009. Source: Federal Reserve Statistical Release, Money Stock Measures, January 14, 2010. For the most recent figures, go to http://www.federalreserve.gov/releases/h6/Current. (M3 was last reported for February 2006.)
Key takeaways
• M1 consists of the most highly liquid assets, including coin and currency in circulation, traveler’s checks, demand deposits, and other checkable deposits.
• M2 is a broader measure of money than M1. It includes all of M1, plus savings accounts, money market deposit accounts, small-time deposits, and retail money market mutual funds.
• M3 is an even broader definition of the money supply that includes M2 plus large-denomination time deposits, balances in institutional money funds, repurchase liabilities, and eurodollars held by U.S. residents at foreign branches of U.S. banks.
• In 2009, the U.S. M1 was at just over \$1.6 trillion, around 10 percent of the U.S. gross domestic product (GDP).
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of M1, M2, or M3, this measure of money is the most liquid.
• Of M1, M2, and/or M3, this measure(s) of money includes checking account deposits.
• Of M1, M2, and/or M3, this measure(s) of money includes savings account deposits.
• Of M1, M2, and/or M3, this measure(s) of money includes coin and currency in circulation.
• Of M1, M2, and/or M3, this measure(s) of money includes eurodollars held by U.S. residents at foreign branches of U.S. banks. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.04%3A_Money_Supply_Measures.txt |
Learning Objective
1. Learn the mechanisms (or tools) the U.S. Federal Reserve Bank can use to control the U.S. money supply.
The size of the money stock in a country is primarily controlled by its central bank. In the United States, the central bank is the Federal Reserve Bank while the main group affecting the money supply is the Federal Open Market Committee (FOMC). This committee meets approximately every six weeks and is the body that determines monetary policy. There are twelve voting members, including the seven members of the Fed Board of Governors and five presidents drawn from the twelve Federal Reserve banks on a rotating basis. The current Chairman of the Board of Governors is Ben Bernanke (as of January 2010). Because Bernanke heads the group that controls the money supply of the largest economy in the world, and because the FOMC’s actions can have immediate and dramatic effects on interest rates and hence the overall United States and international economic condition, he is perhaps the most economically influential person in the world today. As you’ll read later, because of his importance, anything he says in public can have tremendous repercussions throughout the international marketplace.
The Fed has three main levers that can be applied to affect the money supply within the economy: (1) open market operations, (2) reserve requirement changes, and (3) changes in the discount rate.
The Fed’s First Lever: Open Market Operations
The most common lever used by the Fed is open market operations. This refers to Fed purchases or sales of U.S. government Treasury bonds or bills. The “open market” refers to the secondary market for these types of bonds. (The market is called secondary because the government originally issued the bonds at some time in the past.)
When the Fed purchases bonds on the open market it will result in an increase in the money supply. If it sells bonds on the open market, it will result in a decrease in the money supply.
Here’s why. A purchase of bonds means the Fed buys a U.S. government Treasury bond from one of its primary dealers. This includes one of twenty-three financial institutions authorized to conduct trades with the Fed. These dealers regularly trade government bonds on the secondary market and treat the Fed as one of their regular customers. It is worth highlighting that bonds sold on the secondary open market are bonds issued by the government months or years before and will not mature for several months or years in the future. Thus when the Fed purchases a bond from a primary dealer in the future, when that bond matures, the government would have to pay back the Fed, which is the new owner of that bond.
When the open market operation (OMO) purchase is made, the Fed will credit that dealer’s reserve deposits with the sale price of the bond (e.g., $1 million). The Fed will receive the IOU, or “I owe you” (i.e., bond certificate), in exchange. The money used by the Fed to purchase this bond does not need to come from somewhere. The Fed doesn’t need gold, other deposits, or anything else to cover this payment. Instead, the payment is created out of thin air. An accounting notation is made to indicate that the bank selling the bond now has an extra$1 million in its reserve account.
At this point, there is still no change in the money supply. However, because of the increase in its reserves, the dealer now has additional money to lend out somewhere else, perhaps to earn a greater rate of return. When the dealer does lend it, it will create a demand deposit account for the borrower and since a demand deposit is a part of the M1 money supply, money has now been created.
As shown in all introductory macroeconomics textbooks, the initial loan, once spent by the borrower, is ultimately deposited in checking accounts in other banks. These increases in deposits can in turn lead to further loans, subject to maintenance of the bank’s deposit reserve requirements. Each new loan made creates additional demand deposits and hence leads to further increases in the M1 money supply. This is called the money multiplier process. Through this process, each $1 million bond purchase by the Fed can lead to an increase in the overall money supply many times that level. The opposite effect will occur if the Fed sells a bond in an OMO. In this case, the Fed receives payment from a dealer (as in our previous example) in exchange for a previously issued government bond. (It is important to remember that the Fed does not issue government bonds; government bonds are issued by the U.S. Treasury department. If the Fed were holding a mature government bond, the Treasury would be obligated to pay off the face value to the Fed, just as if it were a private business or bank.) The payment made by the dealer comes from its reserve assets. These reserves support the dealer’s abilities to make loans and in turn to stimulate the money creation process. Now that its reserves are reduced, the dealer’s ability to create demand deposits via loans is reduced and hence the money supply is also reduced accordingly. A more detailed description of open market operations can be found at New York Federal Reserve Bank’s Web site at http://www.ny.frb.org/aboutthefed/fedpoint/fed32.html. The Fed’s Second Lever: Reserve Requirement Changes When the Fed lowers the reserve requirement on deposits, the money supply increases. When the Fed raises the reserve requirement on deposits, the money supply decreases. The reserve requirement is a rule set by the Fed that must be satisfied by all depository institutions, including commercial banks, savings banks, thrift institutions, and credit unions. The rule requires that a fraction of the bank’s total transactions deposits (e.g., this would include checking accounts but not certificates of deposit) be held as a reserve either in the form of coin and currency in its vault or as a deposit (reserve) held at the Fed. The current reserve requirement in the United States (as of December 2009) is 10 percent for deposits over$55.2 million. (For smaller banks—that is, those with lower total deposits—the reserve requirement is lower.)
As discussed above, the reserve requirement affects the ability of the banking system to create additional demand deposits through the money creation process. For example, with a reserve requirement of 10 percent, Bank A, which receives a deposit of $100, will be allowed to lend out$90 of that deposit, holding back $10 as a reserve. The$90 loan will result in the creation of a $90 demand deposit in the name of the borrower, and since this is a part of the money supply M1, it rises accordingly. When the borrower spends the$90, a check will be drawn on Bank A’s deposits and this $90 will be transferred to another checking account, say, in Bank B. Since Bank B’s deposits have now risen by$90, it will be allowed to lend out $81 tomorrow, holding back$9 (10 percent) as a reserve. This $81 will make its way to another bank, leading to another increase in deposits, allowing another increase in loans, and so on. The total amount of demand deposits (DD) created through this process is given by the formula $DD = 100 + (.9)100 + (.9)(.9)100 + (.9)(.9)(.9)100 +…. \nonumber$ This simplifies to $DD = 100/(1 − 0.9) = 1,000 \nonumber$ or $DD = 100/RR \nonumber$, where RR refers to the reserve requirement. This example shows that if the reserve requirement is 10 percent, the Fed could increase the money supply by$1,000 by purchasing a $100 Treasury bill (T-bill) in the open market. However, if the reserve requirement were 5 percent, a$100 T-bill purchase would lead to a \$2,000 increase in the money supply.
However, the reserve requirement not only affects the Fed’s ability to create new money but also allows the banking system to create more demand deposits (hence more money) out of the total deposits it now has. Thus if the Fed were to lower the reserve requirement to 5 percent, the banking system would be able to increase the volume of its loans considerably and it would lead to a substantial increase in the money supply.
Because small changes in the reserve requirement can have substantial effects on the money supply, the Fed does not use reserve requirement changes as a primary lever to adjust the money supply.
A more detailed description of open market operations can be found at New York Federal Reserve Bank Web site at http://www.ny.frb.org/aboutthefed/fedpoint/fed45.html.
The Fed’s Third Lever: Discount Rate/Federal Funds Rate Changes
When the Fed lowers its target federal funds rate and discount rate, it signals an expanded money supply and lower overall interest rates.
When the Fed raises its target federal funds rate and discount rate, it signals a reduced money supply and higher overall interest rates.
In news stories immediately after the FOMC meets, one is likely to read that the Fed raised (or lowered) interest rates yesterday. For many who read this, it sounds as if the Fed “sets” the interest rates charged by banks. In actuality, the Fed only sets one interest rate, and that is the discount rate. The rate that is announced every month is not the discount rate, but the federal funds rate. The federal funds rate is the interest rate banks charge each other for short-term (usually overnight) loans. The Fed does not actually set the federal funds rate, but it does employ open market operations to target this rate at a desired level. Thus what is announced at the end of each FOMC meeting is the target federal funds rate.
The main reason banks make overnight loans to each other each day is to maintain their reserve requirements. Each day some banks may end up with excess reserves. Other banks may find themselves short of reserves. Those banks with excess reserves would prefer to loan out as much as possible at some rate of interest rather than earning nothing. Those banks short of reserves are required by law to raise up their reserves to the required level. Thus banks lend money to each other each night.
If there is excess demand for money overnight relative to supply, the Fed keeps the discount window open. The discount window refers to a policy by the Fed to lend money on a short-term basis (usually overnight) to financial institutions. The interest rate charged on these loans is called the discount rate. Before 2003, banks needed to demonstrate that they had exhausted all other options before coming to the discount window. After 2003, the Fed revised its policies and set a primary credit discount rate and a secondary credit discount rate. Primary credit rates are set 100 basis points (1 percent) above the federal funds rate and are available only to very sound, financially strong banks. Secondary credit rates are set 150 basis points above the federal funds target rate and are available to banks not eligible for primary credit. Although these loans are typically made overnight, they can be extended for longer periods and can be used for any purpose.
Before the changes in discount window policy in 2003, very few banks sought loans through the discount window. Hence, it was not a very effective lever in monetary policy.
However, the announcement of the federal funds target rate after each FOMC meeting does remain an important signal about the future course of Fed monetary policy. If the FOMC announces a lower target federal funds rate, one should expect expanded money supply, perhaps achieved through open market operations. If the FOMC announces a higher target rate, one should prepare for a more contractionary monetary policy to follow.
A more detailed description of the discount window can be found on the New York Federal Reserve Bank Web site at http://www.ny.frb.org/aboutthefed/fedpoint/fed18.html. For more information about federal funds, go to http://www.ny.frb.org/aboutthefed/fedpoint/fed15.html.
Key takeaways
• When the Federal Reserve Bank (a.k.a. “Federal Reserve,” or more informally, “the Fed”) purchases bonds on the open market it will result in an increase in the U.S. money supply. If it sells bonds in the open market, it will result in a decrease in the money supply.
• When the Fed lowers the reserve requirement on deposits, the U.S. money supply increases. When the Fed raises the reserve requirement on deposits, the money supply decreases.
• When the Fed lowers its target federal funds rate and discount rate, it signals an expanded U.S. money supply and lower overall interest rates.
• When the Fed raises its target federal funds rate and discount rate, it signals a reduced U.S. money supply and higher overall interest rates.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or no change, the effect on the money supply if the central bank sells government bonds.
• Of increase, decrease, or no change, the effect on the money supply if the central bank lowers the reserve requirement.
• Of increase, decrease, or no change, the effect on the money supply if the central bank lowers the discount rate.
• The name given to the interest rate charged by the Federal Reserve Bank on loans it provides to commercial banks
• The name given to the interest rate charged by commercial banks on overnight loans made to other banks. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.05%3A_Controlling_the_Money_Supply.txt |
learning goals
1. Learn the determinants of money demand in an economy.
The demand for money represents the desire of households and businesses to hold assets in a form that can be easily exchanged for goods and services. Spendability (or liquidity) is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the demand for liquidity.
The demand for money is often broken into two distinct categories: the transactions demand and the speculative demand.
Transactions Demand for Money
The primary reason people hold money is because they expect to use it to buy something sometime soon. In other words, people expect to make transactions for goods or services. How much money a person holds onto should probably depend on the value of the transactions that are anticipated. Thus a person on vacation might demand more money than on a typical day. Wealthier people might also demand more money because their average daily expenditures are higher than the average person’s.
However, in this section we are interested not so much in an individual’s demand for money but rather in what determines the aggregate, economy-wide demand for money. Extrapolating from the individual to the group, we could conclude that the total value of all transactions in the economy during a period would influence the aggregate transactions demand for money. Gross domestic product (GDP), the value of all goods and services produced during the year, will influence the aggregate value of all transactions since all GDP produced will be purchased by someone during the year. GDP may underestimate the demand for money, though, since people will also need money to buy used goods, intermediate goods, and assets. Nonetheless, changes in GDP are very likely to affect transactions demand.
Anytime GDP rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
The GDP that matters here is nominal GDP, meaning GDP measured in terms of the prices that currently prevail (GDP at current prices). Economists often break up GDP into a nominal component and a real component, where real GDP corresponds to a quantity of goods and services produced after eliminating any price level changes that have occurred since the price level base year. To convert nominal to real GDP, simply divide nominal GDP by the current U.S. price level ($P_{}$); thus
$real\ GDP = nominal \ GDP/P_{} \nonumber$.
If we use the variable $Y_{}$ to represent real U.S. GDP and rearrange the equation, we can get
$nominal \ GDP = P_{}Y_{} \nonumber$.
By rewriting in this way we can now indicate that since the transactions demand for money rises with an increase in nominal GDP, it will also rise with either an increase in the general price level or an increase in real GDP.
Thus if the amount of goods and services produced in the economy rises while the prices of all products remain the same, then total GDP will rise and people will demand more money to make the additional transactions. On the other hand, if the average prices of goods and services produced in the economy rise, then even if the economy produces no additional products, people will still demand more money to purchase the higher valued GDP, hence the demand for money to make transactions will rise.
Speculative Demand for Money
The second type of money demand arises by considering the opportunity cost of holding money. Recall that holding money is just one of many ways to hold value or wealth. Alternative opportunities include holding wealth in the form of savings deposits, certificate of deposits, mutual funds, stock, or even real estate. For many of these alternative assets interest payments, or at least a positive rate of return, may be obtained. Most assets considered money, such as coin and currency and most checking account deposits, do not pay any interest. If one does hold money in the form of a negotiable order of withdrawal (NOW) account, a checking account with interest, the interest earned on that deposit will almost surely be less than on a savings deposit at the same institution.
Thus to hold money implies giving up the opportunity of holding other assets that pay interest. The interest one gives up is the opportunity cost of holding money.
Since holding money is costly—that is, there is an opportunity cost—people’s demand for money should be affected by changes in its cost. Since the interest rate on each person’s next best opportunity may differ across money holders, we can use the average interest rate (i\$) in the economy as a proxy for the opportunity cost. It is likely that as average interest rates rise, the opportunity cost of holding money for all money holders will also rise, and vice versa. And as the cost of holding money rises, people should demand less money.
The intuition is straightforward, especially if we exaggerate the story. Suppose interest rates on time deposits suddenly increased to 50 percent per year (from a very low base). Such a high interest rate would undoubtedly lead individuals and businesses to reduce the amount of cash they hold, preferring instead to shift it into the high-interest-yielding time deposits. The same relationship is quite likely to hold even for much smaller changes in interest rates. This implies that as interest rates rise (fall), the demand for money will fall (rise). The speculative demand for money, then, simply relates to component of the money demand related to interest rate effects.
Key Takeaways
• Anytime the gross domestic product (GDP) rises, there will be a demand for more money to make the transactions necessary to buy the extra GDP. If GDP falls, then people demand less money for transactions.
• The interest one gives up is the opportunity cost of holding money.
• As interest rates rise (fall), the demand for money will fall (rise).
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or no change, the effect on the transactions demand for money when interest rates fall.
• Of increase, decrease, or no change, the effect on the transactions demand for money when GDP falls.
• Of increase, decrease, or no change, the effect on the speculative demand for money when GDP falls.
• Of increase, decrease, or no change, the effect on the speculative demand for money when interest rates fall. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.06%3A_Money_Demand.txt |
Learning Objective
1. Define real money demand and supply functions, graph them relative to the interest rate, and use them to define the equilibrium interest rate in an economy.
A money demand function displays the influence that some aggregate economic variables will have on the aggregate demand for money. The above discussion indicates that money demand will depend positively on the level of real gross domestic product (GDP) and the price level due to the demand for transactions. Money demand will depend negatively on average interest rates due to speculative concerns. We can depict these relationships by simply using the following functional representation:
Here \(M^D\) is the aggregate, economy-wide money demand, \(P_{\$}\) is the current U.S. price level, \(Y_{\$}\) is the United States’ real GDP, and \(i_{\$}\) is the average U.S. interest rate. The f stands for “function.” The f is not a variable or parameter value; it simply means that some function exists that would map values for the right-side variables, contained within the brackets, into the left-side variable. The “+” symbol above the price level and GDP levels means that there is a positive relationship between changes in that variable and changes in money demand. For example, an increase (decrease) in \(P_{\$}\) would cause an increase (decrease) in \(M^D\). A “−” symbol above the interest rate indicates that changes in \(i_{\$}\) in one direction will cause money demand to change in the opposite direction.
For historical reasons, the money demand function is often transformed into a real money demand function as follows. First, rewrite the function on the right side to get
In this version, the price level (\(P_{\$}\)) is brought outside the function f( ) and multiplied to a new function labeled L( ), called the “liquidity function.” Note that L( ) is different from f( ) since it contains only \(Y_{\$}\) and \(i_{\$}\) as variables. Since \(P_{\$}\) is multiplied to L( ) it will maintain the positive relationship to \(M^D\) and thus is perfectly consistent with the previous specification. Finally, by moving the price level variable to the left side, we can write out the general form of the real money demand function as
This states that real money demand (\(M^D/P_{\$}\)) is positively related to changes in real GDP (\(Y_{\$}\)) and the average interest rate (\(i_{\$}\)) according to the liquidity function. We can also say that the liquidity function represents the real demand for money in the economy—that is, the liquidity function is equivalent to real money demand.
Finally, simply for intuition’s sake, any real variable represents the purchasing power of the variable in terms of prices that prevailed in the base year of the price index. Thus real money demand can be thought of as the purchasing power of money demanded in terms of base year prices.
Supply
Money supply is much easier to describe because we imagine that the level of money balances available in an economy is simply set by the actions of the central bank. For this reason, it will not depend on other aggregate variables such as the interest rate, and thus we need no function to describe it.
We will use the parameter \(M_{\$}^S\) to represent the nominal U.S. money supply and assume that the Federal Reserve Bank (or simply “the Fed”), using its three levers, can set this variable wherever it chooses. To represent real money supply, however, we will need to convert by dividing by the price level. Hence let represent the real money supply in terms of prices that prevailed in the base year.
Equilibrium
The equilibrium interest rate is determined at the level that will equalize real money supply with real money demand. We can depict the equilibrium by graphing the money supply and demand functions on the following diagram.
The functions are drawn in Figure 7.1 with real money, both supply and demand, plotted along the horizontal axis and the interest rate plotted along the vertical axis.
Real money supply, , is drawn as a vertical line at the level of money balances, measured best by M1. It is vertical because changes in the interest rate will not affect the money supply in the economy.
Real money demand—that is, the liquidity function L(\(i_{\$}\), \(Y_{\$}\))—is a downward sloping line in \(i_{\$}\) reflecting the speculative demand for money. In other words, there is a negative relationship presumed to prevail between the interest rate and real money demand.
Where the two lines cross determines the equilibrium interest rate in the economy (\(i_{\$}\)) since this is the only interest rate that will equalize real money supply with real money demand.
Key takeaways
• Real money demand is positively related to changes in real gross domestic product (GDP) and the average interest rate.
• Real money supply is independent of the average interest rate and is assumed to be determined by the central bank.
• The intersection of the real money supply function and the real money demand function determines the equilibrium interest rate in the economy.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of positive, negative, or no effect, this is the relationship between the interest rate and real money demand.
• Of positive, negative, or no effect, this is the relationship between real GDP and real money demand.
• Of positive, negative, or no effect, this is the relationship between the price level and nominal money demand.
• Of positive, negative, or no effect, this is the relationship between the interest rate and real money supply.
• Of positive, negative, or no effect, this is the relationship between real GDP and real money supply.
• Of positive, negative, or no effect, this is the relationship between the price level and real money supply.
• The endogenous variable (in the money market model) whose value is determined at the intersection of the real money supply curve and the real money demand curve. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.07%3A_Money_Functions_and_Equilibrium.txt |
Learning Objective
1. Learn the equilibrium stories in the money market that describe how the interest rate adjusts when it is not at its equilibrium value.
Any equilibrium in economics has an associated behavioral story to explain the forces that will move the endogenous variable to the equilibrium value. In the money market model, the endogenous variable is the interest rate. This is the variable that will change to achieve the equilibrium. Variables that do not change in the adjustment to the equilibrium are the exogenous variables. In this model, the exogenous variables are \(P_{\$}\), \(Y_{\$}\), and \(M_{\$}^S\). Changes in the exogenous variables are necessary to cause an adjustment to a new equilibrium. However, in telling an equilibrium story, it is typical to simply assume that the endogenous variable is not at the equilibrium (for some unstated reason) and then to explain how and why the variable will adjust to the equilibrium value.
Interest Rate Too Low
Suppose that for some reason the actual interest rate, \(i_{\$}’\) lies below the equilibrium interest rate (\(i_{\$}\)) as shown in Figure 7.2 . At \(i_{\$}’\), real money demand is given by the value A along the horizontal axis, while real money supply is given by the value B. Since A is to the right of B, real demand for money exceeds the real money supply. This means that people and businesses wish to hold more assets in a liquid, spendable form rather than holding assets in a less liquid form, such as in a savings account. This excess demand for money will cause households and businesses to convert assets from less liquid accounts into checking accounts or cash in their pockets. A typical transaction would involve a person who withdraws money from a savings account to hold cash in his wallet.
The savings account balance is not considered a part of the M1 money supply; however, the currency the person puts into his wallet is a part of the money supply. Millions of conversions such as this will be the behavioral response to an interest rate that is below equilibrium. As a result, the financial sector will experience a decrease in time deposit balances, which in turn will reduce their capacity to make loans. In other words, withdrawals from savings and other type of nonmoney accounts will reduce the total pool of funds available to be loaned by the financial sector. With fewer funds to lend and the same demand for loans, banks will respond by raising interest rates. Higher interest rates will reduce the demand for loans helping to equalize supply and demand for loans. Finally, as interest rates rise, money demand falls until it equalizes with the actual money supply. Through this mechanism average interest rates will rise, whenever money demand exceeds money supply.
Interest Rate Too High
If the actual interest rate is higher than the equilibrium rate, for some unspecified reason, then the opposite adjustment will occur. In this case, real money supply will exceed real money demand, meaning that the amount of assets or wealth people and businesses are holding in a liquid, spendable form is greater than the amount they would like to hold. The behavioral response would be to convert assets from money into interest-bearing nonmoney deposits. A typical transaction would be if a person deposits some of the cash in his wallet into his savings account. This transaction would reduce money holdings since currency in circulation is reduced, but will increase the amount of funds available to loan out by the banks. The increase in loanable funds, in the face of constant demand for loans, will inspire banks to lower interest rates to stimulate the demand for loans. However, as interest rates fall, the demand for money will rise until it equalizes again with money supply. Through this mechanism average interest rates will fall whenever money supply exceeds money demand.
Key Takeaways
• If the actual interest rate is lower than the equilibrium rate, the amount of assets people are holding in a liquid form is less than the amount they would like to hold. They respond by converting assets from interest-bearing nonmoney deposits into money. The decrease in loanable funds will cause banks to raise interest rates. Interest rates rise until money supply equals money demand.
• If the actual interest rate is higher than the equilibrium rate, the amount of assets people are holding in a liquid form is greater than the amount they would like to be holding. They respond by converting assets from money into interest-bearing nonmoney deposits. The increase in loanable funds will cause banks to lower interest rates. Interest rates fall until money supply equals money demand.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the effect on the average interest rate when real money supply exceeds real money demand.
• Of increase, decrease, or stay the same, the effect on the average interest rate when real money demand is less than real money supply.
• Of increase, decrease, or stay the same, the effect on the average interest rate when real money demand exceeds real money supply.
• Of increase, decrease, or stay the same, the effect on the average interest rate when households and businesses wish to convert assets from interest-bearing nonmoney deposits into money.
• Of increase, decrease, or stay the same, the effect on the average interest rate when households and businesses wish to convert assets from money into interest-bearing nonmoney deposits. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.08%3A_Money_Market_Equilibrium_Stories.txt |
Learning Objective
1. Learn how a change in the money supply affects the equilibrium interest rate.
Expansionary monetary policy refers to any policy initiative by a country’s central bank to raise (or expand) its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement, or with an announced decrease in the discount rate. In most growing economies the money supply is expanded regularly to keep up with the expansion of gross domestic product (GDP). In this dynamic context, expansionary monetary policy can mean an increase in the rate of growth of the money supply, rather than a mere increase in money. However, the money market model is a nondynamic (or static) model, so we cannot easily incorporate money supply growth rates. Nonetheless, we can project the results from this static model to the dynamic world without much loss of relevance. (In contrast, any decrease in the money supply or decrease in the growth rate of the money supply is referred to as contractionary monetary policy.)
Suppose the money market is originally in equilibrium in Figure 7.3 at point A with real money supply \(M_{S}’/P_{\$}\) and interest rate \(i_{\$}′\) when the money supply increases, ceteris paribus. The ceteris paribus assumption means we assume that all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that real GDP (\(Y_{\$}\)) and the price level (\(P_{\$}\)) remain fixed. An increase in the money supply (\(M^S\)) causes an increase in the real money supply (\(M^S/P_{\$}\)) since \(P_{\$}\) remains constant. In the diagram, this is shown as a rightward shift from \(M^{S′}/P_{\$}\) to \(M^{S″}/P_{\$}\). At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply exceeds money demand, and the actual interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the “interest rate too high” equilibrium story.
The final equilibrium will occur at point B on the diagram. The real money supply will have risen from level 1 to 2 while the equilibrium interest rate has fallen from \(i_{\$}’\) to \(i_{\$}^″\). Thus expansionary monetary policy (i.e., an increase in the money supply) will cause a decrease in average interest rates in an economy. In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy.
Note this result represents the short-run effect of a money supply increase. The short run is the time before the money supply can affect the price level in the economy. In Chapter 7, Section 7.14, we consider the long-run effects of a money supply increase. In the long run, money supply changes can affect the price level in the economy. In the previous exercise, since the price level remained fixed (i.e., subject to the ceteris paribus assumption) when the money supply was increased, this exercise provides the short-run result.
Key takeaways
• An increase (decrease) in the money supply, ceteris paribus, will cause a decrease (increase) in average interest rates in an economy.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Term often used to describe the type of monetary policy that results in a reduction of the money supply.
• Term often used to describe the type of monetary policy that results in an increase in the money supply.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the nominal money supply increases, ceteris paribus.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the nominal money supply decreases, ceteris paribus.
• Term for the time period before price level changes occur in the money market model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.09%3A_Effects_of_a_Money_Supply_Increase.txt |
Learning Objective
1. Learn how a change in the price level affects the equilibrium interest rate.
Now let’s consider the effects of a price level increase in the money market. When the price level rises in an economy, the average price of all goods and services sold is increasing. Inflation is calculated as the percentage increase in a country’s price level over some period, usually a year. This means that in the period during which the price level increases, inflation is occurring. Thus studying the effects of a price level increase is the same as studying the effects of inflation.
Inflation can arise for several reasons that will be discussed later in this chapter. For now, we will imagine that the price level increases for some unspecified reason and consider the consequences.
Suppose the money market is originally in equilibrium at point A in Figure 7.10.1 with real money supply \(M^{S}/P_{\$}’\) and interest rate \(i_{\$}’\). Suppose the price level increases, ceteris paribus. Again, the ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that the money supply (\(M^{S}\)) and real GDP (\(Y_{\$}\)) remain fixed. An increase in the price level (\(P_{\$}\)) causes a decrease in the real money supply (\(M^{S}/P_{\$}\)) since \(M_{S}\) remains constant. In the adjoining diagram, this is shown as a shift from \(M^{S}/P_{\$}’\) to \(M^{S}/P_{\$}^″\). At the original interest rate, \(i_{\$}’\), the real money supply has fallen to level 2 along the horizontal axis, while real money demand remains at level 1. This means that money demand exceeds money supply and the actual interest rate is lower than the new equilibrium rate. Adjustment to the higher interest rate will follow the “interest rate too low” equilibrium story.
More intuition concerning these effects arises if one recalls that price level increases will increase the transactions demand for money. In this version, nominal money demand will exceed nominal money supply and set off the same adjustment process described in the previous paragraph.
The final equilibrium will occur at point B on the diagram. The real money supply will have fallen from level 1 to level 2 while the equilibrium interest rate has risen from \(i_{\$}'\) to \(i_{\$}^″\). Thus an increase in the price level (i.e., inflation) will cause an increase in average interest rates in an economy. In contrast, a decrease in the price level (deflation) will cause a decrease in average interest rates in an economy.
Key Takeaways
• An increase in the price level (i.e., inflation), ceteris paribus, will cause an increase in average interest rates in an economy. In contrast, a decrease in the price level (deflation), ceteris paribus, will cause a decrease in average interest rates in an economy.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used to describe a percentage increase in a country’s price level over a period of time.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the domestic price level decreases, ceteris paribus.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the domestic price level increases, ceteris paribus.
7.11: Effect of a Real GDP Increase (Economic Growth) on Interest Rates
Learning Objective
• Learn how a change in real GDP affects the equilibrium interest rate.
Finally, let’s consider the effects of an increase in real gross domestic product (GDP). Such an increase represents economic growth. Thus the study of the effects of a real GDP increase is the same as asking how economic growth will affect interest rates.
GDP may increase for a variety of reasons, which are discussed in subsequent chapters. For now, we will imagine that GDP increases for some unspecified reason and consider the consequences of such a change in the money market.
Suppose the money market is originally in equilibrium at point A in Figure 7.11.1 with real money supply \(M^{S}/P_{\$}\) and interest rate \(i_{\$}’\). Suppose real GDP (\(Y_{\$}\)) increases, ceteris paribus. Again, the ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that the money supply (\(M^{S}\)) and the price level (\(P_{\$}\)) remain fixed. An increase in GDP will raise the demand for money because people will need more money to make the transactions necessary to purchase the new GDP. In other words, real money demand rises due to the transactions demand effect. This increase is reflected in the rightward shift of the real money demand function from L(\(i_{\$}, Y_{\$}’\)) to L(\(i_{\$}, Y_{\$}^"\)).
At the original interest rate, \(i_{\$}’\), real money demand has increased to level 2 along the horizontal axis while real money supply remains at level 1. This means that real money demand exceeds real money supply and the current interest rate is lower than the equilibrium rate. Adjustment to the higher interest rate will follow the “interest rate too low” equilibrium story.
The final equilibrium will occur at point B on the diagram. As the interest rate rises from \(i_{\$}’\) to \(i_{\$}^″\), real money demand will have fallen from level 2 to level 1. Thus an increase in real GDP (i.e., economic growth) will cause an increase in average interest rates in an economy. In contrast, a decrease in real GDP (a recession) will cause a decrease in average interest rates in an economy.
Key takeaways
• An increase in real gross domestic product (i.e., economic growth), ceteris paribus, will cause an increase in average interest rates in an economy. In contrast, a decrease in real GDP (a recession), ceteris paribus, will cause a decrease in average interest rates in an economy.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used to describe a percentage increase in real GDP over a period of time.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when real GDP decreases, ceteris paribus.
• Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when real GDP increases, ceteris paribus. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.10%3A_Effect_of_a_Price_Level_Increase_%28Inflation%29_on_Interest_Rates.txt |
Learning Objective
• Integrate the money market with the foreign exchange market and highlight the interactions that exist between the two.
In this section, we will integrate the money market with the foreign exchange market to demonstrate the interactions that exist between the two. First, let’s review.
In the money market, the endogenous variable is the interest rate (\(i_{\$}\)). This is the variable that is determined in equilibrium in the model. The exogenous variables are the money supply (\(M^{S}\)), the price level (\(P_{\$}\)), and the level of real gross domestic product (GDP) (Y). These variables are determined outside the money market and treated as known values. Their values determine the supply and demand for money and affect the equilibrium value of the interest rate.
In the foreign exchange (Forex) market, the endogenous variable is the exchange rate, \(E_{\$/£}\). The exogenous variables are the domestic interest rate (\(i_{\$}\)), the foreign interest rate (\(i_{£}\)), and the expected exchange rate (\(E_{\$/£}^e\)). Their values determine the domestic and foreign rates of return and affect the equilibrium value of the exchange rate.
The linkage between the two markets arises because the domestic interest rate is the endogenous variable in the money market and an exogenous variable in the Forex market. Thus when considering the Forex, when we say the interest rate is determined outside of the Forex market, we know where it is determined: it is determined in the U.S. money market as the interest rate that satisfies real supply and demand for money.
Linking the Diagrams
We can keep track of the interactions between these two markets using a simple graphical technique. We begin with the money market diagram as developed in Figure 7.12.1 shows the beginning of the rotation pivoted around the origin at zero.
When rotated the full ninety degrees, it will be positioned as shown in Figure 7.12.2 . The most important thing to remember about this new diagram is that the value of real money supply and demand increases downward away from the origin at zero along the vertical axis. Thus when the money supply “increases,” this will be represented in the diagram as a “downward” shift in the real money supply line. The interest rate, in contrast, increases away from the origin to the right along the horizontal axis when rotated in this position.
Since the interest rate is identical to the rate of return on dollar assets from a U.S. dollar holder’s perspective (i.e., \(R_{0}R_{\$} = i_{\$}\)), we can now place the \(R_{0}R\) diagram directly on top of the rotated money market diagram as shown in Figure 7.12.3 . The equilibrium interest rate (\(i_{\$}’\)), shown along the horizontal axis above the rotated money market diagram, determines the position of the \(R_{0}R_{\$}\) line in the Forex market above. This combined with the \(R_{0}R_{£}\) curve determines the equilibrium exchange rate, \(E_{\$/£}’\), in the Forex market. We will call this diagram the “money-Forex diagram” and the combined model the “money-Forex model.”
key takeaway
• Using a two-quadrant diagram with appropriate adjustments, we can represent the equilibrium in the money market and the foreign exchange market simultaneously.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The value of this endogenous variable is used to determine the position of the U.S. rate of return line.
• In the money-Forex diagram, these are the two endogenous variables.
• In the money-Forex diagram, these are the five exogenous variables. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.12%3A_Integrating_the_Money_Market_and_the_Foreign_Exchange_Markets.txt |
Learning Objective
• Show the effects of an increase in the money supply and an increase in GDP on the interest rate and exchange rate using the two-quadrant money-Forex market diagram.
Comparative statics is any exercise examining how the endogenous variables will be affected when one of the exogenous variables is presumed to change, while holding all other exogenous variables constant. Holding other variables constant at their original values is the “ceteris paribus” assumption. We will do several such exercises here using the combined money-Forex market diagram.
An Increase in the U.S. Money Supply
Suppose the U.S. money supply increases, ceteris paribus. The increase in \(M^{S}\) causes an increase in the real money supply (\(M^{S}/P_{\$}\)), which causes the real money supply line to shift “down” from \(M^{S′}/P_{\$}\) to \(M^{S″}/P_{\$}\) (step 1) in the adjacent Money-Forex diagram, Figure 7.13.1 . (Be careful here: down in the diagram means an increase in the real money supply.) This causes a decrease in the equilibrium interest rate from \(i_{\$}’\) to \(i_{\$}^″\) (step 2). The decrease in the U.S. interest rate causes a decrease in the rate of return on dollar assets: \(R_{0}R_{\$}\) shifts from \(R_{0}R_{\$}’\) to \(R_{0}R_{\$}^″\) (step 3). Finally, the reduction in the dollar rate of return causes an increase in the exchange rate from \(E_{\$/£}’\) to \(E_{\$/£}^”\) (step 4). This exchange rate change corresponds to an appreciation of the British pound and a depreciation of the U.S. dollar. In summary, an increase in the U.S. money supply, ceteris paribus, causes a decrease in U.S. interest rates and a depreciation of the dollar.
An Increase in U.S. GDP
Suppose there is an increase in U.S. GDP, ceteris paribus. This will increase real money demand, causing a “downward” shift in the real money demand curve from L(\(i_{\$}, Y_{\$}’\)) to L(\(i_{\$}, Y_{\$}^″\)) (step 1) in the Money-Forex diagram, Figure 7.13.2 . (Remember, real money increases as you move down on the rotated money diagram.) This causes an increase in the U.S. interest rate from \(i_{\$}’\) to \(i_{\$}^″\) (step 2). The increase in the interest means that the rate of return on dollar assets increases from \(R_{0}R_{\$}’\) to \(R_{0}R_{\$}^”\) (step 3). Finally, the increase in the U.S. \(R_{0}R\) causes a decrease in the exchange rate from \(E_{\$/£}’\) to \(E_{\$/£}^”\) (step 4). The exchange rate change corresponds to an appreciation of the U.S. dollar and a depreciation of the British pound. In summary, an increase in real U.S. GDP, ceteris paribus, causes an increase in U.S. interest rates and appreciation (depreciation) of the U.S. dollar (British pound).
Key Takeaways
• In the money-Forex model, an increase in the U.S. money supply, ceteris paribus, causes a decrease in U.S. interest rates and a depreciation of the dollar.
• In the money-Forex model, an increase in real U.S. gross domestic product (GDP), ceteris paribus, causes an increase in U.S. interest rates and appreciation (depreciation) of the U.S. dollar (British pound).
exercise
1. Using the Forex market and money market models, indicate the effect of each change listed in the first row of the table, sequentially, on the variables listed in the first column. For example, “Expansionary U.S. Monetary Policy” will first cause an increase in the “Real U.S. Money Supply.” Therefore, a “+” is placed in the first box of the table. In the next row, answer how “U.S. Interest Rates” will be affected. You do not need to show your work. Note E\$/* represents the dollar/foreign exchange rate. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
Expansionary U.S. Monetary Policy An Increase in U.S. Price Level An Increase in U.S. Real GDP
Real U.S. Money Supply +
U.S. Interest Rates
RoR on U.S. Assets
Foreign Interest Rates
RoR on Foreign Assets
U.S. Dollar Value
E\$/* | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.13%3A_Comparative_Statics_in_the_Combined_Money-Forex_Model.txt |
Learning Objective
1. Understand the conditions under which changes in the money supply will have a long-run impact on the price level and hence the inflation rate in a country.
In previous sections we assumed that price levels were given exogenously and were unaffected by changes in other variables. In this section, we will argue that money supply increases tend to have a positive effect on the price level and thus the rate of inflation in an economy. This effect is unlikely to occur quickly, instead arising over several months or years. For this reason, we will say the effect occurs in the long run. The magnitude of the price level effect is also greatly influenced by the level of unemployment in the economy. Unemployment affects the degree to which the money increase affects prices and the degree to which it affects output.
The easiest way to see the linkage between money supply and prices is to simplify the story by assuming output cannot change. We tell that in story 1. This assumption allows us to isolate the impact of money on prices alone. In the subsequent adjustment stories, we’ll relax the fixed output assumption to show how money increases can also affect the level of output in an economy.
Story 1: Money Supply Increase with Extreme Full Employment
Here we’ll consider the effects of a money supply increase assuming what I’ll call “extreme full employment.” Extreme full employment means that every person who wishes to work within the economy is employed. In addition, each working person is working the maximum number of hours that he or she is willing to work. In terms of capital usage, this too is assumed to be maximally employed. All machinery, equipment, office space, land, and so on that can be employed in production is currently being used. Extreme full employment describes a situation where it is physically impossible to produce any more output with the resources currently available.
Next, let’s imagine the central bank increases the money supply by purchasing U.S. government Treasury bills (T-bills) in the open market. Suppose the transaction is made with a commercial bank that decides to sell some of its portfolio of Treasury bills to free reserves to make loans to businesses. The transaction transfers the T-bill certificate to the central bank in exchange for an accounting notation the central bank makes in the bank’s reserve account. Since the transaction increases bank reserves without affecting bank deposits, the bank will now exceed its reserve requirement. Thus these new reserves are available for the bank to lend out.
Let’s suppose the value of the T-bills transacted is \$10 million. Suppose the bank decides to lend the \$10 million to Ford Motor Corporation, which is planning to build a new corporate office building. When the loan is made, the bank will create a demand deposit account in Ford’s name, which the company can use to pay its building expenses. Only after the creation of the \$10 million demand deposit account is there an actual increase in the money supply.
With money in the bank, Ford will now begin the process of spending to construct the office building. This will involve hiring a construction company. However, Ford will now run into a problem given our assumption of extreme full employment. There are no construction companies available to begin construction on their building. All the construction workers and the construction equipment are already being used at their maximum capacity. There is no leeway.
Nonetheless, Ford has \$10 million sitting in the bank ready to be spent and it wants its building started. So what can it do?
In this situation, the demand for construction services in the economy exceeds the supply. Profit-seeking construction companies that learn that Ford is seeking to begin building as soon as possible, can offer the following deal: “Pay us more than we are earning on our other construction projects and we’ll stop working there and come over to build your building.” Other construction companies may offer a similar deal. Once the companies, whose construction projects have already started, learn that their construction companies are considering abandoning them for a better offer from Ford, they will likely respond by increasing their payments to their construction crews to prevent them from fleeing to Ford. Companies that cannot afford to raise their payments will be the ones that must cease their construction, and their construction company will flee to Ford. Note that another assumption we must make for this story to work is that there are no enforceable contracts between the construction company and its client. If there were, a company that flees to Ford will find itself being sued for breach of contract. Indeed, this is one of the reasons why contracts are necessary. If all works out perfectly, the least productive construction projects will cease operations since these companies are the ones that are unwilling to raise their wages to keep the construction firm from fleeing.
Once Ford begins construction with its newly hired construction company, several effects are noteworthy. First, Ford’s construction company will be working the same amount of time and producing the same amount of output, though for a different client. However, Ford’s payments to the construction company are higher now. This means some workers or owners in the construction company are going home with a fatter paycheck. Other construction companies are also receiving higher payments so wages and rents will likely be higher for them as well.
Other companies that have hired the construction firms now face a dilemma, however. Higher payments have to come from somewhere. These firms may respond by increasing the prices of their products for their customers. For example, if this other firm is Coca-Cola, which must now pay higher prices to complete its construction project, it most probably will raise the price of Coke to pay for its higher overall production costs. Hence increases in wages and rents to construction companies will begin to cause increases in market prices of other products, such as Coke, televisions, computers, and so on.
At the same time, workers and owners of the construction companies with higher wages will undoubtedly spend more. Thus they will go out and demand more restaurant meals, cameras, and dance lessons and a whole host of other products. The restaurants, camera makers, and dance companies will experience a slight increase in demand for their products. However, due to the assumption of extreme full employment, they have no ability to increase their supply in response to the increase in demand. Thus these companies will do what the profit-seeking construction companies did before…they will raise their prices.
Thus price increases will begin to ripple through the economy as the extra money enters the circular flow, resulting in demand increases. As prices for final products begin to rise, workers may begin to demand higher wages to keep up with the rising cost of living. These wage increases will in turn lead firms to raise the prices of their outputs, leading to another round of increases in wages and prices. This process is known as the wage-price spiral.
Nowhere in this process can there ever be more production or output. That’s because of our assumption of extreme full employment. We have assumed it is physically impossible to produce any more. For this reason, the only way for the market to reach a new equilibrium with aggregate supply equal to aggregate demand is for prices for most inputs and outputs to rise. In other words, the money supply increase must result in an increase in average prices (i.e., the price level) in the economy. Another way of saying this is that money supply increases are inflationary.
The increase in prices will not occur immediately. It will take time for the construction companies to work out their new payment scheme. It will take more time for them to receive their extra wages and rents and begin spending them. It will take more time, still, for the restaurants and camera makers and others to respond to higher demands. And it will take even more time for workers to respond to the increases in prices and to demand higher wages. The total time may be several years before an economy can get back to equilibrium. For this reason, we think about this money supply effect on the price level as a long-run effect. In other words, we say an increase in the money supply will lead to an increase in the price level in the long run.
Inflation arises whenever there is too much money chasing too few goods. This effect is easy to recognize in this example since output does not change when the money supply increases. So, in this example, there is more money chasing the same quantity of output. Inflation can also arise if there is less output given a fixed amount of money. This is an effect seen in the transition economies of the former Soviet Union. After the breakdown of the political system in the early 1990s, output dropped precipitously, while money in circulation remained much the same. The outcome was a very rapid inflation. In these cases, it was the same amount of money chasing fewer goods.
Story 2: Money Supply Increase with High Unemployment
In this story, we relax the assumption of extreme full employment and assume instead that there is a very high rate of unemployment in the economy. This example will show how money supply increases can affect national output as well as prices.
Suppose there is a money supply increase as in the previous story. When Ford Motor Company goes out looking for a construction company to hire, there is now an important new possibility. Since unemployment is very high, it is likely that most construction companies are not operating at their full capacity. Some companies may have laid off workers in the recent past due to a lack of demand. The construction company that wins the Ford contract will not have to give up other construction projects. Instead, it can simply expand output by hiring unemployed workers and capital. Because there is a ready and waiting source of inputs, even at the original wage and rental rates, there is no need for the construction company to charge Ford more than current prices for its services. Thus there is no pressure to increase wages or the prices of construction services.
It is true, there is more money being paid out in wages by this company, and the new workers will go out and spend that money, leading to an increase in demand for restaurant services, cameras, dance lessons, and other products. These companies are also likely to respond by hiring more workers and idle equipment to provide more restaurant meals, cameras, and dance lessons. Here too, with a ready and willing source of new inputs from the ranks of the unemployed, these companies will not have an incentive to raise wages, rents, or prices. Instead, they will provide more output of goods and services.
Thus as the increase in money ripples through the economy, it will stimulate demand for a wide variety of products. However, because of high unemployment, the money supply increase need not result in higher prices. Instead, national output increases and the unemployment rate falls.
A comparison of stories 1 and 2 highlights the importance of the unemployment rate in determining the extent to which a money supply increase will be inflationary. In general, we can conclude that an increase in the money supply will raise the domestic price level to a larger degree in the long run, thus lowering the unemployment rate of labor and capital.
Natural Rate of Unemployment
Economists typically say that an economy is at full employment output when the unemployment rate is at the natural rate. The natural rate is defined as the rate that does not cause inflationary pressures in the economy. It is a rate that allows for common transitions that characterize labor markets. For example, some people are currently unemployed because they have recently finished school and are looking for their first job. Some are unemployed because they have quit one job and are in search of another. Some people have decided to move to another city, and are unemployed during the transition. Finally, some people may have lost a job in a company that has closed or downsized and may spend a few weeks or months in search of their next job.
These types of transitions are always occurring in the labor market and are known as frictional (or transitional) unemployment. When employment surveys are conducted each month, they will always identify a group of people unemployed for these reasons. They count as unemployed, since they are all actively seeking work. However, they all will need some time to find a job. As one group of unemployed workers find employment, others will enter the unemployment ranks. Thus there is a constant turnover of people in this group and thus a natural unemployment rate.This type of unemployment is also called frictional, or transitional, unemployment. It is distinguished from a second type called structural unemployment. Structural unemployment occurs when there is a change in the structure of production in an economy. For example, if the textile and apparel industry closes down and moves abroad, the workers with skills specific to the industry and the capital equipment designed for use in the industry will not be employable in other sectors. These workers and capital may remain unemployed for a longer period of time, or may never find alternative employment.
There is no simple way to measure the natural rate of unemployment. It will likely vary with economic conditions and the fluidity of the labor market. Nonetheless, economists estimate the natural rate of unemployment to be around 5 percent in the United States today.
When economists talk about the inflationary effect of money supply increases, they typically refer to the natural rate of unemployment. A money supply increase will likely be inflationary when the unemployment rate is below the natural rate. In contrast, inflationary effects of money supply increases are reduced if the economy has unemployment above the natural rate. Here’s how the story would work.
Story 3: Money Supply Increase above and below the Natural Unemployment Rate
Suppose there is a money supply increase as in the previous story, but now let’s assume the economy is operating above full employment, meaning that unemployment is below its natural rate.
As the money supply increase ripples through the economy causing excess demand, as described above, businesses have some leeway to expand output. Since unemployment is not zero, they can look to hire unemployed workers and expand output. However, as frictional unemployment decreases, the labor market will pick up speed. Graduating students looking for their first job will find one quickly. Workers moving to another job will also find one quickly. In an effort to get the best workers, firms may begin to raise their wage offers. Workers in transition may quickly find themselves entertaining several job offers, rather than just one. These workers will begin to demand higher wages. Ultimately, higher wages and rents will result in higher output prices, which in turn will inspire demands for higher wages. Thus despite the existence of some unemployment, the money supply increase may increase output slightly but it is also likely to be inflationary.
In contrast, suppose the economy were operating with unemployment above the natural rate. In this case, the increase in demand caused by a money supply increase is likely to have a more significant effect upon output. As firms try to expand output, they will face a much larger pool of potential employees. Competition by several workers for one new job will put power back in the hands of the company, allowing it to hire the best quality worker without having to raise its wage offer to do so. Thus, in general, output will increase more and prices will increase less, if at all. Thus the money supply increase is less likely to be inflationary in the long run when the economy is operating above the natural rate of unemployment.
Key Takeaways
• Inflation arises whenever there is too much money chasing too few goods.
• A money supply increase will lead to increases in aggregate demand for goods and services.
• A money supply increase will tend to raise the price level in the long run.
• A money supply increase may also increase national output.
• A money supply increase will raise the price level more and national output less the lower the unemployment rate of labor and capital is.
• A money supply increase will raise national output more and the price level less the higher the unemployment rate of labor and capital is.
• The natural rate of unemployment is the rate that accounts for frictional unemployment. It is also defined as the rate at which there are no aggregate inflationary pressures.
• If a money supply increase drives an economy below the natural rate of unemployment, price level increases will tend to be large while output increases will tend to be small.
• If a money supply increase occurs while an economy is above the natural rate of unemployment, price level increases will tend to be small while output increases will tend to be large.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term coined in this text for the situation when everybody who wishes to work is employed.
• The term used to describe how increases in output prices lead to increases in wages, which further cause output prices to rise ad infinitum.
• The term for the unemployment rate at which there is no inflationary or deflationary pressure on average prices.
• The term for the level of GDP in an economy when the unemployment rate is at its natural level.
• The term used to describe the type of unemployment that arises because of the typical adjustments of workers into, out of, and between jobs in an economy.
• The likely larger long-run effect of a money supply increase when an economy has unemployment below the natural rate.
• The likely larger long-run effect of a money supply increase when an economy has unemployment above the natural rate. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/07%3A_Interest_Rate_Determination/7.14%3A_Money_Supply_and_Long-Run_Prices.txt |
In most introductory macroeconomics courses, the basic Keynesian model is presented as a way of showing how government spending and taxation policies can influence the size of a country’s growth national product (GNP). This chapter revisits the basic Keynesian model but adds an international angle by including impacts on domestic demand for goods and services caused by changes in the exchange rate. With this relationship in place, the chapter concludes with several comparative statics exercises showing how changes in key variables may influence the level of GNP.
08: National Output Determination
Learning Objective
1. Understand the structure and results of the basic Keynesian model of national output determination.
This chapter describes how the supply and demand for the national output of goods and services combine to determine the equilibrium level of national output for an economy. The model is called the goods and services market model, or just the G&S market model.
In this model, we use gross national product (GNP) as the measure of national output rather than gross domestic product (GDP). This adjustment is made because we wish to define the trade balance ($E X − I M$) as the current account (defined as the difference between exports and imports of goods, services incomes payments/receipts, and unilateral transfers). This adjustment is discussed in more detail in Section 8.6.
The diagram used to display this model is commonly known as the Keynesian cross. The model assumes, for simplicity, that the amount of national output produced by an economy is determined by the total amount demanded. Thus if, for some reason, the demand for GNP were to rise, then the amount of GNP supplied would rise up to satisfy it. If demand for the GNP falls—for whatever reason—then supply of GNP would also fall. Consequently, it is useful to think of this model as “demand driven.”
The model is developed by identifying the key determinants of GNP demand. The starting point is the national income identity, which states that
$G N P = C + I + G + E X − I M, \nonumber$
that is, the gross national product is the sum of consumption expenditures ($C$), investment expenditures ($I$), government spending ($G$), and exports ($E X$) minus imports ($I M$).
Note that the identity uses GNP rather than GDP if we define $E X$ and $I M$ to include income payments, income receipts, and unilateral transfers as well as goods and services trade.
We rewrite this relationship as
$A D = C^{D} + I^{D} + G^{D} + EX^{D} − IM^{D}, \nonumber$
where AD refers to aggregate demand for the GNP and the right-side variables are now read as consumption demand, investment demand, and so on. The model further assumes that consumption demand is positively related to changes in disposable income ($Y_{d}$). Furthermore, since disposable income is in turn negatively related to taxes and positively related to transfer payments, these additional variables can also affect aggregate demand.
The model also assumes that demand on the current account ($CA^{D} = EX^{D} − IM^{D}$) is negatively related to changes in the domestic real currency value (i.e., the real exchange rate) and changes in disposable income. Furthermore, since the domestic real currency value is negatively related to the domestic price level (inflation) and positively related to the foreign price level, these variables will also affect current account demand.
Using the G&S market model, several important relationships between key economic variables are shown:
• When government demand ($G$) or investment demand ($I$) for G&S rises (falls), equilibrium GNP rises (falls).
• When disposable income rises (falls) due to a decrease (increase) in taxes or an increase (decrease) in transfer payments, equilibrium GNP increases (decreases).
• When the real exchange rate depreciates (appreciates), either due to a depreciation of the nominal exchange rate, an increase in the domestic price level, or a decrease in the foreign price level, equilibrium GNP rises (falls).
Connections
The G&S market model connects with the money market because the value of GNP determined in the G&S model affects money demand. If equilibrium GNP rises in the G&S model, then money demand will rise, causing an increase in the interest rate.
The G&S model also connects with the foreign exchange (Forex) market. The equilibrium exchange rate determined in the Forex affects the real exchange rate that in turn influences demand on the current account.
A thorough discussion of these interrelationships is given in Chapter 9.
Omissions
There is one important relationship omitted in this version of the G&S model, and that is the relationship between interest rates and investment. In most standard depictions of the Keynesian G&S model, it is assumed that increases (decreases) in interest rates will reduce (increase) demand for investment. In this version of the model, to keep things simple, investment is assumed to be exogenous (determined in an external process) and unrelated to the level of interest rates.
Some approaches further posit that interest rates affect consumption demand as well. This occurs because household borrowing, to buy new cars or other consumer items, will tend to rise as interest rates fall. However, this relationship is also not included in this model.
Key Takeaways
• The Keynesian, or G&S, model of output determination is a demand-driven model in that the amount of national output produced by an economy is determined by the total amount demanded.
• One important relationship omitted in this version of the G&S model is the lack of a relationship between interest rates and investment.
• The main results from the G&S model are the following:
• When government demand (G) or investment demand (I) for G&S rises (falls), equilibrium GNP rises (falls).
• When disposable income rises (falls) due to a decrease (increase) in taxes or an increase (decrease) in transfer payments, equilibrium GNP increases (decreases).
• When the real exchange rate depreciates (appreciates), either due to a depreciation of the nominal exchange rate, an increase in the domestic price level, or a decrease in the foreign price level, equilibrium GNP rises (falls).
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• In the Keynesian, or G&S, model, this is the primary determinant of aggregate supply.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if government spending decreases in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if investment spending increases in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if tax revenue decreases in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if transfer payments increase in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if the domestic currency depreciates in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if the domestic price level decreases in the G&S model.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP if the foreign price level decreases in the G&S model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.01%3A_Overview_of_National_Output_Determination.txt |
Learning Objective
1. Learn that aggregate demand is the summation of the separate demands for each variable in the national income identity.
The Keynesian model of aggregate demand for goods and services is developed by identifying key determinants of demand for the national output. When we talk about aggregate demand ($A D$), it means demand by households, businesses, and the government for anything and everything produced within the economy. The starting point is the national income identity, which states that
$G N P = C + I + G + EX − IM, \nonumber$
that is, the gross national product is the sum of consumption expenditures, investment expenditures, government spending, and exports minus imports of goods and services.
We rewrite this relationship as
$A D = C^{D} + I^{D} + G^{D} + EX^{D} − IM^{D}, \nonumber$
where the left side, $AD$, refers to aggregate demand for the GNP and the right-side variables are read as consumption demand, investment demand, and so on. Determinants of the right-side variables will be considered in turn.
It is important to remember that demand is merely what households, businesses, and the government “would like” to purchase given the conditions that exist in the economy. Sometimes demand will be realized, as when the economy is in equilibrium, but sometimes demand will not be satisfied. On the other hand, the variable Y, for real GNP, represents the aggregate supply of G&S. This will correspond to the actual GNP whether in equilibrium or not.
Next, we’ll present the determinants of each demand term: consumption, investment, government, and export and import demand.
Key Takeaways
• In the G&S model, aggregate demand for the GNP is the sum of consumption demand, investment demand, government demand, and current account demand.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• In the G&S model, the variable $Y$ stands for this.
• In the G&S model, the variable $A D$ stands for this.
• In the G&S model, the variable $I^{D}$ stands for this.
• In the G&S model, the variable $E X^{D}$ stands for this.
• In the G&S model, the variable $C A^{D}$ stands for this.
8.03: Consumption Demand
Learning Objective
1. Learn the determinants of consumption demand and the effects of changes in these variables.
Consumption demand represents the demand for goods and services by individuals and households in the economy. This is the major category in the national income accounts for most countries, typically comprising from 50 percent to 70 percent of the gross national product (GNP) for most countries.
In this model, the main determinant of consumption demand is disposable income. Disposable income is all the income households have at their disposal to spend. It is defined as national income (GNP) minus taxes taken away by the government, plus transfer payments that the government pays out to people. More formally, this is written as
$Y_{d} = Y − T + TR, \nonumber$
where $Y_{d}$ refers to disposable income, $Y$ is real GNP, $T$ is taxes, and $TR$ represents transfer payments.
In this relationship, disposable income is defined in the same way as in the circular flow diagram presented in Chapter 2, Section 2.7. Recall that taxes withdrawn from GNP are assumed to be all taxes collected by the government from all sources. Thus income taxes, social insurance taxes, profit taxes, sales taxes, and property taxes are all assumed to be included in taxes ($T$). Also, transfer payments refer to all payments made by the government that do not result in the provision of a good or service. All social insurance payments, welfare payments, and unemployment compensation, among other things, are included in transfers ($TR$).
In the G&S model, demand for consumption G&S is assumed to be positively related to disposable income. This means that when disposable income rises, demand for consumption G&S will also rise, and vice versa. This makes sense since households who have more money to spend will quite likely wish to buy more G&S.
We can write consumption demand in a functional form as follows:
This expression says that consumption demand is a function $C^{D}$ that depends positively (+) on disposable income ($Y_{d}$). The second term simply substitutes the variables that define disposable income in place of $Y_{d}$. It is a more complete way of writing the function. Note well that $C^{D}$ here denotes a function, not a variable. The expression is the same as if we had written f(x), but instead we substitute a $C^{D}$ for the f and $Y_{d}$ for the x.
It is always important to keep track of which variables are exogenous and which are endogenous. In this model, real GNP ($Y$) is the key endogenous variable since it will be determined in the equilibrium. Taxes ($T$) and transfer payments ($TR$) are exogenous variables, determined outside the model. Since consumption demand $C^{D}$ is dependent on the value of $Y$, which is endogenous, $C^{D}$ is also endogenous. By the same logic, $Y_{d}$ is endogenous as well.
Linear Consumption Function
It is common in most introductory textbooks to present the consumption function in linear form. For our purposes here, this is not absolutely necessary, but doing so will allow us to present a few important points.
In linear form, the consumption function is written as
Here $C^{0}$ represents autonomous consumption and mpc refers to the marginal propensity to consume.
Autonomous consumption ($C^{0}$) is the amount of consumption that would be demanded even if income were zero. (Autonomous simply means “independent” of income.) Graphically, it corresponds to the y-intercept of the linear function. Autonomous consumption will be positive since households will spend some money (drawing on savings if necessary) to purchase consumption goods (like food) even if income were zero.
The marginal propensity to consume (mpc) represents the additional (or marginal) demand for G&S given an additional dollar of disposable income. Graphically, it corresponds to the slope of the consumption function. This variable must be in the range of zero to one and is most likely to be between 0.5 and 0.8 for most economies. If mpc were equal to one, then households would spend every additional dollar of income. However, because most households put some of their income into savings (i.e., into the bank, or pensions), not every extra dollar of income will lead to a dollar increase in consumption demand. That fraction of the dollar not used for consumption but put into savings is called the marginal propensity to save (mps). Since each additional dollar must be spent or saved, the following relationship must hold:
$m p c + m p s = 1, \nonumber$
that is, the sum of the marginal propensity to consume and the marginal propensity to save must equal 1.
Key Takeaways
• In the G&S model, consumption demand is determined by disposable income.
• A linear consumption function includes the marginal propensity to consume and an autonomous consumption component, besides disposable income.
• Disposable income is defined as national income (GNP) minus taxes plus transfer payments.
• An increase (decrease) in disposable income will cause an increase (decrease) in consumption demand.
• An increase (decrease) in the marginal propensity to consume will cause an increase (decrease) in consumption demand.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term that represents the additional amount of consumption demand caused by an additional dollar of disposable income.
• The term that represents the additional amount of saving caused by an additional dollar of disposable income.
• The term for the amount of consumption demand that would arise even if disposable income were zero.
• Of positive or negative, the relationship between changes in disposable income and changes in consumption demand.
• Of positive or negative, the relationship between changes in tax revenues and changes in consumption demand.
• Of positive or negative, the relationship between changes in real GNP and changes in consumption demand.
• A household purchase of a refrigerator would represent demand recorded in this component of aggregate demand in the G&S model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.02%3A_Aggregate_Demand_for_Goods_and_Services.txt |
Learning Objective
1. Learn the determinants of investment demand and the effects of changes in these variables.
Investment demand refers to the demand by businesses for physical capital goods and services used to maintain or expand its operations. Think of it as the office and factory space, machinery, computers, desks, and so on that are used to operate a business. It is important to remember that investment demand here does not refer to financial investment. Financial investment is a form of saving, typically by households that wish to maintain or increase their wealth by deferring consumption till a later time.
In this model, investment demand will be assumed to be exogenous. This means that its value is determined outside of the model and is not dependent on any variable within the model. This assumption is made primarily to simplify the analysis and to allow the focus to be on exchange rate changes later. The simple equation for investment demand can be written as
$I^{D} = I_{0}, \nonumber$
where the “0,” or naught, subscript on the right side indicates that the variable is exogenous or autonomous. In words, the equation says that investment demand is given exogenously as $I_{0}$.
Admittedly, this is not a realistic assumption. In many other macro models, investment demand is assumed to depend on two other aggregate variables: GNP and interest rates. GNP may affect investment demand since the total demand for business expansion is more likely the higher the total size of the economy. The growth rate of GNP may also be an associated determinant since the faster GNP is growing, the more likely companies will predict better business in the future, inspiring more investment.
Interest rates can affect investment demand because many businesses must borrow money to finance expansions. The interest rate is the cost of borrowing money; thus, the higher the interest rates are, the lower the investment demand should be, and vice versa.
If we included the GNP and interest rate effects into the model, the solution to the extended model later would prove to be much more difficult. Thus we simplify things by assuming that investment is exogenous. Since many students have learned about the GNP and interest rate effect in previous courses, you need to remember that these effects are not a part of this model.
Key Takeaways
• In the G&S model, investment demand is assumed to be exogenous, meaning not dependent on any other variable within the model such as GNP or interest rates.
• The omission of an effect by GNP and interest rates on investment demand is made to simplify the model.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Term for a type of investment by households that wish to maintain or increase their wealth by deferring consumption till a later time.
• Investment demand refers to this type of goods and services.
• Of exogenous or endogenous, this describes investment demand in the G&S model in the text.
• The name of two variables that are likely to influence investment demand in reality but are excluded from the G&S model as a simplification.
• A business purchase of a company delivery van would represent demand recorded in this component of aggregate demand in the G&S model.
8.05: Government Demand
Learning Objective
1. Learn the determinants of government demand and the effects of changes in these variables.
Government demand refers to the government’s demand for goods and services produced in the economy. In some cases this demand is for G&S produced by private businesses, as when the government purchases a naval aircraft. Other government demand is actually produced by the government itself, as what occurs with teachers providing educational services in the public schools. All levels of government demand—federal, state, and local—are included in this demand term. Excluded are transfer payments such as social insurance, welfare assistance, and unemployment compensation.
In this model, government demand is treated the same way as investment demand: it is assumed to be exogenous. This means that its value is determined outside of the model and is not dependent on any variable within the model. A simple equation for government demand can be written as
$G^{D} = G_{0}, \nonumber$
where the “0,” or naught, subscript on the right side indicates that the variable is exogenous or autonomous. In words, the equation says that government demand is given exogenously as $G_{0}$.
This is a more common assumption in many other macro models, even though one could argue dependencies of government demand on GNP and interest rates. However, these linkages are not likely to be as strong as with investment, thus assuming exogeneity here is a more realistic assumption than with investment.
key takeaway
1. In the G&S model, government demand is assumed to be exogenous, meaning not dependent on any other variable within the model such as GNP or interest rates.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• These three levels of government demand are included in $G^{D}$ in the G&S model.
• This type of government expenditure is not included in $G^{D}$ in the G&S model.
• Of exogenous or endogenous, this describes government demand in the G&S model in the text.
• An expenditure by a state school system on teachers’ salaries would represent demand recorded in this component of aggregate demand in the G&S model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.04%3A_Investment_Demand.txt |
Learning Objective
1. Learn the determinants of export and import demand and the effects of changes in these variables.
Export demand refers to the demand by foreign countries for G&S produced domestically. Ultimately, these goods are exported to foreign residents. Import demand refers to demand by domestic residents for foreign-produced G&S. Imported G&S are not a part of domestic GNP. Recall from Chapter 2, Section 2.3 that imports are subtracted from the national income identity because they are included as a part of consumption, investment, and government expenditures as well as in exports. Likewise in this model, consumption, investment, government, and export demand are assumed to include demand for imported goods. Thus imports must be subtracted to assure that only domestically produced G&S are included.
We will define current account demand as \(CA^{D} = EX^{D} − IM^{D}\). The key determinants of current account demand in this model are assumed to be the domestic real currency value and disposable income.
First, let’s define the real currency value, then show how it relates to the demand for exports and imports. The real British pound value in terms of U.S. dollars (also called the real exchange rate between dollars and pounds), \(RE_{\$/£}\), is a measure of the cost of a market basket of goods abroad relative to the cost of a similar basket domestically. It captures differences in prices, converted at the spot exchange rate, between the domestic country and the rest of the world. It is defined as
where \(E_{\$/£}\) is the spot exchange rate, \(CB_{£}\) is the cost of a market basket of goods in Britain, and \(CB_{\$}\) is the cost of a comparable basket of goods in the United States. The top expression, \(E_{\$/£}\) \(CB_{£}\), represents the cost of a British market basket of goods converted to U.S. dollars. Thus if \(RE_{\$/£} > 1\), then a British basket of goods costs more than a comparable U.S. basket of goods. If \(RE_{\$/£} < 1\), then a U.S. basket of goods costs more than a British basket. Also note that \(RE_{\$/£}\) is a unitless number. If \(RE_{\$/£} = 2\), for example, it means that British goods cost twice as much as U.S. goods, on average, at the current spot exchange rate.
Note that we could also have defined the reciprocal real exchange rate, \(RE_{£/\$}\). This real exchange rate is the real value of the pound in terms of U.S. dollars. Since the real exchange rate can be defined in two separate ways between any two currencies, it can be confusing to say things like “the real exchange rate rises” since the listener may not know which real exchange rate the speaker has in mind. Thus it is always preferable to say the real dollar value rises, or the real pound value falls, since this eliminates any potential confusion. In this text, I will always adhere to the convention of writing the spot exchange rate and the real exchange rate with the U.S. dollar in the numerator. Thus references to the real exchange rate in this text will always refer to that form.
Since the cost of a market basket of goods is used to create a country’s price index, changes in CB will move together with changes in the country’s price level \(P\). For this reason, it is common to rewrite the real exchange rate using price levels rather than costs of market baskets and to continue to interpret the expression in the same way. For more information related to this, see Chapter 6, Section 6.2. We will follow that convention here and rewrite \(RE_{\$/£}\) as
where \(P_{£}\) is the British price index and \(P_{\$}\) is the U.S. price index. From this point forward, we’ll mean this expression whenever we discuss the real exchange rate.
Next, we’ll discuss the connection to current account demand. To understand the relationship it is best to consider a change in the real exchange rate. Suppose \(RE_{\$/£}\) rises. This means that the real value of the pound rises and, simultaneously, the real U.S. dollar value falls. This also means that goods and services are becoming relatively more expensive, on average, in Britain compared to the United States.
Relatively cheaper G&S in the United States will tend to encourage U.S. exports since the British would prefer to buy some cheaper products in the United States. Similarly, relatively more expensive British G&S will tend to discourage U.S. imports from Britain. Since U.S. exports will rise and imports will fall with an increase in the real U.S. dollar value, current account demand, \(CA^{D} = EX^{D} − IM^{D}\), will rise. Similarly, if the real U.S. dollar value falls, U.S. exports will fall and imports rise, causing a decrease in \(CA^{D}\). Hence, there is a positive relationship between this real exchange rate (i.e., the real value of the pound) and U.S. current account demand.
Disposable income can also affect the current account demand. In this case, the effect is through imports. An increase in disposable income means that households have more money to spend. Some fraction of this will be consumed, the marginal propensity to consume, and some fraction of that consumption will be for imported goods. Thus an increase in disposable income should result in an increase in imports and a subsequent reduction in current account demand. Thus changes in disposable income are negatively related to current account demand.
We can write current account demand in functional form as follows:
The expression indicates that current account demand is a function of \(RE_{\$/£}\) and \(Y_{d}\). The “+” sign above \(RE_{\$/£}\) indicates the positive relationship between the real exchange rate (as defined) and current account demand. The “−” sign above the disposable income term indicates a negative relationship with current account demand.
Key Takeaways
• The key determinants of current account demand in the G&S model are assumed to be the domestic real currency value and disposable income.
• The real exchange rate captures differences in prices, converted at the spot exchange rate, between the domestic country and the rest of the world.
• In the G&S model, there is a positive relationship between the real exchange rate (as defined) and current account demand and a negative relationship between disposable income and current account demand.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of positive or negative, the relationship between changes in the domestic price level and the real value of the domestic currency.
• Of positive or negative, the relationship between changes in the foreign price level and the real value of the domestic currency.
• Of positive or negative, the relationship between changes in the nominal value of the domestic currency and the real value of the domestic currency.
• Of increase, decrease, or stay the same, the effect of a real appreciation of the domestic currency on current account demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of a depreciation of the domestic currency on current account demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in the domestic price level on current account demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in the foreign price level on current account demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of a decrease in real GNP on current account demand in the G&S model.
• An expenditure by a domestic business for a microscope sold by a Swiss firm would represent demand recorded in this component of aggregate demand in the G&S model.
• An expenditure by a foreign business for a microscope sold by a U.S. firm would represent demand recorded in this component of aggregate demand in the G&S model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.06%3A_Export_and_Import_Demand.txt |
Learning Objective
1. Combine the individual demand functions into an aggregate demand (AD) function.
Notice that the right side indicates that if disposable income were to rise, consumption demand would rise but current account demand, which is negatively related to disposable income, would fall. This would seem to make ambiguous the effect of a disposable income change on aggregate demand. However, by thinking carefully about the circular flow definitions, we can recall that consumption expenditures consist of the sum of expenditures on domestically produced goods and imported goods. This was the reason imports are subtracted away in the national income identity. This also means that the marginal propensity to spend on imported goods must be lower than the total marginal propensity to consume, again since imports are a fraction of total consumption spending. This implies that the negative effect on imports from a \$1 increase in disposable income must be less than the positive impact on consumption demand.
We indicate the net positive effect on aggregate demand of changes in disposable income with the “+” sign above \(Y_{d}\) on the left-hand side. The positive impact of changes in the real exchange rate, investment demand, and government demand is obvious and is also shown.
We can write the aggregate demand function in several different ways. To be more explicit, we can include all the fundamental variables affecting aggregate demand by writing out the disposable income and real exchange rate terms as follows:
Writing the expression in this way allows us to indicate that the spot exchange rate, the price levels domestically and abroad, and domestic taxes and transfer payments also affect aggregate demand. For example, increases in autonomous transfer payments will raise aggregate demand since it raises disposable income, which in turn raises demand. Increases in taxes, however, will lower disposable income, which in turn will lower aggregate demand. Similarly, an increase in the spot exchange rate (as defined) or the foreign price level will raise aggregate demand, since both changes will increase the real exchange rate. However, an increase in the domestic price level will reduce the real exchange rate (because it is in the denominator) and thus reduce aggregate demand.
key takeaway
• Aggregate demand is positively related to changes in disposable income, the real exchange rate (as defined), and investment and government demands.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the effect of a real appreciation of the domestic currency on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in investment demand on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in disposable income on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in income taxes on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in government demand on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in the real currency value on aggregate demand in the G&S model.
• Of increase, decrease, or stay the same, the effect of an increase in the domestic price level on aggregate demand in the G&S model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.07%3A_The_Aggregate_Demand_Function.txt |
Learning Objective
1. Learn how to use the Keynesian cross diagram to describe equilibrium in the G&S market.
The Keynesian cross diagram depicts the equilibrium level of national income in the G&S market model. We begin with a plot of the aggregate demand function with respect to real GNP (Y) in Figure 8.8.1 . Real GNP (Y) is plotted along the horizontal axis, and aggregate demand is measured along the vertical axis. The aggregate demand function is shown as the upward sloping line labeled AD(Y, …). The (…) is meant to indicate that AD is a function of many other variables not listed. There are several important assumptions about the form of the AD function that are needed to assure an equilibrium. We discuss each assumption in turn.
First, the AD function is positively sloped with respect to changes in Y, ceteris paribus. Recall that ceteris paribus means that all other variables affecting aggregate demand are assumed to remain constant as GNP changes. The positive slope arises from the rationale given previously that an increase in disposable income should naturally lead to an increase in consumption demand and a smaller decrease in CA demand, resulting in a net increase in aggregate demand. Next, if GNP rises, ceteris paribus, it means that taxes and transfer payments remain fixed and disposable income must increase. Thus an increase in GNP leads to an increase in AD.
Second, the AD function has a positive vertical intercept term. In other words, the AD function crosses the vertical axis at a level greater than zero. For reasons that are not too important, this feature is critical for generating the equilibrium later. The reason it arises is because autonomous consumption, investment, and government demand are all assumed to be independent of income and positive in value. These assumptions guarantee a positive vertical intercept.
Third, the AD function has a slope that is less than one. This assumption means that for every \$1 increase in GNP (Y), there is a less than \$1 increase in aggregate demand. This arises because the marginal propensity to consume domestic GNP is less than one for two reasons. First, some of the additional income will be spent on imported goods, and second, some of the additional income will be saved. Thus the AD function will have a slope less than one.
Also plotted in the diagram is a line labeled \(AD = Y\). This line is also sometimes called the forty-five-degree line since it sits at a forty-five-degree angle to the horizontal axis. This line represents all the points on the diagram where AD equals GNP. Since GNP can be thought of as aggregate supply, the forty-five-degree line contains all the points where AD equals aggregate supply.
Because of the assumptions about the shape and position of the AD function, AD will cross the forty-five-degree line, only once, from above. The intersection determines the equilibrium value of GNP, labeled Y′ in the diagram.
Key Takeaways
• The Keynesian cross diagram plots the aggregate demand function versus GNP together with a forty-five-degree line representing the set of points where \(AD = GNP\). The intersection of these two lines represents equilibrium GNP in the economy.
• An equilibrium exists if the AD function crosses the forty-five-degree line from above. This occurs if three conditions hold:
1. The AD function has a positive slope. (It does.)
2. The AD function has a slope less than one. (It does.)
3. The AD function intersects the vertical axis in the positive range. (It does.)
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of positive, negative, or zero, the slope of an aggregate demand function with respect to changes in real GNP.
• Of positive, negative, or zero, the value of the vertical intercept of an aggregate demand function.
• Of greater than one, less than one, or equal to one, the value of the slope of an aggregate demand function with respect to changes in real GNP.
• The equality that is satisfied on the forty-five-degree line in a Keynesian cross diagram.
• The value of this variable is determined at the intersection of the aggregate demand function and the forty-five-degree line in a Keynesian cross diagram. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.08%3A_The_Keynesian_Cross_Diagram.txt |
Learning Objective
1. Learn the equilibrium stories in the G&S market that describe how GNP adjusts when it is not at its equilibrium value.
Any equilibrium in economics has an associated behavioral story to explain the forces that will move the endogenous variable to the equilibrium value. In the G&S market model, the endogenous variable is \(Y\), real GNP. This is the variable that will change to achieve the equilibrium. Variables that do not change in the adjustment to the equilibrium are the exogenous variables. In this model, the exogenous variables are \(I_{0}\), \(G_{0}\), \(T\), \(TR\), \(E_{\$/£}\), \(P_{\$}\), and \(P_{£}\). (If one uses a linear consumption demand function, the \(C_{0}\) and mpc are also exogenous.) Changes in the exogenous variables are necessary to cause an adjustment to a new equilibrium. However, in telling an equilibrium story, it is typical to simply assume that the endogenous variable is not at the equilibrium (for some unstated reason) and then to explain how and why the variable will adjust to the equilibrium value.
GNP Too High
Suppose for some reason actual GNP, \(Y_{1}\), is higher than the equilibrium GNP, \(Y′\), as shown in Figure 8.9.1 . In this case, aggregate demand is read from the AD function as \(AD(Y_{1})\) along the vertical axis. We project aggregate supply, \(Y_{1}\), to the vertical axis using the forty-five-degree line so that we can compare supply with demand. This helps us to see that \(Y_{1} > AD(Y_{1})\)—that is, aggregate supply is greater than aggregate demand.
We now tell what can be called the “Inventory Story.” When total demand is less than supply, goods will begin to pile up on the shelves in stores. That’s because at current prices (and all other fixed exogenous parameters), households, businesses, and government would prefer to buy less than what is available for sale. Thus inventories begin to rise. Merchants, faced with storerooms filling up, send orders for fewer goods to producers. Producers respond to fewer orders by producing less, and thus GNP begins to fall.
As GNP falls, disposable income also falls, which causes a drop in aggregate demand as well. In the diagram, this is seen as a movement along the AD curve from \(Y_{1}\) to \(Y’\). However, GNP falls at a faster rate, along the \(AD = Y\) line in the diagram. Eventually, the drop in aggregate supply catches up to the drop in demand when the equilibrium is reached at \(Y’\). At this point, aggregate demand equals aggregate supply and there is no longer an accumulation of inventories.
It is important to recognize a common perception or intuition that does not hold in the equilibrium adjustment process. Many students imagine a case of rising inventories and ask, “Won’t producers just lower their prices to get rid of the excess?” In real-world situations this will frequently happen; however, that response violates the ceteris paribus assumption of this model. We assume here that the U.S. price level (\(P_{\$}\)) and consequently all prices in the economy remain fixed in the adjustment to the new equilibrium. Later, with more elaborate versions of the model, some price flexibility is considered.
GNP Too Low
Suppose for some reason, actual GNP, \(Y_{2}\), is lower than the equilibrium GNP, \(Y’\), as shown in Figure 8.9.2 . In this case, aggregate demand is read from the AD function as \(AD(Y_{2})\) along the vertical axis. We project aggregate supply (\(Y_{2}\)) to the vertical axis using the forty-five-degree line. This shows that \(AD(Y_{2}) > Y_{2}\)—that is, aggregate demand is greater than aggregate supply.
When total demand exceeds supply, inventories of goods that had previously been accumulated will begin to deplete in stores. That’s because, at current prices (and all other fixed exogenous parameters), households, businesses, and government would prefer to buy more than is needed to keep stocks at a constant level. Merchants, faced with depleted inventories and the possibility of running out of goods to sell, send orders to producers for greater quantities of goods. Producers respond to more orders by producing more and thus GNP begins to rise.
As GNP rises, disposable income also rises, which causes an increase in aggregate demand as well. In the diagram, this is seen as a movement along the AD curve from \(Y_{2}\) to \(Y’\). However, GNP rises at a faster rate, along the \(AD = Y\) line in the diagram. Eventually, the increase in aggregate supply catches up to the increase in demand when the equilibrium is reached at \(Y’\). At this point, aggregate demand equals aggregate supply and there is no further depletion of inventories.
Key Takeaways
• If the actual GNP is higher than the equilibrium rate, then excess supply leads to an accumulation of inventories. Firms respond to the surplus by cutting production, causing GNP to fall until the GNP supplied is equal to aggregate demand.
• If the actual GNP is lower than the equilibrium rate, then excess demand leads to a depletion of inventories. Firms respond to the surplus by raising production, which causes GNP to rise until the GNP supplied is equal to aggregate demand.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, this will happen to store inventories when aggregate demand exceeds GNP.
• Of increase, decrease, or stay the same, this will happen to store inventories when actual GNP is greater than equilibrium GNP.
• Of increase, decrease, or stay the same, this is the direction of GNP change when inventories are accumulating in the Keynesian model.
• Of increase, decrease, or stay the same, this is the direction of GNP change when inventories are depleting in the Keynesian model.
• Of faster, slower, or the same rate, the rate of increase of aggregate demand compared to the increase in GNP as GNP rises to an equilibrium value in the Keynesian model. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.09%3A_Goods_and_Services_Market_Equilibrium_Stories.txt |
learning goals
1. Learn how a change in government demand affects equilibrium GNP.
Suppose the economy is initially in equilibrium in the G&S market with government demand at level \(G_{1}\) and real GNP at \(Y_{1}\), shown in Figure 8.10.1 . The initial AD function is written as \(AD(…, G_{1}, …)\) to signify the level of government demand and to denote that other variables affect AD and are at some initial and unspecified values.
Next, suppose the government raises demand for G&S from \(G_{1}\) to \(G_{2}\), ceteris paribus. The increase might arise because a new budget is passed by the legislature with new spending initiatives. The ceteris paribus assumption means that all other exogenous variables are assumed to remain fixed. Most importantly in this context, this means that the increase in government demand is not paid for with increases in taxes or decreases in transfer payments.
Since higher government demand raises aggregate demand, the AD function shifts up from \(AD(…, G_{1}, …)\) to \(AD(…, G_{2}, …)\) (step 1). The equilibrium GNP in turn rises to \(Y_{2}\) (step 2). Thus the increase in government demand causes an increase in real GNP.
The adjustment process follows the “GNP too low” story. When government demand increases, but before GNP rises to adjust, \(AD\) is greater than \(Y_{1}\). The excess demand for G&S depletes inventories, in this case for firms that supply the government, causing merchants to increase order size. This leads firms to increase output, thus raising GNP.
key takeaway
1. In the G&S model, an increase (decrease) in government demand causes an increase (decrease) in real GNP.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the effect on equilibrium real GNP from a decrease in government demand in the G&S model.
• Of increase, decrease, or stay the same, the effect on equilibrium real GNP caused by an increase in government demand in the G&S model.
• Of GNP too low or GNP too high, the equilibrium story that must be told following an increase in government demand in the G&S model.
• Of GNP too low or GNP too high, the equilibrium story that must be told following a decrease in government demand in the G&S model.
2. In the text, the effect of a change in government demand is analyzed. Use the G&S model (diagram) to individually assess the effect on equilibrium GNP caused by the following changes. Assume ceteris paribus.
• An increase in investment demand.
• An increase in transfer payments.
• An increase in tax revenues.
3. Consider an economy in equilibrium in the G&S market.
• Suppose investment demand decreases, ceteris paribus. What is the effect on equilibrium GNP?
• Now suppose investment demand decreases, but ceteris paribus does not apply because at the same time government demand rises. What is the effect on equilibrium GNP?
• In general, which of these two assumptions, ceteris paribus or no ceteris paribus, is more realistic? Explain why.
• If ceteris paribus is less realistic, why do economic models so frequently apply the assumption?
8.11: Effect of an Increase in the U.S. Dollar Value on Real GNP
Learning Objective
1. Learn how a change in the U.S. dollar value affects equilibrium GNP.
Suppose the economy is initially in equilibrium in the G&S market with the exchange rate at level \(E_{\$/£}^{1}\) and real GNP at \(Y_{1}\) as shown in Figure 8.11.1 . The initial AD function is written as \(AD(…, E_{\$/£}^{1}, …)\) to signify the level of the exchange rate and to denote that other variables affect AD and are at some initial and unspecified values.
Next, suppose the U.S. dollar value rises, corresponding to a decrease in the exchange rate from \(E_{\$/£}^{1}\) to \(E_{\$/£}^{2}\), ceteris paribus. As explained in Chapter 8, Section 8.6, the increase in the spot dollar value also increases the real dollar value, causing foreign G&S to become relatively cheaper and U.S. G&S to become more expensive. This change reduces demand for U.S. exports and increases import demand, resulting in a reduction in aggregate demand. The ceteris paribus assumption means that all other exogenous variables are assumed to remain fixed.
Since the higher dollar value lowers aggregate demand, the AD function shifts down from \(AD(…, E_{\$/£}^{1}, …)\) to \(AD(…, E_{\$/£}^{2}, …)\) (step 1), and equilibrium GNP in turn falls to \(Y_{2}\) (step 2). Thus the increase in the U.S. dollar value causes a decrease in real GNP.
The adjustment process follows the “GNP too high” story. When the dollar value rises but before GNP falls to adjust, \(Y_{1} > AD\). The excess supply of G&S raises inventories, causing merchants to decrease order size. This leads firms to decrease output, lowering GNP.
key Takeaway
• In the G&S model, an increase (decrease) in the U.S. dollar value causes a decrease (increase) in real GNP.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the effect on equilibrium real U.S. GNP from a decrease in the value of the U.S. dollar in the G&S model.
• Of increase, decrease, or stay the same, the effect on equilibrium real GNP caused by an increase in the value of the U.S. dollar in the G&S model.
• Of GNP too low or GNP too high, the equilibrium story that must be told following an increase in the value of the U.S. dollar in the G&S model.
• Of GNP too low or GNP too high, the equilibrium story that must be told following a decrease in the value of the U.S. dollar in the G&S model.
2. In the text, the effect of a change in the currency value is analyzed. Use the G&S model (diagram) to individually assess the effect on equilibrium GNP caused by the following changes. Assume ceteris paribus.
• A decrease in the real currency value.
• An increase in the domestic price level.
• An increase in the foreign price level. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.10%3A_Effect_of_an_Increase_in_Government_Demand_on_Real_GNP.txt |
Learning Objective
1. Learn about the J-curve effect that explains how current account adjustment in response to a change in the currency value will vary over time.
In the goods market model, it is assumed that the exchange rate ($E_{/£}$) is directly related to current account demand in the United States. The logic of the relationship goes as follows. If the dollar depreciates, meaning $E_{/£}$ rises, then foreign goods will become more expensive to U.S. residents, causing a decrease in import demand. At the same time U.S. goods will appear relatively cheaper to foreign residents, causing an increase in demand for U.S. exports. The increase in export demand and decrease in import demand both contribute to an increase in the current account demand. Since in the goods market model, any increase in demand results in an increase in supply to satisfy that demand, the dollar depreciation should also lead to an increase in the actual current account balance.
In real-world economies, however, analysis of the data suggests that in many instances a depreciating currency tends to cause, at least, a temporary increase in the deficit rather than the predicted decrease. The explanation for this temporary reversal of the cause-and-effect relationship is called the J-curve theory. In terms of future use of the AA-DD model, we will always assume the J-curve effect is not operating, unless otherwise specified. One should think of this effect as a possible short-term exception to the standard theory.
The theory of the J-curve is an explanation for the J-like temporal pattern of change in a country’s trade balance in response to a sudden or substantial depreciation (or devaluation) of the currency.
Consider Figure 8.12.1 , depicting two variables measured, hypothetically, over some period: the U.S. dollar / British pound ($E_{/£}$) and the U.S. current account balance ($CA = EX − IM$). The exchange rate is meant to represent the average value of the dollar against all other trading country currencies and would correspond to a dollar value index that is often constructed and reported. Since the units of these two data series would be in very different scales, we imagine the exchange rate is measured along the left axis, while the $CA$ balance is measured in different units on the right-hand axis. With appropriately chosen scales, we can line up the two series next to each other to see whether changes in the exchange rate seem to correlate with positive or negative changes in the $CA$ balance.
As previously mentioned, the standard theory suggests a positive relationship between $E_{/£}$ and the U.S. current account, implying that, ceteris paribus, any dollar depreciation (an increase in $E_{/£}$) should cause an increase in the CA balance.
However, what sometimes happens instead, is immediately following the dollar depreciation at time $t_{1}$, the $CA$ balance falls for a period of time, until time $t_{2}$ is reached. In this phase, a $CA$ deficit would become larger, not smaller.
Eventually, after period $t_{2}$, the $CA$ balance reverses direction and begins to increase—in other words, a trade deficit falls. The diagram demonstrates clearly how the $CA$ balance follows the pattern of a “J” in the transition following a dollar depreciation, hence the name J-curve theory.
In the real world, the period of time thought necessary for the $CA$ balance to traverse the J pattern is between one and two years. However, this estimate is merely a rough rule of thumb as the actual paths will be influenced by many other variable changes also occurring at the same time. Indeed, in some cases the J-curve effect may not even arise, so there is nothing automatic about it.
The reasons for the J-curve effect can be better understood by decomposing the current account balance. The basic definition of the current account is the difference between the value of exports and the value of imports. That is,
$CA = EX − IM. \nonumber$
The current account also includes income payments and receipts and unilateral transfers, but these categories are usually small and will not play a big role in this discussion—so we’ll ignore them. The main thing to take note about this definition is that the CA is measured in “value” terms, which means in terms of dollars. The way these values are determined is by multiplying the quantity of imports by the price of each imported item. We expand the CA definition by using the summation symbol and imagining summing up across all exported goods and all imported goods:
$CA = ΣP_{EX}Q_{EX} − ΣP_{IM}Q_{IM}. \nonumber$
Here $ΣP_{EX}Q_{EX}$ represents the summation of the price times quantities of all goods exported from the country, while $ΣP_{EX}Q_{EX}$ is the summation of the price times quantities of all goods imported from the country.
However, for imported goods we could also take note that foreign products are denominated in foreign currency terms. To convert them to U.S. dollars we need to multiply by the current spot exchange rate. Thus we can expand the CA definition further by incorporating the exchange rate into the import term as follows:
$CA = ΣP_{EX}Q_{EX} − ΣE_{/£}P^{*}_{IM}Q_{IM}. \nonumber$
Here $E_{/£}$ represents whatever dollar/pound rate prevailed at the time of imports, and $P_{IM}^{*}$ represents the price of each imported good denominated in foreign (*) pound currency terms. Thus the value of imports is really the summation across all foreign imports of the exchange rate times the foreign price times quantity.
The J-curve theory recognizes that import and export quantities and prices are often arranged in advance and set into a contract. For example, an importer of watches is likely to enter into a contract with the foreign watch company to import a specific quantity over some future period. The price of the watches will also be fixed by the terms of the contract. Such a contract provides assurances to the exporter that the watches he makes will be sold. It provides assurances to the importer that the price of the watches will remain fixed. Contract lengths will vary from industry to industry and firm to firm, but may extend for as long as a year or more.
The implication of contracts is that in the short run, perhaps over six to eighteen months, both the local prices and quantities of imports and exports will remain fixed for many items. However, the contracts may stagger in time—that is, they may not all be negotiated and signed at the same date in the past. This means that during any period some fraction of the contracts will expire and be renegotiated. Renegotiated contracts can adjust prices and quantities in response to changes in market conditions, such as a change in the exchange rate. Thus in the months following a dollar depreciation, contract renegotiations will gradually occur, causing eventual, but slow, changes in the prices and quantities traded.
With these ideas in mind, consider a depreciation of the dollar. In the very short run—say, during the first few weeks—most of the contract terms will remain unchanged, meaning that the prices and quantities of exports and imports will also stayed fixed. The only change affecting the $CA$ formula, then, is the increase in $E_{/*}$. Assuming all importers have not hedged their trades by entering to forward contracts, the increase in $E_{/*}$ will result in an immediate increase in the value of imports measured in dollar terms. Since the prices and quantities do not change immediately, the $CA$ balance falls. This is what can account for the initial stage of the J-curve effect, between periods $t_{1}$ and $t_{2}$.
As the dollar depreciation continues, and as contracts begin to be renegotiated, traders will adjust quantities demanded. Since the dollar depreciation causes imported goods to become more expensive to U.S. residents, the quantity of imported goods demanded and purchased will fall. Similarly, exported goods will appear cheaper to foreigners, and so as their contracts are renegotiated, they will begin to increase demand for U.S. exports. The changes in these quantities will both cause an increase in the current account (decrease in a trade deficit). Thus, as several months and years pass, the effects from the changes in quantities will surpass the price effect caused by the dollar depreciation and the $CA$ balance will rise as shown in the diagram after time $t_{2}$.
It is worth noting that the standard theory, which says that a dollar depreciation causes an increase in the current account balance, assumes that the quantity effects—that is, the effects of the depreciation on export and import demand—are the dominant effects. The J-curve theory qualifies that effect by suggesting that although the quantity or demand effects will dominate, it may take several months or years before becoming apparent.
Key Takeaways
• The J-curve theory represents a short-term exception to the standard assumption applied in the G&S model in which a currency depreciation causes a decrease in the trade deficit.
• The theory of the J-curve is an explanation for the J-like temporal pattern of change in a country’s trade balance in response to a sudden or substantial depreciation (or devaluation) of the currency.
• The J-curve effect suggests that after a currency depreciation, the current account balance will first fall for a period of time before beginning to rise as normally expected. If a country has a trade deficit initially, the deficit will first rise and then fall in response to a currency depreciation.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of short run or long run, the period in which the J-curve theory predicts that a country’s trade deficit will rise with a currency depreciation.
• Of short run or long run, the period in which the J-curve theory predicts that a country’s trade deficit will fall with a currency depreciation.
• Of value of U.S. imports or quantity of U.S. imports, this is expected to rise in the short run after a dollar depreciation according to the J-curve theory.
• Of value of Turkish imports or quantity of Turkish imports, this is expected to fall in the long run after a Turkish lira depreciation according to the J-curve theory.
• Of increase, decrease, or stay the same, the effect on U.S. exports in the short run due to a U.S. dollar depreciation according to the J-curve theory.
• Of increase, decrease, or stay the same, the effect on U.S. imports in the short run due to a U.S. dollar depreciation according to the J-curve theory. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/08%3A_National_Output_Determination/8.12%3A_The_J-Curve_Effect.txt |
Ideally, it would be nice to develop a way to keep track of all the cause-and-effect relationships that are presumed to exist at the same time. From the previous chapters it is clear, for example, that the money supply affects the interest rates in the money market, which in turn affects the exchange rates in the foreign exchange (Forex) market, which in turn affects demand on the current account in the goods and services (G&S) market, which in turn affects the level of GNP, which in turn affects the money market, and so on. The same type of string of repercussions can be expected after many other changes that might occur. Keeping track of these effects and establishing the final equilibrium values would be a difficult task if not for a construction like the AA-DD model. This model merges the money market, the Forex market, and the G&S market into one supermodel. The construction of the AA-DD model is presented in this chapter.
09: The AA-DD Model
Learning Objective
1. Understand the basic structure and results of the AA-DD model of national output and exchange rate determination.
This chapter describes the derivation and the mechanics of the AA-DD model. The AA-DD model represents a synthesis of the three previous market models: the foreign exchange (Forex) market, the money market, and the goods and services market. In a sense, there is really very little new information presented here. Instead, the chapter provides a graphical approach to integrate the results from the three models and to show their interconnectedness. However, because so much is going on simultaneously, working with the AA-DD model can be quite challenging.
The AA-DD model is described with a diagram consisting of two curves (or lines): an AA curve representing asset market equilibriums derived from the money market and foreign exchange markets and a DD curve representing goods market (or demand) equilibriums. The intersection of the two curves identifies a market equilibrium in which each of the three markets is simultaneously in equilibrium. Thus we refer to this equilibrium as a superequilibrium.
Results
The main results of this section are descriptive and purely mechanical. The chapter describes the derivation of the AA and DD curves, explains how changes in exogenous variables will cause shifts in the curves, and explains adjustment from one equilibrium to another.
1. The DD curve is the set of exchange rate and GNP combinations that maintain equilibrium in the goods and services market, given fixed values for all other exogenous variables.
2. The DD curve shifts rightward whenever government demand (\(G\)), investment demand (\(I\)), transfer payments (\(TR\)), or foreign prices (\(P_{£}\)) increase or when taxes (\(T\)) or domestic prices (\(P_{\$}\)) decrease. Changes in the opposite direction cause a leftward shift.
3. The AA curve is the set of exchange rate and GNP combinations that maintain equilibrium in the asset markets, given fixed values for all other exogenous variables.
4. The AA curve shifts upward whenever money supply (\(M^{S}\)), foreign interest rates (\(i_{£}\)), or the expected exchange rate (\(E_{\$/£}^{e}\)) increase or when domestic prices (\(P_{\$}\)) decrease. Changes in the opposite direction cause a downward shift.
5. The intersection of the AA and DD curves depicts a superequilibrium in an economy since at that point the goods and services market, the domestic money market, and the foreign exchange market are all in equilibrium simultaneously.
6. Changes in any exogenous variable that is not plotted on the axes (anything but \(Y\) and \(E_{\$/£}\)) will cause a shift of the AA or DD curves and move the economy out of equilibrium, temporarily. Adjustment to a new equilibrium follows the principle that adjustment in the asset markets occurs much more rapidly than adjustment in the goods and services market. Thus adjustment to the AA curve will always occur before adjustment to the DD curve.
Connections
The AA-DD model will allow us to understand how changes in macroeconomic policy—both monetary and fiscal—can affect key aggregate economic variables when a country is open to international trade and financial flows while accounting for the interaction of the variables among themselves. Specifically, the model is used to identify potential effects of fiscal and monetary policy on exchange rates, trade balances, GDP levels, interest rates, and price levels both domestically and abroad. In subsequent chapters, analyses will be done under both floating and fixed exchange rate regimes.
Key Takeaways
• The AA-DD model integrates the workings of the money-Forex market and the G&S model into one supermodel.
• The AA curve is derived from the money-Forex model. The DD curve is derived from the G&S model.
• The intersection of the AA and DD curves determines the equilibrium values for real GNP and the exchange rate.
• Comparative statics exercises using the AA-DD model allow one to identify the effects of changes in exogenous variables on the level of GDP and the exchange rate, while assuring that the Forex, the money market, and the G&S market all achieve simultaneous equilibrium.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• At the intersection of the AA and DD curves, the goods and services market, the money market, and this market are simultaneously in equilibrium.
• The term used to describe the type of equilibrium at the intersection of the AA curve and the DD curve. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.01%3A_Overview_of_the_AA-DD_Model.txt |
Learning Objective
1. Learn how to derive the DD curve from the G&S model.
The DD curve is derived by transferring information described in the goods and services (G&S) market model onto a new diagram to show the relationship between the exchange rate and equilibrium gross national product (GNP). The original G&S market, depicted in the top part of Figure 9.2.1 , plots the aggregate demand (\(AD\)) function with respect to changes in U.S. GNP (\(Y_{\$}\)). Aggregate demand is measured along the vertical axis and aggregate supply (or the GNP) is measured on the horizontal axis. As discussed in Figure 9.2.1 as \(AD(E_{\$/£}, …)\), where the ellipsis (…) is meant to indicate there are other unspecified variables that also influence \(AD\).
Exogenous Variables \(E_{\$/£}\), \(I\), \(G\),\(T\), \(TR\), \(P_{\$}\),\(P_{£}\)
Endogenous Variable \(Y_{\$}\)
Table \(1\): G&S Market
Initially, let’s assume the exchange rate is at a value in the market given by \(E_{\$/*}^{1}\). We need to remember that all the other variables that affect AD are also at some initial level. Written explicitly, we could write AD as \(AD(E_{\$/£}^{1}, I^{1}, G^{1}, T^{1}, TR^{1}, P_{\$}^{1}, P_{£}^{1})\). The AD function with exchange rate \(E_{\$/£}^{1}\) intersects the forty-five-degree line at point G which determines the equilibrium level of GNP given by \(Y_{\$}^{1}\). These two values are transferred to the lower diagram at point G determining one point on the DD curve (\(Y_{\$}^{1}\), \(E_{\$/£}^{1}\)).
Next, suppose \(E_{\$/£}\) rises from \(E_{\$/£}^{1}\) to \(E_{\$/£}^{2}\), ceteris paribus. This corresponds to a depreciation of the U.S. dollar with respect to the British pound. The ceteris paribus assumption means that investment, government, taxes, and so on stay fixed at levels \(I^{1}\), \(G^{1}\), \(T^{1}\), and so on. Since a dollar depreciation makes foreign G&S relatively more expensive and domestic goods relatively cheaper, AD shifts up to \(AD(E_{\$/£}^{2}, …)\). The equilibrium shifts to point \(H\) at a GNP level \(Y_{\$}^{2}\). These two values are transferred to the lower diagram at point \(H\), determining a second point on the DD curve (\(Y_{\$}^{2}\), \(E_{\$/£}^{2}\)).
The line drawn through points \(G\) and \(H\) on the lower diagram is called the DD curve. The DD curve plots an equilibrium GNP level for every possible exchange rate that may prevail, ceteris paribus. Stated differently, the DD curve is the combination of exchange rates and GNP levels that maintain equilibrium in the G&S market, ceteris paribus. We can think of it as the set of aggregate demand equilibriums.
A Note about Equilibriums
An equilibrium in an economic model typically corresponds to a point toward which the endogenous variable values will converge based on some behavioral assumption about the participants in the model. In this case, equilibrium is not represented by a single point. Instead every point along the DD curve is an equilibrium value.
If the economy were at a point above the DD curve, say, at I in the lower diagram, the exchange rate would be \(E_{\$/£}^{2}\) and the GNP level at \(Y_{\$}^{1}\). This corresponds to point \(I\) in the upper diagram where \(AD > Y\), read off the vertical axis. In the G&S model, whenever aggregate demand exceeds aggregate supply, producers respond by increasing supply, causing GNP to rise. This continues until \(AD = Y\) at point \(H\). For all points to the left of the DD curve, \(AD > Y\), therefore the behavior of producers would cause a shift to the right from any point like \(I\) to a point like \(H\) on the DD curve.
Similarly, at a point such as \(J\), to the right of the DD curve, the exchange rate is \(E_{\$/£}^{1}\) and the GNP level is at \(Y_{\$}^{2}\). This corresponds to point \(J\) in the upper diagram above where aggregate demand is less than supply (\(AD < Y\)). In the G&S model, whenever supply exceeds demand, producers respond by reducing supply, thus GNP falls. This continues until \(AD = Y\) at point \(G\). For all points to the right of the DD curve, \(AD < Y\), therefore the behavior of producers would cause a shift to the left from any point like \(J\) to a point like \(G\) on the DD curve.
A useful analogy is to think of the DD curve as a river flowing through a valley. (See the 3-D diagram in Figure 9.2.2 .) The hills rise up to the right and left along the upward-sloping DD curve. Just as gravity will move a drop of water downhill onto the river valley, firm behavior will move GNP much in the same way: right or left to the lowest point along the DD curve.
Key Takeaways
• The DD curve plots an equilibrium GNP level for every possible exchange rate that may prevail, ceteris paribus.
• Every point on a DD curve represents an equilibrium value in the G&S market.
• The DD curve is positively sloped because an increase in the exchange rate (meaning a decrease in the U.S. dollar value) raises equilibrium GNP in the G&S model.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This is what has happened to its currency value if an economy’s exchange rate and GNP combination moves upward along an upward-sloping DD curve.
• Of greater than, less than, or equal to, this is how aggregate demand compares to GNP when the economy has an exchange rate and GNP combination that places it to the left of the DD curve.
• Of greater than, less than, or equal to, this is how aggregate demand compares to GNP when the economy has an exchange rate and GNP combination that places it on the DD curve.
• The equilibriums along a DD curve satisfy this condition. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.02%3A_Derivation_of_the_DD_Curve.txt |
Learning objective
1. Learn which exogenous variables will shift the DD curve and in which direction.
The DD curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the goods and services (G&S) market model. The exogenous variable assumed to change is the exchange rate. The endogenous variable affected is the gross national product (GNP). At all points along the DD curve, it is assumed that all other exogenous variables remain fixed at their original values.
The DD curve will shift, however, if there is a change in any of the other exogenous variables. We illustrate how this works in Figure 9.3.1 . Here, we assume that the level of investment demand in the economy falls from its initial level \(I_{1}\) to a lower level \(I_{2}\).
At the initial investment level (\(I_{1}\)) and initial exchange rate (\(E_{\$/£}^{1}\)) the AD curve is given by \(AD(…, E_{\$/£}^{1}, I{1}, …)\). The AD curve intersects the forty-five-degree line at point \(G\), which is transferred to point \(G\) on the DD curve below. If the investment level and all other exogenous variables remain fixed while the exchange rate increases to \(E_{\$/£}^{2}\), then the AD curve shifts up to \(AD(…, E_{\$/£}^{2}, I{1}, …)\), generating the equilibrium points \(H\) in both diagrams. This exercise plots out the initial DD curve labeled \(DD|_{I_{1}}\) in the lower diagram connecting points \(G\) and \(H\). \(DD|_{I_{1}}\) is read as “the DD curve given that \(I = I_{1}\).”
Now, suppose \(I\) falls to \(I_{2}\). The reduction in \(I\) leads to a reduction in AD, ceteris paribus. At the exchange rate \(E_{\$/£}^{1}\), the AD curve will shift down to \(AD(…, E_{\$/£}^{1}, I_{2}, …)\), intersecting the forty-five-degree line at point \(K\). Point \(K\) above, which corresponds to the combination (\(E_{\$/£}^{1}, I_{2}\)), is transferred to point \(K\) on the lower diagram. This point lies on a new DD curve because a second exogenous variable, namely \(I\), has changed. If we maintain the investment level at \(I_{2}\) and change the exchange rate up to \(E_{\$/£}^{2}\), the equilibrium will shift to point \(L\) (shown only on the lower diagram), plotting out a whole new DD curve. This DD curve is labeled \(D’D’|_{I_{2}}\), which means “the DD curve given is \(I = I_{2}\).”
The effect of a decrease in investment demand is to lower aggregate demand and shift the DD curve to the left. Indeed, a change in any exogenous variable that reduces aggregate demand, except the exchange rate, will cause the DD curve to shift to the left. Likewise, any change in an exogenous variable that causes an increase in aggregate demand will cause the DD curve to shift right. An exchange rate change will not shift DD because its effect is accounted for by the DD curve itself. Note that curves or lines can shift only when a variable that is not plotted on the axis changes.
The following table presents a list of all variables that can shift the DD curve right and left. The up arrow indicates an increase in the variable, and the down arrow indicates a decrease.
DD right-shifters GITTRP\$P£
DD left-shifters GITTRP\$P£
Refer to Chapter 8 for a complete description of how and why each variable affects aggregate demand. For easy reference, recall that \(G\) is government demand, \(I\) is investment demand, \(T\) refers to tax revenues, \(TR\) is government transfer payments, \(P_{\$}\) is the U.S. price level, and \(P_{£}\) is the foreign British price level.
Key Takeaways
• The effect of an increase in investment demand (an increase in government demand, a decrease in taxes, an increase in transfer payments, a decrease in U.S. prices, or an increase in foreign prices) is to raise aggregate demand and shift the DD curve to the right.
• The effect of a decrease in investment demand (a decrease in government demand, an increase in taxes, a decrease in transfer payments, an increase in U.S. prices, or a decrease in foreign prices) is to lower aggregate demand and shift the DD curve to the left.
exercise
1. Identify whether the DD curve shifts in response to each of the following changes. Indicate whether the curve shifts up, down, left, or right. Possible answers are DD right, DD left, or neither.
• Decrease in government transfer payments.
• Decrease in the foreign price level.
• Increase in foreign interest rates.
• Decrease in the expected exchange rate \(E_{\$/£}^{e}\).
• Decrease in U.S. GNP.
• Decrease in the U.S. money supply. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.03%3A_Shifting_the_DD_Curve.txt |
learning goals
1. Learn how to derive the AA curve from the money-Forex model.
The AA curve is derived by transferring information described in the money market and foreign exchange market models onto a new diagram to show the relationship between the exchange rate and equilibrium GNP. (At this point we will substitute GNP for its virtually equivalent measure, GDP, as a determinant of real money demand.) Since both models describe supply and demand for money, which is an asset, I’ll refer to the two markets together as the asset market. The foreign exchange market, depicted in the top part of Figure 9.4.1 , plots the rates of return on domestic U.S. assets (\(R_{0}R_{\$}\)) and foreign British assets (\(R_{0}R_{£}\)). (See Chapter 5, Section 5.3 for a complete description.) The domestic U.S. money market, in the lower quadrant, plots the real U.S. money supply (\(M_{\$}^{S}/P_{\$}\)) and real money demand (\(L(i_{\$}, Y_{\$})\)). The asset market equilibriums have several exogenous variables that determine the positions of the curves and the outcome of the model. These exogenous variables are the foreign British interest rate (\(i_{£}\)) and the expected future exchange rate (\(E_{\$/£}^{e}\)), which influence the foreign British rate of return (\(R_{0}R_{£}\)); the U.S. money supply (\(M_{\$}^{S}\)) and domestic U.S. price level (\(P_{\$}\)), which influence real money supply; and U.S. GNP (\(Y_{\$}\)), which influences real money demand. The endogenous variables in the asset model are the domestic interest rates (\(i_{\$}\)) and the exchange rate (\(E_{\$/£}\)). See Table 9.2 for easy reference.
Exogenous Variables \(i_{£}, E_{\$/£}^{e}, M_{\$}^{S}, P_{\$}, Y_{\$}\)
Endogenous Variables \(i_{\$}, E_{\$/£}\)
Figure \(2\): Table 9.2 Asset Market (Money + Forex)
Initially, let’s assume GNP is at a value in the market given by \(Y_{\$}^{1}\). We need to remember that all the other exogenous variables that affect the asset market are also at some initial level such as \(i_{£}^{1}\), \(E_{\$/£}^{e1}\), \(M_{\$}^{S1}\), and \(P_{\$}^{1}\). The real money demand function with GNP level \(Y_{\$}^{1}\) intersects with real money supply at point \(G_{1}\) in the money market diagram determining the interest rate \(i_{\$}^{1}\). The interest rate in turn determines \(R_{0}R_{\$}^{1}\), which intersects with \(R_{0}R_{£}\) at point \(G_{2}\), determining the equilibrium exchange rate \(E_{\$/£}^{1}\). These two values are transferred to the lowest diagram at point \(G\), establishing one point on the AA curve (\(Y_{\$}^{1}, E_{\$/£}^{1}\)).
Next, suppose GNP rises, for some unstated reason, from \(Y_{\$}^{1}\) to \(Y_{\$}\), ceteris paribus. The ceteris paribus assumption means that all exogenous variables in the model remain fixed. Since the increase in GNP raises real money demand, \(L(i_{\$}, Y_{\$})\), it shifts out to \(L(i_{\$}, Y_{\$}^{2})\). The equilibrium shifts to point H1, raising the equilibrium interest rate to \(i_{\$}^{2}\). The \(R_{0}R_{\$}\) line shifts right with the interest rate, determining a new equilibrium in the Forex at point \(H_{2}\) with equilibrium exchange rate \(E_{\$/£}^{2}\). These two values are then transferred to the diagram below at point \(H\), establishing a second point on the AA curve (\(Y_{\$}^{2}, E_{\$/£}^{2}\)).
The line drawn through points G and H on the lower diagram in Figure 9.4 is called the AA curve. The AA curve plots an equilibrium exchange rate for every possible GNP level that may prevail, ceteris paribus. Stated differently, the AA curve is the combination of exchange rates and GNP levels that maintain equilibrium in the asset market, ceteris paribus. We can think of it as the set of aggregate asset equilibriums.
A Note about Equilibriums
If the economy were at a point off the AA curve, like at I in the lower diagram, the GNP level is at \(Y_{\$}^{1}\) and the exchange rate is \(E_{\$/£}^{2}\). This corresponds to point I in the upper diagram where \(R_{0}R_{£} \ > R_{0}R_{\$}\). In the Forex model, when foreign assets have a higher rate of return than domestic assets, investors respond by buying pounds in exchange for dollars in the foreign exchange market. This leads to a depreciation of the dollar and an increase in \(E_{\$/£}\). This continues until \(R_{0}R_{£} \ = R_{0}R_{\$}\) at point G. For all points below the AA curve, \(R_{0}R_{£} \ > R_{0}R_{\$}\); therefore, the behavior of investors would cause an upward adjustment toward the AA curve from any point like I to a point like G.
Similarly, at a point such as J, above the DD curve, the GNP level is at \(Y_{2}\) and the exchange rate is \(E_{\$/£}^{1}\). This corresponds to point J in the upper diagram where \(R_{0}R_{\$} \ > R_{0}R_{£}\) and the rate of return on dollar assets is greater than the rate of return abroad. In the Forex model, when U.S. assets have a higher rate of return than foreign assets, investors respond by buying dollars in exchange for pounds in the foreign exchange market. This leads to an appreciation of the dollar and a decrease in \(E_{\$/£}\). This continues until \(R_{0}R_{£} \ = R_{0}R_{\$}\) at point H. For all points above the AA curve, \(R_{0}R_{\$} \ > R_{0}R_{£}\); therefore, the behavior of investors would cause a downward adjustment to the AA curve from a point like J to a point like H.
As with the DD curve, it is useful to think of the AA curve as a river flowing through a valley. (See the 3-D diagram in Figure 9.4.3 .) The hills rise up both above and below. Just as gravity will move a drop of water down the hill to the river valley, in much the same way, investor behavior will move the exchange rate up or down to the lowest point lying on the AA curve.
Key Takeaways
• The AA curve plots an equilibrium exchange rate level for every possible GNP value that may prevail, ceteris paribus.
• Every point on an AA curve represents an equilibrium value in the money-Forex market.
• The AA curve is negatively sloped because an increase in the real GNP lowers the equilibrium exchange rate in the money-Forex model.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This is what has happened to its GNP if an economy’s exchange rate and GNP combination move downward along a downward-sloping AA curve.
• Of greater than, less than, or equal to, this is how the rate of return on domestic assets compares to the rate of return on foreign assets when the economy has an exchange rate and GNP combination that places it above the AA curve.
• Of greater than, less than, or equal to, this is how the rate of return on domestic assets compares to the rate of return on foreign assets when the economy has an exchange rate and GNP combination that places it on the AA curve.
• The equilibriums along an AA curve satisfy this condition. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.04%3A_Derivation_of_the_AA_Curve.txt |
Learning Objective
1. Learn which exogenous variables will shift the AA curve and in which direction.
The AA curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the asset market model. The exogenous variable changed is gross national product (GNP). The endogenous variable affected is the exchange rate. At all points along the AA curve, it is assumed that all other exogenous variables remain fixed at their original values.
The AA curve will shift if there is a change in any of the other exogenous variables. We illustrate how this works in Figure 9.5.1 , where we assume that the money supply in the economy falls from its initial level \(M^{S1}\) to a lower level \(M^{S2}\).
At the initial money supply (\(M^{S1}\)) and initial GNP level \(Y_{\$}^{1}\), real money demand intersects real money supply at point G, determining the interest rate\(i_{\$}^{1}\) . This in turn determines the rate of return on U.S. assets, \(R_{0}R_{\$}^{1}\), which intersects the foreign British \(R_{0}R_{£}\) at G in the upper diagram, determining the equilibrium exchange rate \(E_{\$/£}^{1}\). If the money supply and all other exogenous variables remain fixed, while GNP increases to \(Y_{\$}^{2}\), the equilibriums shift to points H in the lower and upper diagrams, determining exchange rate \(E_{\$/£}^{2}\). This exercise plots out the initial AA curve labeled AA|MS1 in the lower diagram connecting points G and H. Note, \(AA|_{MS1}\) is read as “the AA curve given that \(M^{S} = M^{S1}\).”
Now, suppose the money supply \(M^{S}\) falls to \(M^{S2}\). The reduction in \(M^{S}\) leads to a reduction in the real money supply, which, at GNP level \(Y_{\$}^{1}\), shifts the money market equilibrium to point I, determining a new interest rate, \(i_{\$}^{3}\). In the Forex market, the rate of return rises to \(R_{0}R_{\$}^{3}\), which determines the equilibrium exchange rate \(E_{\$/£}^{3}\). The equilibriums at points I corresponding to the combination (\(Y_{\$}^{1}, E_{\$/£}^{3}\)) are transferred to point I on the lower diagram. This point lies on a new AA curve because a second exogenous variable, namely, \(M^{S}\), has changed. If we maintain the money supply at \(M^{S2}\) and change the GNP up to \(Y_{\$}^{2}\), the equilibrium will shift to point J (shown only on the lower diagram), plotting out a whole new AA curve. This AA curve is labeled \(A'A'|_{MS2}\), which means “the AA curve given that \(M^{S} = M^{S2}\).”
The effect of a decrease in the money supply is to shift the AA curve downward. Indeed, a change in any exogenous variable in the asset markets that reduces the equilibrium exchange rate, except a change in GNP, will cause the AA curve to shift down. Likewise, any change in an exogenous variable that causes an increase in the exchange rate will cause the AA curve to shift up. A change in GNP will not shift AA because its effect is accounted for by the AA curve itself. Note that curves or lines can shift only when a variable not plotted on the axis changes.
The following table presents a list of all variables that can shift the AA curve up and down. The up arrow indicates an increase in the variable, and a down arrow indicates a decrease.
AA up-shifters \(↑M^{S} ↓P_{\$} ↑i_{£} ↑E_{\$/£}^{e}\)
AA down-shifters \(↓M_{S} ↑P_{\$} ↓i_{£} ↓E_{\$/£}^{e}\)
Refer to Chapter 5 and Chapter 7 for a complete description of how and why each variable affects the exchange rate. For easy reference though, recall that \(M^{S}\) is the U.S. money supply, \(P_{\$}\) is the U.S. price level, \(i_{£}\) is the foreign British interest rate, and \(E_{\$/£}^{e}\) is the expected future exchange rate.
Key Takeaways
• The effect of an increase in the money supply (or a decrease in the price level, an increase in foreign interest rates, or an increase in the expected exchange rate [as defined]) is to shift the AA curve upward.
• The effect of a decrease in the money supply (or an increase in the price level, a decrease in foreign interest rates, or a decrease in the expected exchange rate [as defined]) is to shift the AA curve downward.
exercise
1. Identify whether the AA curve shifts in response to each of the following changes. Indicate whether the curve shifts up, down, left, or right. Possible answers are AA right, AA left, or neither.
1. Decrease in government transfer payments.
2. Decrease in the foreign price level.
3. Increase in foreign interest rates.
4. Decrease in the expected exchange rate \(E_{\$/£}^{e}\).
5. Decrease in U.S. GNP.
6. Decrease in the U.S. money supply. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.05%3A_Shifting_the_AA_Curve.txt |
Learning Objective
1. Apply the AA curve and the DD curve to define a superequilibrium.
The DD curve represents the set of equilibriums in the goods and services (G&S) market. It describes an equilibrium gross national product (GNP) level for each and every exchange rate that may prevail. Due to the assumption that firms respond to excess demand by increasing supply (and to excess supply by decreasing supply), GNP rises or falls until the economy is in equilibrium on the DD curve.
The AA curve represents the set of equilibriums in the asset market. It indicates an equilibrium exchange rate for each and every GNP level that might prevail. Due to the assumption that investors will demand foreign currency when the foreign rate of return exceeds the domestic return and that they will supply foreign currency when the domestic rate of return exceeds the foreign return, the exchange rate will rise or fall until the economy is in equilibrium on the AA curve.
Since both the G&S market and the asset markets are operating concurrently, equilibriums in both markets can only occur where the DD curve intersects the AA curve. This is shown in Figure 9.6.1 at point F, with equilibrium GNP (_\$) and exchange rate (\(Ê_{\$/£}\)). It is worth emphasizing that at point F, the three markets—that is, the G&S market, the money market, and the foreign exchange market—are in equilibrium simultaneously. For this reason, point F is more than a plain old equilibrium; instead it is a superequilibrium.
The superequilibrium point is where we would expect behavioral responses by firms, households, and investors to move the exchange rate and GNP level, assuming the exogenous variables remain fixed at their original levels and assuming sufficient time is allowed for adjustment to the equilibrium to take place.
The equilibrium at F is like the lowest point of two intersecting valleys that reach their combined lowest point at a pool where the two valleys meet. A 3-D rendition of this is shown in Figure 9.6.2 . The steepness of the valleys is meant to represent the speed of adjustment. Thus the AA valley is drawn much steeper than the DD valley to reflect the much more rapid adjustment in the asset markets in comparison to goods market adjustment. Anytime the economy is away from the equilibrium, forces will act to move it to the pool in the center. However, as will be shown later, adjustment to the AA curve will occur much faster than adjustment to the DD curve.
Key takeaways
• A superequilibrium describes the GNP level and exchange rate value at the intersection of the AA and DD curves. It represents the values that provide for equilibriums in the money market, the Forex market, and the G&S market simultaneously.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This market is in equilibrium when an economy is on an AA curve.
• This market is in equilibrium when an economy is on a DD curve.
• The term used to describe the equilibrium at the intersection of a DD curve and an AA curve. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.06%3A_Superequilibrium-_Combining_DD_and_AA.txt |
Learning Objective
1. Learn how to describe the complete adjustment to equilibrium in the AA-DD model.
In order to discuss adjustment to the superequilibrium, we must first talk about how an economy can end up out of equilibrium. This will occur anytime there is a change in one or more of the exogenous variables that cause the AA or DD curves to shift. In a real economy, we should expect these variables to be changing frequently. Variables such as interest rates will certainly change every day. A variable such as the average expected future exchange rate held by investors probably changes every minute. Each time an exogenous variable changes, the superequilibrium point will shift, setting off behavioral responses by households, businesses, and investors that will affect the exchange rate and gross national product (GNP) in the direction of the new superequilibrium. However, as we will indicate below, the adjustment process will take time, perhaps several months or more, depending on the size of the change. Since we should expect that as adjustment to one variable change is in process, other exogenous variables will also change, we must recognize that the superequilibrium is really like a moving target. Each day, maybe each hour, the target moves, resulting in a continual adjustment process.
Although an equilibrium may never be reached in the real-world economy, the model remains very useful in understanding how changes in some variables will affect the behavior of agents and influence other variables. The model in essence offers us the opportunity to conduct experiments in simplified settings. Changing one exogenous variable and inferring its effect is a comparative statics experiment because of the ceteris paribus assumption. Ceteris paribus allows us to isolate one change and work through its impact with certainty that nothing else could influence the result.
Below, we’ll consider adjustment to two changes: a reduction in investment demand, which shifts the DD curve, and an increase in foreign interest rates, which shifts the AA curve.
Reduction in Investment
Consider adjustment to a decrease in investment demand. Begin with an original superequilibrium, where DD crosses AA at point F with GNP at \(Y_{\$}^{1}\) and exchange rate at \(E_{\$/£}^{1}\). When investment decreases, ceteris paribus, the DD curve shifts to the left, as was shown in Figure 9.7.1 as a shift from DD to \(D'D'\).
The quick result is that the equilibrium shifts to point G, GNP falls to \(Y_{\$}^{3}\), and the exchange rate rises to \(E_{\$/£}^{1}\). The increase in the exchange rate represents a depreciation of the U.S. dollar value. However, this result does not explain the adjustment process, so let’s take a more careful look at how the economy gets from point F to G.
Step 1: When investment demand falls, aggregate demand falls short of aggregate supply, leading to a buildup of inventories. Firms respond by cutting back supply, and GNP slowly begins to fall. Initially, there is no change in the exchange rate. On the graph, this is represented by a leftward shift from the initial equilibrium at point \(F(Y_{\$}^{1} to Y_{\$}^{2}\)). Adjustment to changes in aggregate demand will be gradual, perhaps taking several months or more to be fully implemented.
Step 2: As GNP falls, it causes a decrease in U.S. interest rates. With lower interest rates, the rate of return on U.S. assets falls below that in the United Kingdom and international investors shift funds abroad, leading to a dollar depreciation (pound appreciation)—that is, an increase in the exchange rate \(E_{\$/£}\). This moves the economy upward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates, so the leftward shift from point F in the diagram results in adjustment upward to regain equilibrium in the asset market on the AA curve.
Step 3: Continuing reductions in GNP caused by excess aggregate demand, results in continuing decreases in interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point G in the diagram.
During the adjustment process, there are several other noteworthy changes taking place. At the initial equilibrium, when investment demand first falls, aggregate supply exceeds demand by the difference of \(Y_{\$}^{2}-Y_{\$}^{A}\). Adjustment in the goods market will be trying to reachieve equilibrium by getting back to the DD curve. However, the economy will never get to \(Y_{\$}^{A}\). That’s because the asset market will adjust in the meantime. As GNP falls, the exchange rate is pushed up to get back onto the AA curve. Remember, that asset market adjustment takes place quickly after an interest rate change (perhaps in several hours or days), while goods market adjustment can take months. When the exchange rate rises, the dollar depreciation makes foreign goods more expensive and reduces imports. It also makes U.S. goods cheaper to foreigners and stimulates exports, both of which cause an increase in current account demand. This change in demand is represented as a movement along the new \(D'D'\) curve. Thus when the exchange rate rises up to \(E_{\$/£}^{2}\) during the adjustment process, aggregate demand will have risen from \(Y_{\$}^{A}\) to \(Y_{\$}^{B}\) along the new \(D'D'\) curve. In other words, the “target” for GNP adjustment moves closer as the exchange rate rises. In the end, the target for GNP reaches \(Y_{\$}^{3}\) just as the exchange rate rises to \(E_{\$/£}^{3}\).
Increase in Foreign Interest Rates
Consider adjustment to an increase in the foreign interest rate, \(i_{£}\). Begin with an original superequilibrium where DD crosses AA at point F with GNP at \(Y^{1}\) and exchange rate at \(E_{\$/£}^{1}\). When the foreign interest rate increases, ceteris paribus, the AA curve shifts upward, as was shown in Figure 9.7.2 as a shift from \(AA\) to \(A'A'\).
The quick result is that the equilibrium shifts to point H, GNP rises to \(Y^{3}\), and the exchange rate rises to \(E^{3}\). The increase in the exchange rate represents a depreciation of the U.S. dollar value.
The convenience of the graphical approach is that it allows us to quickly identify the final outcome using only our knowledge about the mechanics of the AA-DD diagram. However, this quick result does not explain the adjustment process, so let’s take a more careful look at how the economy gets from point F to H.
Step 1: When the foreign interest rate (\(i_{£}\)) rises, the rate of return on foreign British assets rises above the rate of return on domestic U.S. assets in the foreign exchange market. This causes an immediate increase in the demand for foreign British currency, causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (\(E_{\$/£}\)) rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve shifts up to reflect the new set of asset market equilibriums corresponding to the now-higher foreign interest rate. Since the foreign exchange market adjusts very swiftly to changes in interest rates, the economy will not remain off the new A′A′ curve for very long.
Step 2: Now that the exchange rate has risen to \(E_{\$/£}^{2}\), the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and thereby aggregate demand. Note that the new equilibrium demand at exchange rate is temporarily at GNP level \(Y^{4}\), which is on the DD curve given the exchange rate \(E_{\$/£}^{2}\). Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G (small arrow).
Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom and international investors shift funds back to the United States, leading to a dollar appreciation (pound depreciation), or the decrease in the exchange rate (\(E_{\$/£}\)). This moves the economy downward, back to the A′A′ curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A′A′ curve, as shown.
Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.
During the adjustment process, there are several other noteworthy changes taking place. At point G, aggregate demand exceeds supply by the difference \(Y^{4}-Y^{1}\). Adjustment in the goods market will be trying to reachieve equilibrium by getting back to the DD curve. However, the economy will never get to \(Y_{4}\). That’s because the asset market will adjust during the transition. As GNP rises, the exchange rate is gradually pushed down to get back onto the A′A′ curve. When the exchange rate falls, the dollar appreciation makes foreign goods cheaper, raising imports. It also makes U.S. goods more expensive to foreigners, reducing exports—both of which cause a decrease in current account demand. This change in demand is represented as a movement along the DD curve. Thus when the exchange rate falls during the adjustment process, aggregate demand falls from \(Y_{4}\) along the DD curve. In other words, the “target” for GNP adjustment moves closer as the exchange rate falls. In the end, the target for GNP reaches \(Y_{3}\) just as the exchange rate falls to \(E_{\$/£}^{3}\).
Key Takeaways
• Adjustment in the asset market occurs quickly, whereas adjustment in the G&S market occurs much more slowly.
• In the AA-DD model, a decrease in investment demand ultimately reduces GNP and raises the exchange rate, which, as defined, means a depreciation of the dollar.
• In the AA-DD model, an increase in foreign interest rates ultimately raises GNP and raises the exchange rate, which, as defined, means a depreciation of the dollar.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, the final effect on equilibrium GNP following an increase in investment demand in the AA-DD model.
• Of increase, decrease or stay the same, the immediate effect on \(E_{\$/£}\) following an increase in investment demand in the AA-DD model.
• Of increase, decrease, or stay the same, the final effect on equilibrium GNP following a decrease in foreign interest rates in the AA-DD model.
• Of increase, decrease, or stay the same, the immediate effect on \(E_{\$/£}\) following a decrease in British interest rates in the AA-DD model.
• Of faster, slower, or the same rate, this describes the speed of adjustment to a DD curve relative to an AA curve. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.07%3A_Adjustment_to_the_Superequilibrium.txt |
Learning objective
1. Derive a graphical mechanism in the AA-DD model to represent the effects of changes in the superequilibrium on the current account balance.
In later chapters we will use the AA-DD model to describe the effects of policy changes on macroeconomic variables in an open economy. The two most important macro variables are the exchange rate and the current account (trade) balance. The effects of changes on the exchange rate are vividly portrayed in the AA-DD diagram since this variable is plotted along the vertical axis and its value is determined as an element of the equilibrium. The current account (CA) variable is not displayed in the AA-DD diagram, but with some further thought we can devise a method to identify the current account balance at different positions in the AA-DD diagram.
First, note that there is no “equilibrium” current account balance in a floating exchange rate system. Any balance on the current account is possible because any balance can correspond to balance on the balance of payments. The balance of payments is made up of two broad subaccounts: the current account and the financial account, the sum of whose balances must equal zero. When the balances sum to zero, the foreign demand for domestic goods, services, income, and assets is equal to domestic supply of goods, services, income, and assets. Thus there must always be “balance” on the balance of payments regardless of the balances on the individual subaccounts.
Iso-CAB Line
An iso-CAB line is a line drawn on an AA-DD diagram, Figure 9.8.1 , representing a set of points along which the current account balance (CAB) is the same. Note that “iso” is a prefix that means the same. In the adjoining diagram, we have superimposed three-dotted iso-CAB lines labeled \(CC\), \(C'C'\), and \(C^{"}C^{"}\). Each line represents a set of GNP and exchange rate combinations that generate the same balance on the current account. The higher the CAB line, the larger is the balance on the current account. Thus the CAB balance on \(C^{"}C^{"}\) is greater than the balance along \(CC\). Also note that each CAB line is positively sloped with a slope less than the slope of the DD curve. Next, we’ll continue with a justification for this description.
Justifying the Shape of the Iso-CAB Line
Consider the superequilibrium point at the intersection of AA and DD. The positions of these two curves are determined by the values of the exogenous variables in the model, including the domestic price level (\(P_{\$}\)), the foreign price level (\(P_{£}\)), tax revenues (\(T\)), and transfer payments (\(TR\)), among others. The intersection of the two curves determines the equilibrium GNP level (\(Y_{\$}\)) and the exchange rate (\(E_{\$/£}\)) (not labeled in diagram). Recall from Chapter 9, Section 9.2 that the DD curve is derived from the aggregate demand function, one component of which is the current account function. The current account function, as shown below, is a function of all the variables listed immediately above:
Thus at the intersection of AA and DD there are presumed known values for the exogenous variables and determined values for the endogenous variables, \(E_{\$/£}\) and \(Y_{\$}\).
All these values could, in principle, be plugged into the current account demand function (\(CA^{D}\)) to determine the CA balance at the equilibrium. Let’s assume that value is given by K, as shown in the above expression.
Now let’s consider movements in the superequilibrium to other points on the diagram. Let’s suppose that the equilibrium moved to point x directly to the right. That could arise from a rightward shift of DD and an upward shift of AA. We will also assume that this shift did not arise due to changes in \(P_{\$}\), \(P_{£}\), \(T\), or \(TR\), the other exogenous variables that affect the current account. (More on this issue below.) One possibility is an increase in the money supply and an increase in investment demand. Note that these shifts are not depicted.
At point x, GNP is higher while the exchange rate and the other exogenous variables are the same as before. Since an increase in \(Y_{\$}\) raises disposable income, which reduces current account demand, the current account balance must be at a lower level at point x compared to the initial equilibrium.
If the equilibrium had shifted to point z instead, then GNP is lower while the exchange rate and the other exogenous variables are the same as before. Since a decrease in \(Y_{\$}\) lowers disposable income, which raises current account demand, the current account balance must be at a higher level at point z compared to the initial equilibrium.
Next, suppose the equilibrium had shifted to point y instead. In this case, the exchange rate (\(E_{\$/£}\)) is lower while GNP and the other exogenous variables are the same as before. Since a decrease in \(E_{\$/£}\) reduces the real exchange rate, which reduces current account demand, the current account balance must be at a lower level at point y compared to the initial equilibrium.
Finally, suppose the equilibrium had shifted to point w. In this case, the exchange rate, \(E_{\$/£}\), is higher while GNP and the other exogenous variables are the same as before. Since an increase in \(E_{\$/£}\) raises the real exchange rate, which increases current account demand, the current account balance must be at a higher level at point y compared to the initial equilibrium.
Since a movement to w and z results in an increase in the current account balance, while a shift to x or y causes a reduction in the balance, the line representing a constant CAB must be positively sloped.
Another way to see this is to use the \(CA^{D}\) function above. Suppose the CAB is originally at the value K. If the exchange rate (\(E_{\$/£}\)) rises, ceteris paribus, then CA will rise. We can now ask how GNP would have to change to get back to a CA balance of K. Clearly, if Y rises, disposable income rises and the current account balance falls. Raise GNP by precisely the right amount, and we can get the CAB back to K. Thus an increase in \(E_{\$/£}\) must accompany an increase in GNP to maintain a fixed current account balance and therefore an iso-CAB line must be positively sloped.
The last thing we need to show is that the iso-CAB line is less steeply sloped than the DD line. Suppose the economy moved to a point such as v, which is on the same DD curve as the original superequilibrium. Recall from Chapter 9, Section 9.2, the DD curve is derived from a change in the exchange rate and its effect on equilibrium GNP in the G&S market alone. The increase in the exchange rate causes an increase in current account demand through its effect on the real exchange rate. This causes an increase in aggregate demand, which inspires the increase in GNP. When equilibrium is reached in the G&S market, at point v, aggregate supply, Y, will equal aggregate demand and the following expression must hold:
The left side is aggregate supply given by the equilibrium value at point v and the right side is aggregate demand. Since GNP is higher at v, consumption demand (\(C^{D}\)) must also be higher. However, because the marginal propensity to consume is less than one, not all the extra GNP will be spent on consumption goods; some will be saved. Nevertheless, aggregate demand (on the right side) must rise up to match the increase in supply on the left side. Since all the increase in demand cannot come from consumption, the remainder must come from the current account. This implies that a movement along the DD curve to v results in an increase in the current account balance. It also implies that the iso-CAB line must be less steeply sloped than the DD curve.
Using the Iso-CAB Line
The iso-CAB line can be used to assess the change in the country’s current account balance from any exogenous variable change except changes in \(P_{\$}\), \(P_{£}\), \(T\), and \(TR\). The reason we must exclude these variables is because the current account demand function is also dependent on these exogenous variables. If tax revenues increased, for example, all the iso-CAB lines would shift, making it much more difficult to pinpoint the final effect on the current account balance.
However, for monetary policy changes and government spending fiscal policy changes, the iso-CAB line will work. Anytime the superequilibrium shifts above the original iso-CAB line, the economy will move onto another iso-CAB line with a higher balance. (This is like the shift to point v in Figure 9.8.1 .) Recall that the \(CA = EX - IM\), which can be positive or negative. If CAB were in surplus originally, an increase in the CAB (as with a movement to v) would imply an increase in the CA surplus. However, if the CAB were in deficit originally, then an increase in CAB implies a reduction in the deficit. If the increase in the CAB were sufficiently large, the CAB could move from deficit to surplus.
In a similar way, anytime the superequilibrium shifts below an initial iso-CAB line, the CAB surplus will fall, or the CAB deficit will rise.
Remember that the iso-CAB line is only used a reference to track the current account balance. The iso-CAB line is not used to determine the superequilibrium. For this reason, the iso-CAB line is plotted as a dashed line rather than a solid line.
Key Takeaways
• An iso-CAB line is a line drawn on an AA-DD diagram, representing a set of points along which the current account balance (CAB) is the same.
• An iso-CAB line is positively sloped and with a slope that is less than the slope of the DD curve.
• The iso-CAB line can be used to assess the change in the country’s current account balance from any exogenous variable change except changes in \(P_{\$}\), \(P_{£}\), \(T\), and \(TR\).
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of greater than, less than, or equal, the current account balance for an exchange rate and GNP combination that lies above an iso-CAB line relative to a combination that lies on the line.
• Of greater than, less than, or equal, the current account surplus for an exchange rate and GNP combination that lies below an iso-CAB line relative to the surplus for a combination that lies on the line.
• Of greater than, less than, or equal, the current account deficit for an exchange rate and GNP combination that lies below an iso-CAB line relative to the deficit for a combination that lies on the line.
• Of higher, lower, or equal, the position of an iso-CAB line for a country with a current account deficit relative to an iso-CAB line when the country runs a surplus.
• Of positive, negative, or zero, this describes the slope of an iso-CAB line.
• Of steeper, flatter, or the same, this describes an iso-CAB line relative to a DD curve. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/09%3A_The_AA-DD_Model/9.08%3A_AA-DD_and_the_Current_Account_Balance.txt |
The effects of government policies on key macroeconomic variables are an important issue in international finance. The AA-DD model constructed in Chapter 9 is used in this chapter to analyze the effects of fiscal and monetary policy under a regime of floating exchange rates. The results are more comprehensive than the previous analyses of the same policies because they take into account all the between-market effects across the money market, the foreign exchange (Forex) market, and the goods and services (G&S) market.
10: Policy Effects with Floating Exchange Rates
Learning Objective
1. Preview the comparative statics results from the AA-DD model with floating exchange rates.
This chapter uses the AA-DD model to describe the effects of fiscal and monetary policy under a system of floating exchange rates. Fiscal and monetary policies are the primary tools governments use to guide the macroeconomy. In introductory macroeconomics courses, students learn how fiscal and monetary policy levers can be used to influence the level of gross national product (GNP), the inflation rate, the unemployment rate, and interest rates. In this chapter, that analysis is expanded to an open economy (i.e., one open to trade) and to the effects on exchange rates and current account balances.
Results
Using the AA-DD model, several important relationships between key economic variables are shown:
• Expansionary monetary policy (\(↑M^{S}\)) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short run.
• Contractionary monetary policy (\(↓M^{S}\)) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run.
• Expansionary fiscal policy (\(↑G\), \(↑TR\), or \(↓T\)) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policy (\(↓G\), \(↓TR\), or \(↑T\)) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.
• In the long run, once inflation effects are included, expansionary monetary policy (\(↑M^{S}\)) in a full employment economy causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls.
• A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response.
• A central bank can influence the exchange rate with direct Forex interventions (buying or selling domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.
• A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and their effect on interest rates.
• Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.
Connections
The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In Chapter 12, we’ll revisit these same government policies in the context of a fixed exchange rate system.
It is important to recognize that these results are what “would” happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Despite this problem, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements not described in the model may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.
Key Takeaways
• The main objective of the AA-DD model is to assess the effects of monetary and fiscal policy changes.
• It is important to recognize that these results are what “would” happen under the full set of assumptions that describes the AA-DD model; they may or may not accurately describe actual outcomes in actual economies.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the short run if government spending decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the short run if government spending decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the foreign currency value (vis-à-vis the domestic) in the short run if domestic government spending decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the short run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the short run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/10%3A_Policy_Effects_with_Floating_Exchange_Rates/10.01%3A_Overview_of_Policy_with_Floating_Exchange_Rates.txt |
Learning Objectives
1. Learn how changes in monetary policy affect GNP, the value of the exchange rate, and the current account balance in a floating exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the foreign exchange market, and the G&S market.
In this section, we use the AA-DD model to assess the effects of monetary policy in a floating exchange rate system. Recall from Chapter 7 that the money supply is effectively controlled by a country’s central bank. In the case of the United States, this is the Federal Reserve Board, or the Fed for short. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in Chapter 7, Section 7.5.
Expansionary Monetary Policy
Suppose the economy is originally at a superequilibrium shown as point F in Figure 10.2.1 . The original GNP level is \(Y^{1}\) and the exchange rate is \(E_{\$/£}^{1}\). Next, suppose the U.S. central bank (or the Fed) decides to expand the money supply. As shown in Chapter 9, Section 9.5, money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., \(↑M^{S}\) is an AA up-shifter). This is depicted in the diagram as a shift from the red AA to the blue AA′ line.
There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness. First the quick result, then the quick result with the transition process described, and finally the complete adjustment story.
Quick Result
The increase in AA causes a shift in the superequilibrium point from F to H. In adjusting to the new equilibrium at H, GNP rises from \(Y^{1}\) to \(Y^{2}\) and the exchange rate increases from \(E_{\$/£}^{1}\) to \(E_{\$/£}^{2}\). The increase in the exchange rate represents an increase in the British pound value and a decrease in the U.S. dollar value. In other words, it is an appreciation of the pound and a depreciation of the dollar. Since the final equilibrium point H is above the initial iso-CAB line \(CC\), the current account balance increases. (See Chapter 9, Section 9.8 for a description of \(CC\).) If the CAB were in surplus at F, then the surplus increases; if the CAB were in deficit, then the deficit falls. Thus U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.
Transition Description
Consider the upward shift of the AA curve due to the increase in the money supply. Since exchange rates adjust much more rapidly than GNP, the economy will initially adjust back to the new A′A′ curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from \(E_{\$/£}^{1}\) to \(E_{\$/£}^{1'}\), representing a depreciation of the U.S. dollar.
Now at point G, the economy lies to the left of the DD curve. Thus GNP will begin to rise to get back to goods and services (G&S) market equilibrium on the DD curve. However, as GNP rises, the economy moves to the right above the A′A′ curve, which forces a downward readjustment of the exchange rate to get back to A′A′. In the end, the economy will adjust in a stepwise fashion from point G to point H, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the A′A′ curve. This process will continue until the economy reaches the superequilibrium at point H.
Notice that in the transition the exchange rate first rises to \(E_{\$/£}^{1'}\). Above the rate it will ultimately reach \(E_{\$/£}^{2}\) before settling back to superequilibrium value. This is an example of exchange rate overshooting. In the transition, the exchange rate overshoots its ultimate long-run value.
Exchange rate overshooting is used as one explanation for the volatility of exchange rates in floating markets. If many small changes occur frequently in an economy, the economy may always be in transition moving to a superequilibrium. Because of the more rapid adjustment of exchange rates, it is possible that many episodes of overshooting—both upward and downward—can occur in a relatively short period.
Complete Adjustment Story
Step 1: When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average U.S. interest rates, which in turn will result in a lower U.S. rate of return in the Forex market. Since \(R_{0}R_{\$} < R_{0}R_{£}\) now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (\(E_{\$/£}\)) rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher U.S. money supply. Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new A′A′ curve for very long.
Step 2: Now that the exchange rate has risen to \(E_{\$/£}^{1'}\), the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G.
Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate (\(E_{\$/£}\)). This moves the economy downward, back to the A′A′ curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A′A′ curve, as shown in the figure.
Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.
Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 9, Section 9.8, the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.
Contractionary Monetary Policy
Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, \(E_{\$/£}\), implying an appreciation of the U.S. dollar and a decrease in the current account balance.
Key Takeaways
• The U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.
• Contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate (\(E_{\$/£}\)), implying an appreciation of the U.S. dollar and a decrease in the current account balance.
exercise
1. Use the AA-DD model (not necessarily the diagram) to explain the sequential short-run adjustment process of an increase in the money supply on the following economic variables under floating exchange rates. (In other words, first answer how the money supply increase immediately affects the interest rate. Next, answer how the previous economic variable—i.e., the interest rate—affects the nominal exchange rate. Continue this process through investment.)
• The interest rate
• The nominal exchange rate
• The real exchange rate
• The current account balance
• GNP
• Disposable income
• Consumption
• Saving
• Investment
2. Repeat the exercise above assuming a decrease in the money supply.
3. Suppose a country with floating exchange rates has a current account deficit that its government considers too large. Use an AA-DD diagram to show how monetary policy could be used to reduce the current account deficit. Does this action help or hinder its goal of maintaining low unemployment? Explain. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/10%3A_Policy_Effects_with_Floating_Exchange_Rates/10.02%3A_Monetary_Policy_with_Floating_Exchange_Rates.txt |
Learning Objectives
1. Learn how changes in fiscal policy affect GNP, the value of the exchange rate, and the current account balance in a floating exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
In this section, we use the AA-DD model to assess the effects of fiscal policy in a floating exchange rate system. Recall that fiscal policy refers to any change in expenditures or revenues within any branch of the government. This means any change in government spending—transfer payments, or taxes, by either federal, state, or local governments—represents a fiscal policy change. Since changes in expenditures or revenues will often affect a government budget balance, we can also say that a change in the government surplus or deficit represents a change in fiscal policy.
When government spending or transfer payments increase, or tax revenues decrease, we refer to it as expansionary fiscal policy. These actions would also be associated with an increase in the government budget deficit or a decrease in its budget surplus. If the government acts to reduce government spending or transfer payments, or increase tax revenues, it is referred to as contractionary fiscal policy. These actions would also be associated with a decrease in the government budget deficit, or an increase in its budget surplus.
Expansionary Fiscal Policy
Suppose the economy is originally at a superequilibrium shown as point J in Figure 10.3.1 . The original gross national product (GNP) level is \(Y^{1}\) and the exchange rate is \(E_{\$/£}^{1}\). Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). As shown in Chapter 9, Section 9.3, fiscal policy changes cause a shift in the DD curve. More specifically, an increase in government spending (or an increase in transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., \(↑G\), \(↑TR\), and \(↓T\) all are DD right-shifters). This is depicted in the diagram as a shift from the red DD to the blue DD′ line.
There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness: first the quick result, then the quick result with the transition process described, and finally the complete adjustment story.
Quick Result
The increase in DD causes a shift in the superequilibrium point from J to K. In adjusting to the new equilibrium at K, GNP rises from Y1 to Y2 and the exchange rate decreases from \(E_{\$/£}^{1}\). to \(E_{\$/£}^{2}\). The decrease in the exchange represents a decrease in the British pound value and an increase in the U.S. dollar value. In other words, it is a depreciation of the pound and an appreciation of the dollar. Since the final equilibrium point K is below the initial iso-CAB line CC, the current account balance decreases. (Caveat: this will be true for all fiscal expansions, but the iso-CAB line can only be used with an increase in G; see Chapter 9, Section 9.8 for an explanation.) If the CAB were in surplus at J, then the surplus decreases; if the CAB were in deficit, then the deficit rises. Thus the U.S. expansionary fiscal policy causes an increase in the U.S. GNP, an appreciation of the U.S. dollar, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.
Transition Description
If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for goods and services (G&S) will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases, and this causes the rightward shift in the DD curve. Immediately after aggregate demand increases, but before any adjustment has occurred at point J, the economy lies to the left of the new D´D´ curve. Thus GNP will begin to rise to get back to G&S market equilibrium on the D´D´ curve. However, as GNP rises, the economy will move above the AA curve, forcing a downward readjustment of the exchange rate to get back to asset market equilibrium on the AA curve. In the end, the economy will adjust in a stepwise fashion from point J to point K, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the superequilibrium at point K.
Complete Adjustment Story
Step 1: If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for G&S will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases. Before any adjustment occurs, the increase in aggregate demand implies aggregate demand exceeds aggregate supply, which will lead to a decline in inventories. To prevent this decline, retailers (or government suppliers) will signal firms to produce more. As supply increases so does the GNP, and the economy moves to the right of point J.
Step 2: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate \(E_{\$/£}\). This moves the economy downward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point J in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the AA curve, as shown.
Step 3: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point K in the diagram.
Step 4: The equilibrium at K lies to the southeast of J along the original AA curve. As shown in Chapter 9, Section 9.8, the current account balance must be lower at K since both an increase in GNP and a dollar appreciation cause decreases in current account demand. Thus the equilibrium at K lies below the original iso-CAB line. However, this is only assured if the fiscal expansion occurred due to an increase in G.
If transfer payments increased or taxes were reduced, these would both increase disposable income and lead to a further decline in the current account balance. Thus also with these types of fiscal expansions, the current account balance is reduced; however, one cannot use the iso-CAB line to show it.
Contractionary Fiscal Policy
Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments, or an increase in taxes. It would also be represented by a decrease in the government budget deficit or an increase in the budget surplus. In the AA-DD model, a contractionary fiscal policy shifts the DD curve leftward. The effects will be the opposite of those described above for expansionary fiscal policy. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. U.S. contractionary fiscal policy will cause a reduction in GNP and an increase in the exchange rate (\(E_{\$/£}\)), implying a depreciation of the U.S. dollar.
Key Takeaways
• Expansionary fiscal policy causes an increase in GNP, an appreciation of the currency, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.
• Contractionary fiscal policy will cause a reduction in GNP, a depreciation of the currency, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.
Exercises
1. Suppose a country with floating exchange rates has a current account deficit that its government considers too large. Use an AA-DD diagram to show how fiscal policy could be used to reduce the current account deficit. Does this action help or hinder its goal of maintaining low unemployment?
2. The United States maintains a floating exchange rate. In the past few years, its government budget deficit has risen to a very high level. At the same time, its trade deficit has also become much larger.
1. Suppose the government reduces government spending to reduce the budget deficit. Assume the U.S. economy can be described with the AA-DD model. In the adjustment to the new equilibrium, the following variables will be affected in the order listed. Indicate whether each variable rises (+) or falls (−) during the adjustment process.
Indicate + or −
Government Demand (\(G\))
Aggregate Demand (\(AD\))
Aggregate Supply (\(Y_{\$}\))
Real Money Demand (\(L[i_{\$},Y_{\$}]\))
U.S. Interest Rates (\(i_{\$}\))
U.S. Rate of Return (\(R_{0}R_{\$}\))
Exchange Rate (\(E_{\$/£}\))
Foreign Rate of Return (\(R_{0}R_{£}\))
Real Exchange Rate (\(q_{\$/£}\))
Current Account Demand (\(CA^{D}\))
Aggregate Demand (\(AD\))
2. Once the final short-run equilibrium is reached, indicate the effect of the decrease in government spending on the following variables:
Indicate + or −
U.S. Government Budget Deficit
U.S. Dollar Value
U.S. Current Account Deficit
U.S. GNP
3. Consider the following actions/occurrences listed in the first column. For each one, use the AA-DD model to determine the impact on the variables from the twin-deficit identity listed along the top row. Consider the final equilibrium short-run effects. Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
Impact on
\(S_{p}\) \(I\) \(IM − EX\) \(G + TR − T\)
a. A decrease in investment demand with floating ERs
b. A decrease in investment demand under floating ERs
c. An increase in foreign interest rates under floating ERs
d. An increase in government demand under floating ERs | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/10%3A_Policy_Effects_with_Floating_Exchange_Rates/10.03%3A_Fiscal_Policy_with_Floating_Exchange_Rates.txt |
Learning Objective
1. Learn how changes in monetary policy affect GNP and the value of the exchange rate in a floating exchange rate system in the context of the AA-DD model in the long run.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
If expansionary monetary policy occurs when the economy is operating at full employment output, then the money supply increase will eventually put upward pressure on prices. Thus we say that eventually, or in the long run, the aggregate price level will rise and the economy will experience an episode of inflation in the transition. See Chapter 7, Section 7.14 for a complete description of this process.
Here, we will describe the long-run effects of an increase in the money supply using the AA-DD model. We break up the effects into short-run and long-run components. In the short run, the initial money supply effects are felt and investor anticipations about future effects are implemented. In the long run, we allow the price level to rise.
Suppose the economy is originally at a superequilibrium, shown as point F in Figure 10.4.1 . The original GNP level is \(Y^{F}\), and the exchange rate is \(E^{1}\). \(Y^{F}\) represents the full-employment level of output, which also implies that the natural rate of unemployment prevails. Any movement of the economy to the right of \(Y^{F}\) will cause an eventual increase in the aggregate price level. Any movement to the left of \(Y^{F}\) causes an eventual decrease in the price level.
Next, suppose the U.S. central bank (or the Fed) decides to expand the money supply. As shown in Chapter 9, Section 9.5, money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., \(↑M^{S}\) is an AA up-shifter). This is depicted in the diagram as a shift from the AA line to the red AA′ line.
In the long-run adjustment story, several different changes in exogenous variables will occur sequentially, thus it is difficult to describe the quick final result, so we will only describe the transition process in partial detail.
Partial Detail
The increase in the money supply causes the first upward shift of the AA curve, shown as step 1 in the diagram. Since exchange rates adjust much more rapidly than gross national product (GNP), the economy will quickly adjust to the new A′A′ curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from \(E^{1}\) to \(E^{2}\), representing a depreciation of the U.S. dollar.
The second effect is caused by changes in investor expectations. Investors generally track important changes in the economy, including money supply changes, because these changes can have important implications for the returns on their investments. Investors who see an increase in money supply in an economy at full employment are likely to expect inflation to occur in the future. When investors expect future U.S. inflation, and when they consider both domestic and foreign investments, they will respond today with an increase in their expected future exchange rate (\(E_{\$/£}^{e}\)). There are two reasons to expect this immediate effect:
1. Investors are very likely to understand the story we are in the process of explaining now. As we will see below, the long-run effect of a money supply increase for an economy (initially, at full employment) is an increase in the exchange rate (\(E_{\$/£}\))—that is, a depreciation of the dollar. If investors believe the exchange rate will be higher next year due to today’s action by the Fed, then it makes sense for them to raise their expected future exchange rate in anticipation of that effect. Thus the average \(E_{\$/£}^{e}\) will rise among investors who participate in the foreign exchange (Forex) markets.
2. Investors may look to the purchasing power parity (PPP) theory for guidance. PPP is generally interpreted as a long-run theory of exchange rate trends. If PPP holds in the long run, then \(E_{\$/£} = P_{\$}/P_{£}\). In other words, the exchange rate will equal the ratio of the two countries’ price levels. If \(P_{\$}\) is expected to rise due to inflation, then PPP predicts that the exchange rate (\(E_{\$/£}\)) will also rise and the dollar will depreciate.
The timing of the change in \(E_{\$/£}^{e}\) will depend on how quickly investors recognize the money supply change, compute its likely effect, and incorporate it into their investment plans. Since investors are typically very quick to adapt to market changes, the expectations effect should take place in the short run, perhaps long before the inflation ever occurs. In some cases, the expectations change may even occur before the Fed increases the money supply, if investors anticipate the Fed’s action.
The increase in the expected exchange rate (this means a decrease in the expected future dollar value) causes a second upward shift of the AA curve, shown as step 2 in the diagram. Again, rapid exchange rate adjustment implies the economy will quickly adjust to the new A″A″ curve at point H directly above. The exchange rate will now increase from \(E^{2}\) to \(E^{3}\), representing a further depreciation of the U.S. dollar.
Once at point H, aggregate demand, which is on the DD curve to the right of H, exceeds aggregate supply, which is still at \(Y^{F}\). Thus GNP will begin to rise to get back to G&S market equilibrium on the DD curve. However, as GNP rises, the economy moves above the A″A″ curve that forces a downward readjustment of the exchange rate to get back to asset market equilibrium on A″A″. In the end, the economy will adjust in a stepwise fashion from point H to point I, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the A″A″ curve. This process will continue until the economy reaches the temporary superequilibrium at point I.
The next effect occurs because GNP, now at \(Y^{2}\) at point I, has risen above the full employment level at \(Y^{F}\). This causes an increase in U.S. prices, meaning that \(P_{\$}\) (the U.S. price level) begins to rise. The increase in U.S. prices has two effects as shown in Figure 10.4.2 . An increase in \(P_{\$}\) is both a DD left-shifter and an AA down-shifter.
In step 3, we depict a leftward shift of DD to DD′. DD shifts left because higher U.S. prices will reduce the real exchange rate. This makes U.S. G&S relatively more expensive compared with foreign G&S, thus reducing export demand, increasing import demand, and thereby reducing aggregate demand.
In step 4, we depict a downward shift of A″A to A′″A′″. AA shifts down because a higher U.S. price level reduces real money supply. As the real money supply falls, U.S. interest rates rise, leading to an increase in the rate of return for U.S. assets as considered by international investors. This in turn raises the demand for U.S. dollars on the Forex, leading to a dollar appreciation. Since this effect occurs for any GNP level, the entire AA curve shifts downward.
Steps 3 and 4 will both occur simultaneously, and since both are affected by the increase in the price level, it is impossible to know which curve will shift faster or precisely how far each curve will shift. However, we do know two things. First, the AA and DD shifting will continue as long as GNP remains above the full employment level. Once GNP falls to YF, there is no longer upward pressure on the price level and the shifting will cease. Second, the final equilibrium exchange rate must lie above the original exchange rate. This occurs because output will revert back to its original level, the price level will be higher, and according to PPP, eventually the exchange rate will have to be higher as well.
The final equilibrium will be at a point like J, which lies to the left of I. In this transition, the exchange rate will occasionally rise when DD shifts left and will occasionally fall when AA shifts down. Thus the economy will wiggle its way up and down, from point I to J. Once at point J, there is no reason for prices to rise further and no reason for a change in investor expectations. The economy will have reached its long-run equilibrium.
Note that one cannot use the iso-CAB line to assess the long-run effect on the current account balance. In the final adjustment, although the final equilibrium lies above the original iso-CAB line, in the long run the \(P_{\$}\) changes will raise the iso-CAB lines, making it impossible to use these to identify the final effect.
However, in adjusting to the long-run equilibrium, the only two variables affecting the current account that will ultimately change are the exchange rate and the price level. If these two rise proportionally to each other, as they would if purchasing power parity held, then there will be no long-run effect on the current account balance.
The final long-run effect of an increase in the U.S. money supply in a floating exchange rate system is a depreciation of the U.S. dollar and no change in real GNP. Along the way, GNP temporarily rises and unemployment falls below the natural rate. However, this spurs an increase in the price level, which reduces GNP to its full employment level and raises unemployment back to its natural rate. U.S. inflation occurs in the transition while the price level is increasing.
key takeaway
• The final long-run effect of an increase in the money supply in a floating exchange rate system is a depreciation of the currency and no change in real GNP. In the transition process, there is an inflationary effect.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the long run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the long run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
2. Repeat the analysis in the text for contractionary monetary policy. Explain each of the four adjustment steps and depict them on an AA-DD diagram. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/10%3A_Policy_Effects_with_Floating_Exchange_Rates/10.04%3A_Expansionary_Monetary_Policy_with_Floating_Exchange_Rates_in_the_Long_Run.txt |
Learning Objectives
1. Learn how a country’s central bank can intervene to affect the value of the country’s currency in a floating exchange rate system.
2. Learn the mechanism and purpose of a central bank sterilized intervention in a Forex market.
In a pure floating exchange rate system, the exchange rate is determined as the rate that equalizes private market demand for a currency with private market supply. The central bank has no necessary role to play in the determination of a pure floating exchange rate. Nonetheless, sometimes central banks desire or are pressured by external groups to take actions (i.e., intervene) to either raise or lower the exchange rate in a floating exchange system. When central banks do intervene on a semiregular basis, the system is sometimes referred to as a “dirty float.” There are several reasons such interventions occur.
The first reason central banks intervene is to stabilize fluctuations in the exchange rate. International trade and investment decisions are much more difficult to make if the exchange rate value is changing rapidly. Whether a trade deal or international investment is good or bad often depends on the value of the exchange rate that will prevail at some point in the future. (See Chapter 4, Section 4.3 for a discussion of how future exchange rates affect returns on international investments.) If the exchange rate changes rapidly, up or down, traders and investors will become more uncertain about the profitability of trades and investments and will likely reduce their international activities. As a consequence, international traders and investors tend to prefer more stable exchange rates and will often pressure governments and central banks to intervene in the foreign exchange (Forex) market whenever the exchange rate changes too rapidly.
The second reason central banks intervene is to reverse the growth in the country’s trade deficit. Trade deficits (or current account deficits) can rise rapidly if a country’s exchange rate appreciates significantly. A higher currency value will make foreign goods and services (G&S) relatively cheaper, stimulating imports, while domestic goods will seem relatively more expensive to foreigners, thus reducing exports. This means a rising currency value can lead to a rising trade deficit. If that trade deficit is viewed as a problem for the economy, the central bank may be pressured to intervene to reduce the value of the currency in the Forex market and thereby reverse the rising trade deficit.
There are two methods central banks can use to affect the exchange rate. The indirect method is to change the domestic money supply. The direct method is to intervene directly in the foreign exchange market by buying or selling currency.
Indirect Forex Intervention
The central bank can use an indirect method to raise or lower the exchange rate through domestic money supply changes. As was shown in Chapter 10, Section 10.2, increases in the domestic U.S. money supply will cause an increase in \(E_{\$/£}\), or a dollar depreciation. Similarly, a decrease in the money supply will cause a dollar appreciation.
Despite relatively quick adjustments in assets markets, this type of intervention must traverse from open market operations to changes in domestic money supply, domestic interest rates, and exchange rates due to new rates of returns. Thus this method may take several weeks or more for the effect on exchange rates to be realized.
A second problem with this method is that to affect the exchange rate the central bank must change the domestic interest rate. Most of the time, central banks use interest rates to maintain stability in domestic markets. If the domestic economy is growing rapidly and inflation is beginning to rise, the central bank may lower the money supply to raise interest rates and help slow down the economy. If the economy is growing too slowly, the central bank may raise the money supply to lower interest rates and help spur domestic expansion. Thus to change the exchange rate using the indirect method, the central bank may need to change interest rates away from what it views as appropriate for domestic concerns at the moment. (Below we’ll discuss the method central banks use to avoid this dilemma.)
Direct Forex Intervention
The most obvious and direct way for central banks to intervene and affect the exchange rate is to enter the private Forex market directly by buying or selling domestic currency. There are two possible transactions.
First, the central bank can sell domestic currency (let’s use dollars) in exchange for a foreign currency (say, pounds). This transaction will raise the supply of dollars on the Forex (also raising the demand for pounds), causing a reduction in the value of the dollar and thus a dollar depreciation. Of course, when the dollar depreciates in value, the pound appreciates in value with respect to the dollar. Since the central bank is the ultimate source of all dollars (it can effectively print an unlimited amount), it can flood the Forex market with as many dollars as it desires. Thus the central bank’s power to reduce the dollar value by direct intervention in the Forex is virtually unlimited.
If instead, the central bank wishes to raise the value of the dollar, it will have to reverse the transaction described above. Instead of selling dollars, it will need to buy dollars in exchange for pounds. The increased demand for dollars on the Forex by the central bank will raise the value of the dollar, thus causing a dollar appreciation. At the same time, the increased supply of pounds on the Forex explains why the pound will depreciate with respect to the dollar.
The ability of a central bank to raise the value of its currency through direct Forex interventions is limited, however. In order for the U.S. Federal Reserve Bank (or the Fed) to buy dollars in exchange for pounds, it must have a stockpile of pound currency (or other pound assets) available to exchange. Such holdings of foreign assets by a central bank are called foreign exchange reserves. Foreign exchange reserves are typically accumulated over time and held in case an intervention is desired. In the end, the degree to which the Fed can raise the dollar value with respect to the pound through direct Forex intervention will depend on the size of its pound denominated foreign exchange reserves.
Indirect Effect of Direct Forex Intervention
There is a secondary indirect effect that occurs when a central bank intervenes in the Forex market. Suppose the Fed sells dollars in exchange for pounds in the private Forex. This transaction involves a purchase of foreign assets (pounds) in exchange for U.S. currency. Since the Fed is the ultimate source of dollar currency, these dollars used in the transaction will enter into circulation in the economy in precisely the same way as new dollars enter when the Fed buys a Treasury bill on the open market. The only difference is that with an open market operation, the Fed purchases a domestic asset, while in the Forex intervention it buys a foreign asset. But both are assets all the same and both are paid for with newly created money. Thus when the Fed buys pounds and sells dollars on the Forex, there will be an increase in the U.S. money supply.
The higher U.S. money supply will lower U.S. interest rates, reduce the rate of return on U.S. assets as viewed by international investors, and result in a depreciation of the dollar. The direction of this indirect effect is the same as the direct effect.
In contrast, if the Fed were to buy dollars and sell pounds on the Forex, there will be a decrease in the U.S. money supply. The lower U.S. money supply will raise U.S. interest rates, increase the rate of return on U.S. assets as viewed by international investors, and result in an appreciation of the dollar.
The only difference between the direct and indirect effects is the timing and sustainability. The direct effect will occur immediately with central bank intervention since the Fed will be affecting today’s supply of dollars or pounds on the Forex. The indirect effect, working through money supply and interest rates, may take several days or weeks. The sustainability of the direct versus indirect effects is discussed next when we introduce the idea of a sterilized Forex intervention.
Sterilized Forex Interventions
There are many times in which a central bank either wants or is pressured to affect the exchange rate value by intervening directly in the foreign exchange market. However, as shown above, direct Forex interventions will change the domestic money supply. A change in the money supply will affect the average interest rate in the short run and the price level, and hence the inflation rate, in the long run. Because central banks are generally entrusted to maintain domestic price stability or to assist in maintaining appropriate interest rates, a low unemployment rate, and GDP growth, Forex intervention will often interfere with one or more of their other goals.
For example, if the central bank believes that current interest rates should be raised slowly during the next several months to slow the growth of the economy and prevent a resurgence of inflation, then a Forex intervention to lower the value of the domestic currency would result in increases in the money supply and a decrease in interest rates, precisely the opposite of what the central bank wants to achieve. Conflicts such as this one are typical and usually result in a central bank choosing to sterilize its Forex interventions.
The intended purpose of a sterilized intervention is to cause a change in the exchange rate while at the same time leaving the money supply and hence interest rates unaffected. As we will see, the intended purpose is unlikely to be realized in practice.
A sterilized foreign exchange intervention occurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. For example, suppose the U.S. Fed decides to intervene to lower the value of the U.S. dollar. This would require the Fed to sell dollars and buy foreign currency on the Forex. Sterilization, in this case, involves a Fed open market operation in which it sells Treasury bonds (T-bonds) at the same time and in the same value as the dollar sale in the Forex market. For example, if the Fed intervenes and sells \$10 million on the Forex, sterilization means it will also sell \$10 million of Treasury bonds on the domestic open market at the same time.
Consider the effects of a sterilized Forex intervention by the U.S. Fed shown in the adjoining AA-DD diagram, Figure 10.5.1 . Suppose the economy is initially in equilibrium at point F with GDP (\(Y^{1}\)) and exchange rate (\(E_{\$/£}^{1}\)). Now, suppose the Fed intervenes in the Forex by selling dollars and buying British pounds. The direct effect on the exchange rate is not represented in the AA-DD diagram. The only way it can have an effect is through the increase in the money supply, which will shift the AA curve up from AA to AA′. However, sterilization means the Fed will simultaneously conduct an offsetting open market operation, in this case selling Treasury bonds equal in value to the Forex sales. The sale of T-bonds will lower the U.S. money supply, causing an immediate shift of the AA curve back from AA′ to AA. In fact, because the two actions take place on the same day or within the same week at least, the AA curve does not really shift out at all. Instead, a sterilized Forex intervention maintains the U.S. money supply and thus achieves the Fed’s objective of maintaining interest rates.
However, because there is no shift in the AA or DD curves, the equilibrium in the economy will never move away from point F. This implies that a sterilized Forex intervention not only will not affect GNP, but also will not affect the exchange rate. This suggests the impossibility of the Fed’s overall objective to lower the dollar value while maintaining interest rates.
Empirical studies of the effects of sterilized Forex interventions tend to support the results of this simple model. In other words, real-world sterilizations have generally been ineffective in achieving any lasting effect upon a country’s currency value.
However, there are several reasons why sterilized interventions may be somewhat effective nonetheless. Temporary effects are certainly possible. If a central bank makes a substantial intervention in the Forex over a short period, this will certainly change the supply or demand of currency and have an immediate effect on the exchange rate on those days.
A more lasting impact can occur if the intervention leads investors to change their expectations about the future. This could happen if investors are not sure whether the central bank is sterilizing its interventions. Knowing that sterilization is occurring would require a careful observation of several markets unless the Fed announces its policy. However, rather than announcing a sterilized intervention, a central bank that wants to affect expectations should announce the Forex intervention while hiding its offsetting open market operation. In this way, investors may be fooled into thinking that the Forex intervention will lower the future dollar value and thus may adjust their expectations.
If investors are fooled, they will raise \(E_{\$/£}^{e}\) in anticipation of the future dollar depreciation. The increase in \(E_{\$/£}^{e}\) will shift the AA curve upward, resulting in an increase in GNP and a depreciation of the dollar. In this way, sterilized interventions may have a more lasting effect on the exchange rate. However, the magnitude of the exchange rate change in this case—if it occurs—will certainly be less than that achieved with a nonsterilized intervention.
Key Takeaways
• If the central bank sells domestic currency in exchange for a foreign currency on the Forex, it will cause a direct reduction in the value of the domestic currency, or a currency depreciation.
• If the Fed were to sell dollars on the Forex, there will be an increase in the U.S. money supply that will reduce U.S. interest rates, decrease the rate of return on U.S. assets, and lead to a depreciation of the dollar.
• A sterilized foreign exchange intervention occurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market.
• The intended purpose of a sterilized intervention is to cause a change in the exchange rate while at the same time leaving interest rates unaffected.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of buy domestic currency or sell domestic currency on the foreign exchange market, this is one thing a central bank can do to cause a domestic currency depreciation.
• Of buy foreign currency or sell foreign currency on the foreign exchange market, this is one thing a central bank can do to cause a domestic currency appreciation.
• Of increase, decrease, or keep the same, this is one thing a central bank can do to the domestic money supply to induce a domestic currency appreciation.
• Of increase, decrease, or keep the same, this is one thing a central bank can do to the domestic money supply to induce a domestic currency depreciation.
• The term used to describe a central bank transaction on the domestic bond market intended to offset the central bank’s intervention on the foreign exchange market.
• Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the short run if the central bank sterilizes a sale of foreign reserves on the foreign exchange market in the AA-DD model with floating exchange rates.
• Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the short run if the central bank sterilizes a purchase of foreign reserves on the foreign exchange market in the AA-DD model with floating exchange rates. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/10%3A_Policy_Effects_with_Floating_Exchange_Rates/10.05%3A_Foreign_Exchange_Interventions_with_Floating_Exchange_Rates.txt |
Fixed exchange rates around the world were once the only game in town; however, since the collapse of the Bretton Woods system in 1973, floating exchange rates predominate for the world’s most-traded currencies. Nonetheless, many countries continue to use some variant of fixed exchange rates even today. This chapter addresses both the historical fixed exchange rate systems like the gold standard as well as the more modern variants like crawling pegs and currency boards.
11: Fixed Exchange Rates
Learning Objective
1. Preview the discussion about fixed exchange rate systems, their varieties, and their mechanisms.
This chapter begins by defining several types of fixed exchange rate systems, including the gold standard, the reserve currency standard, and the gold exchange standard. The price-specie flow mechanism is described for the gold standard. It continues with other modern fixed exchange variations such as fixing a currency to a basket of several other currencies, crawling pegs, fixing within a band or range of exchange rates, currency boards, and finally the most extreme way to fix a currency: adopting another country’s currency as your own, as is done with dollarization or euroization.
The chapter proceeds with the basic mechanics of a reserve currency standard in which a country fixes its currency to another’s. In general, a country’s central bank must intervene in the foreign exchange (Forex) markets, buying foreign currency whenever there is excess supply (resulting in a balance of payments surplus) and selling foreign currency whenever there is excess demand (resulting in a balance of payments deficit). These actions will achieve the fixed exchange rate version of the interest parity condition in which interest rates are equalized across countries. However, to make central bank actions possible, a country will need to hold a stock of foreign exchange reserves. If a country’s central bank does not intervene in the Forex in a fixed exchange system, black markets are shown to be a likely consequence.
Results
• Gold standard rules: (1) fix currency to a weight of gold; (2) central bank freely exchanges gold for currency with public.
• Adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate.
• Reserve currency rules: (1) fix currency to another currency, known as the reserve currency; (2) central bank must hold a stock of foreign exchange reserves to facilitate Forex interventions.
• Gold-exchange standard rules: (1) reserve country fixes its currency to a weight of gold, (2) all other countries fix their currencies to the reserve, (3) reserve central bank freely exchanges gold for currency with other central banks, (4) nonreserve countries hold a stock of the reserve currency to facilitate intervention in the Forex.
• The post–World War II fixed exchange rate system, known as the Bretton Woods system, was a gold exchange standard.
• Some countries fix their currencies to a weighted average of several other currencies, called a “basket of currencies.”
• Some countries implement a crawling peg in which the fixed exchange rate is adjusted regularly.
• Some countries set a central exchange rate and allow free floating within a predefined range or band.
• Some countries implement currency boards to legally mandate Forex interventions.
• Some countries simply adopt another country’s currency, as with dollarization, or choose a brand-new currency, as with the euro.
• The interest rate parity condition becomes the equalization of interest rates between two countries in a fixed exchange rate system.
• A balance of payments surplus (deficit) arises when the central bank buys (sells) foreign reserves on the Forex in exchange for its own currency.
• A black market in currency trade arises when there is unsatisfied excess demand or supply of foreign currency in exchange for domestic currency on the Forex.
key takeaway
• See the main results previewed above.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term for the currency standard that fixes its circulating currency to a quantity of gold.
• The term for the currency standard in which a reserve currency is fixed to a quantity of gold while all other currencies are fixed to the reserve currency.
• The currency standard used during the post–World War II Bretton Woods era.
• The term describing the deficits and surpluses run by a country to maintain a fixed exchange rate.
• The term used to describe a decision by another country to adopt the U.S. dollar as its currency.
• The nonintervention in the Forex market by a country’s central bank is likely to lead to the development of these kinds of market activities. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.01%3A_Overview_of_Fixed_Exchange_Rates.txt |
Learning Objective
1. Recognize the varieties of ways that exchange rates can be fixed to a particular value.
2. Understand the basic operation and the adjustment mechanism of a gold standard.
There are two basic systems that can be used to determine the exchange rate between one country’s currency and another’s: a floating exchange rate system and a fixed exchange rate system.
Under a floating exchange rate system, the value of a country’s currency is determined by the supply and demand for that currency in exchange for another in a private market operated by major international banks.
In contrast, in a fixed exchange rate system, a country’s government announces (or decrees) what its currency will be worth in terms of something else and also sets up the rules of exchange. The “something else” to which a currency value is set and the “rules of exchange” determine the type of fixed exchange rate system, of which there are many. For example, if the government sets its currency value in terms of a fixed weight of gold, then we have a gold standard. If the currency value is set to a fixed amount of another country’s currency, then it is a reserve currency standard.
As we review several ways in which a fixed exchange rate system can work, we will highlight some of the advantages and disadvantages of the system. In anticipation, it is worth noting that one key advantage of fixed exchange rates is the intention to eliminate exchange rate risk, which can greatly enhance international trade and investment. A second key advantage is the discipline a fixed exchange rate system imposes on a country’s monetary authority, with the intention of inducing a much lower inflation rate.
The Gold Standard
Most people are aware that at one time the world operated under something called a gold standard. Some people today, reflecting back on the periods of rapid growth and prosperity that occurred when the world was on a gold standard, have suggested that the world abandon its current mixture of fixed and floating exchange rate systems and return to this system. (For a discussion of some pros and cons see Alan Greenspan’s remarks on this from the early 1980s.See Alan Greenspan’s remarks in “Can the US Return to a Gold Standard,” Wall Street Journal, September 1, 1981; reprinted online at www.gold-eagle.com/greenspan011098.html[0]. See Murray Rothbard’s article for an argument in favor of a return to the gold standard.See Murray Rothbard, “The Case for a Genuine Gold Dollar,” in The Gold Standard: An Austrian Perspective (Lexington, MA: D. C. Heath, 1985), 1–17; also available online at http://www.mises.org/rothbard/genuine.asp.) Whether or not countries seriously consider this in the future, it is instructive to understand the workings of a gold standard, especially since, historically, it is the first major international system of fixed exchange rates.
Most of the world maintained a pure gold standard during the late 1800s and early 1900s, with a major interruption during World War I. Before the enactment of a gold standard, countries were generally using a Bimetallic standard consisting of both gold and silver.See Angela Radish, “Bimetallism,” Economic History Online at http://www.eh.net/encyclopedia/?article=redish.bimetallism The earliest establishment of a gold standard was in Great Britain in 1821, followed by Australia in 1852 and Canada in 1853. The United States established its gold standard system with the Coinage Act of 1873, sometimes known as “The Crime of ’73.” For more info see Wikipedia, “Coinage Act of 1873,” http://en.Wikipedia.org/wiki/Coinage_Act_of_1873. The gold standard was abandoned in the early days of the Great Depression. Britain dropped the standard in 1931, the United States in 1933.
The rules of a gold standard are quite simple. First, a country’s government declares that its issued currency (it may be coin or paper currency) will exchange for a weight in gold. For example, in the United States during the late 1800s and early 1900s, the government set the dollar exchange rate to gold at the rate \$20.67 per troy ounce. During the same period, Great Britain set its currency at the rate £4.24 per troy ounce. Second, in a pure gold standard, a country’s government declares that it will freely exchange currency for actual gold at the designated exchange rate. This “rule of exchange” means that anyone can go to the central bank with coin or currency and walk out with pure gold. Conversely, one could also walk in with pure gold and walk out with the equivalent in coin or currency.
Because the government bank must always be prepared to give out gold in exchange for coin and currency on demand, it must maintain a storehouse of gold. That store of gold is referred to as “gold reserves.” That is, the central bank maintains a reserve of gold so that it can always fulfill its promise of exchange. As discussed in Chapter 11, Section 11.4, a well-functioning system will require that the central bank always have an adequate amount of reserves.
The two simple rules, when maintained, guarantee that the exchange rate between dollars and pounds remains constant. Here’s why.
First, the dollar/pound exchange rate is defined as the ratio of the two-currency-gold exchange rates. Thus
Next, suppose an individual wants to exchange \$4.875 for one pound. Following the exchange rules, this person can enter the central bank in the United States and exchange dollars for gold to get
This person can then take the gold into the central bank in the United Kingdom, and assuming no costs of transportation, can exchange the gold into pounds as follows:
Hence, the \$4.875 converts to precisely £1 and this will remain the fixed exchange rate between the two currencies, as long as the simple exchange rules are followed. If many countries define the value of their own currency in terms of a weight of gold and agree to exchange gold freely at that rate with all who desire to exchange, then all these countries will have fixed currency exchange rates with respect to each other.
Price-Specie Flow Mechanism
The price-specie flow mechanism is a description about how adjustments to shocks or changes are handled within a pure gold standard system. Although there is some disagreement whether the gold standard functioned as described by this mechanism, the mechanism does fix the basic principles of how a gold standard is supposed to work.
Consider the United States and United Kingdom operating under a pure gold standard. Suppose there is a gold discovery in the United States. This will represent a shock to the system. Under a gold standard, a gold discovery is like digging up money, which is precisely what inspired so many people to rush to California after 1848 to strike it rich.
Once the gold is unearthed, the prospectors bring it into town and proceed to the national bank where it can be exchanged for coin and currency at the prevailing dollar/gold exchange rate. The new currency in circulation represents an increase in the domestic money supply.
Indeed, it is this very transaction that explains the origins of the gold and silver standards in the first place. The original purpose of banks was to store individuals’ precious metal wealth and to provide exchangeable notes that were backed by the gold holdings in the vault. Thus rather than carrying around heavy gold, one could carry lightweight paper money. Before national or central banks were founded, individual commercial banks issued their own currencies, which circulated together with many other bank currencies. However, it was also common for governments to issue coins that were made directly from gold or silver.
Now, once the money supply increases following the gold discovery, it can have two effects: operating through the goods market and financial market. The price-specie flow mechanism describes the adjustment through goods markets.
First, let’s assume that the money increase occurs in an economy that is not growing—that is, with a fixed level of GDP. Also assume that both purchasing power parity (PPP) and interest rate parity (IRP) holds. PPP implies an equalization of the cost of a market basket of goods between the United States and the United Kingdom at the current fixed exchange rate. IRP implies an equalization of the rates of return on comparable assets in the two countries.
As discussed in Chapter 7, Section 7.14, when the U.S. money supply increases, and when there is no subsequent increase in output, the prices of goods and services will begin to rise. This inflationary effect occurs because more money is chasing (i.e., demanding) the same amount of goods and services. As the price level rises in an economy open to international trade, domestic goods become more expensive relative to foreign goods. This will induce domestic residents to increase demand for foreign goods; hence import demand will rise. Foreign consumers will also find domestic goods more expensive, so export supply will fall. The result is a demand for a current account deficit. To make these transactions possible in a gold standard, currency exchange will take place as follows.
U.S. residents wishing to buy cheaper British goods will first exchange dollars for gold at the U.S. central bank. Then they will ship that gold to the United Kingdom to exchange for the pounds that can be used to buy UK goods. As gold moves from the United States to the United Kingdom, the money supply in the United States falls while the money supply in the United Kingdom rises. Less money in the United States will eventually reduce prices, while more money in the United Kingdom will raise prices. This means that the prices of goods will move together until purchasing power parity holds again. Once PPP holds, there is no further incentive for money to move between countries. There will continue to be demand for UK goods by U.S. residents, but this will balance with the United Kingdom demands for similarly priced U.S. goods. Hence, the trade balance reverts to zero.
The adjustment process in the financial market under a gold standard will work through changes in interest rates. When the U.S. money supply rises after the gold discovery, average interest rates will begin to fall. Lower U.S. interest rates will make British assets temporarily more attractive, and U.S. investors will seek to move investments to the United Kingdom. The adjustment under a gold standard is the same as with goods. Investors trade dollars for gold in the United States and move that gold to the United Kingdom where it is exchanged for pounds and used to purchase UK assets. Thus the U.S. money supply will begin to fall, causing an increase in U.S. interest rates, while the UK money supply rises, leading to a decrease in UK interest rates. The interest rates will move together until interest rate parity again holds.
In summary, adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. The only requirement for the government to maintain this type of fixed exchange rate system is to maintain the fixed price of its currency in terms of gold and to freely and readily exchange currency for gold on demand.
Reserve Currency Standard
In a reserve currency system, another country’s currency takes the role that gold played in a gold standard. In other words a country fixes its own currency value to a unit of another country’s currency. For example, suppose Britain decided to fix its currency to the dollar at the exchange rate \(E_{\$/£} = 1.50\). To maintain this fixed exchange rate, the Bank of England would stand ready to exchange pounds for dollars (or dollars for pounds) on demand at the specified exchange rate. To accomplish this, the Bank of England would need to hold dollars on reserve in case there was ever any excess demand for dollars in exchange for pounds on the Forex. In the gold standard, the central bank held gold to exchange for its own currency; with a reserve currency standard, it must hold a stock of the reserve currency. Always, the reserve currency is the currency to which the country fixes.
A reserve currency standard is the typical method for fixing a currency today. Most countries that fix its exchange rate will fix to a currency that either is prominently used in international transactions or is the currency of a major trading partner. Thus many countries fixing their exchange rate today fix to the U.S. dollar because it is the most widely traded currency internationally. Alternatively, fourteen African countries that were former French colonies had established the CFA franc zone and fixed the CFA franc (current currency used by these African countries) to the French franc. Since 1999, the CFA franc has been fixed to the euro. Namibia, Lesotho, and Swaziland are all a part of the common monetary area (CMA) and fix their currency to the South African rand.
Gold Exchange Standard
A gold exchange standard is a mixed system consisting of a cross between a reserve currency standard and a gold standard. In general, it includes the following two rules:
1. A reserve currency is chosen. All nonreserve countries agree to fix their exchange rates to the reserve at some announced rate. To maintain the fixity, these nonreserve countries will hold a stockpile of reserve currency assets.
2. The reserve currency country agrees to fix its currency value to a weight in gold. Finally, the reserve country agrees to exchange gold for its own currency with other central banks within the system on demand.
One key difference in this system from a gold standard is that the reserve country does not agree to exchange gold for currency with the general public, only with other central banks.
The system works exactly like a reserve currency system from the perspective of the nonreserve countries. However, if over time the nonreserve countries accumulate the reserve currency, they can demand exchange for gold from the reserve country central bank. In this case, gold reserves will flow away from the reserve currency country.
The fixed exchange rate system set up after World War II was a gold exchange standard, as was the system that prevailed between 1920 and the early 1930s. The post–World War II system was agreed to by the allied countries at a conference in Bretton Woods, New Hampshire, in the United States in June 1944. As a result, the exchange rate system after the war also became known as the Bretton Woods system.
Also proposed at Bretton Woods was the establishment of an international institution to help regulate the fixed exchange rate system. This institution was the International Monetary Fund (IMF). The IMF’s main mission was to help maintain the stability of the Bretton Woods fixed exchange rate system.
Basket of Currencies
Countries that have several important trading partners, or who fear that one currency may be too volatile over an extended period, have chosen to fix their currency to a basket of several other currencies. This means fixing to a weighted average of several currencies. This method is best understood by considering the creation of a composite currency. Consider the following hypothetical example: a new unit of money consisting of 1 euro, 100 Japanese yen, and one U.S. dollar. Call this new unit a Eur-yen-dol. A country could now fix its currency to one Eur-yen-dol. The country would then need to maintain reserves in one or more of the three currencies to satisfy excess demand or supply of its currency on the Forex.
A better example of a composite currency is found in the SDR. SDR stands for special drawing rights. It is a composite currency created by the International Monetary Fund (IMF). One SDR now consists of a fixed quantity of U.S. dollars, euros, Japanese yen, and British pounds. For more info on the SDR see the IMF factsheet.International Monetary Fund, About the IMF, Factsheet, “Special Drawing Rights (SDRs),” http://www.imf.org/external/np/exr/facts/sdr.htm[0]. Now Saudi Arabia officially fixes its currency to the SDR. Botswana fixes to a basket consisting of the SDR and the South African rand.
Crawling Pegs
A crawling peg refers to a system in which a country fixes its exchange rate but also changes the fixed rate at periodic or regular intervals. Central bank interventions in the Forex may occur to maintain the temporary fixed rate. However, central banks can avoid interventions and save reserves by adjusting the fixed rate instead. Since crawling pegs are adjusted gradually, they can help eliminate some exchange rate volatility without fully constraining the central bank with a fixed rate. In 2010 Bolivia, China, Ethiopia, and Nicaragua were among several countries maintaining a crawling peg.
Pegged within a Band
In this system, a country specifies a central exchange rate together with a percentage allowable deviation, expressed as plus or minus some percentage. For example, Denmark, an EU member country, does not yet use the euro but participates in the Exchange Rate Mechanism (ERM2). Under this system, Denmark sets its central exchange rate to 7.46038 krona per euro and allows fluctuations of the exchange rate within a 2.25 percent band. This means the krona can fluctuate from a low of 7.63 kr/€ to a high of 7.29 kr/€. (Recall that the krona is at a high with the smaller exchange rate value since the kr/euro rate represents the euro value.) If the market determined floating exchange rate rises above or falls below the bands, the Danish central bank must intervene in the Forex. Otherwise, the exchange rate is allowed to fluctuate freely.
As of 2010, Slovenia, Syria, and Tonga were fixing their currencies within a band.
Currency Boards
A currency board is a legislated method to provide greater assurances that an exchange rate fixed to a reserve currency will indeed remain fixed. In this system, the government requires that domestic currency is always exchangeable for the specific reserve at the fixed exchange rate. The central bank authorities are stripped of all discretion in the Forex interventions in this system. As a result, they must maintain sufficient foreign reserves to keep the system intact.
In 2010 Bulgaria, Hong Kong, Estonia, and Lithuania were among the countries using a currency board arrangement. Argentina used a currency board system from 1991 until 2002. The currency board was very effective in reducing inflation in Argentina during the 1990s. However, the collapse of the exchange rate system and the economy in 2002 demonstrated that currency boards are not a panacea.
Dollarization/Euroization
The most extreme and convincing method for a country to fix its exchange rate is to give up one’s national currency and adopt the currency of another country. In creating the euro-zone among twelve of the European Union (EU) countries, these European nations have given up their own national currencies and have adopted the currency issued by the European Central Bank. This is a case of euroization. Since all twelve countries now share the euro as a common currency, their exchange rates are effectively fixed to each other at a 1:1 ratio. As other countries in the EU join the common currency, they too will be forever fixing their exchange rate to the euro. (Note, however, that although all countries that use the euro are fixed to each other, the euro itself floats with respect to external currencies such as the U.S. dollar.)
Other examples of adopting another currency as one’s own are the countries of Panama, Ecuador, and El Salvador. These countries have all chosen to adopt the U.S. dollar as their national currency of circulation. Thus they have chosen the most extreme method of assuring a fixed exchange rate. These are examples of dollarization.
key takeways
• In a gold standard, a country’s government declares that its issued currency will exchange for a weight in gold and that it will freely exchange currency for actual gold at the designated exchange rate.
• Adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate.
• In a reserve currency system, a country fixes its own currency value to a unit of another country’s currency. The other country is called the reserve currency country.
• A gold exchange standard is a mixed system consisting of a cross between a reserve currency standard and a gold standard. First, a reserve currency is chosen. Second, the reserve currency country agrees to fix its currency value to a weight in gold. Finally, the reserve country agrees to exchange gold for its own currency with other central banks within the system on demand.
• The post–World War II Bretton Woods system was a gold exchange currency standard.
• Other fixed exchange rate choices include fixing to a market basket, fixing in a nonrigid way by implementing a crawling peg or an exchange rate band, implementing a currency board, or adopting another country’s currency.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used to describe the adjustment mechanism within a gold standard.
• The term given to the currency standard using both gold and silver.
• The term given to the currency standard in which all countries fix to one central currency, while the central currency is not fixed to anything.
• The name of the international organization created after World War II to oversee the fixed exchange rate system.
• In the late nineteenth century, the U.S. dollar was fixed to gold at this exchange rate.
• In the late nineteenth century, the British pound was fixed to gold at this exchange rate.
• In the late nineteenth century, one U.S. dollar was worth approximately this many shillings (note: a shilling is one-tenth of a pound).
• Of gold inflow or gold outflow, this is likely to occur for a country whose interest rates rise under a gold standard with free capital mobility.
• The term used to describe a currency system in which a country fixes its exchange rate but also changes the fixed rate at periodic or regular intervals.
• As of 2004, Estonia and Hong Kong implemented this type of currency system.
2. Use the IMF’s “De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks” at http://www.imf.org/external/np/mfd/er/2008/eng/0408.htm to answer the following questions:
• What are four countries that maintained currency board arrangements?
• What are four countries that maintained a conventional fixed peg?
• What are four countries that maintained a crawling peg?
• What are four countries whose currencies were independently floating? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.02%3A_Fixed_Exchange_Rate_Systems.txt |
Learning Objective
1. Learn how the interest rate parity condition changes in a system of credible fixed exchange rates.
One of the main differences between a fixed exchange rate system and a floating system is that under fixed exchange rates the central bank will have to “do something” periodically. In contrast, in a floating system, the central bank can just sit back and watch since it has no responsibility for the value of the exchange rate. In a pure float, the exchange rate is determined entirely by private transactions.
However, in a fixed exchange rate system, the central bank will need to intervene in the foreign exchange market, perhaps daily, if it wishes to maintain the credibility of the exchange rate.
We’ll use the AA-DD model to explain why. Although the AA-DD model was created under the assumption of a floating exchange rate, we can reinterpret the model in light of a fixed exchange rate assumption. This means we must look closely at the interest rate parity condition, which represents the equilibrium condition in the foreign exchange market.
Recall that the AA-DD model assumes the exchange rate is determined as a result of investor incentives to maximize their rate of return on investments. The model ignores the potential effect of importers and exporters on the exchange rate value. That is, the model does not presume that purchasing power parity holds. As such, the model describes a world economy that is very open to international capital flows and international borrowing and lending. This is a reasonable representation of the world in the early twenty-first century, but would not be the best characterization of the world in the mid-1900s when capital restrictions were more common. Nonetheless, the requisite behavior of central banks under fixed exchange rates would not differ substantially under either assumption.
When investors seek the greatest rate of return on their investments internationally, we saw that the exchange rate will adjust until interest rate parity holds. Consider interest rate parity (IRP) for a particular investment comparison between the United States and the United Kingdom. IRP means that $R_{0}R_{} = R_{0}R_{£}$. We can write this equality out in its complete form to get
where the left-hand side is the U.S. interest rate and the right side is the more complicated rate of return formula for a UK deposit with interest rate $i_{£}$. (See Chapter 4 and Chapter 5 for the derivation of the interest rate parity condition.) The last term on the right represents the expected appreciation (if positive) or depreciation (if negative) of the pound value with respect to the U.S. dollar.
In a floating exchange rate system, the value of this term is based on investor expectations about the future exchange rate as embodied in the term $E_{/£}^{e}$, which determines the degree to which investors believe the exchange rate will change over their investment period.
If these same investors were operating in a fixed exchange rate system, however, and if they believed the fixed exchange rate would indeed remain fixed, then the investors’ expected exchange rate should be set equal to the current fixed spot exchange rate. In other words, under credible fixed exchange rates, $E_{/£}^{e} = E_{/£}$. Investors should not expect the exchange rate to change from its current fixed value. (We will consider a case in which the investors’ expected exchange rate does not equal the fixed spot rate in Chapter 12, Section 12.6.)
With $E_{/£}^{e} = E_{/£}$, the right side of the above expression becomes zero, and the interest rate parity condition under fixed exchange rates becomes
$i_{} = i_{£}. \nonumber$
Thus for interest rate parity to hold in a fixed exchange rate system, the interest rates between two countries must be equal.
Indeed, the reason this condition in a floating system is called “interest rate parity” rather than “rate of return parity” is because of our history with fixed exchange rates. Before 1973, most of the world had maintained fixed exchange rates for most of the time. We can see now that under fixed exchange rates, rates of return in each country are simply the interest rates on individual deposits. In other words, in a fixed system, which is what most countries had through much of their histories, interest rate parity means the equality of interest rates. When the fixed exchange rate system collapsed, economists and others continued to use the now-outdated terminology: interest rate parity. Inertia in language usage is why the traditional term continues to be applied (somewhat inappropriately) even today.
key takeaway
• For interest rate parity to hold in a fixed exchange rate system, the interest rates between two countries must be equal.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• These must be equalized between countries for interest rate parity to hold under fixed exchange.
• If the fixed exchange rates are credible, then the expected exchange rate should be equal to this exchange rate.
• Of intervene or do not intervene, this is what a central bank should do in the Forex market if it intends to maintain credible fixed exchange rates. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.03%3A_Interest_Rate_Parity_with_Fixed_Exchange_Rates.txt |
Learning Objective
1. Learn what a central bank must do to maintain a credible fixed exchange rate in a reserve currency system.
In a fixed exchange rate system, most of the transactions of one currency for another will take place in the private market among individuals, businesses, and international banks. However, by fixing the exchange rate the government would have declared illegal any transactions that do not occur at the announced rate. However, it is very unlikely that the announced fixed exchange rate will at all times equalize private demand for foreign currency with private supply. In a floating exchange rate system, the exchange rate adjusts to maintain the supply and demand balance. In a fixed exchange rate system, it becomes the responsibility of the central bank to maintain this balance.
The central bank can intervene in the private foreign exchange (Forex) market whenever needed by acting as a buyer and seller of currency of last resort. To see how this works, consider the following example.
Suppose the United States establishes a fixed exchange rate to the British pound at the rate \(Ē_{\$/£}\). In Figure 11.4.1 , we depict an initial private market Forex equilibrium in which the supply of pounds (\(S_{£}\)) equals demand (\(D_{£}\)) at the fixed exchange rate (\(Ē_{\$/£}\)). But suppose, for some unspecified reason, the demand for pounds on the private Forex rises one day to \(D_{£}’\).
At the fixed exchange rate (\(Ē_{\$/£}\)), private market demand for pounds is now \(Q_{2}\), whereas supply of pounds is \(Q_{1}\). This means there is excess demand for pounds in exchange for U.S. dollars on the private Forex.
To maintain a credible fixed exchange rate, the U.S. central bank would immediately satisfy the excess demand by supplying additional pounds to the Forex market. That is, it sells pounds and buys dollars on the private Forex. This would cause a shift of the pound supply curve from \(S_{£}\) to \(S_{£}'\). In this way, the equilibrium exchange rate is automatically maintained at the fixed level.
Alternatively, consider Figure 11.4.2 , in which again the supply of pounds (\(S_{£}\)) equals demand (\(D_{£}\)) at the fixed exchange rate (\(Ē_{\$/£}\)). Now suppose, for some unspecified reason, the demand for pounds on the private Forex falls one day to \(D_{£}'\). At the fixed exchange rate (\(Ē_{\$/£}\)), private market demand for pounds is now \(Q_{2}\), whereas supply of pounds is \(Q_{1}\). This means there is excess supply of pounds in exchange for U.S. dollars on the private Forex.
In this case, an excess supply of pounds also means an excess demand for dollars in exchange for pounds. The U.S. central bank can satisfy the extra dollar demand by entering the Forex and selling dollars in exchange for pounds. This means it is supplying more dollars and demanding more pounds. This would cause a shift of the pound demand curve from \(D_{£}’\) back to \(D_{£}\). Since this intervention occurs immediately, the equilibrium exchange rate is automatically and always maintained at the fixed level.
Key Takeaways
• If, for example, the United States fixes its currency to the British pound (the reserve), when there is excess demand for pounds in exchange for U.S. dollars on the private Forex, the U.S. central bank would immediately satisfy the excess demand by supplying additional pounds to the Forex market. By doing so, it can maintain a credible fixed exchange rate.
• If, for example, the United States fixes its currency to the British pound (the reserve), when there is excess demand for dollars in exchange for British pounds on the private Forex, the U.S. central bank would immediately satisfy the excess demand by supplying dollars to the Forex market. By doing so, it can maintain a credible fixed exchange rate.
Exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of buy, sell, or do nothing, this is what a central bank must do with its reserve currency if there is excess demand for its own currency in the private Forex market while maintaining a fixed exchange rate.
• Of buy, sell, or do nothing, this is what a central bank must do with its reserve currency if there is excess demand for the reserve currency in the private Forex market while maintaining a fixed exchange rate.
• Of buy dollars, sell dollars, or do nothing, this is what China’s central bank must do if there is excess demand for Chinese yuan in the private Forex market if China fixes its currency to the U.S. dollar.
• Of buy yuan, sell yuan, or do nothing, this is what China’s central bank must do if there is excess demand for U.S. dollars in the private Forex market if China fixes its currency to the U.S. dollar. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.04%3A_Central_Bank_Intervention_with_Fixed_Exchange_Rates.txt |
Learning Objective
1. Learn the definitions and usage of balance of payments deficits and surpluses in a fixed exchange rate system.
To maintain a fixed exchange rate, the central bank will need to automatically intervene in the private foreign exchange (Forex) by buying or selling domestic currency in exchange for the foreign reserve currency. Clearly, in order for these transactions to be possible, a country’s central bank will need a stock of the foreign reserve currency at the time the fixed exchange rate system begins. Subsequently, if excess demand for foreign currency in some periods is balanced with excess supply in other periods, then falling reserves in some periods (when dollars are bought on the Forex) will be offset with rising reserves in other periods (when dollars are sold in the Forex) and a central bank will be able to maintain the fixed exchange rate. Problems arise, though, if a country begins to run out of foreign reserves. But before discussing that situation, we need to explain some terminology.
When the central bank buys domestic currency and sells the foreign reserve currency in the private Forex, the transaction indicates a balance of payments deficit. Alternatively, when the central bank sells domestic currency and buys foreign currency in the Forex, the transaction indicates a balance of payments surplus.
Central bank transactions are recorded in an account titled official reserve transactions. It is found in the financial account of the balance of payments. If this account indicates an addition to official reserves over some period, then the country is running a balance of payments surplus. If over some period the official reserve balance is falling, then the country is running a balance of payments deficit. The deficit or surplus terminology arises from the following circumstances.
Suppose a country runs a trade deficit in a fixed exchange rate system. A trade deficit means that demand for imports exceeds foreign demand for our exports. This implies that domestic demand for foreign currency (to buy imports) exceeds foreign demand for domestic currency (to buy our exports). Assuming no additional foreign demands for domestic currency on the financial account (to keep the exchange rate fixed), the central bank would need to intervene by selling foreign currency in exchange for domestic currency. This would lead to a reduction of foreign reserves and hence a balance of payments deficit. In the absence of transactions on the financial account, to have a trade deficit and a fixed exchange rate implies a balance of payments deficit as well.
More generally, a balance of payments deficit (surplus) arises whenever there is excess demand for (supply of) foreign currency on the private Forex at the official fixed exchange rate. To satisfy the excess demand (excess supply), the central bank will automatically intervene on the Forex and sell (buy) foreign reserves. Thus by tracking sales or purchases of foreign reserves in the official reserve account, we can determine if the country has a balance of payments deficit or surplus.
Note that in a floating exchange rate system, a central bank can intervene in the private Forex to push the exchange rate up or down. Thus official reserve transactions can show rising or falling foreign reserves and hence suggest a balance of payments deficit or surplus in a floating exchange system. However, it is not strictly proper to describe a country with floating exchange rates as having a balance of payment deficit or surplus. The reason is that interventions are not necessary in a floating exchange rate. In a floating system, an imbalance between supply and demand in the private Forex is relieved by a change in the exchange rate. Thus there need never be an imbalance in the balance of payments in a floating system.
Key Takeaways
• When the central bank buys domestic currency and sells the foreign reserve currency in the private Forex, the transaction indicates a balance of payments deficit.
• When the central bank sells domestic currency and buys foreign currency in the Forex, the transaction indicates a balance of payments surplus.
• A balance of payments deficit (surplus) arises whenever there is excess demand for (supply of) foreign currency on the private Forex at the official fixed exchange rate.
exercies
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The account on the balance of payments (BoP) used to record all central bank transactions.
• The balance on the BoP when the central bank sells foreign reserves.
• Of BoP deficit, BoP surplus, or BoP balance, this is what a central bank will run if there is excess demand for its own currency in the private Forex market while maintaining a fixed exchange rate.
• Of BoP deficit, BoP surplus, or BoP balance, this is what a central bank will run if there is excess demand for the reserve currency in the private Forex market while maintaining a fixed exchange rate.
• Of BoP deficit, BoP surplus, or BoP balance, this is what China’s central bank will run if there is excess demand for Chinese yuan in the private Forex market if China fixes its currency to the U.S. dollar.
• Of BoP deficit, BoP surplus, or BoP balance, this is what China’s central bank will run if there is excess demand for U.S. dollars in the private Forex market if China fixes its currency to the U.S. dollar. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.05%3A_Balance_of_Payments_Deficits_and_Surpluses.txt |
Learning Objective
1. Learn the five different reasons why trade between countries may occur.
Till now we have said that a central bank must intervene in the foreign exchange (Forex) market whenever there is excess demand or supply of foreign currency. However, we might consider what would happen if the central bank did not intervene. Surely the government could simply mandate that all Forex transactions take place at the official fixed rate and implement severe penalties if anyone is caught trading at a different rate. A black market arises, however, when exchanges for foreign currency take place at an unofficial (or illegal) exchange rate.
Let’s consider why a black market may arise. Suppose the United States fixes its exchange rate to the British pound at the rate \(Ē_{\$/£}\). This is indicated in Figure 11.6.1 as a horizontal line drawn at \(Ē_{\$/£}\). Suppose further that demand for pounds (\(Q_{1}\)) on the private Forex exceeds supply (\Q_{2}\)) at the official fixed exchange rate, but the central bank does not intervene to correct the imbalance. In this case, suppliers of pounds will come to the market with \(Q_{2}\) quantity of pounds, but many people who would like to buy pounds will not find a willing supplier. Those individuals and businesses demanding the excess (\(Q_{1} − Q_{2}\)) will leave the market empty-handed. Now if this were a one-time occurrence, the unsatisfied demand might be fulfilled in later days when excess supply of pounds comes to the market. However, a more likely scenario is that this unsatisfied demand persists for a long period. With each passing day of unsatisfied demand, total unsatisfied demand grows insidiously.
Together with the excess demand is a willingness to pay more than the official rate to obtain currency. Since the market equilibrium rate is at \(E_{\$/£}^{1}\), excess demanders would be willing to pay more dollars to obtain a pound than is required in the official market. The willingness to pay more creates a profit-making possibility. Suppose an individual or business obtains pounds, perhaps by selling goods in Britain and being paid in foreign currency. This person could convert the pounds for dollars at the official rate or, if he or she wants to make more money, could trade the currency “unofficially” at a higher exchange rate. The only problem is finding someone willing to buy the pounds at the unofficial rate. This turns out rarely to be a problem. Wherever black markets develop, unofficial traders find each other on street corners, at hotels, and even within banks.
Thus a central bank doesn’t absolutely need to intervene in the Forex market in a fixed exchange rate system. However, if it does not, a black market will very likely arise and the central bank will lose control of the exchange rate. One main purpose of fixed exchange rates, namely the certainty of knowing what the currency will exchange for, is also lost since traders will have to decide whether to trade officially or unofficially. Furthermore, the black market exchange rate typically rises and falls with changes in supply and demand, thus one is never sure what that rate will be.
In light of the potential for black markets to arise, if a government wishes to maintain a credible fixed exchange rate, regular intervention to eliminate excess demand or supply of foreign currency is indeed required.
Key Takeaways
• A black market arises when exchanges for foreign currency take place at an unofficial (or illegal) exchange rate.
• If a central bank does not intervene regularly in the Forex market, a black market will very likely arise and the central bank will lose control of the exchange rate.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term used to describe currency transactions that occur at unofficial exchange rates in a fixed exchange rate system.
• Of buy, sell, or do nothing, a central bank will likely do this with its reserve currency if excess demand for its own currency leads to illegal trades at a higher value.
• Of credible or not credible, this describes a fixed exchange rate system that coexists with a black market. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/11%3A_Fixed_Exchange_Rates/11.06%3A_Black_Markets.txt |
Government policies work differently under a system of fixed exchange rates rather than floating rates. Monetary policy can lose its effectiveness whereas fiscal policy can become supereffective. In addition, fixed exchange rates offer another policy option, namely, exchange rate policy. Even though a fixed exchange rate should mean the country keeps the rate fixed, sometimes countries periodically change their fixed rate.
This chapter considers these policies under the assumptions of the AA-DD model. It concludes with a case study about the decline of the Bretton Woods fixed exchange rate system that was in place after World War II.
12: Policy Effects with Fixed Exchange Rates
Learning Objective
1. Preview the comparative statics results from the AA-DD model with fixed exchange rates.
This chapter uses the AA-DD model to describe the effects of fiscal, monetary, and exchange rate policy under a system of fixed exchange rates. Fiscal and monetary policies are the primary tools governments use to guide the macroeconomy. With fixed exchange rates, a third policy option becomes available—that is, exchange rate policy. Thus we also examine the effects of changes in the fixed exchange rate. These exchange rate changes are called devaluations (sometimes competitive devaluations) and revaluations.
In introductory macroeconomics courses, students learn how government policy levers can be used to influence the level of the gross national product (GNP), inflation rate, unemployment rate, and interest rates. In this chapter, that analysis is expanded to an open economy (i.e., one open to trade) and to the effects on exchange rates and current account balances.
Results
Using the AA-DD model, several important relationships between key economic variables are shown:
• A monetary policy (change in \(M^{S}\)) has no effect on GNP or the exchange rate in a fixed exchange system. As such, the trade balance, unemployment, and interest rates all remain the same as well. Monetary policy becomes ineffective as a policy tool in a fixed exchange rate system.
• Expansionary fiscal policy (\(↑G\), \(↑TR\), or \(↓T\)) causes an increase in GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment are both reduced.
• Contractionary fiscal policy (\(↓G\), \(↓TR\), or \(↑T\)) reduces GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment both rise.
• A competitive devaluation lowers the currency value and causes an increase in GNP. Unemployment falls, interest rates remain the same, and the trade balance rises.
• A currency revaluation raises the currency value and causes a decrease in GNP. Unemployment rises, interest rates remain the same, and the trade balance falls.
• Monetary expansion by the reserve currency country forces the domestic country to run a balance of payments surplus to maintain its fixed exchange rate. The resulting money supply increase causes domestic interest rates to fall to maintain equality with the falling foreign interest rates. Domestic GNP remains fixed, as do unemployment and the trade balance.
• A currency crisis arises when a country runs persistent balance of payments deficits while attempting to maintain its fixed exchange rate and is about to deplete its foreign exchange reserves. A crisis can force a country to devalue its currency or move to a floating exchange rate. To postpone the crisis, countries can sometimes borrow money from organizations like the International Monetary Fund (IMF).
• Anticipation of a balance of payments crisis can induce investors to sell domestic assets in favor of foreign assets. This is called capital flight. Capital flight will worsen a balance of payments problem and can induce a crisis to occur.
Connections
The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The main levers the government controls are monetary policy (changes in the money supply), fiscal policy (changes in the government budget), and exchange rate policy (setting the fixed exchange rate value). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a fixed exchange rate system. In Chapter 10, we considered these same government policies in the context of a floating exchange rate system. In Chapter 13, we’ll compare fixed and floating exchange rate systems and discuss the pros and cons of each system.
It is important to recognize that these results are what “would” happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Nevertheless, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements (not described in the model) may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.
Key Takeaways
• The main objective of the AA-DD model is to assess the effects of monetary, fiscal, and exchange rate policy changes.
• It is important to recognize that these results are what “would” happen under the full set of assumptions that describes the AA-DD model; they may or may not accurately describe actual outcomes in actual economies.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of appreciation, depreciation, or no change, the effect of expansionary monetary policy on the domestic currency value under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of contractionary monetary policy on GNP under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of expansionary monetary policy on the current account deficit under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of contractionary monetary policy on the current account surplus under fixed exchange rates in the AA-DD model.
• Of appreciation, depreciation, or no change, the effect of expansionary fiscal policy on the domestic currency value under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of contractionary fiscal policy on GNP under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of expansionary fiscal policy on the current account deficit under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of a devaluation on GNP under fixed exchange rates in the AA-DD model.
• Of increase, decrease, or no change, the effect of a revaluation on the current account deficit under fixed exchange rates in the AA-DD model.
• The term used to describe a rapid purchase of foreign investments often spurred by the expectation of an imminent currency devaluation.
• The term used to describe the situation when a central bank runs persistent balance of payments deficits and is about to run out of foreign exchange reserves. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.01%3A_Overview_of_Policy_with_Fixed_Exchange_Rates.txt |
Learning Objective
1. Learn how changes in monetary policy affect GNP, the value of the exchange rate, and the current account balance in a fixed exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
In this section, we use the AA-DD model to assess the effects of monetary policy in a fixed exchange rate system. Recall from Chapter 7 that the money supply is effectively controlled by a country’s central bank. In the case of the United States, this is the Federal Reserve Board, or the Fed. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in Chapter 7, Section 7.5.
Expansionary Monetary Policy
Suppose the United States fixes its exchange rate to the British pound at the rate \(Ē_{\$/£}\). This is indicated in Figure 12.2.1 as a horizontal line drawn at \(Ē_{\$/£}\). Suppose also that the economy is originally at a superequilibrium shown as point F with original gross national product (GNP) level \(Y^{1}\). Next, suppose the U.S. central bank (the Fed) decides to expand the money supply by conducting an open market operation, ceteris paribus. Ceteris paribus means that all other exogenous variables are assumed to remain at their original values. A purchase of Treasury bonds by the Fed will lead to an increase in the dollar money supply. As shown in Chapter 9, Section 9.5, money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., \(↑M^{S}\) is an AA up-shifter). This is depicted in the diagram as a shift from the red AA to the blue AA′ line.
The money supply increase puts upward pressure on the exchange rate in the following way. First, a money supply increase causes a reduction in U.S. interest rates. This in turn reduces the rate of return on U.S. assets below the rate of return on similar assets in Britain. Thus international investors will begin to demand more pounds in exchange for dollars on the private Forex to take advantage of the relatively higher \(R_{0}R\) of British assets. In a floating exchange system, excess demand for pounds would cause the pound to appreciate and the dollar to depreciate. In other words, the exchange rate \(E_{\$/£}\) would rise. In the diagram, this would correspond to a movement to the new A′A′ curve at point G.
However, because the country maintains a fixed exchange rate, excess demand for pounds on the private Forex will automatically be relieved by Fed intervention. The Fed will supply the excess pounds demanded by selling reserves of pounds in exchange for dollars at the fixed exchange rate. As we showed in Chapter 10, Section 10.5, Fed sales of foreign currency result in a reduction in the U.S. money supply. This is because when the Fed buys dollars in the private Forex, it is taking those dollars out of circulation and thus out of the money supply. Since a reduction of the money supply causes AA to shift back down, the final effect will be that the AA curve returns to its original position. This is shown as the up and down movement of the AA curve in the diagram. The final equilibrium is the same as the original at point F.
The AA curve must return to the same original position because the exchange rate must remain fixed at \(Ē_{\$/£}\). This implies that the money supply reduction due to Forex intervention will exactly offset the money supply expansion induced by the original open market operation. Thus the money supply will temporarily rise but then will fall back to its original level. Maintaining the money supply at the same level also assures that interest rate parity is maintained. Recall that in a fixed exchange rate system, interest rate parity requires equalization of interest rates between countries (i.e., \(i_{\$} = i_{£}\)). If the money supply did not return to the same level, interest rates would not be equalized.
Thus after final adjustment occurs, there are no effects from expansionary monetary policy in a fixed exchange rate system. The exchange rate will not change and there will be no effect on equilibrium GNP. Also, since the economy returns to the original equilibrium, there is also no effect on the current account balance.
Contractionary Monetary Policy
Contractionary monetary policy corresponds to a decrease in the money supply or a Fed sale of Treasury bonds on the open bond market. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. U.S. contractionary monetary policy with a fixed exchange rate will have no effects within the economy. \(E_{\$/£}\), \(Y_{\$}\) and the current account balance will all be maintained or return to their initial levels.
Discussion
This result indicates that monetary policy is ineffective in influencing the economy in a fixed exchange rate system. In contrast, in a floating exchange rate system, monetary policy can either raise or lower GNP, at least in the short run. Thus monetary policy has some effectiveness in a floating system, and central bank authorities can adjust policy to affect macroeconomic conditions within their economy. For example, if the economy is growing only sluggishly, or perhaps is contracting, the central bank can raise the money supply to help spur an expansion of GNP, if the economy has a floating exchange rate. However, with a fixed exchange rate, the central bank no longer has this ability. This explains why countries lose monetary autonomy (or independence) with a fixed exchange rate. The central bank can no longer have any influence over the interest rate, exchange rate, or the level of GNP.
One other important comparison worth making is between expansionary monetary policy in a fixed exchange rate system with sterilized foreign exchange (Forex) interventions in a floating system. In the first case, expansionary monetary policy is offset later with a contraction of the money supply caused by automatic Forex intervention. In the second case, Forex intervention leading to an expansion of the money supply is countered with contractionary open market operations. In the first case, the interest rate is maintained to satisfy interest rate parity. In the second case, the interest rate remains fixed by design. Clearly, these two situations represent exactly the same set of actions, though in a different order. Thus it makes sense that the two policies would have the same implications—that is, “no impact” on any of the economic variables.
Key Takeaways
• There are no effects from expansionary or contractionary monetary policy in a fixed exchange rate system. The exchange rate will not change, there will be no effect on equilibrium GNP, and there will be no effect on the current account balance.
• Monetary policy in a fixed exchange rate system is equivalent in its effects to sterilized Forex interventions in a floating exchange rate system.
exercise
1. Suppose that Latvia can be described with the AA-DD model and that Latvia fixes its currency, the lats (Ls), to the euro. Consider the changes in the exogenous variable in the left column. Indicate the short-run effects on the equilibrium levels of Latvian GNP, the Latvian interest rate (\(i_{Ls}\)) , the Latvian trade balance, and the exchange rate (\(E_{Ls/€}\)). Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
GNP \(i_{Ls}\) Trade Balance \(E_{Ls/€}\)
An increase in the Latvian money supply
A decrease in the Latvian money supply | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.02%3A_Monetary_Policy_with_Fixed_Exchange_Rates.txt |
Learning objectives
1. Learn how changes in fiscal policy affect GNP, the value of the exchange rate, and the current account balance in a fixed exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
In this section, we use the AA-DD model to assess the effects of fiscal policy in a fixed exchange rate system. Recall from Chapter 8 that fiscal policy refers to any change in expenditures or revenues within any branch of the government. This means any change in government spending (e.g., transfer payments or taxes) by federal, state, or local governments represents a fiscal policy change. Since changes in expenditures or revenues will often affect a government budget balance, we can also say that a change in the government surplus or deficit represents a change in fiscal policy.
When government spending or transfer payments increase, or tax revenues decrease, we refer to it as expansionary fiscal policy. These actions would also be associated with an increase in the government budget deficit, or a decrease in its budget surplus. If the government acts to reduce government spending or transfer payments, or increase tax revenues, it is referred to as contractionary fiscal policy. These actions would also be associated with a decrease in the government budget deficit, or an increase in its budget surplus.
Expansionary Fiscal Policy
Suppose the United States fixes its exchange rate to the British pound at the rate \(Ē_{\$/£}\). This is indicated in Figure 12.3.1 as a horizontal line drawn at \(Ē_{\$/£}\). Suppose also that the economy is originally at a superequilibrium shown as point J with GNP at level \(Y^{1}\). Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). As shown in Chapter 9, Section 9.3, fiscal policy changes cause a shift in the DD curve. More specifically, an increase in government spending (or an increase in transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., \(↑G\), \(↑TR\), and \(↓T\) all are DD right-shifters). This is depicted in the diagram as a shift from the red DD to the blue DD′ line (step 1).
If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for goods and services (G&S) will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case, aggregate demand increases. Before any adjustment occurs, the increase in aggregate demand causes aggregate demand to exceed aggregate supply, which will lead to an expansion of GNP. Thus the economy will begin to move rightward from point J.
As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom and international investors increase demand for dollars (in exchange for pounds) on the private Forex. In a floating exchange rate system this would lead to a U.S. dollar appreciation (and pound depreciation)—that is, a decrease in the exchange rate \(E_{\$/£}\).
However, because the country maintains a fixed exchange rate, excess demand for dollars on the private Forex will automatically be relieved by the U.S. Federal Reserve (or the Fed) intervention. The Fed will supply the excess dollars demanded by buying pounds in exchange for dollars at the fixed exchange rate. As we showed in Chapter 10, Section 10.5, the foreign currency purchases by the Fed result in an increase in the U.S. money supply. This is because when the Fed sells dollars in the private Forex, these dollars are entering into circulation and thus become a part of the money supply. The increase in the money supply causes the AA curve to shift up (step 2). The final equilibrium will be reached when the new A′A′ curve intersects the D′D′ curve at the fixed exchange rate (\(Ē_{\$/£}\)) shown at point K.
Note that in the transition, the Fed intervention in the Forex occurred because investors responded to rising U.S. interest rates by increasing demand for dollars on the Forex. The Fed’s response causes an increase in the money supply, which in turn will lower interest rates back to their original level. This result is necessary to maintain the fixed exchange rate interest rate parity (IRP) condition of \(i_{\$} = i_{£}\).
Note also that as GNP increases in the transition, causing interest rates to rise, this rise is immediately countered with automatic Fed intervention in the Forex. Thus the exchange rate will never fall below the fixed rate. There will be pressure for the exchange rate to fall, but the Fed will always be there to relieve the pressure with its intervention. Thus the adjustment path from the original equilibrium at J to the final equilibrium at K will follow the rightward arrow between the two points along the fixed exchange rate.
The final result is that expansionary fiscal policy in a fixed exchange rate system will cause an increase in GNP (from \(Y^{1}\) to \(Y^{2}\)) and no change in the exchange rate in the short run. Since the new equilibrium at K lies below the original CC curve representing a fixed current account balance, expansionary fiscal policy, consisting of an increase in G, will cause the current account balance to fall. This corresponds to a decrease in a trade surplus or an increase in a trade deficit.
Contractionary Fiscal Policy
Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments, or an increase in taxes. It would also be represented by a decrease in the government budget deficit or an increase in the budget surplus. In the AA-DD model, a contractionary fiscal policy shifts the DD curve leftward. The effects will be the opposite of those described above for expansionary fiscal policy. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. Contractionary fiscal policy in a fixed exchange rate system will cause a decrease in GNP and no change in the exchange rate in the short run. Contractionary fiscal policy, consisting of a decrease in G, will also cause the current account balance to rise. This corresponds to an increase in a trade surplus or a decrease in a trade deficit.
Key Takeaways
• Expansionary fiscal policy in a fixed exchange rate system will cause an increase in GNP, no change in the exchange rate (of course), and a decrease in the current account balance.
• Contractionary fiscal policy in a fixed exchange rate system will cause a decrease in GNP, no change in the exchange rate (of course), and an increase in the current account balance.
Exercises
1. Sri Lanka fixes its currency, the Sri Lankan rupee (LKR), to the U.S. dollar. Suppose Sri Lanka can be described using the AA-DD model. Consider changes in the exogenous variables in Sri Lanka in the left column. Suppose each change occurs ceteris paribus. Indicate the short-run effects on the equilibrium values of Sri Lankan GNP, the Sri Lankan interest rate (\(i_{LKR}\)), the Sri Lankan trade deficit, and the exchange rate (\(E_{LKR/\$}\)). Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
GNP \(i_{LKR}\) Sri Lankan Trade Deficit \(E_{LKR/\$}\)
A decrease in domestic taxes
An increase in government demand
An increase in transfer payments
2. Consider the following occurrences. Use the AA-DD model to determine the impact on the variables (+, −, 0, or A) from the twin-deficit identity listed along the top row. Consider only short-run effects (i.e., before inflationary effects occur) and assume ceteris paribus for all other exogenous variables.
Impact on
\(S_{p}\) \(I\) \(IM − EX\) \(G + TR − T\)
A reduction in government spending with a fixed exchange rate
An increase in transfer payments with fixed exchange rates
A decrease in taxes with fixed exchange rates | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.03%3A_Fiscal_Policy_with_Fixed_Exchange_Rates.txt |
Learning objectives
1. Learn how changes in exchange rate policy affect GNP, the value of the exchange rate, and the current account balance in a fixed exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
In this section, we use the AA-DD model to assess the effects of exchange rate policy in a fixed exchange rate system. In a sense we can say that the government’s decision to maintain a fixed exchange is the country’s exchange rate policy. However, over time, the government does have some discretion concerning the value of the exchange rate. In this section, we will use “exchange rate policy” to mean changes in the value of the fixed exchange rate.
If the government lowers the value of its currency with respect to the reserve currency or to gold, we call the change a devaluation. If the government raises the value of its currency with respect to the reserve currency or to gold, we call the change a revaluation. The terms devaluation and revaluation should properly be used only in reference to a government change in the fixed exchange rate since each term suggests an action being taken. In contrast, natural market changes in supply and demand will result in changes in the exchange rate in a floating system, but it is not quite right to call these changes devaluations or revaluations since no concerted action was taken by anyone. Nonetheless, some writers will sometimes use the terms this way.
In most cases, devaluations and revaluations occur because of persistent balance of payments disequilibria. We will consider these situations in Chapter 12, Section 12.6 on balance of payments crises and capital flight. In this section, we will consider the basic effects of devaluations and revaluations without assuming any notable prior events caused these actions to occur.
Devaluation
Suppose the United States fixes its exchange rate to the British pound at the rate \(Ē_{\$/£}\). This is indicated in Figure 12.4.1 as a horizontal line drawn at \(Ē_{\$/£}\). Suppose also that the economy is originally at a superequilibrium shown as point F with gross national product (GNP) at level \(Y^{1}\). Next, suppose the U.S. central bank (or the Fed) decides to devalue the U.S. dollar with respect to the British pound corresponding to an increase in the fixed rate from \(Ē_{\$/£}\) to \(Ê_{\$/£}\). Recall that a devaluation corresponds to an increase in the \$/£ exchange rate. Assume that there was no anticipation of the devaluation and that it comes about as a complete surprise to all market participants.
The first effect of the devaluation, of course, is that the exchange rate rises. Immediately the economy moves from F to G on the diagram. It may seem that this would move the economy off the AA curve, but instead the AA curve shifts up with the devaluation to A′A′. This occurs because the AA curve is a function of the expected exchange rate. As long as investors believe that the new exchange rate will now remain fixed at its new rate (\(Ê_{\$/£}\)), the expected future exchange rate will immediately rise to this new level as well. It is this increase in \(E_{\$/£}^{e}\) that causes AA to shift up.
When at point G, however, the economy is not at a superequilibrium. Because of the dollar devaluation, the real exchange rate has increased, making foreign goods relatively more expensive and U.S. goods relatively cheaper. This raises aggregate demand, which at the new exchange rate (\(Ê_{\$/£}\)) is now at the level where the exchange rate line crosses the DD curve at point H.
Since the economy, for now, lies at G to the left of point H on the DD curve, aggregate demand exceeds supply. Producers will respond by increasing supply to satisfy the demand, and GNP will begin to rise.
As GNP rises, real money demand will rise, causing an increase in U.S. interest rates, which will raise the rate of return on U.S. assets. Investors will respond by increasing their demand for U.S. dollars on the foreign exchange (Forex) market, and there will be pressure for a dollar appreciation.
To maintain the fixed exchange rate, however, the U.S. Fed will have to automatically intervene on the Forex and sell dollars to satisfy the excess demand in exchange for pounds. This represents a balance of payments surplus since by buying pounds on the Forex the United States is adding to its stock of foreign reserves. A balance of payments surplus in turn causes an increase in the U.S. money supply, which will shift the AA curve to the right.
As GNP rises toward \(Y^{2}\) at point H, the AA curve will shift right with the Fed intervention to maintain the equilibrium exchange rate at the new fixed value, which is \(Ê_{\$/£}\). The final superequilibrium occurs at point H where excess aggregate demand is finally satisfied.
The final result is that a devaluation in a fixed exchange rate system will cause an increase in GNP (from \(Y^{1}\) to \(Y^{2}\)) and an increase in the exchange rate to the new fixed value in the short run. Since the new equilibrium at H lies above the original CC curve representing a fixed current account balance, a devaluation will cause the current account balance to rise. This corresponds to an increase in a trade surplus or a decrease in a trade deficit.
Revaluation
A revaluation corresponds to change in the fixed exchange rate such that the country’s currency value is increased with respect to the reserve currency. In the AA-DD model, a U.S. dollar revaluation would be represented as a decrease in the fixed \$/£ exchange rate. The effects will be the opposite of those described above for a devaluation. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. A revaluation in a fixed exchange rate system will cause a decrease in GNP and a decrease in the fixed exchange rate in the short run. A revaluation will also cause the current account balance to fall. This corresponds to a decrease in a trade surplus or an increase in a trade deficit.
key Takeaways
• If the government lowers (raises) the value of its currency with respect to the reserve currency, or to gold, we call the change a devaluation (revaluation).
• A devaluation in a fixed exchange rate system will cause an increase in GNP, an increase in the exchange rate to the new fixed value in the short run, and an increase in the current account balance.
• A revaluation in a fixed exchange rate system will cause a decrease in GNP, an increase in the currency value to the new fixed rate, and a decrease in the current account balance.
Exercises
1. Vietnam fixes its currency, the Vietnamese dong (VND), to the US dollar. Suppose Vietnam can be described using the AA-DD model. Consider changes in the exogenous variables in Vietnam in the left column. Suppose each change occurs ceteris paribus. Indicate the short-run effects on the equilibrium values of Vietnamese GNP, the Vietnamese interest rate (\(i_{VND}\)), the Vietnamese trade deficit, and the exchange rate (\(E_{VND//\$}\)). Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
GNP \(i_{VND}\) \(E_{VND//\$}\)
A devaluation of the Vietnamese dong
A revaluation of the Vietnamese dong
2. Consider the following occurrences. Use the AA-DD model to determine the impact on the variables (+, −, 0, or A) from the twin-deficit identity listed along the top row. Consider only short-run effects (i.e., before inflationary effects occur) and assume ceteris paribus for all other exogenous variables.
Impact on
\(S_{p}\) \(I\) \(IM − EX\) \(G + TR − T\)
A currency devaluation under fixed exchange rates
A currency revaluation under fixed exchange rates
3. China maintains an exchange rate fixed to the U.S. dollar at the rate \(E_{1}\). Use the following AA-DD diagram for China to depict answers to the questions below. Suppose China’s current account is in surplus originally. Suppose \(Y_{F}\) indicates the full employment level of output.
• Suppose China unexpectedly revalues its currency under pressure from the U.S. government. Draw a line for the new exchange rate and mark the graph with an \(E_{2}\).
• Mark the graph with a T to indicate the position of the economy immediately after the revaluation when investor expectations adjust to the new exchange rate.
• What effect does the revaluation have for the prices of Chinese goods to Americans?
• Mark the graph with a W to indicate the position of the economy once a new short-run equilibrium is achieved. Mark the graph with \(Y_{2}\) to indicate the new level of GDP.
• Does China’s stock of foreign reserves rise or fall after the revaluation?
• Does China’s current account surplus rise or fall?
• In the adjustment to a long-run equilibrium, would the Chinese price level rise or fall? | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.04%3A_Exchange_Rate_Policy_with_Fixed_Exchange_Rates.txt |
Learning Objectives
1. Learn how monetary policy in the foreign reserve country affects domestic GNP, the value of the exchange rate, and the current account balance in a fixed exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.
Suppose the United States fixes its exchange rate to the British pound. In this circumstance, the exchange rate system is a reserve currency standard in which the British pound is the reserve currency. The U.S. government is the one that fixes its exchange rate and will hold some quantity of British pounds on reserve so it is able to intervene on the Forex to maintain the credible fixed exchange rate.
It is worth noting that since the United States fixes its exchange rate to the pound, the British pound is, of course, fixed to the U.S. dollar as well. Since the pound is the reserve currency, however, it has a special place in the monetary system. The Bank of England, Britain’s central bank, will never need to intervene in the Forex market. It does not need to hold dollars. Instead, all market pressures for the exchange rate to change will be resolved by U.S. intervention, that is, by the nonreserve currency country.
Expansionary Monetary Policy by the Reserve Country
Now let’s suppose that the reserve currency country, Britain, undertakes expansionary monetary policy. We will consider the impact of this change from the vantage point of the United States, the nonreserve currency country. Suppose the United States is originally in a superequilibrium at point F in the adjoining diagram with the exchange rate fixed at \(Ē_{\$/£}\). An increase in the British money supply will cause a decrease in British interest rates, \(i_{£}\).
As shown in Figure 12.5.1 as a shift from the red AA to the blue A′A′ line.
The money supply decrease puts downward pressure on the exchange rate in the following way. When British interest rates fall, it will cause \(i_{£} \ < i_{\$}\) and interest rate parity (IRP) will be violated. Thus international investors will begin to demand more dollars in exchange for pounds on the private Forex to take advantage of the relatively higher rate of return on U.S. assets. In a floating exchange system, excess demand for dollars would cause the dollar to appreciate and the pound to depreciate. In other words, the exchange rate (\(E_{\$/£}\)) would fall. In the diagram, this would correspond to a movement to the new A′A′ curve at point G.
Because the country maintains a fixed exchange rate, however, excess demand for dollars on the private Forex will automatically be relieved by the U.S. Federal Reserve (or the Fed) intervention. The Fed will supply the excess dollars demanded by buying pounds in exchange for dollars at the fixed exchange rate. As we showed in Chapter 10, Section 10.5, the foreign currency purchases by the Fed result in an increase in the U.S. money supply. This is because when the Fed sells dollars in the private Forex, these dollars are entering into circulation and thus become a part of the money supply. Since an increase in the money supply causes AA to shift up, the AA curve will return to its original position to maintain the fixed exchange rate. This is shown as the up-and-down movement of the AA curve in the diagram. Thus the final equilibrium is the same as the original equilibrium at point F.
Remember that in a fixed exchange rate system, IRP requires equalization of interest rates between countries. When the British interest rates fell, they fell below the rates in the United States. When the U.S. Fed intervenes on the Forex, however, the U.S. money supply rises and U.S. interest rates are pushed down. Pressure for the exchange rate to change will cease only when U.S. interest rates become equal to British interest rates and IRP (\(i_{£} = i_{\$}\)) is again satisfied.
Thus after final adjustment occurs, expansionary monetary policy by the foreign reserve currency country in a fixed exchange rate system causes no effects on U.S. GNP or the exchange rate. Since the economy also returns to the original equilibrium, there is also no effect on the current account balance. Fed intervention in the Forex to maintain the fixed exchange rate, however, will cause U.S. interest rates to fall to maintain IRP with the lower reserve country interest rates.
Contractionary Monetary Policy by the Reserve Country
Contractionary monetary policy corresponds to a decrease in the British money supply that would lead to an increase in British interest rates. In the AA-DD model, an increase in foreign interest rates shifts the AA curve upward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.
Key Takeaways
• Expansionary monetary policy by the foreign reserve currency country in a fixed exchange rate system causes no effects on domestic GNP, the exchange rate, or the current account balance in the AA-DD model. However, it will cause domestic interest rates to fall.
• Contractionary monetary policy by the foreign reserve currency country in a fixed exchange rate system causes no effects on domestic GNP, the exchange rate, or the current account balance in the AA-DD model. However, it will cause domestic interest rates to rise.
Exercises
• Honduras fixes its currency, the Honduran lempira (HNL), to the U.S. dollar. Suppose Honduras can be described using the AA-DD model. Consider changes in the exogenous variables in the left column. Suppose each change occurs ceteris paribus. Indicate the short-run effects on the equilibrium values of Honduran GNP, the Honduran interest rate (\(i_{HNL}\)), the Honduran trade deficit, and the exchange rate (\(E_{HNL/\$}\)). Use the following notation:
+ the variable increases
the variable decreases
0 the variable does not change
A the variable change is ambiguous (i.e., it may rise, it may fall)
GNP \(i_{HNL}\) \(E_{HNL/\$}\)
An increase in U.S. interest rates
A decrease in U.S. interest rates
• Consider the following occurrences. Use the AA-DD model to determine the impact on the variables (+, −, 0, or A) from the twin-deficit identity listed along the top row. Consider only short-run effects (i.e., before inflationary effects occur) and assume ceteris paribus for all other exogenous variables.
Impact on
\(S_{p}\) \(I\) \(IM − EX\) \(G + TR − T\)
An increase in foreign interest rates under fixed exchange rates
A decrease in foreign interest rates under fixed exchange rates | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.05%3A_Reserve_Country_Monetary_Policy_under_Fixed_Exchange_Rates.txt |
Learning Objective
1. Learn how currency crises develop and lead to capital flight.
To maintain a credible fixed exchange rate system, a country will need to buy and sell the reserve currency whenever there is excess demand or supply in the private foreign exchange (Forex). To make sales of foreign currency possible, a country will need to maintain a foreign exchange reserve. The reserve is a stockpile of assets denominated in the reserve currency. For example, if the United States fixes the dollar to the British pound, then it would need to have a reserve of pound assets in case it needs to intervene on the Forex with a sale of pounds.
Generally, a central bank holds these reserves in the form of Treasury bonds issued by the reserve country government. In this way, the reserve holdings earn interest for the central bank and thus the reserves will grow in value over time. Holding reserves in the form of currency would not earn interest and thus are less desirable. Nonetheless, a central bank will likely keep some of its reserves liquid in the form of currency to make anticipated daily Forex transactions. If larger sales of reserves become necessary, the U.S. central bank can always sell the foreign Treasury bonds on the bond market and convert those holdings to currency.
A fixed exchange rate is sustainable if the country’s central bank can maintain that rate over time with only modest interventions in the Forex. Ideally, one would expect that during some periods of time, there would be excess demand for domestic currency on the Forex, putting pressure on the currency to appreciate. In this case, the central bank would relieve the pressure by selling domestic currency and buying the reserve on the Forex, thus running a balance of payments (BoP) surplus. During these periods, the country’s reserve holdings would rise. At other periods, there may be excess demand for the reserve currency, putting pressure on the domestic currency to depreciate. Here, the central bank would relieve the pressure by selling the reserve currency in exchange for domestic currency, thus running a balance of payments deficit. During these periods, the country’s reserve holdings would fall. As long as the country’s reserve holdings stay sufficiently high during its ups and downs, the fixed exchange rate could be maintained indefinitely. In this way, the central bank’s interventions “smooth-out” the fluctuations that would have occurred in a floating system.
Problems arise if the reserves cannot be maintained if, for example, there is a persistent excess demand for the foreign currency over time with very few episodes of excess supply. In this case, the central bank’s persistent BoP deficits will move reserve holdings closer and closer to zero. A balance of payments crisis occurs when the country is about to run out of foreign exchange reserves.
Borrowing Reserves
Several things may happen leading up to a balance of payments crisis. One option open to the central bank is to borrow additional quantities of the reserve currency from the reserve country central bank, government, or an international institution like the International Monetary Fund (IMF). The IMF was originally created to help countries with balance of payments problems within the Bretton Woods fixed exchange rate system (1945–1973). When a country was near to depleting its reserves, it could borrow reserve currency from the IMF. As long as the balance of payments deficits leading to reserve depletion would soon be reversed with balance of payments surpluses, the country would be able to repay the loans to the IMF in the near future. As such, the IMF “window” was intended to provide a safety valve in case volatility in supply and demand in the Forex was greater than a country’s reserve holdings could handle.
Devaluation
If a country cannot acquire additional reserves and if it does not change domestic policies in a way that causes excess demand for foreign currency to cease or reverse, then the country will run out of foreign reserves and will no longer be able to maintain a credible fixed exchange rate. The country could keep the fixed exchange rate at the same level and simply cease intervening in the Forex; however, this would not relieve the pressure for the currency to depreciate and would quickly create conditions for a thriving black market.
If the country remains committed to a fixed exchange rate system, its only choice is to devalue its currency with respect to the reserve. A lower currency value will achieve two things. First, it will reduce the prices of all domestic goods from the viewpoint of foreigners. In essence, a devaluation is like having a sale in which all the country’s goods are marked down by some percentage. At the same time, the devaluation will raise the price of foreign goods to domestic residents. Thus foreign goods have all been marked up in price by some percentage. These changes should result in an increase in demand for domestic currency to take advantage of the lower domestic prices and a decrease in demand for foreign currency due to the higher foreign prices.
The second effect occurs for investors. When the currency is devalued, the rate of return on foreign assets may fall, especially if investors had anticipated a devaluation and had adjusted their expectations accordingly. (See the next section on capital flight for further discussion.) When the rate of return on foreign assets falls, the demand for foreign currency will also fall.
If the devaluation is large enough to reverse the currency demand in the Forex, generating excess demand for the domestic currency, the central bank will have to buy foreign reserves to maintain the new devalued exchange rate and can begin to accumulate a stockpile of reserves once again.
Capital Flight
Balance of payments crises are often anticipated by investors in the marketplace. When this occurs it will result in capital flight, which in turn is likely to aggravate the balance of payments crisis. Here’s why.
The interest rate parity condition holds when rates of return on domestic and foreign assets are equalized. Recall from Chapter 11, Section 11.3 that in a fixed exchange rate system the IRP condition simplifies to equalization of interest rates between two countries. However, this result assumed that investors expected the currency to remain fixed indefinitely. If investors believe instead that a country is about to suffer a balance of payments crisis and run out of foreign reserves, they will also anticipate that a devaluation will occur soon.
Assume as before that the United States fixes its currency to the British pound. The interest rate parity condition can be written as
where the left side is the rate of return on U.S. assets, equal to the average U.S. interest rate, and the right side is the rate of return on British assets. When there is no imminent balance of payments crisis, investors should expect the future exchange rate (\(E_{\$/£}^{e}\)) to equal the current fixed exchange rate (\(E_{\$/£}\)) and the interest parity condition simplifies to \(i_{\$} = i_{£}\). However, if investors recognize that the central bank is selling large quantities of its foreign reserves in the Forex regularly, then they are likely also to recognize that the balance of payments deficits are unsustainable. Once the reserves run out, the central bank will be forced to devalue its currency. Thus forward-looking investors should plan for that event today. The result is an increase in the expected exchange rate, above the current fixed rate, reflecting the expectation that the dollar will be devalued soon.
This, in turn, will increase the expected rate of return of British assets, raising the right side of the above expression. Now, \(R_{o}R_{£} \ > R_{o}R_{\$}\), and investors will increase demand for British pounds on the Forex. In this instance, investors are “fleeing” their own domestic assets to purchase foreign assets (or capital) that now have a greater expected return. Thus the action is called capital flight.
The intuition for capital flight is simple. If an investor expects the domestic currency (and assets denominated in that currency) will soon fall in value, it is better to sell now before the value actually does fall. Also, as the domestic currency falls in value, the British pound is expected to rise in value. Thus it is wise to buy British pounds and assets while their prices are lower and profit on the increase in the pound value when the dollar devaluation occurs.
The broader effect of capital flight, which occurs in anticipation of a balance of payments crisis, is that it can actually force a crisis to occur much sooner. Suppose the United States was indeed running low on foreign reserves after running successive balance of payments deficits. Once investors surmise that a crisis may be possible soon and react with a change in their expected exchange rate, there will be a resulting increase in demand for pounds on the Forex. This will force the central bank to intervene even further in the Forex by selling foreign pound reserves to satisfy investor demand and to keep the exchange rate fixed. However, additional interventions imply an even faster depletion of foreign reserve holdings, bringing the date of crisis closer in time.
It is even possible for investor behavior to create a balance of payments crisis when one might not have occurred otherwise. Suppose the U.S. central bank (or the Fed) depletes reserves by running balance of payments deficits. However, suppose the Fed believes the reserve holdings remain adequate to defend the currency value, whereas investors believe the reserve holdings are inadequate. In this case, capital flight will likely occur that would deplete reserves much faster than before. If the capital flight is large enough, even if it is completely unwarranted based on market conditions, it could nonetheless deplete the remaining reserves and force the central bank to devalue the currency.
Return to Float
There is one other possible response for a country suffering from a balance of payments crisis. The country could always give up on the fixed exchange rate system and allow its currency to float freely. This means the central bank no longer needs to intervene on the Forex and the exchange rate value will be determined by daily supply and demand conditions on the private Forex. Since the reason for the BoP crisis was continual pressure for the currency to depreciate, moving to a floating system would undoubtedly result in a rapidly depreciating currency.
The main advantage of returning to a floating exchange rate is that the private Forex market will quickly move the exchange rate to the level that equalizes supply and demand. In contrast, many times countries that devalue their fixed exchange rate do not devalue sufficiently and a second devaluation becomes necessary shortly thereafter. When the countries in the Bretton Woods system switched to floating rates in 1973, the original intention was to allow markets to adjust to the equilibrium exchange rates reflecting market conditions and then to refix the exchange rates at the sustainable equilibrium level. However, an agreement to reestablish fixed rates was never implemented. The U.S. dollar and many other currencies have been floating ever since.
A second advantage of switching to a floating system is that it relieves the central bank from the necessity of maintaining a stockpile of reserves. Thus the whole problem of balance of payments crises disappears completely once a country lets its currency float.
Key Takeaways
• A fixed exchange rate is sustainable if the country’s central bank can maintain that rate over time with only modest interventions in the Forex.
• A balance of payments crisis occurs when persistent balance of payments deficits bring a country close to running out of foreign exchange reserves.
• BoP crises can be resolved by (a) borrowing foreign reserves, (b) devaluation of the currency, or (c) moving to a floating exchange rate.
• In the midst of a BoP crisis, investors often purchase assets abroad in anticipation of an imminent currency devaluation or depreciation. This is known as capital flight.
• Capital flight works to exacerbate the BoP crisis because it results in a more rapid depletion of foreign exchange reserves and makes the crisis more likely to occur.
learning goals
1. List the three ways in which a balance of payments crisis can be resolved either temporarily or permanently. Which of these methods will be most effective, especially if the country continues to pursue the policies that led to the crisis?
2. Explain why capital flight, spurred by the expectation of a currency devaluation, can be a self-fulfilling prophecy.
3. If an expected currency devaluation inspires capital flight, explain what might happen if investors expect a currency revaluation. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.06%3A_Currency_Crises_and_Capital_Flight.txt |
Learning Objectives
1. Learn how the Bretton Woods system of fixed exchange rates set up after World War II was supposed to work.
2. Learn how and why the system collapsed in 1973.
3. Recognize some of the problems inherent in one type of fixed exchange rate system.
In July 1944, delegates from forty-five of the allied powers engaged in World War II met in Bretton Woods, New Hampshire, in the United States to plan for the economic institutions believed necessary to assist in the reconstruction, development, and growth of the postwar economy. Foremost on the delegates’ minds was the instability of the international economic system after World War I, including the experiences of hyperinflation as in Germany in 1922–1923 and the worldwide depression of the 1930s. One element believed necessary to avoid repeating the mistakes of the past was to implement a system of fixed exchange rates. Not only could fixed exchange rates help prevent inflation, but they could also eliminate uncertainties in international transactions and thus serve to promote the expansion of international trade and investment. It was further hoped that economic interconnectedness would make it more difficult for nationalism to reassert itself.
The Bretton Woods system of exchange rates was set up as a gold exchange standard, a cross between a pure gold standard and a reserve currency standard. In a gold exchange standard, one country is singled out to be the reserve currency. In the Bretton Woods case, the currency was the U.S. dollar. The U.S. dollar was fixed to a weight in gold, originally set at \$35 per ounce. The U.S. central bank agreed to exchange dollars for gold on demand, but only with foreign central banks. In a pure gold standard, the central bank would exchange gold for dollars with the general public as well.
The nonreserve countries agreed to fix their currencies to the U.S. dollar or to gold.More accurately, countries agreed to establish a “par value” exchange rate to the dollar and to maintain the exchange to within a 1 percent band around that par value. However, this detail is not an essential part of the story that follows. However, there was no obligation on the part of the nonreserve countries to exchange their currencies for gold. Only the reserve country had that obligation. Instead, the nonreserve-currency countries were obliged to maintain the fixed exchange rate to the U.S. dollar by intervening on the foreign exchange (Forex) market and buying or selling dollars as necessary. In other words, when there was excess demand on the Forex for the home currency in exchange for dollars, the nonreserve central bank would supply their currency and buy dollars, thus running a balance of payments surplus, to maintain the fixity of their exchange rate. Alternatively, when there was excess supply of the home currency, in exchange for dollars, the nonreserve central bank would supply dollars and buy its own currency on the Forex, resulting in a balance of payments deficit. Thus for all nonreserve countries the Bretton Woods system functioned like a reserve currency standard.
One of the problems that typically arises with a reserve currency standard is the persistence of balance of payments (BoP) deficits. BoP deficits require a country to sell its dollar reserves on the Forex market. When these deficits are recurring and large, a country will eventually run out of reserves. When that happens, it will no longer be able to defend its fixed currency value. The likely outcome would be a devaluation, an action that runs counter to the goals of the system, namely to maintain exchange rate stability and to ward off inflationary tendencies.
To provide a safety valve for countries that may face this predicament, the International Monetary Fund (IMF) was established to provide temporary loans to countries to help maintain their fixed exchange rates. Each member country was required to maintain a quota of reserves with the IMF that would then be available to lend to those countries experiencing balance of payments difficulties.
Today the IMF maintains the same quota system and member countries enjoy the same privilege to borrow even though many are no longer maintaining a fixed exchange rate. Instead, many countries borrow from the IMF when they become unable to maintain payments on international debts. Go to the IMF Factsheet for more information about the current quota system.International Monetary Fund, Factsheet, “IMF Quotas,” http://www.imf.org/external/np/exr/facts/quotas.htm
The Bretton Woods exchange rate system was an imperfect system that suffered under many strains during its history. Nonetheless, it did achieve fixed exchange rates among its members for almost thirty years. For a more detailed, though brief, account of the history of the system, see Benjamin Cohen’s article.Benjamin Cohen, “Bretton Woods System,” http://www.polsci.ucsb.edu/faculty/cohen/recent/bretton.html.
We can learn much about the intended workings of the system by studying the system’s collapse. The collapse occurred mostly because the United States would not allow its internal domestic policies to be compromised for the sake of the fixed exchange rate system. Here’s a brief account of what happened. For a more detailed account, see Barry Eichengreen’s Globalizing CapitalBarry Eichengreen, Globalizing Capital: A History of the International Monetary System (Princeton, NJ: Princeton University Press, 1996). and Alfred Eckes’s A Search for Solvency.Alfred E. Eckes Jr., A Search for Solvency (Austin, TX: University of Texas Press, 1975).
Throughout the 1960s and early 1970s, there was excessive supply of U.S. dollars on Forex markets in exchange for other currencies. This put pressure on the U.S. dollar to depreciate and nonreserve currencies to appreciate. To maintain the fixed exchange rate, nonreserve countries were required to intervene on the private Forex. For example, the British central bank was required to run a balance of payments surplus, buy the excess dollars, and sell pounds on the private Forex market.
As was shown in Chapter 12, Section 12.6, persistent balance of payments surpluses do not pose a long-term problem in the same way as BoP deficits. The British central bank had an unlimited capacity to “print” as many pounds as necessary to buy the oversupplied dollars on the Forex. However, persistently large BoP surpluses will result in an ever-increasing British money supply that will lead to inflationary effects eventually.
Indeed, U.S. inflation was rising, especially in the late 1960s. Federal government spending was rising quickly—first, to finance the Vietnam War, and second, to finance new social spending arising out of President Johnson’s Great Society initiatives. Rather than increasing taxes to finance the added expenses, the United States resorted to expansionary monetary policy, effectively printing money to finance growing government budget deficits. This is also called “monetizing the debt.”
The immediate financial impact of a rising U.S. money supply was lower U.S. interest rates, leading to extra demand for foreign currency by investors to take advantage of the higher relative rates of return outside the United States. The longer-term impact of a rising U.S. money supply was inflation. As U.S. prices rose, U.S. goods became relatively more expensive relative to foreign goods, also leading to extra demand for foreign currency.
A look at the statistics of the 1960s belies this story of excessive monetary expansion and fiscal imprudence. Between 1959 and 1970, U.S. money supply growth and U.S. inflation were lower than in every other G-7 country. U.S. government budget deficits were also not excessively large. Nonetheless, as Eichengreen suggests, the G-7 countries could support a much higher inflation rate than the United States since they were starting from such low levels of GDP in the wake of post–World War II reconstruction.Barry Eichengreen, Globalizing Capital: A History of the International Monetary System (Princeton, NJ: Princeton University Press, 1996), 131. Thus the U.S. policy required to maintain a stable exchange rate without intervention would correspond to an inflation rate that was considerably lower vis-à-vis the other G-7 countries.
In any case, to maintain the fixed exchange rate, non-U.S. countries’ central banks needed to run balance of payments surpluses. BoP surpluses involved a nonreserve central bank purchase of dollars and sale of their own domestic currency. Thus the German, British, French, Japanese, et al., central banks bought up dollars in great quantities and at the same time continually increased their own domestic money supplies.
One effect of the continual balance of payments surpluses was a subsequent increase in inflation caused by rising money supplies in the nonreserve countries. In effect, expansionary monetary policy in the United States, and its inflationary consequences, are exported to the nonreserve countries by virtue of the fixed exchange rate system. This effect was not welcomed by the nonreserve countries like Britain, France, and Germany.
A second effect of the continual balance of payments surpluses was a rising stock of dollar reserves. Nonreserve central banks held those reserves in the form of U.S. Treasury bills; thus, increasingly, U.S. government debt was held by foreign countries.
Although such BoP surpluses could technically continue indefinitely, the inflationary consequences in Europe and Japan and the rising dollar holdings abroad put the sustainability of the system into question. Ideally in a fixed exchange system, BoP surpluses will be offset with comparable BoP deficits over time, if the exchange rate is fixed at an appropriate (i.e., sustainable) level. Continual BoP surpluses, however, indicate that the sustainable exchange rate should be at a much lower U.S. dollar value if the surpluses are to be eliminated. Recognition of this leads observers to begin to expect a dollar devaluation.
If (or when) a dollar devaluation occurred, dollar asset holdings by foreigners—including the U.S. government Treasury bills comprising the reserves held by foreign central banks—would suddenly fall in value. In other words, foreign asset holders would lose a substantial amount of money if the dollar were devalued.
For private dollar investors there was an obvious response to this potential scenario: divest of dollar assets—that is, sell dollars and convert to pounds, deutschmarks, or francs. This response in the late 1960s and early 1970s contributed to the capital flight from the U.S. dollar, put added downward pressure on the U.S. dollar value, and led to even greater BoP surpluses by nonreserve central banks.
The nonreserve central banks, on the other hand, could not simply convert dollars to pounds or francs, as this would add to the pressure for a depreciating dollar. Further, it was their dollar purchases that were preventing the dollar depreciation from happening in the first place.
During the 1960 and early 1970s the amount of U.S. dollar reserves held by nonreserve central banks grew significantly, which led to what became known as the Triffin dilemma (dollar overhang). Robert Triffin was a Belgian economist and Yale University professor who highlighted the problems related to dollar overhang. Dollar overhang occurred when the amount of U.S. dollar assets held by nonreserve central banks exceeded the total supply of gold in the U.S. Treasury at the exchange rate of \$35 per ounce. Dollar overhang occurred in the system by 1960 and continued to worsen throughout the decade of the 1960s. By 1971 foreign holdings of U.S. dollars stood at \$50 billion while U.S. gold reserves were valued at only \$15 billion.Déclaration de Valéry Giscard d’Estaing à l’Assemblée nationale (12 mai 1971), dans La politique étrangère de la France. 1er semestre, octobre 1971, pp. 162–67. Translated by le CVCE [Declaration by Valerie Giscargd’Estaing to the National Assembly (May 12, 1971)].
Under the Bretton Woods system, foreign central banks were allowed to exchange their dollars for gold at the rate of \$35 per ounce. Once the dollar overhang problem arose, it became conceivable that the United States could run out of its reserve asset—gold. Thus the potential for this type of BoP deficit could lead to speculation that the U.S. dollar would have to be devalued at some point in the future.
Now, if one expects the dollar will fall in value at some future date, then it would make sense to convert those dollars to something that may hold its value better; gold was the alternative asset. Throughout the 1950s and 1960s, foreign central banks did convert some of their dollar holdings to gold, but not all. In 1948, the United States held over 67 percent of the world’s monetary gold reserves. By 1970, however, the U.S. gold holdings had fallen to just 16 percent of the world total.Alfred E. Eckes Jr., A Search for Solvency (Austin, TX: University of Texas Press, 1975), 238. In a gold exchange standard, the linkage between gold and the reserve currency is supposed to provide the constraint that prevents the reserve currency country from excessive monetary expansion and its subsequent inflationary effects. However, in the face of BoP deficits leading to a severe depletion of gold reserves, the United States had several adjustment options open.
One option was a devaluation of the dollar. However, this option was not easy to implement. The U.S. dollar could not be devalued with respect to the pound, the franc, or the yen since the United States did not fix its currency to them. (Recall that the other countries were fixed to the dollar.) Thus the only way to realize this type of dollar devaluation was for the other countries to “revalue” their currencies with respect to the dollar. The other “devaluation” option open to the United States was devaluation with respect to gold. In other words, the United States could raise the price of gold to \$40 or \$50 per ounce or more. However, this change would not change the fundamental conditions that led to the excess supply of dollars. At most, this devaluation would only reduce the rate at which gold flowed out to foreign central banks. Also, since U.S. gold holdings had fallen to very low levels by the early 1970s and since the dollar overhang was substantial, the devaluation would have had to be extremely large to prevent the depletion of U.S. gold reserves.
The other option open to the United States was a change in domestic monetary policy to reduce the excess supply of dollars on the Forex. Recall that money supply increases were high to help finance rising federal deficit spending. A reversal of this policy would mean a substantial reduction in the growth of the money supply. If money supply increases were not available to finance the budget deficit, the government would have to resort to a much more unpopular method of financing—that is, raising taxes or reducing spending.
The unpopularity and internal difficulty of such fiscal and monetary prudence led the United States to resort to other options. One suggestion made repeatedly by the United States was that the nonreserve countries should “revalue” their currencies to the dollar. However, their response was that the fundamental problem was not their fault; therefore, they shouldn’t be the ones to implement a solution. Instead, it was the United States that needed to change.
By the spring of 1971, the imbalances in the system reached crisis proportions. In April 1971, the Bundesbank (Germany’s central bank) purchased over \$3 billion to maintain the fixed exchange rate. In early May, it bought over \$2 billion in just two days to maintain the rate. Fearing inflation after such huge purchases, Germany decided to let its currency float to a new value, 8 percent higher than its previous fixed rate. Austria, Holland, and Switzerland quickly followed suit.Alfred E. Eckes Jr., A Search for Solvency (Austin, TX: University of Texas Press, 1975), 261. Despite these revaluations, they were insufficient to stem the excess supply of dollars on the Forex. By August 1971, another major realignment seemed inevitable that substantially increased the pace of dollar capital flight. On August 15, 1971, President Nixon announced a bold plan for readjustment. The plan had three main aspects:
1. A 10 percent import surcharge on all imports was implemented. This tariff would remain in effect until a new international monetary order was negotiated.
2. Suspension of dollar convertibility into gold. Foreign central banks would no longer have the option to exchange dollars for gold with the U.S. central bank.
3. Wage and price controls were implemented to stem the rising U.S. inflation
The import surcharge meant that an extra 10 percent would be assessed over the existing import tariff. This was implemented to force other countries to the bargaining table where, presumably, they would agree to a multilateral revaluation of their currencies to the dollar. The tax was especially targeted to pressure Japan, which had not revalued its currency as others had done during the previous years, to agree to a revaluation. The 10 percent import tax effectively raised the prices of foreign goods in U.S. markets and would have a similar effect as a 10 percent currency revaluation. The expectation was that the average revaluation necessary to bring the system into balance would be somewhat less than 10 percent, thus an 8 percent revaluation, say, would be less painful to exporters than a 10 percent import tax.
The suspension of dollar-gold convertibility was really the more significant change as it effectively ended the gold exchange standard and marked the death of the Bretton Woods system. With no obligation to exchange gold for dollars, the system essentially was changed to a reserve currency system. Previous constraints on the United States, caused when it runs a BoP deficit and loses gold reserves, were thus eliminated. There was no longer a possibility that the United States could run out of gold.
The wage and price controls, implemented for a ninety-day period, put added pressure on foreign exporters. Being forced to pay a 10 percent surcharge but not being allowed to raise prices meant they would not be allowed to push the tax increase onto consumers.
These three measures together resulted in a rapid renegotiation of the Bretton Woods system, culminating in the Smithsonian Agreement in December 1971. In this agreement, the nonreserve countries accepted an average 8 percent revaluation of their currencies to the dollar in return for the elimination of the import surcharge. They also enlarged the currency bands around the par values from 1 percent to 2.25 percent. By virtue of the revaluations, the dollar naturally became “devalued.” The United States also devalued dollars with respect to gold, raising the price to \$38 per ounce. However, since the United States did not agree to reopen the gold window, the change in the price of gold was meaningless.
More important, since the United States no longer needed to be concerned about a complete loss of gold reserves, the dollar overhang problem was “solved,” and it was free to continue its monetary growth and inflationary policies. During the following year, the United States did just that; within a short time, there arose renewed pressure for the dollar to depreciate from its new par values.
In the end, the Smithsonian Agreement extended the life of Bretton Woods for just over a year. By March 1973, a repeat of the severe dollar outflows in 1971 led to a suspension of Forex trading for almost three weeks. Upon reopening, the major currencies were floating with respect to each other. The Bretton Woods system was dead.
The hope at the time was that floating rates could be allowed for a time to let exchange rates move to their market equilibrium rates. Once stability to the exchange rates was restored, a new fixed exchange rate system could be implemented. However, despite negotiations, an agreement was never reached, and a unified international system of fixed exchange rates has never since been tried.
How Bretton Woods Was Supposed to Work
In theory, a gold-exchange standard can work to provide exchange rate stability and reduce inflationary tendencies. However, it will only work if the reserve currency country maintains prudent monetary policies and if countries follow the rules of the system.
For the nonreserve countries, their task was to avoid balance of payments deficits. These deficits would arise if they pursued excessive expansionary monetary policy. The lower interest rates and eventual inflation would lead to capital flight, creating pressure for the currency to depreciate. To avoid a devaluation, and hence to follow the fixity rule, the nonreserve country would have to contract its money supply to take pressure off its currency and to reverse the BoP deficits.
The problem that usually arises here is that contractionary monetary policies will raise interest rates and eliminate an important source of government budget financing, namely debt monetization (printing money). These changes are likely to result in an increase in taxes, a decrease in government spending, a contraction of the economy, and a loss of jobs. Thus following the rules of the system will sometimes be painful.
However, this was not the source of the Bretton Woods collapse. Instead, it was excessive monetary expansion by the reserve country, the United States. In this case, when the United States expanded its money supply, to finance budget deficits, it caused lower U.S. interest rates and had inflationary consequences. This led to increased demand for foreign currency by investors and traders. However, the United States was not obligated to intervene to maintain the fixed exchange rates since the United States was not fixing to anyone. Rather, it was the obligation of the nonreserve countries to intervene, buy dollars, sell their own currencies, and consequently run BoP surpluses. These surpluses resulted in the growing stock of dollar reserves abroad.
However, if the system had worked properly, foreign central banks would have cashed in their dollar assets for gold reserves long before the dollar overhang problem arose. With diminishing gold reserves, the United States would have been forced (i.e., if it followed the rules of the system) to reverse its expansionary monetary practices. However, as mentioned above, contractionary monetary policies will likely result in higher taxes, lower government spending, a contraction of the economy, and a loss of jobs.
Most countries faced with a choice between a policy that violates international monetary system rules and policies that maintain domestic vitality, even if only temporarily, will usually choose in favor of domestic interests. Of course, this choice will likely have negative longer-term consequences. Price and exchange rate stability will be compromised through these actions, and it will eliminate the benefits that would have come from expanded trade and international investments.
The gold exchange standard might have worked effectively if the United States and the others had committed themselves more intently on following the rules of the system. In the final analysis, what matters is the importance placed on maintaining the integrity of the cooperative fixed exchange rate system relative to the importance placed on domestic economic and political concerns. In the Bretton Woods case, domestic interests clearly dominated international interests.
The Bretton Woods experience should cast a shadow of doubt on fixed exchange rate systems more generally too. Every fixed exchange rate system requires countries to give up the independence of their monetary policy regardless of domestic economic circumstances. That this is difficult, or impossible, to do is demonstrated by the collapse of the Bretton Woods system.
Key Takeaways
• The Bretton Woods system of exchange rates was set up as a gold exchange standard. The U.S. dollar was the reserve currency, and the dollar was fixed to gold at \$35 per ounce.
• The International Monetary Fund (IMF) was established to provide temporary loans to countries to help maintain their fixed exchange rates.
• U.S. expansionary monetary policy and its inflationary consequences were exported to the nonreserve countries by virtue of the fixed exchange rate system.
• The suspension of dollar-gold convertibility in 1971 effectively ended the gold exchange standard and marked the death of the Bretton Woods system.
• The Bretton Woods system collapsed in 1973 when all the currencies were allowed to float.
• A fixed exchange rate system requires nonreserve countries to give up the independence of their monetary policy regardless of domestic economic circumstances.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The Bretton Woods exchange system was this type of exchange rate standard.
• The price of gold in terms of dollars when the Bretton Woods system began.
• This international organization was created to help countries with balance of payments problems in the Bretton Woods system.
• The percentage of world monetary gold held by the United States in 1948.
• The percentage of world monetary gold held by the United States in 1970.
• The name given to the problem of excessive U.S. dollar holdings by foreign central banks.
• This country’s suspension of dollar convertibility to gold eliminated an important constraint that allowed the system to function properly.
• The name of the agreement meant to salvage the Bretton Woods system in the early 1970s.
• The month and year in which the Bretton Woods system finally collapsed. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/12%3A_Policy_Effects_with_Fixed_Exchange_Rates/12.07%3A_Case_Study-_The_Breakup_of_the_Bretton_Woods_System_1973.txt |
One of the big issues in international finance is the appropriate choice of a monetary system. Countries can choose between a floating exchange rate system and a variety of fixed exchange rate systems. Which system is better is explored in this chapter. However, rather than suggesting a definitive answer, the chapter highlights the pros and cons of each type of system, arguing in the end that both systems can and have worked in some circumstances and failed in others.
13: Fixed versus Floating Exchange Rates
Learning Objective
1. Preview the discussion about fixed versus floating exchange rate systems.
This chapter addresses what is perhaps the most important policy issue in international finance: to have fixed or floating exchange rates. The chapter focuses on three main features that affect the choice of system: volatility and risk, inflationary consequences, and monetary autonomy.
Volatility and risk refers to the tendency for exchange rates to change and the effect these changes have on the risk faced by traders and investors. Although in floating exchange systems volatility is a natural day-to-day occurrence, even in fixed exchange systems, devaluations or revaluations make volatility an issue. This chapter compares the two systems in light of this issue.
Inflationary consequences are shown to be a major potential problem for countries with floating exchange rates. For many countries facing this problem, fixed exchange rate systems can provide relief. The section shows that the relationship between inflation and the exchange rate system is an important element in the choice of system.
Finally, monetary autonomy, and the ability to control the economy, is lost with the choice of fixed exchange rates. We discuss why this loss of autonomy can be problematic in some circumstances but not in others.
The chapter concludes by providing some answers to the policy question, “fixed or floating?”
Key Takeaways
• Three main features affect the choice of the exchange rate system: volatility and risk, inflationary consequences, and monetary autonomy.
• The choice between fixed and floating exchange rates is one of the most important policy decisions in international finance.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The choice between these two types of exchange rate systems is an important policy debate in international finance.
• This term describing the extent to which an exchange rate may vary over time is an important consideration in the choice of exchange rate systems.
• This term describing the likelihood of losing money is an important consideration in the choice of exchange rate systems.
• Fixed exchange rates are sometimes chosen to mitigate this kind of general price problem.
• This term describing the ability to influence the economy through monetary policy is an important consideration in the choice of exchange rate systems.
13.02: Exchange Rate Volatility and Risk
Learning Objective
1. Learn how exchange rate volatility raises risk for international traders and investors.
Probably the most important characteristic of alternative exchange rate systems is the feature used to describe them, namely fixed or floating. Fixed exchange rates, by definition, are not supposed to change. They are meant to remain fixed, preferably permanently. Floating rates float up and down and down and up from year to year, week to week, and minute by minute. What a floating exchange rate will be a year from now, or even a week from now, is often very difficult to predict.
Volatility represents the degree to which a variable changes over time. The larger the magnitude of a variable change, or the more quickly it changes over time, the more volatile it is.
Since fixed exchange rates are not supposed to change—by definition—they have no volatility. Please note the cautious wording because fixed exchange rates are quite frequently devalued or revalued, implying that they can and do indeed change. However, we will explore this issue in more detail later. A floating exchange rate may or may not be volatile depending on how much it changes over time. However, since floating exchange rates are free to change, they are usually expected to be more volatile.
Volatile exchange rates make international trade and investment decisions more difficult because volatility increases exchange rate risk. Exchange rate risk refers to the potential to lose money because of a change in the exchange rate. Below are two quick examples of how traders and investors may lose money when the exchange rate changes.
Exchange Rate Risk for Traders
First consider a business that imports soccer balls into the United States. Suppose one thousand soccer balls purchased from a supplier in Pakistan costs 300,000 Pakistani rupees. At the current exchange rate of 60 Rs/\$, it will cost the importer \$5,000 dollars or \$5 per soccer ball. The importer determines that transportation, insurance, advertising, and retail costs will run about \$5 per soccer ball. If the competitive market price for this type of soccer ball is \$12, he will make a \$2 profit per ball if all balls are sold.
Suppose the shipment is scheduled to occur in three months and that payment for the shipment need not be made until that time. Let’s assume the importer waits to convert currency until the payment is made and that in three months’ time the Pakistani rupee has appreciated to a new value of 55 Rs/\$. The shipment cost in rupees remains the same at Rs 300,000, but the dollar value of the shipment rises to \$5,454 or \$5.45 per soccer ball. Assuming the same \$5 of extra costs and a \$12 final sale price, the importer will now make only \$1.45 profit per soccer ball, if all balls are sold. While this is still a profit, it is about 25 percent less than expected when the decision to purchase was made three months before.
This is an example of the risk an importer faces because of a change in the currency value. Of course, it is true that the currency value could have changed in the opposite direction. Had the rupee value risen to 65 Rs/\$, the shipment value would have cost just \$4,615, or \$4.62 per ball, generating a profit of \$2.38 per soccer ball. In this case, the currency moves in the importer’s favor. Thus a volatile exchange rate will sometimes lead to greater losses than expected, and at other times, to greater gains.
There are several methods to protect oneself from this type of currency risk. The importer could have exchanged currency at the time the deal was struck and held his 300,000 rupees in a Pakistani bank until payment is made. However, this involves a substantial additional opportunity cost since the funds must be available beforehand and become unusable while they are held in a Pakistani bank account. Alternatively, the importer may be able to find a bank willing to write a forward exchange contract, fixing an exchange rate today for an exchange to be made three months from now.
In any case, it should be clear that exchange rate fluctuations either increase the risk of losses relative to plans or increase the costs to protect against those risks.
Exchange Rate Risk for Investors
Volatile exchange rates also create exchange rate risk for international investors. Consider the following example. Suppose in October 2004, a U.S. resident decides to invest (i.e., save) \$10,000 for the next year. Given that the U.S. dollar had been weakening with respect to the Danish krone for several years and since the interest rate on a money market deposit was slightly higher in Denmark at 2.25 percent compared to the 1.90 percent return in the United States, the investor decides to put the \$10,000 into the Danish account. At the time of the deposit, the exchange rate sits at 5.90 kr/\$. In October 2005, the depositor cashes in and converts the money back to U.S. dollars. The exchange rate in October 2005 was 6.23 kr/\$. To determine the return on the investment we can apply the rate of return formula derived in Chapter 4, Section 4.3 and Chapter 4, Section 4.4:
The rate of return works out to be negative, which means that instead of making money on the foreign deposit, this investor actually loses \$317. Had he deposited the \$10,000 in a U.S. account, he would have had a guaranteed return of 1.90 percent, earning him \$190 instead.
By depositing in a foreign account, the depositor subjected himself to exchange rate risk. The dollar unexpectedly appreciated during the year, resulting in a loss. Had the dollar remain fixed in value during that same time, the foreign return would have been 2.25 percent, which is larger than that obtained in the United States.
Thus fluctuating exchange rates make it more difficult for investors to know the best place to invest. One cannot merely look at what the interest rate is across countries but must also speculate about the exchange rate change. Make the wrong guess about the exchange rate movement and one could lose a substantial amount of money.
There are some ways to hedge against exchange rate risk. For example, with short-term deposits, an investor can purchase a forward contract or enter a futures market. In these cases, the investor would arrange to sell Danish krone in the future when the deposit is expected to be converted back to dollars. Since the future exchange rate is predetermined on such a contract, the rate of return is guaranteed as well. Thus the risk of floating exchange rates can be reduced. However, for long-term investment such as foreign direct investment, these types of arrangements are more difficult and costly to implement.
Volatility and the Choice of Exchange Rate System
On the face of it, floating exchange rates would appear to be riskier than fixed rates since they are free to change regularly. For this reason, countries may choose fixed exchange rates to reduce volatility and thus to encourage international trade and investment.
The problem with this perception is that it has not worked out this way in practice. A 2004 International Monetary Fund (IMF) studyPeter Clark, Natalia Tamirisa, and Shang-Jin Wei, “Exchange Rate Volatility and Trade Flows—Some New Evidence,” International Monetary Fund, May 2004[0], http://www.imf.org/external/np/res/exrate/2004/eng/051904.pdf. notes that on average, during the 1970s, 1980s, and 1990s, the volatility of fixed exchange rates was approximately the same as that of floating rates. There are two reasons this can occur. First, a currency fixed to another reserve currency will continue to float against other currencies. Thus when China pegged its currency to the U.S. dollar, it continued to float with the dollar vis-à-vis the euro. Second, it is common for fixed currencies to be devalued or revalued periodically, sometimes dramatically. When this happens, the effects of volatility are concentrated in a very short time frame and can have much larger economic impacts.
The second thing noted by this study is that volatility had only a small effect on bilateral international trade flows, suggesting that the choice of exchange rate system on trade flows may be insignificant. However, the study does not consider the effects of volatility on international investment decisions. Other studies do show a negative relationship between exchange rate volatility and foreign direct investment. But if these results were true and fixed exchange rates are just as volatile as floating rates, then there is no obvious exchange system “winner” in terms of the effects on volatility. Nevertheless, volatility of exchange rate systems remains something to worry about and consider in the choice of exchange rate systems.
Key Takeaways
• Volatile exchange rates make international trade and investment decisions more difficult because volatility increases exchange rate risk.
• Volatile exchange rates can quickly and significantly change the expected rates of return on international investments.
• Volatile exchange rates can quickly and significantly change the profitability of importing and exporting.
• Despite the expectation that fixed exchange rates are less volatile, a 2004 IMF study notes that on average, during the 1970s, 1980s, and 1990s, the volatility of fixed exchange rates was approximately the same as that of floating rates.
Exercises
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• This term describes the unpredictable movement of an exchange rate.
• Of increase, decrease, or no change, the effect on an importer’s profits if he waits to exchange currency and the foreign currency rises in value vis-à-vis the domestic currency in the meantime.
• Of increase, decrease, or no change, the effect on an importer’s profits if he waits to exchange currency and the domestic currency falls in value vis-à-vis the foreign currency in the meantime.
• Of increase, decrease, or no change, the effect on an investor’s rate of return on foreign assets if the foreign currency rises in value more than expected vis-à-vis the domestic currency after purchasing a foreign asset.
• Of increase, decrease, or no change, the effect on an investor’s rate of return on foreign assets if the foreign currency falls in value less than expected vis-à-vis the domestic currency after purchasing a foreign asset.
2. Between 2007 and 2008, the U.S. dollar depreciated significantly against the euro. Answer the following questions. Do not use graphs to explain. A one- or two-sentence verbal explanation is sufficient.
• Explain whether European businesses that compete against U.S. imports gain or lose because of the currency change.
• Explain whether European businesses that export their products to the United States gain or lose because of the currency change.
• Explain whether European investors who purchased U.S. assets one year ago gain or lose because of the currency change. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/13%3A_Fixed_versus_Floating_Exchange_Rates/13.01%3A_Overview_of_Fixed_versus_Floating_Exchange_Rates.txt |
Learning Objective
1. Learn how a fixed exchange rate system can be used to reduce inflation.
One important reason to choose a system of fixed exchange rates is to try to dampen inflationary tendencies. Many countries have (over time) experienced the following kind of situation. The government faces pressure from constituents to increase spending and raise transfer payments, which it does. However, it does not finance these expenditure increases with higher taxes since this is very unpopular. This leads to a sizeable budget deficit that can grow over time. When the deficits grow sufficiently large, the government may become unable to borrow additional money without raising the interest rate on bonds to unacceptably high levels. An easy way out of this fiscal dilemma is to finance the public deficits with purchases of bonds by the country’s central bank. In this instance, a country will be financing the budget deficit by monetizing the debt, also known as printing money. New money means an increase in the domestic money supply, which will have two effects.
The short-term effect will be to lower interest rates. With free capital mobility, a reduction in interest rates will make foreign deposits relatively more attractive to investors and there is likely to be an increase in supply of domestic currency on the foreign exchange market. If floating exchange rates are in place, the domestic currency will depreciate with respect to other currencies. The long-term effect of the money supply increase will be inflation, if the gross domestic product (GDP) growth does not rise fast enough to keep up with the increase in money. Thus we often see countries experiencing a rapidly depreciating currency together with a rapid inflation rate. A good example of this trend was seen in Turkey during the 1980s and 1990s.
One effective way to reduce or eliminate this inflationary tendency is to fix one’s currency. A fixed exchange rate acts as a constraint that prevents the domestic money supply from rising too rapidly. Here’s how it works.
Suppose a country fixes its currency to another country—a reserve country. Next, imagine that the same circumstances from the story above begin to occur. Rising budget deficits lead to central bank financing, which increases the money supply of the country. As the money supply rises, interest rates decrease and investors begin to move savings abroad, and so there is an increase in supply of the domestic currency on the foreign exchange market. However, now the country must prevent the depreciation of the currency since it has a fixed exchange rate. This means that the increase in supply of domestic currency by private investors will be purchased by the central bank to balance supply and demand at the fixed exchange rate. The central bank will be running a balance of payments deficit in this case, which will result in a reduction in the domestic money supply.
This means that as the central bank prints money to finance the budget deficit, it will simultaneously need to run a balance of payments deficit, which will soak up domestic money. The net effect on the money supply should be such as to maintain the fixed exchange rate with the money supply rising proportionate to the rate of growth in the economy. If the latter is true, there will be little to no inflation occurring. Thus a fixed exchange rate system can eliminate inflationary tendencies.
Of course, for the fixed exchange rate to be effective in reducing inflation over a long period, it will be necessary that the country avoid devaluations. Devaluations occur because the central bank runs persistent balance of payments deficits and is about to run out of foreign exchange reserves. Once the devaluation occurs, the country will be able to support a much higher level of money supply that in turn will have a positive influence on the inflation rate. If devaluations occur frequently, then it is almost as if the country is on a floating exchange rate system in which case there is no effective constraint on the money supply and inflation can again get out of control.
To make the fixed exchange rate system more credible and to prevent regular devaluation, countries will sometime use a currency board arrangement. With a currency board, there is no central bank with discretion over policy. Instead, the country legislates an automatic exchange rate intervention mechanism that forces the fixed exchange rate to be maintained.
For even more credibility, countries such as Ecuador and El Salvador have dollarized their currencies. In these cases, the country simply uses the other country’s currency as its legal tender and there is no longer any ability to print money or let one’s money supply get out of control.
However, in other circumstances fixed exchange rates have resulted in more, rather than less, inflation. In the late 1960s and early 1970s, much of the developed world was under the Bretton Woods system of fixed exchange rates. The reserve currency was the U.S. dollar, meaning that all other countries fixed their currency value to the U.S. dollar. When rapid increases in the U.S. money supply led to a surge of inflation in the United States, the other nonreserve countries like Britain, Germany, France, and Japan were forced to run balance of payments surpluses to maintain their fixed exchange rates. These BoP surpluses raised these countries’ money supplies, which in turn led to an increase in inflation. Thus, in essence, U.S. inflation was exported to many other countries because of the fixed exchange rate system.
The lesson from these stories is that sometimes fixed exchange rates tend to lower inflation while at other times they tend to increase it. The key is to fix your currency to something that is not likely to rise in value (inflate) too quickly. In the 1980 and 1990s, when the European Exchange Rate Mechanism (ERM) was in place, countries were in practice fixed to the German deutschmark. Since the German central bank was probably the least prone to inflationary tendencies, all other European countries were able to bring their inflation rates down substantially due to the ERM system. However, had the countries fixed to the Italian lira, inflation may have been much more rapid throughout Europe over the two decades.
Many people propose a return to the gold standard precisely because it fixes a currency to something that is presumed to be steadier in value over time. Under a gold standard, inflation would be tied to the increase in monetary gold stocks. Because gold is strictly limited in physical quantity, only a limited amount can be discovered and added to gold stocks each year, Thus inflation may be adequately constrained. But because of other problems with a return to gold as the monetary support, a return to this type of system seems unlikely.
Key Takeaways
• A fixed exchange rate can act as a constraint to prevent the domestic money supply from rising too rapidly (i.e., if the reserve currency country has noninflationary monetary policies).
• Adoption of a foreign country’s currency as your own is perhaps the most credible method of fixing the exchange rate.
• Sometimes, as in the Bretton Woods system, a fixed exchange rate system leads to more inflation. This occurs if the reserve currency country engages in excessively expansionary monetary policy.
• A gold standard is sometimes advocated precisely because it fixes a currency to something (i.e., gold) that is presumed to be more steady in value over time.
exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
1. Hyperactivity in this aggregate variable is often a reason countries turn to fixed exchange rates.
2. If a country fixes its exchange rate, it effectively imports this policy from the reserve country.
3. A country fixing its exchange rate can experience high inflation if this country also experiences high inflation.
4. Of relatively low or relatively high, to limit inflation a country should choose to fix its currency to a country whose money supply growth is this.
5. The name for the post–World War II exchange rate system that demonstrated how countries fixing their currency could experience high inflation. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/13%3A_Fixed_versus_Floating_Exchange_Rates/13.03%3A_Inflationary_Consequences_of_Exchange_Rate_Systems.txt |
Learning Objective
1. Learn how floating and fixed exchange rate systems compare with respect to monetary autonomy.
Monetary autonomy refers to the independence of a country’s central bank to affect its own money supply and conditions in its domestic economy. In a floating exchange rate system, a central bank is free to control the money supply. It can raise the money supply when it wishes to lower domestic interest rates to spur investment and economic growth. By doing so it may also be able to reduce a rising unemployment rate. Alternatively, it can lower the money supply, to raise interest rates and to try to choke off excessive growth and a rising inflation rate. With monetary autonomy, monetary policy is an available tool the government can use to control the performance of the domestic economy. This offers a second lever of control, beyond fiscal policy.
In a fixed exchange rate system, monetary policy becomes ineffective because the fixity of the exchange rate acts as a constraint. As shown in Chapter 12, Section 12.2, when the money supply is raised, it will lower domestic interest rates and make foreign assets temporarily more attractive. This will lead domestic investors to raise demand for foreign currency that would result in a depreciation of the domestic currency, if a floating exchange rate were allowed. However, with a fixed exchange rate in place, the extra demand for foreign currency will need to be supplied by the central bank, which will run a balance of payments deficit and buy up its own domestic currency. The purchases of domestic currency in the second stage will perfectly offset the increase in money in the first stage, so that no increase in money supply will take place.
Thus the requirement to keep the exchange rate fixed constrains the central bank from using monetary policy to control the economy. In other words, the central bank loses its autonomy or independence.
In substitution, however, the government does have a new policy lever available in a fixed system that is not available in a floating system, namely exchange rate policy. Using devaluations and revaluations, a country can effectively raise or lower the money supply level and affect domestic outcomes in much the same way as it might with monetary policy. However, regular exchange rate changes in a fixed system can destroy the credibility in the government to maintain a truly “fixed” exchange rate. This in turn could damage the effect fixed exchange rates might have on trade and investment decisions and on the prospects for future inflation.
Nonetheless, some countries do apply a semifixed or semifloating exchange rate system. A crawling peg, in which exchange rates are adjusted regularly, is one example. Another is to fix the exchange rate within a band. In this case, the central bank will have the ability to control the money supply, up or down, within a small range, but will not be free to make large adjustments without breaching the band limits on the exchange rate. These types of systems provide an intermediate degree of autonomy for the central bank.
If we ask which is better, monetary autonomy or a lack of autonomy, the answer is mixed. In some situations, countries need, or prefer, to have monetary autonomy. In other cases, it is downright dangerous for a central bank to have autonomy. The determining factor is whether the central bank can maintain prudent monetary policies. If the central bank can control money supply growth such that it has only moderate inflationary tendencies, then monetary autonomy can work well for a country. However, if the central bank cannot control money supply growth, and if high inflation is a regular occurrence, then monetary autonomy is not a blessing.
One of the reasons Britain has decided not to join the eurozone is because it wants to maintain its monetary autonomy. By joining the eurozone, Britain would give up its central bank’s ability to control its domestic money supply since euros would circulate instead of British pounds. The amount of euros in circulation is determined by the European Central Bank (ECB). Although Britain would have some input into money supply determinations, it would clearly have much less influence than it would for its own currency. The decisions of the ECB would also reflect the more general concerns of the entire eurozone rather than simply what might be best for Britain. For example, if there are regional disparities in economic growth (e.g., Germany, France, etc., are growing rapidly, while Britain is growing much more slowly), the ECB may decide to maintain a slower money growth policy to satisfy the larger demands to slow growth and subsequent inflation in the continental countries. The best policy for Britain alone, however, might be a more rapid increase in money supply to help stimulate its growth. If Britain remains outside the eurozone, it remains free to determine the monetary policies it deems best for itself. If it joins the eurozone, it loses its monetary autonomy.
In contrast, Argentina suffered severe hyperinflations during the 1970s and 1980s. Argentina’s central bank at the time was not independent of the rest of the national government. To finance large government budget deficits, Argentina resorted to running the monetary printing presses, which led to the severe hyperinflations. In this case, monetary autonomy was a curse, not a blessing.
In an attempt to restrain the growth of the money supply, Argentina imposed a currency board in 1992. A currency board is a method of fixing one’s exchange rate with a higher degree of credibility. By legislating mandatory automatic currency interventions, a currency board operates in place of a central bank and effectively eliminates the autonomy that previously existed. Although Argentina’s currency board experiment collapsed in 2002, for a decade Argentina experienced the low inflation that had been so elusive during previous decades.
Key Takeaways
• Monetary autonomy refers to the independence of a country’s central bank to affect its own money supply and, through that, conditions in its domestic economy.
• In a fixed exchange rate system, a country maintains the same interest rate as the reserve country. As a result, it loses the ability to use monetary policy to control outcomes in its domestic economy.
• In a floating exchange rate system, a country can adjust its money supply and interest rates freely and thus can use monetary policy to control outcomes in its domestic economy.
• If the central bank can control money supply growth such that it has only moderate inflationary tendencies, then monetary autonomy (floating) can work well for a country. However, if the central bank cannot control money supply growth, and if high inflation is a regular occurrence, then monetary autonomy (floating) will not help the country.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• The term describing the relationship between the U.S. Federal Reserve Board and the U.S. government that has quite likely contributed to the low U.S. inflation rate in the past two decades.
• In part to achieve this, the United Kingdom has refused to adopt the euro as its currency.
• Of fixed or floating, in this system a country can effectively set its money supply at any level desired.
• Of fixed or floating, in this system a country’s interest rate will always be the same as the reserve country’s.
• Of fixed or floating, in this system a country can control inflation by maintaining moderate money supply growth. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/13%3A_Fixed_versus_Floating_Exchange_Rates/13.04%3A_Monetary_Autonomy_and_Exchange_Rate_Systems.txt |
Learning Objective
1. Learn the pros and cons of both floating and fixed exchange rate systems.
The exchange rate is one of the key international aggregate variables studied in an international finance course. It follows that the choice of exchange rate system is one of the key policy questions.
Countries have been experimenting with different international payment and exchange systems for a very long time. In early history, all trade was barter exchange, meaning goods were traded for other goods. Eventually, especially scarce or precious commodities, for example gold and silver, were used as a medium of exchange and a method for storing value. This practice evolved into the metal standards that prevailed in the nineteenth and early twentieth centuries. By default, since gold and silver standards imply fixed exchange rates between countries, early experience with international monetary systems was exclusively with fixed systems. Fifty years ago, international textbooks dealt almost entirely with international adjustments under a fixed exchange rate system since the world had had few experiences with floating rates.
That experience changed dramatically in 1973 with the collapse of the Bretton Woods fixed exchange rate system. At that time, most of the major developed economies allowed their currencies to float freely, with exchange values being determined in a private market based on supply and demand, rather than by government decree. Although when Bretton Woods collapsed, the participating countries intended to resurrect a new improved system of fixed exchange rates, this never materialized. Instead, countries embarked on a series of experiments with different types of fixed and floating systems.
For example, the European Economic Community (now the EU) implemented the exchange rate mechanism in 1979, which fixed each other’s currencies within an agreed band. These currencies continued to float with non-EU countries. By 2000, some of these countries in the EU created a single currency, the euro, which replaced the national currencies and effectively fixed the currencies to each other immutably.
Some countries have fixed their currencies to a major trading partner, and others fix theirs to a basket of currencies comprising several major trading partners. Some have implemented a crawling peg, adjusting the exchange values regularly. Others have implemented a dirty float where the currency value is mostly determined by the market but periodically the central bank intervenes to push the currency value up or down depending on the circumstances. Lastly, some countries, like the United States, have allowed an almost pure float with central bank interventions only on rare occasions.
Unfortunately, the results of these many experiments are mixed. Sometimes floating exchange rate systems have operated flawlessly. At other times, floating rates have changed at breakneck speed, leaving traders, investors, and governments scrambling to adjust to the volatility. Similarly, fixed rates have at times been a salvation to a country, helping to reduce persistent inflation. At other times, countries with fixed exchange rates have been forced to import excessive inflation from the reserve country.
No one system has operated flawlessly in all circumstances. Hence, the best we can do is to highlight the pros and cons of each system and recommend that countries adopt that system that best suits its circumstances.
Probably the best reason to adopt a fixed exchange rate system is to commit to a loss in monetary autonomy. This is necessary whenever a central bank has been independently unable to maintain prudent monetary policy, leading to a reasonably low inflation rate. In other words, when inflation cannot be controlled, adopting a fixed exchange rate system will tie the hands of the central bank and help force a reduction in inflation. Of course, in order for this to work, the country must credibly commit to that fixed rate and avoid pressures that lead to devaluations. Several methods to increase the credibility include the use of currency boards and complete adoption of the other country’s currency (i.e., dollarization or euroization). For many countries, for at least a period, fixed exchange rates have helped enormously to reduce inflationary pressures.
Nonetheless, even when countries commit with credible systems in place, pressures on the system sometimes can lead to collapse. Argentina, for example, dismantled its currency board after ten years of operation and reverted to floating rates. In Europe, economic pressures have led to some “talk” about giving up the euro and returning to national currencies. The Bretton Woods system lasted for almost thirty years but eventually collapsed. Thus it has been difficult to maintain a credible fixed exchange rate system for a long period.
Floating exchange rate systems have had a similar colored past. Usually, floating rates are adopted when a fixed system collapses. At the time of a collapse, no one really knows what the market equilibrium exchange rate should be, and it makes some sense to let market forces (i.e., supply and demand) determine the equilibrium rate. One of the key advantages of floating rates is the autonomy over monetary policy that it affords a country’s central bank. When used wisely, monetary policy discretion can provide a useful mechanism for guiding a national economy. A central bank can inject money into the system when the economic growth slows or falls, or it can reduce money when excessively rapid growth leads to inflationary tendencies. Since monetary policy acts much more rapidly than fiscal policy, it is a much quicker policy lever to use to help control the economy.
Prudent Monetary and Fiscal Policies
Interestingly, monetary autonomy is both a negative trait for countries choosing fixed rates to rid themselves of inflation and a positive trait for countries wishing have more control over their domestic economies. It turns out that the key to success in both fixed and floating rates hinges on prudent monetary and fiscal policies. Fixed rates are chosen to force a more prudent monetary policy, while floating rates are a blessing for those countries that already have a prudent monetary policy.
A prudent monetary policy is most likely to arise when two conditions are satisfied. First, the central bank, and the decisions it makes, must be independent of the national government that makes government-spending decisions. If it is not, governments have always been inclined to print money to finance government-spending projects. This has been the primary source of high inflation in most countries. The second condition is a clear guideline for the central bank’s objective. Ideally, that guideline should broadly convey a sense that monetary policy will satisfy the demands of a growing economy while maintaining sufficiently low inflation. When these conditions are satisfied, autonomy for a central bank and floating exchange rates will function well. Mandating fixed exchange rates can also work well, but only if the system can be maintained and if the country to which the other country fixes its currency has a prudent monetary policy.
Both systems can experience great difficulties if prudent fiscal policies are not maintained. This requires governments to maintain a balanced budget over time. Balance over time does not mean balance in every period but rather that periodic budget deficits should be offset with periodic budget surpluses. In this way, government debt is managed and does not become excessive. It is also critical that governments do not overextend themselves in terms of international borrowing. International debt problems have become the bane of many countries.
Unfortunately, most countries have been unable to accomplish this objective. Excessive government deficits and borrowing are the norm for both developing and developed countries. When excessive borrowing needs are coupled with a lack of central bank independence, tendencies to hyperinflations and exchange rate volatility are common. When excessive borrowing is coupled with an independent central bank and a floating exchange rate, exchange rate volatility is also common.
Stability of the international payments system then is less related to the type of exchange rate system chosen than it is to the internal policies of the individual countries. Prudent fiscal and monetary policies are the keys.
With prudent domestic policies in place, a floating exchange rate system will operate flawlessly. Fixed exchange systems are most appropriate when a country needs to force itself to a more prudent monetary policy course.
Key Takeaways
• Historically, no one system has operated flawlessly in all circumstances.
• Probably the best reason to adopt a fixed exchange rate system is whenever a central bank has been independently unable to maintain prudent monetary policy, leading to a reasonably low inflation rate.
• Probably the best reason to adopt a floating exchange rate system is whenever a country has more faith in the ability of its own central bank to maintain prudent monetary policy than any other country’s ability.
• The key to success in both fixed and floating rates hinges on prudent monetary and fiscal policies. Fixed rates are chosen to force a more prudent monetary policy; floating rates are a blessing for those countries that already have a prudent monetary policy.
exercise
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
• Of fixed or floating, this system is often chosen by countries that in their recent history experienced very high inflation.
• Of fixed or floating, this system is typically chosen when a country has confidence in its own ability to conduct monetary policy effectively.
• Of fixed or floating, this system is typically chosen when a country has little confidence in its own ability to conduct monetary policy effectively.
• Of fixed or floating, this system is sometimes rejected because it involves the loss of national monetary autonomy.
• Of fixed or floating, this system is sometimes chosen because it involves the loss of national monetary autonomy. | textbooks/biz/Finance/Book%3A_International_Finance__Theory_and_Policy/13%3A_Fixed_versus_Floating_Exchange_Rates/13.05%3A_Which_Is_Better-_Fixed_or_Floating_Exchange_Rates.txt |
Chapter 1 “Personal Financial Planning” introduces four major themes of the textbook:
1. Financial decisions are individual-specific
2. Financial decisions are economic decisions
3. Financial decision-making is a continuous process
4. Professional advisers work for financial decision-makers
These themes emphasize the idiosyncratic, systemic, and continuous nature of personal finance, putting decisions within the larger contexts of an entire lifetime and an economy.
• 1.1: Personal Financial Planning
This chapter introduces the basic financial and accounting categories of revenues, expenses, assets, liabilities, and net worth as tools to understand the relationships between them as a way, in turn, of organizing financial thinking. It also introduces the concepts of opportunity costs and sunk costs as implicit but critical considerations in financial thinking.
• 1.2: Basic Ideas of Finance
This chapter continues with the discussion of organizing financial data to help in decision-making and introduces basic analytical tools that can be used to clarify the situation portrayed in financial statements.
• 1.3: Financial Statements
This chapter introduces the critical relationship of time and risk to value. It demonstrates the math but focuses on the role that those relationships play in financial thinking, especially in comparing and evaluating choices in making financial decisions.
• 1.4: Evaluating Choices- Time, Risk, and Value
This chapter demonstrates how organized financial data can be used to create a plan, monitor progress, and adjust goals.
• 1.5: Financial Plans- Budgets
• 1.6: Taxes and Tax Planning
This chapter discusses the role of taxation in personal finance and its effects on earnings and on accumulating wealth. The chapter emphasizes the types, purposes, and impacts of taxes; the organization of resources for information; and the areas of controversy that lead to changes in the tax rules.
01: Learning Basic Skills Knowledge and Context
INTRODUCTION
Skyler and Lori are just one semester shy of graduating from First Nations University of Canada. Both are good friends and have supported one another a lot throughout university. Skyler is getting a bachelor of administration degree with a major in accounting. Skyler wants a job that comes with a lot of job security and opportunities for career growth.
Lori is getting a bachelor of social work degree and hopes to eventually become a school counsellor. She has interviews lined up at nearby schools. Both Skyler and Lori will need additional training to have the jobs they want, and they are already in debt for their educations.
Lori qualified for a student loan. She will owe about \$30,000 of principal plus interest. Lori plans to start working immediately on graduation and to take classes on the job or at night for as long as it takes to get the extra certification she needs. Unsubsidized, the extra training would cost about \$3,500. She presently earns about \$5,000 a year working weekends as a home health aide and could easily double that after she graduates. Lori also qualified for a grant of around \$5,000 each year she was a full-time student, which has paid for her rooms in an off-campus student housing unit.
Skyler was awarded post-secondary funding from his First Nation and received some money from his relatives to support his education. He has also taken out a small loan from his credit union. He has been attending classes part-time year-round so he can work to earn money for university and living expenses. He earns about \$19,000 a year working for catering services. Skyler feels very strongly about repaying his relatives who have helped finance his education.
Lori has managed to put aside \$3,000 in a savings account earmarked for clothes and gifts. Skyler has sunk all his savings into tuition and books, and his only other asset is his trusty old pickup truck, which has no liens and a trade-in value of \$3,900. For both Lori and Skyler, having reliable transportation to their jobs is a concern. Lori hopes to continue using public transportation to get to a new job after graduation. Both Skyler and Lori are smart enough about money to have avoided getting into credit card debt. Each keeps only one major credit card and a debit card and with rare exceptions pays statements in full each month.
After graduation, Skyler plans to rent an apartment. Skyler also has a rent-free option of moving in temporarily with his brother. Lori feels very strongly about saving money to buy a home. Although still young, Skyler is concerned about being able to retire—the sooner the better—but he has no idea how that would be possible. He thinks he would enjoy running his own catering firm as a retirement business one day.
Lori’s starting salary as a school counsellor will be about \$32,289, and as an entry-level accountant Skyler would have a starting salary of about \$38,000. Both have the potential to double their salaries after fifteen years on the job. Aside from Lori’s savings bonds, she and Skyler are not in the investment market, although as soon as he can, Skyler wants to invest in a diversified registered retirement savings plan (RRSP) that includes corporate stocks and municipal bonds.
Lori and Skyler certainly have a lot of decisions to make, and some of those decisions have high-stakes consequences for their lives. To understand their decision-making process, we should consider some of the following questions:
1. What individual or personal factors will affect Lori’s and Skyler’s financial thinking and decision-making?
2. When should Skyler and Lori invest in the additional job training each will need, and how can they finance that training?
3. How will Lori pay off her university loan, and how much will it cost? How soon can she get out of debt?
4. How will Skyler repay his loan reflecting his family’s investment in his education?
5. What are Lori’s short- and long-term goals? What are Skyler’s?
6. What should they do about retirement needs?
7. What should they do about saving and investing?
8. What should they do about buying a home and a car?
9. What is Skyler’s present and projected income from all sources? What is Lori’s?
10. What budget categories would you create for Lori’s and Skyler’s expenses and expenditures over time?
11. How could Lori and Skyler adjust their budgets to meet their short- and long-term goals?
12. On the basis of your analysis and investigations, what five-year financial plan would you develop for Lori and Skyler?
13. How will larger economic factors affect the decisions Skyler and Lori make and the outcomes of those decisions?
You will make financial decisions all your life. Sometimes you can see those decisions coming and plan accordingly; sometimes, well, stuff happens, and you are faced with a more sudden decision. Personal financial planning is about making both deliberate decisions that allow you to get closer to your goals and sudden decisions that allow you to stay on track, even when things take an unexpected turn.
Blair Stonechild states “currency is only a medium of exchange and not a goal in itself” (Stonechild, 2016, p. 196). As a medium of exchange, it is used to trade goods and services instead of barter. Money measures the value of goods and services and stores value that can be used for future purchases (Ebert, Griffin, Starke, and Dracopoulos, 2017). Indigenous Elders offer a distinct perspective on money in many of the interviews shared throughout this text. Elder Ermine, for instance, states that “Money is a tool” that you use to create certain conditions (Elder Ermine, Video 1A).
According to Richards (2015), “Tools are meant to be used. They’re not meant to sit on a shelf and collect dust.” Richards provides an example of a family that saves for a family vacation. Instead of judging the expenditure of money as bad or good, positive or negative, he views it as a tool that has helped that family to achieve their objective, which is more time together. In order to fully benefit from our tools, we must understand how to use them and what we are using them for. Some students might want to pursue a degree, while others might want to buy a home for their families, and some might want to go on a vacation. It is difficult to accomplish any of these goals without money. Money is a way to achieve our goals and not a goal in itself (Stonechild, 2016, p. 196).
The idea of personal financial planning is really no different from the idea of planning almost anything: you figure out where you’d like to be, where you are, and how to go from here to there. The process is complicated by the number of factors to consider, by their complex relationships to each other, and by the profound nature of these decisions, because how you finance your life will, to a large extent, determine the life that you live. The process is also complicated—often enormously—by risk: you are often making decisions with plenty of information, but little certainty or even predictability.
Personal financial planning is a lifelong process. Your time horizon is as long as can be—until the very end of your life—and during that time your circumstances will change in predictable and unpredictable ways. A financial plan has to be re-evaluated, adjusted, and readjusted. It has to be flexible enough to be responsive to unanticipated needs and desires, robust enough to advance specific goals, and all the while be able to protect from unimagined risks.
One of the most critical resources in the planning process is information. We live in a world full of information—and no shortage of advice—but to use that information well you have to understand what it is telling you, why it matters, where it comes from, and how to use it in the planning process. You need to be able to put that information in context before you can use it wisely. That context includes factors in your individual situation that affect your financial thinking, and factors in the wider economy that affect your financial decision-making.
REFERENCES
Richards, C. (2015). “Rethinking Money, not as Good or Bad but as a Tool.” New York Times, Feb. 17. Retrieved from: https://www.nytimes.com/2015/02/17/business/re thinking-moneynot-as-good-or-bad-but-as-a-tool.htm.
Stonechild, B. (2016). The Knowledge Seeker: Embracing Indigenous Spirituality. Regina: University of Regina Press.
1.1 INDIVIDUAL OR “MICRO” FACTORS THAT AFFECT FINANCIAL THINKING
Learning Objectives
1. List individual factors that strongly influence financial thinking.
2. Discuss how income, income needs, risk tolerance, and wealth are affected by individual factors.
3. Explain how life stages affect financial decision-making.
4. Summarize the basis of sound financial planning.
The circumstances or characteristics of your life influence your financial concerns and plans. What you want and need—and how and to what extent you want to satisfy your wants and needs—all depend on how you live and how you’d like to live in the future. While everyone is different, there are common circumstances of life that affect personal financial concerns and thus affect everyone’s financial planning. Factors that affect personal financial concerns are family structure, health, career choices, and age.
Family Structure
Marital status and dependents, such as children, parents, or siblings, determine whether you are planning only for yourself or for others as well. If you have a spouse, partner, or dependents, you have a financial responsibility to someone else, and that includes a responsibility to include them in your financial thinking. Not only is it important to know our own beliefs and attitudes about money, but it is also critical to understand those of our spouses or partners. You may expect the dependence of a family member to end at some point, as with children or elderly parents, or you may have lifelong responsibilities to and for another person.
Partners and dependents affect your financial planning as you seek to provide for them, such as paying for children’s education. Parents typically want to protect or improve their children’s quality of life, and they may choose to limit their own fulfillment to achieve that end.
Providing for others increases income needs. Being responsible for others also affects your attitudes toward and tolerance of risk. Typically, both the willingness and ability to assume risk, the possibility or uncertainty of loss, diminishes with dependents and a desire for more financial protection grows. People often seek protection for their income or assets even past their own lifetimes to ensure the continued well-being of partners and dependents. An example is a life insurance policy naming a spouse or dependents as beneficiaries.
Health
Your health is another defining circumstance that will affect your expected income needs and risk tolerance and thus your personal financial planning. Personal financial planning should include some protection against the risk of chronic illness, accident, or long-term disability, and some provision for short-term events such as pregnancy and birth. If your health limits your earnings or ability to work or adds significantly to your expenditures, your income needs may increase. The need to protect yourself against further limitations or increased costs may also increase. At the same time, your tolerance for risk may decrease, further affecting your financial decisions.
Career Choice
Your career choices affect your financial planning, especially through educational requirements, income potential, and characteristics of the occupation or profession you choose. Careers have different hours, pay, benefits, risk factors, and patterns of advancement over time. Thus, your financial planning will reflect the realities of being a postal worker, professional athlete, commissioned sales representative, corporate lawyer, freelance photographer, librarian, building contractor, tax preparer, professor, web site designer, and so on. For example, the careers of most athletes end before middle age, include a higher risk of injury, and command steady, higher-than-average incomes, while the careers of most sales representatives last longer with greater risk of unpredictable income fluctuations. Table 1.1.1 compares the median salaries of certain careers.
Table 1.1.1 Canadian Median Salary Comparisons by Profession
Profession Median Salary
Accountant 54,600
Personal Financial Advisor 66,100
Sports Competitor 41,100
Interior Designer 42,300
Substance Abuse Social Worker 35,400
Computer Programmer 65,500
Elementary School Teacher 45,600
Cafeteria Cook 20,400
Dentist 132,000
Pharmacist 94,500
Lawyer 102,500
Sales Manager 91,600
Fire Fighter 41,200
Lab Technician 32,800
Data Source: Original table adapted by Bettina Schneider, 2018; Payscale, 2017.
Most people begin their independent financial lives by selling their labour to create an income by working. Over time, they may choose to change careers, develop additional sources of concurrent income, move between employment and self-employment, or become unemployed or re-employed. Along with career choices, all these changes affect personal financial management and planning.
Age
Needs, desires, values, and priorities all change over a lifetime, and financial concerns change accordingly. Ideally, personal finance is a process of management and planning that anticipates or keeps abreast with such changes. Although everyone is different, some financial concerns are common to or typical of the different stages of adult life. Analysis of life stages is part of financial planning.
At the beginning of your adult life, you are more likely to have no dependents, little if any accumulated wealth, and few assets. Assets are resources that can be used to create income, decrease expenses, or store wealth as an investment. As a young adult, you also are likely to have comparatively small income needs, especially if you are providing only for yourself. Your employment income is probably your primary or sole source of income. Having no one and almost nothing to protect, your willingness to assume risk is usually high. At this point in your life, you are focused on developing your career and increasing your earned income. Any investments you may have are geared toward growth.
As your career progresses, income increases, but so does spending. Lifestyle expectations increase. If you now have a spouse and dependents and elderly parents to look after, you have additional needs to manage. In middle adulthood, you may also be acquiring more assets, such as a house, a retirement account, or an inheritance.
As income, spending, and asset base grow, ability to assume risk grows but willingness to do so typically decreases. Now you have things that need protection: dependents and assets. As you age, you realize that you require more protection. You may want to stop working one day, or you may suffer a decline in health. As an older adult, you may want to create alternative sources of income, perhaps a retirement fund, as insurance against a loss of employment or income. Table 1.1.2 suggests the effects of life stages on financial decision-making.
Table 1.1.2 Financial Decisions Related to Life Stages
Young
Adulthood
Middle
Adulthood
Older
Adulthood
Retirement
Source of Income Wages
Wages /
Investment
Wages /
Investment
Investment
Asset Base None Accumulating Growing Using up
Expenses Low Growing Growing Low
Risk: Ability Low Higher Higher High
Risk: Willingness High Lower Lower Low
Early and middle adulthood are periods of building up: building a family, building a career, increasing earned income, and accumulating assets. Spending needs increase, but so do investments and alternative sources of income.
Later adulthood is a period of spending down. There is less reliance on earned income and more on the accumulated wealth of assets and investments. You are likely to be without dependents, as your children have grown up or your parents passed on, and without the responsibility of providing for them your expenses are lower. You are likely to have more leisure time, especially after retirement.
Without dependents, spending needs decrease. On the other hand, you may feel free to finally indulge in those things that you’ve “always wanted.” There are no longer dependents to protect, but assets demand even more protection as, without employment, they are your only source of income. Typically, your ability to assume risk is high because of your accumulated assets, but your willingness to assume risk is low, as you are now dependent on those assets for income. As a result, risk tolerance decreases: you are less concerned with increasing wealth than you are with protecting it.
Effective financial planning depends largely on an awareness of how your current and future stages in life may influence your financial decisions.
Key Takeaways
1. Personal circumstances that influence financial thinking include family structure, health, career choice, and age.
2. Family structure and health affect income needs and risk tolerance.
3. Career choice affects income and wealth or asset accumulation.
4. Age and stage of life affect sources of income, asset accumulation, spending needs, and risk tolerance.
5. Sound personal financial planning is based on a thorough understanding of your personal circumstances and goals.
Exercises
1. After reading this chapter, identify and describe your current life stage. How does your current age or life stage affect your financial thinking and behaviour? To what extent and in what ways does your financial thinking anticipate your next stage of life? What financial goals are you aware of that you have set? How are your current experiences informing your financial planning for the future? You may be surprised at what you discover. In the process, consider how information in this text specifically relates to your observations and insights.
2. Continue your personal financial journal by describing how other micro factors, such as your present family structure, health, career choices, and other individual factors, are affecting your financial planning.
3. Find the age range for your stage of life and read “Your Financial Checklist For Every Stage of Life” from Forbes’ website. According to the article, what should be your top priorities in financial planning right now? How are your financial planning priorities likely to change?
REFERENCES
Ebert, R. J., R. W. Griffin, F. A. Starke, and G. Dracopoulos. (2017). Business Essentials (8th Ed.). Toronto: Pearson Canada.
Payscale. (2017). “Salary Date and Career Research Center (Canada).” Retrieved from: http://www.payscale.com/research/CA/...=Canada/Salary.
1.2 SYSTEMIC OR “MACRO” FACTORS THAT AFFECT FINANCIAL THINKING
Learning Objectives
1. Identify the systemic or macro factors that affect personal financial planning.
2. Describe the impact of inflation or deflation on disposable income.
3. Describe the effect of rising unemployment on disposable income.
4. Explain how economic indicators can have an impact on personal finances.
Financial planning has to take into account conditions in the wider economy and in the markets that make up the economy. The labour market, for example, is where labour is traded through hiring or employment. Workers compete for jobs and employers compete for workers. In the capital market, capital (cash or assets) is traded, most commonly in the form of stocks and bonds (along with other ways to package capital). In the credit market, a part of the capital market, capital is loaned and borrowed rather than bought and sold. These and other markets exist in a dynamic economic environment, and those environmental realities are part of sound financial planning.
In the long term, history has proven that an economy can grow over time, that investments can earn returns, and that the value of currency can remain relatively stable. In the short term, however, that is not continuously true. Contrary or unsettled periods can upset financial plans, especially if they last long enough or happen at just the wrong time in your life. Understanding large-scale economic patterns and factors that indicate the health of an economy can help you make better financial decisions. These systemic factors include, for example, business cycles and employment rates.
Business Cycles
Ideally, an economy should be productive enough to provide for the wants of its members. Normally, economic output increases as population increases or as people’s expectations grow. An economy’s output or productivity is measured by its gross domestic product (GDP), the value of what is produced in a period. When the GDP is increasing the economy is in an expansion, and when it is decreasing the economy is in a contraction. An economy that contracts for half a year is said to be in recession; a prolonged recession is a depression. The GDP is a closely watched barometer of the economy. However, GDP can be considered a limited indicator of economic growth because it doesn’t measure goods and services that are not paid for. For example, caring for children or housework is not counted as part of GDP unless it is done by a daycare or a hired cleaner. Furthermore, GDP doesn’t account for negative externalities such as the “harm done by industrial pollution or the health costs resulting from a polluted water system; these should be accounted as debits to the national income. Conversely the benefits of clean water and clean environment are not counted within GDP” (Orr and Weir, 2013, p. 110).
Over time, the economy tends to be cyclical, usually expanding but sometimes contracting. This is called the business cycle. Periods of contraction are generally seen as market corrections, or the market regaining its equilibrium, after periods of growth. Growth is never perfectly smooth, so sometimes certain markets become unbalanced and need to correct themselves. Over time, the periods of contraction seem to have become less frequent. The business cycles still occur nevertheless.
There are many metaphors to describe the cyclical nature of market economies: “peaks and troughs,” “boom and bust,” “growth and contraction,” “expansion and correction,” and so on. While each cycle is born of a unique combination of circumstances, cycles occur because things change and upset economic equilibrium. That is, events change the balance between supply and demand in the economy overall. Sometimes demand grows too fast and supply can’t keep up, and sometimes supply grows too fast for demand. There are many reasons that this could happen, but whatever the reasons, buyers and sellers react to this imbalance, which then creates a change.
Employment Rate
An economy produces not just goods and services to satisfy its members, but also jobs, because most people participate in the market economy by trading their labour and most rely on wages as their primary source of income. The economy must therefore provide opportunities to earn wages so more people can participate in the economy through the market. Otherwise, more people must be provided for in some other way, such as a private or public subsidy (charity or welfare).
The unemployment rate is a measure of an economy’s shortcomings, because it shows the proportion of people who want to work but don’t because the economy cannot provide them jobs. There is always a so-called natural rate of unemployment, as people move in and out of the workforce as the circumstances of their lives change—for example, as they retrain for a new career or take time out for family. But natural unemployment should be consistently low and not affect the productivity of the economy.
Unemployment also shows that the economy is not efficient, because it is not able to put all its productive human resources to work.
The employment rate shows how successful an economy is at creating opportunities to sell labour and efficiently using its human resources. Statistics Canada defines the employment rate as “the number of employed people as a percentage of the population aged 15 and older. The rate for a particular group (for example, youths aged 15 to 24) is the number employed in that group as a percentage of the population for that group” (Statistics Canada, 2018, p. 5). In contrast, the participation rate includes both unemployed and employed Canadians, or, as Stats Canada puts it, “The participation rate is the number of employed and unemployed people as a percentage of the population” (Statistics Canada, 2018, p. 5).
A healthy market economy uses its labour productively, is productive, and provides employment opportunities as well as consumer satisfaction through its markets. Table 1.2.1 shows the relationship between GDP and unemployment and each stage of the business cycle.
Table 1.2.1 Cyclical Economic Effects
Boom Expansion Recession Depression
Rate of GDP Increase Unsustainably High Positive Negative Unsustainably Low
Rate of Unemployment Unsustainably Low “Natural” or Minimal Higher Unsustainably High
At either end of this scale of growth, the economy is in an unsustainable position: either growing too fast, with too much demand for labour, or shrinking, with too little demand for labour.
If there is too much demand for labour—more jobs than workers to fill them—then wages will rise, pushing up the cost of everything and causing prices to rise. Prices usually rise faster than wages, for many reasons, which would discourage consumption that would eventually discourage production and cause the economy to slow down from its “boom” condition into a more manageable rate of growth.
If there is too little demand for labour—more workers than jobs—then wages will fall or, more typically, there will be people without jobs, or unemployment. If wages become low enough, employers will (theoretically) be encouraged to hire more labour, which would bring employment levels back up. However, it doesn’t always work that way, because people have job mobility—they are willing and able to move between economies to seek employment.
If unemployment is high and prolonged, then too many people are without wages for too long, and they are not able to participate in the economy because they have nothing to trade. In that case, the market economy is just not working for too many people, and they will eventually demand a change (which is how most revolutions have started).
Other Indicators of Economic Health
Other economic indicators give us clues as to how “successful” our economy is, how well it is growing, or how well positioned it is for future growth. These indicators include statistics, such as the number of houses being built or existing home sales, orders for durable goods (e.g., appliances and automobiles), consumer confidence, producer prices, and so on. However, GDP growth and unemployment are the two most closely watched indicators because they get at the heart of what our economy is supposed to do: provide diverse opportunities for the highest number of people to participate in the economy, to create jobs, and to satisfy these individuals’ needs.
An expanding and healthy economy will offer its participants more choices—namely, more choices for trading labour and for trading capital. It offers more opportunities to earn a return or an income and therefore also offers more diversification and less risk.
Naturally, everyone would rather operate in a healthier economy, but this is not always possible. Financial planning must include planning for the risk that economic factors will affect one’s financial realities. A recession may increase unemployment, lowering the return on labour—wages—or making it harder to anticipate an increase in income. Wage income could be lost altogether. Such temporary involuntary loss of wage income will probably happen to you during your lifetime, as you inevitably will endure economic cycles.
A hedge against lost wages is investment to create other forms of income. In a period of economic contraction, however, the usefulness of capital, and thus its value, may decline as well. Some businesses and industries are considered immune to economic cycles (e.g., public education and health care), but overall, investment returns may suffer. Thus, during your lifetime business cycles will likely affect your participation in the capital markets as well.
Currency Value
Stable currency value is another important indicator of a healthy economy and a critical element in financial planning. Like anything else, a currency’s value is based on its usefulness. We use currency as a medium of exchange, so its value is based on how it can be used in trade, which in turn is based on what is produced in the economy. If an economy produces little that anyone wants, then its currency has little value relative to other currencies, because there is little use for it in trade. So, a currency’s value is an indicator of how productive an economy is.
A currency’s usefulness is based on what it can buy, or its purchasing power. The more a currency can buy, the more useful and valuable it is. When prices rise or when things cost more, purchasing power decreases; the currency buys less and its value decreases.
When the value of a currency decreases, an economy has inflation. Its currency has less value because it is less useful—that is, less can be bought with it. Prices are rising. It takes more units of currency to buy the same amount of goods. When the value of a currency increases, on the other hand, an economy has deflation. Prices are falling; the currency is worth more and buys more.
For example, say you can buy five video games for \$20. Each game is worth \$4, or each dollar buys one-quarter of a game. Then we have inflation, and prices—including the price of video games—rise. A year later you want to buy games, but now your \$20 only buys two games. Each one costs \$10, or each dollar only buys one-tenth of a game. Rising prices have eroded the purchasing power of your dollars.
If there is deflation, prices fall, so maybe a year later you could buy ten video games with your same \$20. Now each game costs only \$2, and each dollar buys half a game. The same amount of currency buys more games: its purchasing power has increased, as has its usefulness and its value. Table 1.2.2 provides an overview of how prices, purchasing power, and currency value change during periods of inflation and deflation.
Table 1.2.2 Dynamics of Currency Value
Inflation Deflation
Prices Rise Fall
Purchasing Power Decreases Increases
Currency Value Falls Rises
Inflation is most commonly measured by the consumer price index (CPI), which is a measure of inflation or deflation based on a national average of prices for a “basket” of common goods and services purchased by the average consumer as determined by the federal government. It is an accepted way of tracking rising or falling price levels, and as such is indicative of inflation or deflation.
Currency instabilities can also affect investment values, because the dollars that investments return don’t have the same value as the dollars that the investment was expected to return. Say you lend \$100 to your sister, who is supposed to pay you back one year from now. There is inflation, so over the next year, the value of the dollar decreases (it buys less as prices rise). Your sister does indeed pay you back on time, but now the \$100 that she gives back to you is worth less (because it buys less) than the \$100 you gave her. Your investment, although nominally returned, has lost value: you have your \$100 back, but you can’t do as much with it; it is less useful.
If the value of currency—the units in which wealth is measured and stored—is unstable, then investment returns are harder to predict. In those circumstances, investment involves more risk. Both inflation and deflation are currency instabilities that are troublesome for an economy and also for the financial planning process. An unstable currency affects the value or purchasing power of income. Price changes affect consumption decisions, and changes in currency value affect investing decisions.
It is human nature to assume that things will stay the same, but financial planning must include the assumption that over a lifetime you will encounter and endure economic cycles. You should try to anticipate the risks of an economic downturn and the possible loss of wage income and/or investment income. At the same time, you should not assume or rely on the windfalls of an economic expansion.
Key Takeaways
1. Business cycles include periods of expansion and contraction (including recessions), as measured by the economy’s productivity (GDP).
2. An economy is in an unsustainable situation when it grows too fast or too slowly, as each situation causes too much stress in the economy’s markets.
3. In addition to GDP, measures of the health of an economy include:
• the rates of employment and unemployment, and
• the value of currency (the consumer price index).
4. Financial planning should take into account the fact that periods of inflation or deflation change the value of currency, affecting purchasing power and investment values.
5. Thus, personal financial planning should take into account:
• business cycles,
• changes in the economy’s productivity,
• changes in the currency value, and
• changes in other economic indicators.
Exercises
1. Record in your personal financial journal the macroeconomic factors that are influencing your financial thinking and behaviour today. What are some specific examples? How have large-scale economic changes or cycles affected your financial planning and decision-making?
2. How does the health of the economy affect your financial health? How healthy is the Canadian economy right now? On what measures do you base your judgments? How will your appreciation of the big picture help you in planning for your future?
3. How do business cycles and the health of the economy affect the value of your labour? In terms of supply and demand, what are the optimal conditions in which to sell your labour? How might further education increase your mobility in the labour market (the value of your labour)?
REFERENCES
Orr, J. and W. Weir, eds. (2013). Aboriginal Measures for Economic Development. Halifax: Fernwood Publishers.
Statistics Canada. (2018). “Labour Force Survey, March 2018.” Retrieved from: http://www.statcan.gc.ca/daily-quoti...80406a-eng.htm.
1.3 THE PLANNING PROCESS
Learning Objectives
1. Trace the steps of the financial planning process and explain why that process needs to be repeated over time.
2. Characterize effective goals and differentiate goals in terms of timing.
3. Explain and illustrate the relationships among costs, benefits, and risks.
4. Analyze cases of financial decision-making by applying the planning process.
A financial planning process involves figuring out where you’d like to be, where you are, and how to go from here to there. More formally, a financial planning process means the following:
• Defining goals
• Assessing the current situation
• Identifying choices
• Evaluating choices
• Choosing
• Assessing the resulting situation
• Redefining goals
• Identifying new choices
• Evaluating new choices
• Choosing
• Assessing the resulting situation over and over again
Personal circumstances change, and the economy changes, so your plans must be flexible enough to adapt to those changes yet be steady enough to eventually achieve long-term goals. You must be constantly alert to those changes but “have a strong foundation when the winds of changes shift” (Dylan, 1973).
Defining Goals
Figuring out where you want to go is a process of defining goals. You have shorter-term (one to two years), intermediate (two to five years), and longer-term goals that are quite realistic, and goals that are more wishful. Setting goals is a skill that usually improves with experience. According to a popular model, to be truly useful goals must be specific, measurable, attainable, realistic, and timely (SMART). Goals change over time, and certainly over a lifetime. Whatever your goals, however, life is complicated and risky, and having a plan and a method to reach your goals increases your odds of doing so.
For example, after graduating from university, Brittany has an immediate focus on earning income to provide for living expenses and debt (student loan) obligations. She is fortunate that her family assists her with child care. Within the next decade, she foresees going to graduate school and perhaps purchasing a house for her and her daughter. Her income will have to provide for her increased expenses and also generate a surplus that can be saved to accumulate these assets.
In the long term, she will want to be able to retire and derive all her income from her accumulated assets, and perhaps travel around the world. In order to do so, she will have to accumulate enough assets to provide for her retirement income and for the travel. Table 1.3.1 shows the relationship between timing, goals, and sources of income.
Table 1.3.1 Timing, Goals, and Income
Timing Goals Income Sources
Short-Term Reduce Debt Wages/Salary
Intermediate Accumulate Assets Wages/Salary
Long-Term Create Retirement Income Investment Returns
Brittany’s income will be used to meet her goals, so it’s important for her to understand where her income will be coming from and how it will help in achieving her goals. She needs to assess her current situation.
Assessing the Current Situation
Figuring out where you are, or assessing the current situation, involves understanding what your present situation is and the choices that it creates. There may be many choices, but you want to identify those that will be most useful in reaching your goals.
Assessing the current situation is a matter of organizing your personal financial information into summaries that can clearly show different and important aspects of your financial life—your assets, debts, incomes, and expenses. These numbers are expressed in financial statements—in an income statement, balance sheet, and cash flow statement (topics discussed in Chapter 3 “Financial Statements”). Businesses also use these three types of statements in their financial planning.
For now, we can assess Brittany’s situation by identifying her assets and debts and by listing her annual incomes and expenses; that will show if she can expect a budget surplus or deficit. But more importantly, it will show how possible her goals are and whether she is making progress toward them. Even a ballpark assessment of the current situation can be illuminating.
Brittany’s assets may be a car worth about \$5,000 and a savings account with a balance of \$250. Her debts include a student loan with a balance of \$53,000 and a car loan with a balance of \$2,700. These are shown in Table 1.3.2.
Table 1.3.2 Brittany’s Financial Situation
Assets Debts
Car: 5,000 Car Loan: 2,700
Savings: 250 Student Loan: 53,000
Total: 5,250 Total: 55,700
Her annual disposable income (after tax income or take-home pay) may be \$35,720, and annual expenses are expected to be \$10,800 for rent and \$14,400 for living expenses—food, gas, entertainment, clothing, and so on. Her annual loan payments are \$2,400 for the car loan and \$7,720 for the student loan, as shown in Table 1.3.3.
Table 1.3.3 Brittany’s Income and Expenses
After tax income 35,720
Rent 10,800
Living expenses 14,400
Remaining for debt reduction and savings 10,520
Student loan payments 7,720
Car loan payments 2,400
Remaining for savings 400
Brittany will have an annual budget surplus of just \$400. She will be achieving her short-term goal of reducing debt, but with a small annual budget surplus it will be difficult for her to begin to achieve her goal of accumulating assets.
To reach that intermediate goal, she will have to increase income or decrease expenses to create more of an annual surplus. When her car loan is paid off next year, she hopes to buy another car, but she will have at most only \$650 (\$250 + \$400) in savings for a down payment for the car, and that assumes she can save all her surplus. When her student loans are paid off in about five years, she will no longer have student loan payments, and that will increase her surplus significantly (by \$7,720 per year) and allow her to put that money toward asset accumulation and her graduate degree. Brittany’s long-term goals also depend on her ability to accumulate productive assets, as she wants to be able to quit working and live on the income from her assets in retirement. Brittany is making progress toward meeting her short-term goals of reducing debt, which she must do before being able to work toward her intermediate and long-term goals. Until she reduces her debt, which would reduce her expenses and increase her income, she will not make progress toward her intermediate and long-term goals.
Assessing her current situation allows Brittany to see that she has to delay accumulating assets until she can reduce expenses by reducing debt (and thus her student loan payments). She is now reducing debt, and as she continues to do so, her financial situation will begin to look different, and new choices will be available to her.
Brittany learned about her current situation by compiling two simple lists: one of her assets and debts, and the other of her income and expenses. Even in this simple example it is clear that the process of articulating the current situation can put information into a very useful context. It can reveal the critical paths to achieving goals.
Evaluating Alternatives and Making Choices
Figuring out how to go from here to there is a process of identifying immediate choices and longer-term strategies or series of choices. To do this you have to be both realistic and imaginative about your current situation; this will allow you to see the choices you are presented with and the future choices that your current choices may create. The characteristics of your living situation—family structure, age, career choice, and health—and the larger context of the economic environment will affect or define the relative value of your choices.
After you have identified alternatives, you must evaluate each one. The obvious things to look for and assess are its costs and benefits, but you also want to think about its risks, where it will leave you, and how well positioned it will leave you to make the next decision. You want to have as many choices as you can at any point in the process, and you want your choices to be diversified. That way you can choose with an understanding of how this choice will affect the next choice, and the next, and so on. The further along in the process you can think, the better you can plan.
In her current situation, Brittany is reducing debt, an obligation for which she is liable, so one choice would be to continue on this path. She could begin to accumulate assets—cash or property with a monetary value—sooner if she could reduce expenses to create more of a budget surplus (Kapoor, Dlabay, Hughes, and Ahmad, 2015). Brittany looks over her expenses and decides she really can’t cut them back much. She decides that the alternative of reducing expenses is not feasible. She could increase income, however. She has two choices: work a second job or go to Las Vegas to play poker.
Brittany could work a second, part-time job that would increase her after tax income but leave her more tired and with less time for other interests. The economy is in a bit of a slump too—unemployment is up a bit—so her second job probably wouldn’t pay much. She could go to Vegas and win big, with the cost of the trip as her only expense. To evaluate her alternatives, Brittany needs to calculate the benefits and costs of each, as in Table 1.3.4.
Table 1.3.4 Brittany’s Choices: Benefits and Costs
Choices Benefit Explicit Cost Implicit Cost
Continue Reduce debt None None
Second job Reduce debt and increase surplus a little (more income) None Give up leisure pursuits
Vegas Eliminate debt and increase surplus a lot (no debt payment) Airfare and hotel in Vegas Risk of increased deficit and debt
Laying out Brittany’s choices in this way shows their consequences more clearly. The alternative with the biggest benefit is the trip to Vegas, but that also has the biggest cost because it has the biggest risk: if she loses, she could have even more debt. That would put her further from her goal of beginning to accumulate assets, which would have to be postponed until she could eliminate that new debt as well as her existing debt.
Thus, she would have to increase her income and decrease her expenses. Simply continuing as she does now would no longer be an option because the new debt increases her expenses and creates a budget deficit. Her only remaining alternative to increase income would be to take the second job that she had initially rejected because of its implicit cost. She would probably have to reduce expenses as well, an idea she initially rejected as an unreasonable choice. Thus, the risk of the Vegas option is that it could force her to “choose” alternatives that she had initially rejected as too costly.
Chart 1.3.1 Considering Risk in Brittany’s Choice
The Vegas option becomes least desirable when its risk is included in the calculations of its costs, especially as they compare with its benefits.
Its obvious risk is that Brittany will lose wealth, but its even costlier risk is that it will limit her future choices. Without including risk as a cost, the Vegas option looks attractive—which is, of course, why Vegas exists. But when risk is included, and when the decision involves thinking strategically not only about immediate consequences, but also about the choices it will preserve or eliminate, that option can be seen in a very different light.
Table 1.3.5 Brittany’s Choices: Benefits and More Costs
Choices Benefit Explicit Cost Implicit Cost Strategic Cost
Continue Reduce debt None None
Preserves
alternatives
Second job Reduce debt and increase surplus a little (more income) None Give up leisure pursuits
Preserves
alternatives
Vegas Eliminate debt and increase surplus a lot (no debt payment) Airfare and hotel in Vegas Risk of increased deficit and debt
Eliminates
alternatives
You may sometimes choose an alternative with less apparent benefit than another but also with less risk. You may sometimes choose an alternative that provides less immediate benefit but more choices later. Risk itself is a cost and choice a benefit, and they should be included in your assessment.
Key Takeaways
1. Financial planning is a recursive process that involves:
• defining goals,
• assessing the current situation,
• identifying choices,
• evaluating choices, and
• choosing.
2. Choosing further involves assessing the resulting situation, redefining goals, identifying new choices, evaluating new choices, and so on.
3. Goals are shaped by current and expected circumstances, family structure, career, health, and larger economic forces.
4. Depending on the factors shaping them, goals are short-term, intermediate, and long-term.
5. Choices will allow faster or slower progress toward goals and may digress or regress from goals; goals can be eliminated.
6. You should evaluate your feasible choices by calculating the benefits, explicit costs, implicit costs, and the strategic costs of each one.
Exercises
1. Assess and summarize your current financial situation. What measures are you using to describe where you are? Your assessment should include an appreciation of your financial assets, debts, incomes, and expenses.
2. Use the SMART planning model and information in this section to evaluate Brittany’s goals. Write your answers in your financial planning journal and discuss your evaluations with classmates.
• Pay off student loan
• Buy a house and save for children’s education
• Accumulate assets
• Retire
• Travel around the world in a sailboat
3. Identify and prioritize your immediate, short-term, and long-term goals at this time in your life. Why will you need different strategies to achieve these goals? For each goal identify a range of alternatives for achieving it. How will you evaluate each alternative before making a decision?
4. In your personal financial journal, record specific examples of your use of the following kinds of strategies in making financial decisions:
• Weigh costs and benefits
• Respond to incentives
• Learn from experience
• Avoid a feared consequence or loss
• Avoid risk
• Throw caution to the wind.
5. On average, would you rate yourself as a rational or non-rational financial decision-maker?
REFERENCES
Dylan, B. (1973). “Forever Young.” On Planet Waves, Asylum Records, 33⅓ rpm.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
1.4 FINANCIAL PLANNING PROFESSIONALS
Learning Objectives
1. Identify the professions of financial advisers.
2. Discuss how training and compensation may affect your choice of adviser.
3. Describe the differences between objective and subjective advice and how that may affect your choice of adviser.
4. Discuss how the kind of advice you need may affect your choice of adviser.
Even after reading this book, or perhaps especially after reading this book, you may want some help from a professional who specializes in financial planning. As with any professional that you go to for advice, you want expertise to help make your decisions, but in the end, you are the one who will certainly have to live with the consequences of your decisions, and you should make your own decisions accordingly.
There are a multitude of financial advisers to help with financial planning, such as accountants, investment advisers, tax advisers, estate planners, or insurance agents. Many financial advisers also work as financial planners. They have different kinds of training and qualifications, different educations and backgrounds, and different approaches to financial planning. To have a set of initials after their name, all have met educational and professional experience requirements and have passed exams administered by professional organizations, testing their knowledge in the field.
Certifications are useful because they indicate training and experience in a particular aspect of financial planning. When looking for advice, however, it is important to understand where the adviser’s interests lie (as well as your own). It is always important to know where your information and advice come from and what that says about the quality of that information and advice. Specifically, how is the adviser compensated?
Some advisers just give, and get paid for, advice; some are selling a product, such as a particular investment or mutual fund or life insurance policy, and get paid when it gets sold. Others are selling a service, such as brokerage or mortgage servicing, and get paid when the service is used. All may be highly ethical and well-intentioned, but when choosing a financial planning adviser, it is important to be able to distinguish among them.
Sometimes a friend or family member who knows you well and has your personal interests in mind may be a great resource for information and advice, but perhaps not as objective or knowledgeable as a disinterested professional. It is good to diversify your sources of information and advice, using both professional and “amateur,” subjective and objective advisers. As always, diversification decreases risk.
Now you know a bit about the planning process, the personal factors that affect it, the larger economic contexts, and the business of financial advising. The next steps in financial planning have to do with details, especially how to organize your financial information to see your current situation and how to begin to evaluate your alternatives.
References to Professional Organizations
The references that follow provide information for further research on the professionals and professional organizations mentioned in this chapter.
Table 1.4.1 References to Professional Organizations
Professional Organizations Websites
The Association of Chartered Certified Accountants (ACCA) http://www.accaglobal.com/ca/en.html
The Association for Financial Counseling and Planning Education http://www.afcpe.org
Canadian Institute of Chartered Accountants (CICA) http://www.cica.ca
Certified Financial Planner Board of Standards http://www.cfp.net
Chartered Financial Analyst Institute http://www.cfainstitute.org
Financial Planners Standards Council of Canada http://www.fpsccanada.org
The National Association of Estate Planners and Councils http://www.naepc.org
Key Takeaways
1. Financial advisers may be working as financial planners, accountants, investment advisers, tax advisers, estate planners, or insurance agents.
2. You should always understand how your adviser is trained and how that may be related to the kind of advice that you receive.
3. You should always understand how your adviser is compensated and how that may be related to the kind of advice that you receive.
4. You should diversify your sources of information and advice by using subjective advisers—friends and family—as well as objective, professional advisers. Diversification, as always, reduces risk.
Exercises
1. Where do you get your financial advice? Identify all the sources. In what circumstances might you seek a professional financial adviser?
2. Read the following information from the Financial Consumer Agency of Canada on “Choosing a financial adviser.” Which recommendations about getting financial advice do you find most valuable? Share your views with classmates. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.01%3A_Personal_Financial_Planning.txt |
INTRODUCTION
Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The great difficulty is to get that little.
—Adam Smith, The Wealth of Nations (1776)
Personal finance addresses the “great difficulty” of getting a little money. It is about creating productive assets—that is, resources that can be used to create future economic benefit, such as increasing income, decreasing expenses, or storing wealth, as an investment, and about protecting existing and expected value in those assets. In other words, personal finance is about learning how to achieve your goals and how to protect what is important to you.
There is no trick to managing your personal finances. Making good financial decisions is largely a matter of understanding how the economy works, how money flows through it, and how other people make financial decisions. The better your understanding, the better your ability to plan, take advantage of opportunities, and avoid disappointments. Life can never be planned entirely, of course, and the best-laid plans can go awry, but anticipating risks and protecting against them can minimize your exposure to the inevitable mistakes and ups and downs of life that we all experience.
The AFOA BC equates financial literacy with financial fitness: “when you are financially fit you are able to make informed choices about finances and you understand how your choices are going to impact your wallet and your life” (AFOA BC, 2011, p. 7). Just like it takes effort to become and remain physically fit, it takes effort to become financially fit: “you have to train. You have to obtain information, knowledge and skills and apply them so you can make good choices about how you treat your money and how your money treats you” (AFOA BC, 2011, p. 7). You don’t need lots of money to be financially fit—after all, there are plenty of people with money who aren’t financially fit—but you must build your skills and knowledge base “about money, savings, spending, credit, investing, and everything else people do with money. Then you can use what you learn to make choices for you and your family that help—not hurt—your bank account” (AFOA BC, 2011, p. 8).
2.1 INCOME AND EXPENSES
Learning Objectives
1. Identify and compare the sources and uses of income.
2. Define and illustrate the budget balances that result from the uses of income.
3. Outline the remedies for budget deficits and surpluses.
4. Define opportunity and sunk costs and discuss their effects on financial decision-making.
Personal finance is the process of paying for or financing a life and a way of living. Just as a business must be financed—its buildings, equipment, use of labour and materials, and operating costs must be paid for—so must a person’s possessions and living expenses. Just as a business relies on its revenues from selling goods or services to finance its costs, so a person relies on income earned from selling labour or capital to finance his or her costs. You need to understand this financing process and the terms used to describe it. In the next chapter, you’ll look at how to account for it.
Where Does Income Come From?
Income is what is earned or received in a given period. There are various terms for income because there are various ways of earning income. Income from employment or self-employment is wages or salary. Deposit accounts, like savings accounts, earn interest, which could also come from lending. Owning stock entitles the shareholder to a dividend, if there is one.
The two fundamental ways of earning income in a market-based economy are by selling labour or selling capital. Selling labour means working, either for someone else or for yourself. Income comes in the form of a paycheque. Total compensation may include other benefits, such as retirement contributions, health insurance, or life insurance. Labour is sold in the labour market.
Selling capital means investing: taking excess cash and selling it or renting it to someone who needs liquidity (access to cash). Lending is renting out capital; the interest is the rent. You can lend privately by direct arrangement with a borrower, or you can lend through a public debt exchange by buying corporate, government, or government agency bonds. Investing in or buying corporate stock is an example of selling capital in exchange for a share of the company’s future value.
You can invest in many other kinds of assets, like art, land, or commodities such as soybeans, live cattle, or potash. The principle is the same: investing is renting capital or selling it for an asset that can be resold later, or that can create future income, or both. Capital is sold in the capital market and lent in the credit market—a specific part of the capital market (just like the dairy section is a specific part of the supermarket). Table 2.1.1 shows the sources of income.
Table 2.1.1 Sources of Income
Work Invest Lend
Trade Sell Labour Sell Capital Rent Capital
Return/Income Wages or Salary Profit or Dividend Capital Gain (Loss) Interest
Market Labour Market Capital Market Credit Market
In the labour market, the price of labour is the wage that an employer (buyer of labour) is willing to pay to the employee (seller of labour). For any given job, that price is determined by many factors. The nature of the work defines the education and skills required, and the price may reflect other factors as well, such as the status or desirability of the job.
In turn, the skills needed and the attractiveness of the work determine the supply of labour for that particular job—the number of people who could and would want to do the job. If the supply of labour is greater than the demand—if there are more people to work at a job than are needed—then employers will have more hiring choices. That labour market is a buyers’ market, and the buyers can hire labour at lower prices. If there are fewer people willing and able to do a job than there are jobs, then that labour market is a sellers’ market, and workers can sell their labour at higher prices.
Similarly, the fewer skills required for the job, the more people there will be who are able to do it, which in turn creates a buyers’ market. The more skills required for a job, the fewer people there will be to do it, and the more leverage or advantage the seller has in negotiating a price. People pursue education to make themselves more highly skilled and therefore able to compete in a sellers’ labour market.
When you are starting your career, you are usually in a buyers’ market (unless you have some unusual gift or talent), if only because of your lack of experience. As your career progresses, you have more, and perhaps more varied, experience and presumably more skills, and so can sell your labour in more of a sellers’ market. You may change careers or jobs more than once, but you would hope to be doing so to your advantage—that is, always to be gaining bargaining power in the labour market.
Many people love their work for a variety of reasons other than the pay, however, and they choose it for those rewards. Labour is more than a source of income; it can also be a source of intellectual, social, and other personal gratifications. Your labour is nevertheless a tradable commodity as well and therefore has a market value. The personal rewards of your work may ultimately determine your choices, but you should be aware of the market value of those choices as you make them.
Your ability to sell labour and earn income reflects your situation in your labour market. Earlier in your career, you can expect to earn less than you will as your career progresses. Most people would like to reach a point where they don’t have to sell labour at all. They hope to retire someday and pursue other hobbies or interests. They can retire if they have alternative sources of income—if they can earn income from savings and from selling capital.
Capital markets exist so that buyers can buy capital. Businesses always need capital and have limited ways of raising it. Sellers and lenders (investors), on the other hand, have many more choices of how to invest their excess cash in the capital and credit markets, so those markets are much more like sellers’ markets. The following are examples of ways to invest in the capital and credit markets:
• Buying stocks
• Buying government or corporate bonds
• Lending a mortgage
The market for any particular investment or asset may be a sellers’ or buyers’ market at any particular time, depending on economic conditions, if there are more sellers than buyers. Typically, however, there is as much or more demand for capital as there is supply. The more capital you have to sell, the more ways you can sell it to more kinds of buyers, and the more those buyers may be willing to pay. At first, however, for most people, selling labour is their only practical source of income.
Where Does Income Go?
Expenses are costs for items or resources that are used up or consumed in the course of daily living. Expenses recur (i.e., they happen over and over again) because food, housing, clothing, energy, and so on are used up on a daily basis.
When income is less than expenses, you have a budget deficit: too little cash to provide for your wants or needs. A budget deficit is not sustainable; it is not financially viable. The only choices are to eliminate the deficit by 1) increasing income, 2) reducing expenses, or 3) borrowing to make up the difference. Borrowing may seem like the easiest and quickest solution, but borrowing also increases expenses because it creates an additional expense: interest. Unless income can also be increased, borrowing to cover a deficit will only increase it.
A better, although usually harder, choice is to either increase income or decrease expenses. Table 2.1.2 shows the choices created by a budget deficit.
Table 2.1.2 Budget Deficit
Income Less Than Expenses = Budget Deficit
1. Reduce expenses = consume less = reduce budget deficit
2. Increase income = sell more labour or capital = reduce budget deficit
3. Borrow = increase (interest) expenses = increase budget deficit
When income for a period is greater than expenses, there is a budget surplus. That situation is sustainable and remains financially viable. You could choose to decrease income by, say, working less. More likely, though, you would use the surplus in one of two ways: consume more or save it. If consumed, the income is gone, although presumably you enjoyed it.
If saved, however, the income can be stored, perhaps in a piggy bank or cookie jar, and used later. A more profitable way to save income is to invest it in some way—deposit it in a bank account, lend it with interest, or trade it for an asset, such as a stock or a bond or real estate. Those ways of saving are ways of selling your excess capital in the capital markets to increase your wealth. The following are examples of savings:
1. Depositing into a savings account at a bank
2. Contributing to a retirement account
3. Purchasing a guaranteed investment certificate
4. Purchasing a government savings bond
Table 2.1.3 shows the choices created by a budget surplus.
Table 2.1.3 Budget Surplus
Income Greater Than Expenses = Budget Surplus
1. Increase expenses = consume more = reduce budget surplus
2. Reduce income = sell less labour or capital = reduce budget surplus
3. Save and invest = increase income = increase budget surplus
Opportunity Costs and Sunk Costs
Aside from expenses, there are two other important kinds of costs that affect your financial life. Suppose you can afford a new jacket or new boots, but not both, because your resources—the income you can use to buy clothing—are limited. If you buy the jacket, you cannot also buy the boots. Not getting the boots is an opportunity cost of buying the jacket; it is the cost of sacrificing your next-best choice.
In personal finance, there is always an opportunity cost. You always want to make a choice that will create more value than cost, and so you always want the opportunity cost to be less than the benefit from trade. You bought the jacket instead of the boots because you decided that having the jacket would bring more benefit than the cost of not having the boots. You believed your benefit would be greater than your opportunity cost.
In personal finance, opportunity costs affect not only consumption decisions but also financing decisions, such as whether to borrow or to pay cash. Borrowing has obvious costs, whereas paying with your own cash or savings seems costless. Using your cash does have an opportunity cost, however: you lose whatever interest you may have had on your savings, and you lose liquidity. In other words, if you need cash for something else, like a better choice or an emergency, you no longer have it and may even have to borrow it at a higher cost.
When buyers and sellers make choices, they weigh opportunity costs, and sometimes regret them, especially when the benefits from trade are disappointing. Regret can colour future choices. Sometimes regret can keep us from recognizing sunk costs.
Sunk costs are costs that have already been spent; whatever resources you traded are gone, and there is no way to recover them. Decisions, by definition, can be made only about the future, not about the past. A trade, when it’s over, is over and done, so recognizing that sunk costs are truly sunk can help you make better decisions.
For example, the money you spent on your jacket is a sunk cost. If it snows next week and you decide you really do need boots too, that money is gone and you cannot use it to buy boots. If you really want the boots, you will have to find another way to pay for them.
Unlike a price tag, opportunity cost is not obvious. You tend to focus on what you are getting in the trade rather than what you are not getting. This tendency is a cheerful aspect of human nature, but it can hamper the kind of strategic decision-making that is so essential to financial planning. Human nature may also make you focus too much on sunk costs, but all the relish or regret in the world cannot change past decisions. Learning to recognize sunk costs is an important part of making good financial decisions.
Key Takeaways
1. It is important to understand the sources (incomes) and uses (expenses) of funds, and the budget deficit or budget surplus that may result.
2. Wages or salary is income from employment or self-employment; interest is earned by lending; a dividend is the income from owning corporate stock; and a draw is income from a partnership.
3. Deficits or surpluses need to be addressed, and that means making decisions about what to do with them.
4. Increasing income, reducing expenses, and borrowing are three ways to deal with budget deficits.
5. Spending more, saving, and investing are three ways to deal with budget surpluses.
6. Opportunity costs and sunk costs are hidden expenses that affect financial decision-making.
Exercises
1. Where does your income come from, and where does it go? Analyze your inflows of income from all sources and use of income through expenditures in a month, quarter, or year. After analyzing your numbers and converting them to percentages, show your results in two tables, using proportions of a loonie to show where your income comes from and proportions of another loonie to show how you spend your income. How would you like your income to change? How would you like your distribution of expenses to change? Use your investigation to develop a rough personal budget.
2. Examine your budget and distinguish between wants and needs. How do you define a financial need? What are your fixed expenses, or costs you must pay regularly each week, month, or year? Which of your budget categories must you provide for first before satisfying others? To what extent is each expense discretionary—under your control in terms of spending more or less for that item or resource? Which of your expenses could you reduce if you had to or wanted to for any reason?
3. If you had a budget deficit, what could you do about it? What would be the best solution for the long term? If you had a budget surplus, what could you do about it? What would be your best choice, and why?
4. You need a jacket, boots, and gloves, but the jacket you want will use up all the money you have available for outerwear. What is your opportunity cost if you buy the jacket? What is your sunk cost if you buy the jacket? How could you modify your consumption to reduce opportunity cost? If you buy the jacket but find that you need the boots and gloves, how could you modify your budget to compensate for your sunk cost?
REFERENCES
Aboriginal Financial Officers Association of British Columbia. (2011). First Nations Financial Fitness: Your Guide for Getting Healthy, Wealthy and Wise. Retrieved from: http://www.afoabc.org/wp-content/upl...y-handbook.pdf.
Smith, A. (1776) 2000. The Wealth of Nations, Book I, Chapter ix. New York: Modern Library.
2.2 ASSETS
Learning Objectives
1. Identify the purposes and uses of assets.
2. Identify the types of assets.
3. Explain the role of assets in personal finance.
4. Explain how a capital gain or loss is created.
As defined earlier in this chapter, an asset is any item with economic value that can be converted to cash. As such, they can be used to create income or reduce expenses and to store value. The following are examples of tangible (material) assets:
• Car
• Savings account
• Wind-up toy collection
• Shares of stock
• Forty acres of farmland
• Home
Selling excess capital in the capital markets in exchange for an asset is a way of storing wealth, and hopefully of generating income as well. The asset is your investment—a use of your liquidity. Some assets are more liquid than others. For example, you can probably sell your car more quickly than you can sell your house. As an investor, you assume that when you want your liquidity back, you can sell the asset. This assumes that it has some liquidity and market value (some use and value to someone else) and that it trades in a reasonably efficient market. Otherwise, the asset is not an investment, but merely a possession, which may bring great happiness but will not serve as a store of wealth.
Assets may be used to store wealth, create income, and reduce future expenses.
Assets Store Wealth
If the asset is worth more when it is resold than it was when it was bought, then you have earned a capital gain: the investment has not only stored wealth but also increased it. Of course, things can go the other way too: the investment can decrease in value while owned and be worth less when resold than it was when bought. In that case, you have a capital loss. The investment not only did not store wealth, it lost some. Table 2.2.1 shows how capital gains and losses are created.
Table 2.2.1 Gains and Losses
Buy lower, then sell higher → Capital GAIN
Buy higher, then sell lower → Capital LOSS
The better investment asset is the one that increases in value—creates a capital gain—during the time you are storing it.
Assets Create Income
Some assets not only store wealth, but also create income. An investment in an apartment or house can potentially store wealth and create rental income, for example. An investment in a share of stock stores wealth and also perhaps creates dividend income. A deposit in a savings account stores wealth and creates interest income.
Some investors care more about increasing asset value than about income. For example, an investment in a share of corporate stock may produce a dividend, which is a share of the corporation’s profit, or the company may keep all its profit rather than pay dividends to shareholders. Reinvesting that profit in the company may help the company to increase in value. If the company increases in value, the stock increases in value too, thereby increasing investors’ wealth. Further, increases in wealth through capital gains are taxed differently than income, making capital gains more valuable than an increase in income for some investors.
On the other hand, some investors care more about receiving income from their investments. For example, retirees who no longer have employment income may be relying on investments to provide income for living expenses. Being older and having a shorter horizon, retirees may be less concerned with growing wealth than with creating income.
Assets Reduce Expenses
Some assets are used to reduce living expenses. Purchasing an asset and using it may be cheaper than arranging for an alternative. For example, buying a car to drive to work may be cheaper, in the long run, than renting one or using public transportation. The car typically will not increase in value, so it cannot be expected to be a store of wealth; its only role is to reduce future expenses.
Sometimes an asset may be expected to both store wealth and reduce future expenses. For example, buying a house to live in may be cheaper, in the long run, than renting one. In addition, real estate may appreciate in value, allowing you to realize a gain when you sell the asset. In this case, the house has effectively stored wealth. Appreciation in value, however, depends on the real estate market and demand for housing when the asset is sold, so you cannot count on such a gain. Still, a house usually can reduce living expenses and be a potential store of wealth. In some cases, a house not only reduces living expenses and potentially stores wealth, but also increases income if, for example, the basement or other spaces in the house are rented by tenants.
Table 2.2.2 shows the roles of assets in reducing expenses, increasing income, and storing wealth.
Table 2.2.2 Assets and the Roles of Assets
Asset Reduce Expenses Increase Income Store Wealth
Car Yes No No
Savings Account No Yes Yes
Home Yes No Yes
Rental Property No Yes Yes
Investment in Bonds No Yes Yes
Investment in Stocks No Yes Yes
The choice of investment asset, then, depends on your belief in its ability to store and increase wealth, create income, or reduce expenses. Ideally, your assets will store and increase wealth while increasing income or reducing expenses. Otherwise, acquiring the asset will not be a productive use of liquidity. Also, in that case, the opportunity cost will be greater than the benefit from the investment, since there are many assets to choose from.
Key Takeaways
1. Assets are items with economic value that can be converted to cash. You use excess liquidity or surplus cash to buy an asset and store wealth until you resell the asset.
2. An asset can create income, reduce expenses, and store wealth.
3. To have value as an investment, an asset must either store wealth, create income, or reduce expenses.
4. Whatever the type of asset you choose, investing in assets or selling capital can be more profitable than selling labour.
5. Selling an asset can result in a capital gain or capital loss.
6. Selling capital means trading in the capital markets, which is a sellers’ market. You can do this only if you have a budget surplus, or an excess of income over expenses.
Exercises
1. Record your answers to the following questions in your personal finance journal. What are your assets? How do your assets store your wealth? How do your assets make income for you? How do your assets help you reduce your expenses?
2. List your assets in the order of their cash or market value (most valuable to least valuable). Then list them in terms of their degree of liquidity. Which assets do you think you might sell in the next ten years? Why? What new assets do you think you would like to acquire and why? How could you reorganize your budget to make it possible to invest in new assets?
2.3 DEBT AND EQUITY
Learning Objectives
1. Define equity and debt.
2. Compare and contrast the benefits and costs of debt and equity.
3. Illustrate the uses of debt and equity.
4. Analyze the costs of debt and equity.
Borrowing enables you to invest without first owning capital. By using other people’s money to finance the investment you get to use an asset before actually owning it, free and clear, assuming you can repay out of future earnings.
Borrowing capital has costs, however, so the asset will have to increase wealth, increase earnings, or decrease expenses enough to compensate for its costs. In other words, the asset will have to be more productive to earn enough to cover its financing costs—the cost of buying or borrowing capital to buy the asset.
Buying capital gives you equity, borrowing capital gives you debt, and both kinds of financing have costs and benefits. When you buy or borrow liquidity or cash, you become a buyer in the capital market.
The Costs of Debt and Equity
You can buy capital from other investors in exchange for an ownership share or equity, which represents your claim on any future gains or future income. If the asset is productive in storing wealth, generating income, or reducing expenses, the equity holder or shareholder or owner enjoys that benefit in proportion to the share of the asset owned. If the asset actually loses value, the owner bears a portion of the loss in proportion to the share of the asset owned. The cost of equity is in having to share the benefits from the investment.
In 2004, for example, Google, a company that produced a very successful Internet search engine, decided to buy capital by selling shares of the company (shares of stock or equity securities) in exchange for cash. Google sold over nineteen million shares for a total of \$1.67 billion. Those who bought the shares were then owners or shareholders of Google, Inc. Each shareholder has equity in Google, and as long as they own the shares they will share in the profits and value of Google, Inc. The original founders and owners of Google, Larry Page and Sergey Brin, have since had to share their company’s gains (income) or losses with all those shareholders. In this case, the cost of equity is the minimum rate of return Google must offer its shareholders to compensate them for waiting for their returns and for bearing some risk that the company might not do as well in the future.
Borrowing is renting someone else’s money for a period of time, and the result is debt. During that period of time, rent or interest must be paid, which is a cost of debt. When that period of time expires, all the capital (the principal amount borrowed) must be given back. The investment’s earnings must be enough to cover the interest, and its growth in value must be enough to return the principal. Thus, debt is a liability—an obligation for which the borrower is liable.
In contrast, the cost of equity may need to be paid only if there is an increase in income or wealth, and even then can be deferred. So, from the buyer’s point of view, purchasing liquidity by borrowing (debt) has a more immediate effect on income and expenses. Interest must be added as an expense, and repayment must be anticipated.
Table 2.3.1 shows the implications of equity and debt as the sources of capital.
Table 2.3.1 Sources of Capital
Equity Debt
Trade Buy Capital Borrow Capital
Cost/Expense Share Profits and Gains Pay Interest
Market Capital Market Credit Market
The Uses of Debt
Debt is a way to make an investment that could not otherwise be made, to buy an asset (e.g., house, car, corporate stock) that you couldn’t buy without borrowing. If that asset is expected to provide enough benefit (e.g., increase value, create income, or reduce expense) to compensate for its additional costs, then the debt is worth it. However, if debt creates additional expense without enough additional benefit, then it is not worth it. The trouble is, while the costs are usually known up front, the benefits are not. That adds a dimension of risk to debt, which is another factor in assessing whether it’s desirable.
For example, after the housing boom in the United States began to go bust in 2008, homeowners began losing value in their homes as housing prices dropped. Some homeowners were in the unfortunate position of owing more on their mortgage than their house was worth. The costs of their debt were knowable up front, but the consequences—the house losing value and becoming worth less than the debt—were not.
Debt may also be used to cover a budget deficit, or the excess of expenses over income. As mentioned previously, however, in the long run the cost of the debt will increase expenses that are already too big, which is what created the deficit in the first place. Unless income can also be increased, debt can only aggravate a deficit.
The Value of Debt
The value of debt includes the benefits of having the asset sooner rather than later, something that debt financing enables. For example, many people want to buy a house when they have children, perhaps because they want bedrooms and bathrooms and maybe a yard for their children. Not far into adulthood, would-be homebuyers may not have had enough time to save enough to buy the house outright, so they borrow to make up the difference. Over the length of their mortgage (real estate loan), they pay the interest.
The alternative would be to rent a living space. If the rent on a comparable home were more than the mortgage interest (which it often is, because a landlord usually wants the rent to cover the mortgage and create a profit), it would make more sense, if possible, to borrow and buy a home and be able to live in it. And, extra bedrooms and bathrooms and a yard are valuable while children are young and live at home. If you wait until you have saved enough to buy a home, you may be much older, and your children may be off on their own.
Another example of the value of debt is using debt to finance an education. Education is valuable because it has many benefits that can be enjoyed over a lifetime. One benefit is an increase in potential earnings in wages and salaries. Demand for the educated or skilled employee is generally greater than for the uneducated or less-skilled employee. So, education creates a more valuable and thus higher-priced employee.
It makes sense to be able to maximize value by becoming educated as soon as possible so that you have as long as possible to benefit from increased income. It even makes sense to invest in an education before you sell your labour because your opportunity cost of going to school—in this case, the “lost” wages of not working—is lowest. Without income or savings (or very little) to finance your education, you typically borrow. Debt enables you to use the value of the education to enhance your income, out of which you can pay back the debt.
The alternative would be to work and save and then get an education, but you would be earning income less efficiently until you completed your education, and then you would have less time to earn your return. Waiting decreases the value of your education—that is, its usefulness—over your lifetime.
In the examples shown in Table 2.3.2, debt creates a cost, but it reduces expenses or increases income to offset that cost. Debt allows this to happen sooner than it otherwise could, which allows you to realize the maximum benefit for the investment. In such cases, debt is “worth” it.
Table 2.3.2 Debt: Uses, Value, and Cost
Debt Debt Used to Finance Value Cost Paid From
Credit Cards Living Expenses Convenience Income
Auto Loan Car Reduce Expenses Income
Mortgage Home Reduce Expenses Income
College Loan Education Increase (Future) Income Future Income
Key Takeaways
1. Financing assets through equity means sharing ownership and whatever gains or losses that brings.
2. Financing assets through borrowing and creating debt means taking on a financial obligation that must be repaid.
3. Both equity and debt have costs and value.
4. Both equity and debt enable you to use an asset sooner than you otherwise could and therefore to reap more of its rewards.
Exercises
1. Research the founding of Google online—for example, at Ubergizmo “Google’s First Steps” and the Ted Talks webpage on Larry Page. How did the young entrepreneurs Larry Page and Sergey Brin use equity and debt to make their business successful and increase their personal wealth? Discuss your findings with classmates.
2. Record your answers to the following questions in your personal finance journal. What equity do you own? What debt do you owe? In each case, what do your equity and debt finance? What do they cost you? How do they benefit you?
3. Read the Financial Consumer Agency of Canada’s website “Paying back student debt.” Students fear going into debt for their education or later have difficulty paying off student loans. What are four practical financial planning tips to take advantage of debt financing your education? If payments on student loans become overwhelming, what should you do to avoid default?
2.4 INCOME AND RISK
Learning Objectives
1. Describe how sources of income may be diversified.
2. Describe how investments in assets may be diversified.
3. Explain the use of diversification as a risk-management strategy.
Personal finance is not just about getting what you want; it is also about protecting what you have. Since the way to accumulate assets is to create surplus capital by having an income larger than your expenses, and since you rely on income to provide for living expenses, you also need to think about protecting your income. One way to do so is through diversification, or spreading the risk.
You already know not to put all your eggs in one basket, because if something happens to that basket, all the eggs are gone. If the eggs are in many baskets, on the other hand, the loss of any one basket would mean the loss of just a fraction of the eggs. The more baskets, the smaller your proportional loss would be. Then if you put many different baskets in many different places, your eggs are diversified even more effectively, because all the baskets aren’t exposed to the same environmental risks.
Diversification is more often discussed in terms of investment decisions, but diversification of sources of income works the same way and makes the same kind of sense for the same reasons. If sources of income are diverse—in number and kind—and one source of income ceases to be productive, then you still have others to rely on.
If you sell your labour to only one buyer, then you are exposed to more risk than if you can generate income by selling your labour to more than one buyer. You have only so much time you can devote to working, however; having more than one employer could be exhausting and perhaps impossible. Selling your labour to more than one buyer also means that you are still dependent on the labour market, which could suffer from an economic cycle such as a recession affecting many buyers (employers).
Jeff, for example, works as a graphics designer, tutors on the side, paints houses in the summers, and buys and sells sports memorabilia on the Internet. If he got laid off from his graphics design job, he would lose his paycheque but still be able to create income by tutoring, painting, and trading memorabilia.
Similarly, if you sell your capital to only one buyer—that is, if you invest in only one asset—then you are exposed to more risk than if you generate income by investing in a variety of assets. Diversifying investments means you are dependent on trade in the capital markets, however, which likewise could suffer from unfavourable economic conditions.
Jeff has a chequing account, a high-interest savings account, an RRSP, and a tax-free savings account (TSFA) that is invested in a balanced portfolio of stocks. If his stock portfolio lost value, he would still have the value in his other accounts.
A better way to diversify sources of income is to sell both labour and capital. Then you are trading in different markets, and are not totally exposed to risks in either one. In Jeff’s case, if all his incomes dried up, he would still have his investments, and if all his investments lost value, he would still have his paycheque and other incomes. To diversify to that extent, you need surplus capital to trade. This brings us full circle to Adam Smith, quoted at the beginning of this chapter, who said, essentially, “It takes money to make money.”
Key Takeaways
Diversifying sources of income in both the labour market and the capital markets is the best hedge against risks in any one market.
Exercises
Record your answers to the following questions in your personal finance journal. How can you diversify your sources of income to spread the risk of losing income? How can you diversify your investments to spread the risk of losing return on investment? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.02%3A_Basic_Ideas_of_Finance.txt |
INTRODUCTION
Measuring by counting, by adding it all up, by taking stock, is probably as old as any human activity.
In financial planning, assessing the current situation is crucial to determining any sort of financial plan. This assessment is the point of departure for any strategy. It becomes the mark from which any progress is measured, the principal from which any return is calculated. It can determine your practical or realistic goals and the strategies to achieve them. Eventually, the current situation becomes a time forgotten with the pride of success, or remembered with the regret of failure.
Understanding the current situation is not just a matter of measuring it, but also of putting it in perspective and in context, relative to your own past performance and future goals, and relative to the realities of the economic world around you. Tools for understanding your current situation are your accounting and financial statements.
3.1 ACCOUNTING AND FINANCIAL STATEMENTS
Learning Objectives
1. Distinguish between accrual and cash accounting.
2. Compare and contrast the three common financial statements.
3. Identify the results shown on the income statement, balance sheet, and cash flow statement.
4. Explain the calculation and meaning of net worth.
5. Trace how a bankruptcy can occur.
Clay tablets interested Sumerian traders because the records gave them a way to see their financial situation and to use that insight to measure progress and plan for the future. The method of accounting universally used in business today is known as accrual accounting. In this system events are accounted for even if cash does not change hands. That is, transactions are recorded at the time they occur rather than when payment is actually made or received. Anticipated or preceding payments and receipts (cash flows) are recorded as accrued or deferred. Accrual accounting is the opposite of cash accounting, in which transactions are recognized only when cash is exchanged.
Accrual accounting defines earning as an economic event signified by an exchange of goods rather than by an exchange of cash. In this way, accrual accounting allows for the separation in time of the exchange of goods and the exchange of cash. A transaction can be completed over time and distance, which allows for extended—and extensive—trade. Another advantage of accrual accounting is that it gives a business a more accurate picture of its present situation.
In personal finance, it almost always makes more sense to use cash accounting, to define and account for events when the cash changes hands. As a result, incomes and expenses are noted when the cash is received or paid, or when the cash flows.
The Accounting Process
Financial decisions result in transactions, actual trades that buy or sell, invest or borrow. In the market economy, something is given up in order to get something, so each trade involves at least one thing given up and one thing gotten—two things flowing in at least two directions. The process of accounting records these transactions and records what has been gotten and what has been given up in exchange, what flows in and what flows out.
In business, accounting journals and ledgers are set up to record transactions as they happen. In personal finance, a chequebook records most transactions, with statements from banks or investment accounts providing records of the rest. Periodically, the transaction information is summarized in financial statements so it can be read most efficiently.
Events are recorded through bookkeeping—the process of recording what, how, and by how much a transaction affects the financial situation. Since the advent of accounting software, bookkeeping, like long division and spelling, has become somewhat obsolete, although human judgment is still required. What is more interesting and useful are the summary reports that can be produced once all this information is recorded: the income statement, cash flow statement, and balance sheet.
Income Statement
The income statement summarizes incomes and expenses for a period of time. In business, income is the value of whatever is sold, expenses are the costs of earning that income, and the difference is profit. In personal finance, income is what is earned as wages or salary and as interest or dividends, and expenses are the costs of things consumed in the course of daily living: the costs of sustaining you while you earn income. Thus, the income statement is a measure of what you have earned and what your cost of living was while earning it. The difference is personal profit, which, if accumulated as investment, becomes your wealth.
The income statement clearly shows the relative size of your income and expenses. If income is greater than expenses, there is a surplus, and that surplus can be used to save or to spend more (and create more expenses). If income is less than expenses, then there is a deficit that must be addressed. If the deficit continues, it creates debts—unpaid bills—that must eventually be paid. Over the long term, a deficit is not a viable scenario.
The income statement can be useful for its level of detail too. You can see which of your expenses consumes the greatest portion of your income or which expense has the greatest or least effect on your bottom line. If you want to reduce expenses, you can see which would have the greatest impact or would free up more income if you reduced it. If you want to increase income, you can see how much more that would buy you in terms of your expenses. For example, consider Brittany’s situation in Table 3.1.1.
Table 3.1.1 Brittany’s Situation
Gross wages 44,650
Income taxes and deductions 8,930
Rent expense 10,800
Living expenses 14,400
In addition to the figures outlined above, Brittany also had car payments of \$2,400 and student loan payments of \$7,720. Each loan payment actually covers the interest expense and partial repayment of the loan. The interest is an expense representing the cost of borrowing, and thus of having, the car and the education. The repayment of the loan is not an expense, however, but is just giving back something that was borrowed. The loan payments breakdown is shown in Table 3.1.2.
Table 3.1.2 Brittany’s Loan Payments (Annually)
Interest Debt Repayment
Car Loan 240 2,160
Student Loan 4,240 3,480
Breaking down Brittany’s living expenses in more detail and adding in her interest expenses, Brittany’s income statement would look like Table 3.1.3.
Table 3.1.3 Brittany’s Income Statement for the Year 2016
Gross wages 44,650
Income taxes and deductions 8,930
Disposable income 35,720
Rent 10,800
Food 3,900
Car expenses 3,600
Clothing 1,800
Cell phone 1,200
Internet and cable TV 1,200
Entertainment, travel, etc. 2,700
Total living expenses 25,200
Car loan interest 240
Student loan interest 4,240
Total interest expenses 4,480
Net income 6,040
Brittany’s disposable income, or income to meet expenses after taxes have been accounted for, is \$35,720. Brittany’s net income, or net earnings or personal profit, is the remaining income after all other expenses have been deducted, in this case \$6,040.
Now Brittany has a much clearer view of what’s going on in her financial life. She can see, for example, that living expenses take the biggest bite out of her income and that rent is her biggest single expense. If she wanted to decrease expenses, finding a place to live with a cheaper rent will make the most impact on her bottom line. Or perhaps it would make more sense to make many small changes rather than one large change. She could begin by cutting back on the expense items that she feels are least necessary or that she could most easily live without. Perhaps she could do with less entertainment or clothing or travel, for example. Whatever choices she subsequently made would be reflected in her income statement. The value of the income statement is in presenting income and expenses in detail for a particular period of time.
Cash Flow Statement
The cash flow statement shows how much cash came in and where it came from, and how much cash went out and where it went, over a specific period of time. This differs from the income statement because it may include cash flows that are not from income and expenses. Examples of such cash flows would be receiving repayment of money that you loaned, repaying money that you borrowed, or using money in exchanges such as buying or selling an asset.
The cash flow statement is important because it can show how well you do at creating liquidity, as well as your net income. Liquidity is nearness to cash, and liquidity has value. An excess of liquidity can be sold or lent, creating additional income. A lack of liquidity must be addressed by buying it or borrowing, creating additional expense.
Looking at Brittany’s situation, she has two loan repayments that are not expenses and so are not included on her income statement. These payments reduce her liquidity, however, making it harder for her to create excess cash. Table 3.1.4 shows what Brittany’s cash flow statement looks like.
Table 3.1.4 Brittany’s Cash Flow Statement for the Year 2016
Cash from gross wages 44,650
Cash paid for:
Income taxes and deductions (8,930)
Rent (10,800)
Food (3,900)
Car expenses (3,600)
Clothing (1,800)
Cell phone (1,200)
Internet and cable TV (1,200)
Entertainment, travel, etc. (2,700)
Car loan interest (240)
Student loan interest (4,240)
Cash for repayment of car loan (2,160)
Cash for repayment of student loan (3,480)
Net cash flow 400
Note that on a cash flow statement, negative and positive numbers indicate direction of flow. A negative number is cash flowing out, and a positive number is cash flowing in. Conventionally, negative numbers are in parentheses.
As with the income statement, the cash flow statement is more useful if there are subtotals for the different kinds of cash flows, as defined by their sources and uses. The cash flows from income and expenses are operating cash flows, or cash flows that are a consequence of earning income or paying for the costs of earning income. The loan repayments are cash flows from financing assets or investments that will increase income. In this case, cash flows from financing include repayments on the car and the education. Although Brittany doesn’t have any in this example, there could also be cash flows from investing, from buying or selling assets. Free cash flow is the cash available to make investments or finance decisions after taking care of operations and debt obligations. It is calculated as cash flow from operations less debt repayments. Net cash flow is the gain or loss of funds over a period after all operation expenses, debts, and investment activities are paid for. The most significant difference between the three categories of cash flows—operating, investing, or financing—is whether or not the cash flows may be expected to recur regularly. Operating cash flows recur regularly; they are the cash flows that result from income and expenses or consumption, and therefore can be expected to occur every year. Operating cash flows may be different amounts in different periods, but they will happen in every period. Investing and financing cash flows, on the other hand, may or may not recur, and indeed are often unusual events. Typically, for example, you would not borrow or lend or buy or sell assets in every year. Table 3.1.5 illustrates how Brittany’s cash flows would be classified.
Table 3.1.5 Brittany’s Cash Flow Statement for the Year 2016
Cash from gross wages 44,650
Cash paid for:
Income taxes and deductions (8,930)
Rent (10,800)
Food (3,900)
Car expenses (3,600)
Clothing (1,800)
Cell phone (1,200)
Internet and cable TV (1,200)
Entertainment, travel, etc. (2,700)
Car loan interest (240)
Student loan interest (4,240)
Operating cash flows 6,040
Cash for repayment of car loan (2,160)
Cash for repayment of student loan (3,480)
Financing cash flows (5,640)
Net cash flow 400
This cash flow statement more clearly shows how liquidity is created and where liquidity could be increased. If Brittany wanted to create more liquidity, it is obvious that eliminating those loan payments would be a big help.
Balance Sheet
In business or in personal finance, a critical piece in assessing the current situation is the balance sheet. Often referred to as the “statement of financial condition,” the balance sheet is a snapshot of what you have and what you owe at a given point in time. Unlike income or cash flow statements, it is not a record of performance over a period of time, but simply a statement of where things stand at a certain moment.
The balance sheet is a list of assets, debts or liabilities, and equity or net worth, with their values. In business, assets are resources that can be used to create income, while debt and equity are the capital that financed those assets. Thus, the value of the assets must equal the value of the debt and the equity. In other words, the value of the business’s resources must equal the value of the capital it borrowed or bought in order to get those resources.
assets = liabilities + equity
In business, the accounting equation is as absolute as the law of gravity. It simply must always be true, because if there are assets, they must have been financed somehow—either through debt or equity. The value of that debt and equity financing must equal or balance the value of the assets it bought. Thus, it is called the “balance” sheet because it always balances the debt and equity with the value of the assets.
In personal finance, assets are also things that can be sold to create liquidity. Liquidity is needed to satisfy or repay debts. Because your assets are what you use to satisfy your debts when they become due, the assets’ value should be greater than the value of your debts. That is, you should have more to work with to meet your obligations than you owe.
The difference between what you have and what you owe is your net worth. Literally, net worth is everything that you own. It is the value of what you have net of (less) what you owe to others. Whatever asset value is left over after you meet your debt obligations is your own worth. It is the value of what you have that you can claim free and clear.
assets − debt = net worth
Your net worth is really your equity or financial ownership in your own life. Here, too, the personal balance sheet must balance, because if
assets − debt = net worth
then it should also be
assets = debt + net worth
It is important to note that the prices of most assets fluctuate, but many debts are fixed so that net worth can change as a result of market fluctuations in asset prices.
Brittany could write a simple balance sheet to see her current financial condition. She has two assets (her car and her savings account), and she has two debts (her car and student loans), as illustrated in Table 3.1.6.
Table 3.1.6 Brittany’s Balance Sheet, December 31, 2016
Assets Liabilities
Car: 5,000 Car Loan: 2,700
Savings: 250 Student Loan: 53,000
Total: 5,250 Total: 55,700
Net Worth: (50,450)
Brittany’s balance sheet presents her with a much clearer picture of her financial situation, but also with a dismaying prospect: she seems to have negative net worth. Negative net worth results whenever the value of debts or liabilities is actually greater than the assets’ value.
Net worth is positive if liabilities<assets; assets − liabilities>0; net worth>0
Net worth is negative if liabilities>assets; assets − liabilities<0; net worth<0
Negative net worth implies that the assets don’t have enough value to satisfy the debts. Since debts are obligations, this would cause some concern.
Net Worth and Bankruptcy
In business, when liabilities are greater than the assets to meet them, the business has negative equity and is literally bankrupt. In that case, it may go out of business, selling all its assets and giving whatever it can to its creditors or lenders, who will have to settle for less than what they are owed. More usually, the business continues to operate in bankruptcy, if possible, and must still repay its creditors, although perhaps under somewhat easier terms. Creditors (and the laws) allow these terms because creditors would rather get paid in full later than get paid less now or not at all.
In personal finance, personal bankruptcy may occur when debts are greater than the value of assets. But because creditors would rather be paid eventually than never, the bankrupt person is usually allowed to continue to earn income in the hopes of repaying the debt later or with easier terms. Often, the bankrupt person is forced to liquidate (sell) some or all of his or her assets.
Because debt is a legal as well as an economic obligation, there are laws governing bankruptcies that differ from province to province and from country to country. For more information on bankruptcy, see Chapter 7 “Financial Management.”
The use of another’s property or wealth is a serious responsibility, so debt is a serious obligation.
However, Brittany’s case is actually not as dismal as it looks, because Brittany has an “asset” that is not listed on her balance sheet—that is, her education. It is not listed on her balance sheet because the value of her education, like the value of any asset, comes from how useful it is, and its usefulness has not happened yet, but will happen over her lifetime, based on how she chooses to use her education to increase her income and wealth. It is difficult to assign a monetary value to her education now. Brittany knows what she paid for her education, but, sensibly, its real value is not its cost but its potential return, or what it can earn for her as she puts it to use in the future.
Current studies show that a university education has economic value because a university graduate earns more over a lifetime than a high school graduate (Statistics Canada, 2017; Berger and Parkin, 2016; Baum, Ma, and Payea, 2013). How much more one will earn varies and is dependent on a number of different variables such as your geographical location and the degree pursued.
If Brittany assumes that her education will be worth \$1,000,000 in extra income over her lifetime, and she includes that asset value on her balance sheet, then it would look more like what is listed in Table 3.1.7.
Table 3.1.7 Brittany’s Balance Sheet, December 31, 2016
Assets Liabilities
Car: 5,000 Car Loan: 2,700
Savings: 250 Student Loan: 53,000
Education: 1,000,000 Total: 55,700
Total: 1,005,250 Net Worth: 949,550
This looks much better, but it’s not sound accounting practice to include an asset—and its value—on the balance sheet before it really exists. After all, education generally pays off, but until it does, it hasn’t yet and there is a chance, however slim, that it won’t for Brittany. A balance sheet is a snapshot of one’s financial situation at one particular time. At this particular time, Brittany’s education has value, but its amount is unknown.
It is easy to see, however, that the only thing that creates negative net worth for Brittany is her student loan. The student loan causes her liabilities to be greater than her assets—and if that were paid off, her net worth would be positive. Given that Brittany is just starting her adult earning years, her situation seems quite reasonable.
Key Takeaways
1. Three commonly used financial statements are the income statement, the cash flow statement, and the balance sheet.
2. Results for a period are shown on the income statement and the cash flow statement. Current conditions are shown on the balance sheet.
3. The income statement lists income and expenses.
4. The cash flow statement lists three kinds of cash flows: operating (recurring), financing (nonrecurring), and investing (nonrecurring).
5. The balance sheet lists assets, liabilities (debts), and net worth.
6. Net worth = assets − debts.
7. Bankruptcy occurs when there is negative net worth, or when debts are greater than assets.
Exercises
1. Prepare a personal income statement for the past year, using the same format as Brittany’s income statement in this chapter. Include all relevant categories of income and expenses. What does your income statement tell you about your current financial situation? For example, where does your income come from, and where does it go? Do you have a surplus of income over expenses? If so, what are you doing with the surplus? Do you have a deficit? What can you do about that? Which of your expenses has the greatest effect on your bottom line? What is the biggest expense? Which expenses would be easiest to reduce or eliminate? How else could you reduce expenses? Realistically, how could you increase your income? How would you like your income statement for the next year to look?
2. Using the format for Brittany’s cash flow statement, prepare your cash flow statement for the same one-year period. Include your cash flows from all sources in addition to your operating cash flows: the income and expenses that appear on your income statement. What, if any, were the cash flows from financing and the cash flows from investing? Which of your cash flows are recurring, and which are nonrecurring? What does your cash flow statement tell you about your current financial situation? If you wanted to increase your liquidity, what would you try to change about your cash flows?
3. Prepare a balance sheet, again based on Brittany’s form. List your assets, liabilities, and debts, and equity from all sources. What does the balance sheet show about your financial situation at this moment in time? What is your net worth? Do you have positive or negative net worth at this time, and what does that mean? To increase your liquidity, how would your balance sheet need to change? What would be the relationship between your cash flow statement and your budget?
REFERENCES
Baum, S.,, J. Ma, and Payea, K. (2013). Education Pays: The Benefits of Higher Education for Individuals and Society. Princeton, NJ: The College Board.
Berger, J., Motte, A. and Parkin, A. (2009). The Price of Knowledge: Access and Student Finance in Canada. Montreal: The Canada Millenium Scholarship Foundation. Retrieved from http://www.yorku.ca/pathways/literature/Access/The Price of Knowledge 2009.pdf.
Statistics Canada. (2017). Does Education Pay? A Comparison of earnings by level of education in Canada and its provinces. Retrieved from: https://www12.statcan.gc.ca/census-r...016024-eng.cfm.
3.2 COMPARING AND ANALYZING FINANCIAL STATEMENTS
Learning Objectives
1. Explain the use of common-size statements in financial analysis.
2. Discuss the design of each common-size statement.
3. Demonstrate how changes in the balance sheet may be explained by changes on the income and cash flow statements.
4. Identify the purposes and uses of ratio analysis.
5. Describe the uses of comparing financial statements over time.
Financial statements are valuable summaries of financial activities because they can organize information and make it easier to see and therefore to understand. Each one—the income statement, cash flow statement, and balance sheet—conveys a different aspect of the financial picture; viewed together, the picture is pretty complete. The three provide a summary of earning and expenses, of cash flows, and of assets and debts.
Since the three statements offer three different kinds of information, sometimes it is useful to look at each in the context of the others, and to look at specific items in this larger context. This is the purpose of financial statement analysis: creating comparisons and contexts to gain a better understanding of the financial picture.
Common-Size Statements
On common-size statements, each item’s value is listed as a percentage of another. This compares items, showing their relative size and their relative significance (see Table 3.2.1 “Common Common-Size Statements”). On the income statement, each income and expense may be listed as a percentage of the total income. This shows the contribution of each kind of income to the total, and thus the diversification of income. It shows the burden of each expense on total income or how much income is needed to support each expense.
On the cash flow statement, each cash flow can be listed as a percentage of total positive cash flows, again showing the relative significance and diversification of the sources of cash, and the relative size of the burden of each use of cash.
On the balance sheet, each item is listed as a percentage of total assets, showing the relative significance and diversification of assets, and highlighting the use of debt as financing for the assets.
Table 3.2.1 Common-Size Statements
Income Statement Cash Flow Statement Balance Sheet
Items as a % of Total Income Total Positive Cash Flows Total Assets
Brittany can look at a common-size income statement by looking at her expenses as a percentage of her income and comparing the size of each expense to a common denominator: her income. This shows her how much of her income, proportionately, is used up for each expense.
Table 3.2.2 Brittany’s Common-Size Income Statement for the Year 2016
Gross wages 44,650 100.00%
Income taxes and deductions 8,930 20.00%
Disposable income 35,720 80.00%
Rent 10,800 24.19%
Food 3,900 8.73%
Car expenses 3,600 8.06%
Clothing 1,800 4.03%
Cell phone 1,200 2.69%
Internet and cable TV 1,200 2.69%
Entertainment, travel, etc. 2,700 6.05%
Total living expenses 25,200 56.44%
Car loan interest 240 0.54%
Student loan interest 4,240 9.50%
Total interest expenses 4,480 10.03%
Net income 6,040 13.53%
Seeing the common-size statement as a pie chart makes the relative size of the slices even clearer.
Chart 3.2.1 Brittany’s Common-Size Income Statement for the Year 2016
The biggest discretionary use of Brittany’s wages is her rent expense, followed by food, car expenses, and entertainment. Her income tax expense is a big use of her wages, but it is unavoidable or nondiscretionary.
Ranking expenses by size offers interesting insight into lifestyle choices. It is also a valuable way of framing financial decisions, pointing out which expenses have the largest impact on income and thus on the resources for making financial decisions. If Brittany wanted more discretionary income to make more or different choices, she could easily see that reducing rent expense would have the most impact on freeing up some of her wages for another use.
Common-Size Cash Flow Statement
Looking at Brittany’s negative cash flows as percentages of her positive cash flow (on the cash flow statement), or the uses of cash as percentages of the sources of cash, creates the common-size cash flows. As with the income statement, this gives Brittany a clearer and more immediate view of the largest uses of her cash, as can be seen in Table 3.2.3.
Table 3.2.3 Brittany’s Common-Size Cash Flow Statement for the Year 2016
Cash from gross wages 44,650 100.00%
Cash paid for:
Income taxes and deductions (8,930) -20.00%
Rent (10,800) -24.19%
Food (3,900) -8.73%
Car expenses (3,600) -8.06%
Clothing (1,800) -4.03%
Cell phone (1,200) -2.69%
Internet and cable TV (1,200) -2.69%
Entertainment, travel, etc. (2,700) -6.05%
Car loan interest (240) -0.54%
Student loan interest (4,240) -9.50%
Operating cash flows 6,040 13.53%
Cash for repayment of car loan (2,160) -4.84%
Cash for repayment of student loan (3,480) -7.79%
Financing cash flows (5,640) -12.63%
Net cash flow 400 0.00%
Chart 3.2.2 Brittany’s Common-Size Cash Flow Statement
Again, rent is the biggest discretionary use of cash for living expenses, but debts demand the most significant portion of cash flows. Repayments and interest together are 30 per cent of Brittany’s cash—as much as she pays for rent and food. Eliminating those debt payments would create substantial liquidity for Brittany.
Common-Size Balance Sheet
On the balance sheet, looking at each item as a percentage of total assets allows for measuring how much of the assets’ value is obligated to cover each debt, or how much of the assets’ value is claimed by each debt.
Table 3.2.4 Brittany’s Common-Size Balance Sheet, December 31, 2016
Assets Liabilities
Car 5,000 95% Car Loan 2,700 51%
Savings 250 5% Student Loan 53,000 1,010%
Total 5,250 100% Total 55,700 1,061%
Net Worth (50,450) (961%)
This common-size balance sheet allows “over-sized” items to be more obvious. For example, it is immediately obvious that Brittany’s student loan dwarfs her assets’ value and creates her negative net worth.
Common-size statements allow you to look at the size of each item relative to a common denominator: total income on the income statement, total positive cash flow on the cash flow statement, or total assets on the balance sheet. The relative size of the items helps you spot anything that seems disproportionately large or small. The common-size analysis is also useful for comparing the diversification of items on the financial statement—the diversification of incomes on the income statement, cash flows on the cash flow statement, and assets and liabilities on the balance sheet. Diversification reduces risk, so you want to diversify the sources of income and assets you can use to create value.
For example, Brittany has only two assets, and one—her car—provides 95 per cent of her assets’ value. If something happened to her car, her assets would lose 95 per cent of their value. Her asset value would be less exposed to risk if she had asset value from other assets to diversify the value invested in her car.
Likewise, both her income and her positive cash flows come from only one source, her paycheque. Because her positive net earnings and positive net cash flows depend on this one source, she is exposed to risk, which she could decrease by diversifying her sources of income. She could diversify by adding earned income—taking on a second job, for example—or by creating investment income. In order to create investment income, however, she needs to have a surplus of liquidity, or cash, to invest. Brittany has run head-first into Adam Smith’s “great difficulty”: that it takes some money to make money (see Chapter 2 “Basic Ideas of Finance”).
Relating the Financial Statements
Common-size statements highlight the details of the financial statements relative to a common factor for each statement. But each financial statement is also related to the others, and as important as it is to see each individual piece, it is also important to see that larger picture. To make sound financial decisions, you need to be able to foresee the consequences of a decision, to understand how a decision may affect the different aspects of the bigger picture.
For example, what happens in the income statement and cash flow statements is reflected on the balance sheet because the earnings and expenses and the other cash flows affect the asset values and the values of debts, and thus the net worth. Cash may be used to purchase assets, so a negative cash flow may increase assets. Cash may be used to pay off debt, so a negative cash flow may decrease liabilities. Cash may be received when an asset is sold, so a decrease to assets may create positive cash flow. Cash may be received when money is borrowed, so an increase in liabilities may create a positive cash flow.
There are many other possible scenarios and transactions, but you can begin to see that the balance sheet at the end of a period is changed from what it was at the beginning of the period by what happens during the period, and what happens during the period is shown on the income statement and the cash flow statement. So, as shown in Chart 3.2.4, the income statement and cash flow information, related to each other, also relate the balance sheet at the end of the period to the balance sheet at the beginning of the period.
The significance of these relationships becomes even more important when evaluating alternatives for financial decisions. When you understand how the statements are related, you can use that understanding to project the effects of your choices on different aspects of your financial reality and see the consequences of your decisions.
Ratio Analysis
Creating ratios is another way to see the numbers in relation to each other. Any ratio shows the relative size of the two items compared, just as a fraction compares the numerator to the denominator or a percentage compares a part to the whole. The percentages on the common-size statements are ratios, although they only compare items within a financial statement. Ratio analysis is used to make comparisons across statements. For example, you can see how much debt you have just by looking at your total liabilities, but how can you tell if you can afford the debt you have? That depends on the income you have to meet your interest and repayment obligations, or the assets you could use (sell) to meet those obligations. Ratio analysis can give you the answer.
The financial ratios you use depend on the perspective you need or the question(s) you need answered. Some of the more common ratios (and questions) are presented in Table 3.2.5.
Table 3.2.5 Common Personal Financial Ratios
Ratio Calculation Question it helps to answer
Net income margin
Net income /
Total income
How much income is used up by expenses?
Return on assets
Net income /
Total assets
How big is the income supporting the assets?
Return on net worth
Net income /
Net worth
How big is income relative to net worth?
Debt to assets
Total debt /
Total assets
How much asset value is financed by debt? Or how much asset value is there to satisfy debt?
Total debt
Total debt /
Net worth
How large is debt relative to net worth?
Interest coverage
Income before interest/
Interest expense
How well does income cover interest expenses?
Cash flow to income
Net cash flow /
Net income
How much do payments for investments and financing take from income?
Cash flow to assets
Net cash flow /
Total assets
How much cash flow supports assets?
These ratios all get “better” or show improvement as they get bigger, with two exceptions: debt to assets and total debt. Those two ratios measure levels of debt, and the smaller the ratio, the less the debt. Ideally, the two debt ratios would be less than one. If your debt-to-assets ratio is greater than one, then debt is greater than assets, and you are bankrupt. If the total debt ratio is greater than one, then debt is greater than net worth, and you “own” less of your assets’ value than your creditors do.
Some ratios will naturally be less than one, but the bigger they are, the better. For example, net income margin will always be less than one because net income will always be less than total income (net income = total income − expenses). The larger that ratio is, and the fewer expenses that are taken away from the total income, the better.
Some ratios should be greater than one, and the bigger they are, the better. For example, the interest coverage ratio should be greater than one, because you should have more income to cover interest expenses than you have interest expenses, and the more you have, the better. Table 3.2.6 suggests what to look for in the results of your ratio analyses.
Table 3.2.6 Results of Ratio Analysis
Ratio Calculation Question it helps to answer Better as it gets…
Net income margin
Net income /
Total income
How much income is used up by expenses? Bigger
Return on assets
Net income /
Total assets
How big is the income supporting the assets? Bigger
Return on net worth
Net income /
Net worth
How big is income relative to net worth? Bigger
Debt to assets
Total debt /
Total assets
How much asset value is financed by debt? Or how much asset value is there to satisfy debt?
Smaller:
Should be < 1
Total debt
Total debt /
Net worth
How large is debt relative to net worth?
Smaller:
Should be < 1
Interest coverage
Income before interest/
Interest expense
How well does income cover interest expenses?
Bigger:
Should be > 1
Cash flow to income
Net cash flow /
Net income
How much do payments for investments and financing take from income? Bigger
Cash flow to assets
Net cash flow /
Total assets
How much cash flow supports assets? Bigger
While you may have a pretty good “feel” for your situation just by paying the bills and living your life, it often helps to have the numbers in front of you. Table 3.2.7 illustrates Brittany’s ratio analysis for 2016.
Table 3.2.7 Brittany’s Ratio Analysis, 2016
Ratio Calculation Result
Net income margin Net income / Total income 0.1353
Return on assets Net income / Total assets 1.1505
Return on net worth Net income / Net worth (0.1197)
Debt to assets Total debt / Total assets 10.6095
Interest coverage Income before interest/ Interest expense 2.3482
Cash flow to income Net cash flow / Net income 0.0662
Cash flow to assets Net cash flow / Total assets 0.0762
The ratios that involve net worth—return on net worth and total debt—are negative for Brittany because she has negative net worth (her debts are larger than her assets). She can see how much larger her debt is than her assets by looking at her debt-to-assets ratio. Although she has a lot of debt (relative to assets and to net worth), she can earn enough income to cover its cost or interest expense, as shown by the interest coverage ratio.
Brittany is earning well. Her income is larger than her assets. She is able to live efficiently. Her net income is a healthy 13.53 per cent of her total income (net income margin), which means that her expenses are only 86.47 per cent of it, but her cash flows are much less (cash flow to income), meaning that a significant portion of earnings is used up in making investments or, in Brittany’s case, debt repayments. In fact, her debt repayments don’t leave her with much free cash flow—that is, cash flow not used up on living expenses or debts.
Looking at the ratios, it is even more apparent how much—and yet how subtle—of a burden Brittany’s debt is. In addition to giving her negative net worth, it keeps her from increasing her assets and creating positive net worth—and potentially more income—by obligating her to use up her cash flows. Debt repayment keeps her from being able to invest.
Currently, Brittany can afford the interest and the repayments. Her debt does not keep her from living her life, but it does limit her choices, which in turn restricts her decisions and future possibilities.
Comparisons Over Time
Another useful way to compare financial statements is to look at how the situation has changed over time. Comparisons over time provide insights into the effects of past financial decisions and changes in circumstance. That insight can guide you in making future financial decisions, particularly in foreseeing the potential costs or benefits of a choice. Looking backward can be very helpful in looking forward.
Fast-forward ten years: Brittany is now in her early thirties. Her career has progressed and her income has grown. She has paid off her student loan and has begun to save for retirement and perhaps a down payment on a house.
A comparison of Brittany’s financial statements shows the change over the decade, both in absolute dollar amounts and as a percentage (see the following tables: Table 3.2.8 “Brittany’s Income Statements: Comparison Over Time,” Table 3.2.9 “Brittany’s Cash Flow Statements: Comparison Over Time,” and Table 3.2.10 “Brittany’s Balance Sheets: Comparison Over Time”). For the sake of simplicity, this example assumes that neither inflation nor deflation have significantly affected currency values during this period.
Table 3.2.8 Brittany’s Income Statement: Comparison Over Time
For Year Ending 12/31/16 12/31/26 Change % Change
Gross wages 44,650 74,000 29,350 65.73%
Income taxes and deductions 8,930 18,500 9,570 107.17%
Disposable income 35,720 55,500 19,780 55.38%
Rent 10,800 18,000 7,200 66.67%
Food 3,900 3,900 0 0.00%
Car expenses 3,600 3,600 0 0.00%
Clothing 1,800 1,800 0 0.00%
Cell phone 1,200 1,200 0 0.00%
Internet and cable TV 1,200 1,200 0 0.00%
Entertainment, travel, etc. 2,700 5,200 2,500 92.59%
Total living expenses 25,200 34,900 9,700 38.49%
Car loan interest 240 757 517 215.42%
Student loan interest 4,240 0 4,240 -100.00%
Total interest expenses 4,480 757 3,723 -83.10%
Net income 6,040 19,843 13,803 228.53%
Table 3.2.9 Brittany’s Cash Flow Statement: Comparison Over Time
For Year Ending 12/31/16 12/31/26 Change % Change
Cash from gross wages 44,650 74,000 29,350 65.73%
Cash paid for:
Income taxes and deductions (8,930) (18,500) 9,570 107.17%
Rent (10,800) (18,000) 7,200 66.67%
Food (3,900) (3,900) 0 0.00%
Car expenses (3,600) (3,600) 0 0.00%
Clothing (1,800) (1,800) 0 0.00%
Cell phone (1,200) (1,200) 0 0.00%
Internet and cable TV (1,200) (1,200) 0 0.00%
Entertainment, travel, etc. (2,700) (5,200) 2,500 92.59%
Car loan interest (240) (757) 517 215.42%
Student loan interest (4,240) 0 4,240 -100.00%
Operating cash flows 6,040 19,843 13,803 228.53%
Cash invested in RRSP 0 (3,000) 3,000 100.00%
Cash invested in car 0 (6,300) 6,300 100.00%
Investing cash flows 0 (9,300) 9,300 100.00%
Cash for repayment of car loan (2,160) (4,610) 2,450 113.43%
Cash for repayment of student loan (3,480) -100.00%
Financing cash flows (5,640) (4,610) 1,030 -18.26%
Net cash flow 400 5,933 5,533 1383.25%
Table 3.2.10 Brittany’s Balance Sheet: Comparison Over Time
As of 12/31/16 12/31/26 Change % Change
Assets
Cash/Chequing 0 5,000 5,000 100.00%
Savings 250 250 0 0.00%
Money Market 0 2,600 2,600 100.00%
Pension 0 13,000 13,000 100.00%
RRSP 0 7,400 7,400 100.00%
Car 5,000 15,000 10,000 200.00%
Total assets 5,250 43,250 38,000 723.81%
Liabilities
Car loan 2,700 4,610 1,910 70.74%
Student loan 53,000 0 53,000 -100.00%
Total liabilities 55,700 4,610 51,090 -91.72%
Net worth -50,450 38,640 89,090 176.59%
Starting with the income statement, Brittany’s income has increased. Her income tax withholding and deductions have also increased, but she still has higher disposable income (take-home pay). Many of her living expenses have remained consistent; rent and entertainment have increased. Interest expense on her car loan has increased, but since she has paid off her student loan, that interest expense has been eliminated, so her total interest expense has decreased. Overall, her net income, or personal profit—what she clears after covering her living expenses—has almost doubled.
Her cash flows have also improved. Operating cash flows, like net income, have almost doubled—due primarily to eliminating the student loan interest payment. The improved cash flow allowed her to make a down payment on a new car, invest in her RRSP, make the payments on her car loan, and still increase her net cash flow by a factor of ten.
Brittany’s balance sheet is most telling when it comes to the changes in her life, especially what is now her positive net worth. She has more assets. She has begun saving for retirement and has more liquidity, distributed in her chequing, savings, and money market accounts. Since she has less debt as a result of having paid off her student loan, she now has positive net worth.
Comparing the relative results of the common-size statements provides an even deeper view of the relative changes in Brittany’s situation (See the following tables: Table 3.2.11 “Comparing Brittany’s Common-Size Statements for 2016 and 2026: Income Statements,” Table 3.2.12 “Comparing Brittany’s Common-Size Statements for 2016 and 2026: Cash Flow Statements,” and Table 3.2.13 “Comparing Brittany’s Common-Size Statements for 2016 and 2026: Balance Sheets”).
Table 3.2.11 Comparing Brittany’s Common-Size Statements for 2016 and 2026: Income Statement
For the Year Ending 12/31/16 12/31/26
Gross wages 100.00% 100.00%
Income taxes and deductions 20.00% 25.00%
Disposable income 80.00% 75.00%
Rent 24.19% 24.32%
Food 8.73% 5.27%
Car expenses 8.06% 4.86%
Clothing 4.03% 2.43%
Cell phone 2.69% 1.62%
Internet and cable TV 2.69% 1.62%
Entertainment, travel, etc. 6.05% 7.03%
Total living expenses 56.44% 47.16%
Car loan interest 0.54% 1.02%
Student loan interest 9.50% 0.00%
Total interest expenses 10.03% 1.02%
Net income 13.53% 26.81%
Table 3.2.12 Comparing Brittany’s Common-Size Statements for 2016 and 2026: Cash Flow Statement
For the Year Ending 12/31/16 12/31/26
Cash from gross wages 100.00% 100.00%
Cash paid for:
Income taxes and deductions -20.00% -25.00%
Rent -24.19% -24.32%
Food -8.73% -5.27%
Car expenses -8.06% -4.86%
Clothing -4.03% -2.43%
Cell phone -2.69% -1.62%
Internet and cable TV -2.69% -1.62%
Entertainment, travel, etc. -6.05% -7.03%
Car loan interest -0.54% -1.02%
Student loan interest -9.50% 0.00%
Operating cash flows 13.53% 26.81%
Cash invested in pension 0.00% -4.05%
Cash invested in car 0.00% -8.51%
Investing cash flows 0.00% -12.57%
Repayment of car loan -4.84% -6.23%
Repayment of student loan -7.79% 0.00%
Financing cash flows -12.63% -6.23%
Net cash flow 0.90% 8.02%
Table 3.2.13 Comparing Brittany’s Common-Size Statements for 2016 and 2026: Balance Sheet
As of 12/31/16 12/31/26
Assets
Cash/Chequing 0.00% 11.56%
Savings 4.76% 0.58%
Money Market 0.00% 6.01%
Pension 0.00% 30.06%
RRSP 0.00% 17.11%
Car 95.24% 34.68%
Total assets 100.00% 100.00%
Liabilities
Car loan 51.43% 10.66%
Student loan 1009.52% 0.00%
Total liabilities 1006.95% 10.66%
Net worth -960.95% 89.34%
Although income taxes and rent have increased as a percentage of income, living expenses have declined, showing Brittany’s real progress in raising her standard of living: it now costs her less of her income to sustain herself. Interest expense has decreased substantially as a portion of income, resulting in a net income or personal profit that is not only larger, but larger relative to income. More of her income is profit, left for other discretionary uses.
The change in operating cash flows confirms this. Although her investing activities now represent a significant use of cash, her need to use cash in financing activities—debt repayment—is so much less that her net cash flow has increased substantially. The cash that used to have to go toward supporting debt obligations now goes toward building an asset base, such as the RRSP, which may provide income in the future.
Changes in the balance sheet show a much more diversified and therefore much less risky asset base. Although almost half of Brittany’s assets are restricted for a specific purpose, such as her RRSP account, she still has significantly more liquidity and more liquid assets. Debt has fallen from ten times the assets’ value to one-tenth of it, creating some ownership for Brittany. Finally, Brittany can compare her ratios over time, as seen in Table 3.2.14.
Table 3.2.14 Ratio Analysis Comparison
Ratio Analysis 12/31/16 12/31/26
Net income margin 0.1353 0.2681
Return on assets 1.1505 0.4588
Return on net worth -0.1197 0.5135
Debt to assets 10.6095 0.1066
Interest coverage 1.3482 26.2127
Cash flow to income 0.0662 0.2990
Cash flow to assets 0.0762 0.1372
Most immediately, her net worth is now positive, and so are the return on net worth and the total debt ratios. As her debt has become less significant, her ability to afford it has improved (to pay for its interest and repayment). Both her interest coverage and free cash flow ratios show large increases. Since her net income margin (and income) has grown, the only reason her return-on-asset ratio has decreased is because her assets have grown even faster than her income.
By analyzing over time, you can spot trends that may be happening too slowly or too subtly for you to notice in daily living, but which may become significant over time. It is recommended to review your situation at least every year.
Key Takeaways
1. Each financial statement shows a piece of the larger picture. Financial statement analysis puts this information in context and so in sharper focus.
2. Common-size statements show the size of each item relative to a common denominator.
3. On the income statement, each income and expense is shown as a percentage of total income.
4. On the cash flow statement, each cash flow is shown as a percentage of total positive cash flow.
5. On the balance sheet, each asset, liability, and net worth is shown as a percentage of total assets.
6. The income and cash flow statements explain the changes in the balance sheet over time.
7. Ratio analysis is a way of creating a context by comparing items from different statements.
8. Comparisons made over time can demonstrate the effects of past decisions to better understand the significance of future decisions.
9. Financial statements should be compared at least annually.
Exercises
1. Prepare common-size statements for your income statement, cash flow statement, and balance sheet. What do your common-size statements reveal about your financial situation? How will your common-size statements influence your personal financial planning?
2. Calculate your debt-to-income ratio and other ratios using the financial tools found in the article on the U.S. News & World Report website “Debt-to-Income Ratio: Are You In Over Your Head?.” According to the calculation, are you carrying a healthy debt load? Why or why not? If not, what can you do to improve your situation?
3. Read a 2006 article by Charles Farrell in the Financial Planning Association Journal—“Personal Financial Ratios: An Elegant Roadmap to Financial Health and Retirement”. Farrell focuses on three ratios: savings to income, debt to income, and savings rate to income. Where, how, and why might these ratios appear on the chart of common personal financial ratios in this chapter?
4. If you increased your income and assets and reduced your expenses and debt, your personal wealth and liquidity would grow. In your personal financial journal, outline a general plan for how you would use or allocate your growing wealth to further reduce your expenses and debt, to acquire more assets or improve your standard of living, and to further increase your real or potential income.
3.3 ACCOUNTING SOFTWARE: AN OVERVIEW
Learning Objectives
1. Identify the uses of personal finance software.
2. List the common features of personal financial software.
3. Demonstrate how actual financial calculations may be accomplished using personal financial software.
4. Discuss how personal financial software can assist in your personal financial decisions.
Many software products are available to help you organize your financial information to be more useful in making financial decisions. They are designed to make the record-keeping aspects of personal finance—the collection, classification, and sorting of financial data—as easy as possible. The programs are also designed to produce summary reports (e.g., income statements, cash flow statements, and balance sheets) as well as many calculations that may be useful for various aspects of financial planning. For example, financial planning software exists for managing education and retirement savings, debt and mortgage repayment, and income and expense budgeting.
Collecting the Data
Most programs have designed their data input to look like a chequebook, which is what most people use to keep personal financial records. This type of user interface is intended to be recognizable and familiar, similar to the manual record keeping that you may already do.
When you input your chequebook data into the program, the software does the bookkeeping, creating the journals, ledgers, adjustments, and trial balances that people have done—albeit more tediously, with parchment and quill or with ledger paper and pencil—for generations. Most personal financial transactions happen as cash flows through a chequing account, so the chequebook becomes the primary source of data.
More and more personal transactions are done by electronic transfer—that is, no paper changes hands, but cash still flows to and from an account, usually a chequing account.
Data for other transactions, such as income from investments or changes in investment value, are usually received from periodic statements issued by investment managers: banks where you have savings accounts; brokers or mutual fund companies that manage investments; or employers’ retirement account statements.
Most personal financial software allows you to download account information directly from the source—your bank, broker, or employer—which saves you from manually entering the data into the program. Aside from providing convenience, downloading directly should eliminate human error in transferring the data.
Reporting Results and Planning Ahead
All personal financial software produces the essential summary reports—the income statement, cash flow statement, and balance sheet—that show the results of financial activity for the period. Most will also report more specific aspects of activities, such as listing all transactions for a particular income or expense.
Most will provide separate reports on activities that have some tax consequence, since users always need to be aware of tax obligations and tax consequences of financial decisions. Some programs, especially those produced by companies that also sell tax software, allow you to export data from your financial software to your tax program, which makes tax preparation—or at least tax record keeping—easier. In some programs, you need to know which activities are taxable and flag them as such. Some programs recognize that information already, while others may still prompt you for tax information.
All programs allow you to play “What If?”; this is a marvelous feature of computing power and the virtual world in general, and certainly helpful when it comes to making financial decisions. All programs include a budgeting feature that allows you to foresee or project possible scenarios and gauge your ability to live with them. This feature is particularly useful when budgeting for income and living expenses. Budgeting is discussed more thoroughly in Chapter 5 “Financial Plans: Budgets.” Most programs have features that allow you to project the results of savings plans for education or retirement. None can dictate the future, or allow you to, but they can certainly help you to have a better view.
Security, Benefits, and Costs
All programs are designed to be installed on a personal computer or a handheld device such as a smart phone, but some can also be run from a website and therefore do not require a download. Product and service providers are very concerned with security.
As with all Internet transactions, you should be aware that the more your data is transferred, downloaded, or exported over the Internet, the more exposed it is to theft. Personal financial data theft is a serious and growing problem worldwide, and security systems are hard pressed to keep up with the ingenuity of hackers. The convenience gained by having your bank, brokerage, tax preparer, and so on, accessible to you (and your data accessible to them), or your data accessible to you wherever you are, must be weighed against the increased exposure to data theft. As always, the potential benefit should be considered against the costs.
Keeping digital records of your finances may be more secure than keeping them scattered in shoeboxes or files, where they are exposed to risks such as fire, flood, and theft. Digital records are often easily retrievable because the software organizes them systematically for you. Space is not a practical issue with digital storage, so records may be kept longer. As with anything digital, however, you must be diligent about backing up your data, although many programs will do that automatically or regularly prompt you to do so. Hard-copy records must be disposed of periodically, and judging how long to keep them is always difficult. Throwing them in the trash may be risky because of “dumpster diving,” a well-known method of identity theft, so documents with financial information should always be shredded before disposal.
Personal financial software is usually quite reasonably priced, with many programs selling for less than \$50, and most for less than \$100. Buying the software usually costs less than buying an hour of accounting expertise from an accountant or financial planner. While software cannot replace financial planning professionals’ valuable judgment, it can allow you to hire them only for their judgment rather than to collect, classify, sort, and report your financial data.
Software will not improve your financial situation, but it can improve the organization of your financial data monthly and yearly, allowing you a much clearer view and almost certainly a much better understanding of your situation.
Software References
1. Visit thebalance.com and read the article “Best Online Personal Finance Software Apps” for information on how to manage and save money with different apps.
2. Visit the product review website Top Ten Reviews and read the article “Best Personal Finance Software of 2018” to find personal financial software favourites that are reasonably priced.
Key Takeaways
1. Personal finance software provides convenience and skill for collecting, classifying, sorting, reporting, and securing financial data to better assess you current situation.
2. To help you better evaluate your choices, personal finance software provides calculations for projecting information such as the following:
• Education savings
• Retirement savings
• Debt repayment
• Mortgage repayment
• Income and expense budgeting
Exercises
1. Explore free online resources for developing and comparing baseline personal financial statements. One good resource is a blog from Money Musings called “It’s Your Money”. View the post “The Worth of Net Worth.” This site also explains how and where to find the tables you need for accurate and complete income statements and balance sheets.
2. Compare and contrast the features of popular personal financial planning software at the following websites: Mint.com, www.quicken.com/canada, and Moneydance.com. Record your findings in your personal finance journal. Which software, if any, would be your first choice, and why? Share your experience and views with others taking this course.
3. The Financial Consumer Agency of Canada explains the key components of financial planning in Module 11: Financial planning of its Financial Toolkit. What goes into a financial plan? What aspects of financial planning do you already have in place? What aspects of financial planning should you consider next? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.03%3A_Financial_Statements.txt |
INTRODUCTION
Financial decisions can only be made about the future. As much as analysis may tell us about the outcomes of past decisions, the past is “sunk”: it can be known but not decided upon. Decisions are made about the future, which cannot be known with certainty, so evaluating alternatives for financial decisions always involves speculation on both the kind of result and the value of the result that will occur. It also involves understanding and measuring the risks or uncertainties that time presents and the opportunities—and opportunity costs—that time creates.
4.1 THE TIME VALUE OF MONEY
Learning Objectives
1. Explain the value of liquidity.
2. Demonstrate how time creates distance, risk, and opportunity cost.
3. Demonstrate how time affects liquidity.
4. Analyze how time affects value.
Part of the planning process is evaluating the possible future results of a decision. Since those results will occur sometime in the future, it is critical to understand how the passage of time may affect those benefits and costs—not only the probability of their occurrence, but also their value when they do. Time affects value because time affects liquidity.
Liquidity is valuable, and the liquidity of an asset affects its value: all things being equal, the more liquid an asset is, the more valuable it is. This relationship—how the passage of time affects the liquidity of money and thus its value—is commonly referred to as the time value of money, which can actually be calculated concretely as well as understood abstractly.
Suppose you went to Mexico, where the currency is the peso. Coming from Canada, you have dollars to spend. When you get there, you are hungry. You see and smell a taco stand and decide to have a taco. Before you can buy the taco, however, you have to get some pesos so that you can pay for it because the right currency is needed to trade in that market. You have wealth (your fistful of dollars), but you don’t have wealth that is liquid. In order to change your dollars into pesos and acquire liquidity, you need to exchange currency. There is a fee to exchange your currency: a transaction cost, which is the cost of simply making the trade. It also takes a bit of time, and you could be doing other things, so it creates an opportunity cost (see Chapter 2 “Basic Ideas of Finance”). There is also the chance that you won’t be able to make the exchange for some reason, or that it will cost more than you thought, so there is a bit of risk involved. Obtaining liquidity for your wealth creates transaction costs, opportunity costs, and risk.
In general, transforming not-so-liquid wealth into liquid wealth creates transaction costs, opportunity costs, and risk, all of which take away from the value of wealth. Liquidity has value because it can be used without any additional costs.
One dimension of difference between not-so-liquid wealth and liquidity is time. Cash flows in the past are sunk, cash flows in the present are liquid, and cash flows in the future are not yet liquid. You can only make choices with liquid wealth, not with cash that you don’t have yet or that has already been spent. Separated from your liquidity and your choices by time, there is an opportunity cost: if you had liquidity now, you could use it for consumption or investment and benefit from it now. There is also risk, as there is always some uncertainty about the future: whether or not you will actually get your cash flows and just how much they’ll be worth when you do.
The further in the future cash flows are, the farther away you are from your liquidity, the more opportunity cost and risk you have, and the more that takes away from the present value of your wealth, which is not yet liquid. In other words, time puts distance between you and your liquidity, and that creates costs that take away from value. The more time there is, the larger its effect on the value of wealth.
Financial plans are expected to happen in the future, so financial decisions are based on values some distance away in time. You could be trying to project an amount at some point in the future—perhaps an investment payout or college tuition payment. Or perhaps you are thinking about a series of cash flows that happen over time—for example, annual deposits into and then withdrawals from a retirement account. To really understand the time value of those cash flows, or to compare them in any reasonable way, you have to understand the relationships between the nominal or face values in the future and their equivalent present values (i.e., what their values would be if they were liquid today). The equivalent present values today will be less than the nominal or face values in the future because that distance over time, that separation from liquidity, costs us by discounting those values.
Key Takeaways
1. Liquidity has value because it enables choice.
2. Time creates distance or delay from liquidity.
3. Distance or delay creates risk and opportunity costs.
4. Time affects value by creating distance, risk, and opportunity costs.
5. Time discounts value.
Exercises
1. How does the expression “a bird in the hand is worth two in the bush” relate to the concept of the time value of money?
2. In what four ways can “delay to liquidity” affect the value of your wealth?
4.2 CALCULATING THE RELATIONSHIP OF TIME AND VALUE
Learning Objectives
1. Identify the factors you need to know to relate a present value to a future value.
2. Write the algebraic expression for the relationship between present and future value.
3. Discuss the use of the algebraic expression in evaluating the relationship between present and future values.
4. Explain the importance of understanding the relationships among the factors that affect future value.
Financial calculation is not often a necessary skill since it is easier to use calculators, spreadsheets, and software. However, understanding the calculations is important in understanding the relationships between time, risk, opportunity cost, and value.
To do the math, you need to know:
1. what the future cash flows will be,
2. when the future cash flows will be, and
3. the rate at which time affects value (e.g., the costs per time period, or the magnitude [the size or amount] of the effect of time on value).
It is usually not difficult to forecast the timing and amounts of future cash flows. Although there may be some uncertainty about them, gauging the rate at which time affects money can require some judgment. That rate, commonly called the discount rate because time discounts value, is the opportunity cost of not having liquidity. Opportunity cost derives from forgone choices or sacrificed alternatives, and sometimes it is not clear what those might have been (see Chapter 2 “Basic Ideas of Finance”). It is an important judgment call to make, though, because the rate will directly affect the valuation process.
At times, the alternatives are clear: you could be putting the liquidity in an account earning 3 per cent, so that’s your opportunity cost of not having it. Or you are paying 6.5 per cent on a loan, which you wouldn’t be paying if you had enough liquidity to avoid having to borrow; that’s your opportunity cost. Sometimes, however, your opportunity cost is not so clear.
Say that today is your twentieth birthday. Your grandparents have promised to give you \$1,000 for your twenty-first birthday, one year from today. If you had the money today, what would it be worth? That is, how much would \$1,000 worth of liquidity one year from now be worth today?
That depends on the cost of its not being liquid today, or on the opportunity costs and risks created by not having liquidity today. If you had \$1,000 today, you could buy things and enjoy them, or you could deposit it in an interest-bearing account. So on your twenty-first birthday, you would have more than \$1,000—you would have the \$1,000 plus whatever interest it had earned. If your bank pays 4 per cent per year (interest rates are always stated as annual rates) on your account, then you would earn \$40 of interest in the next year, or \$1,000 × .04. So, on your twenty-first birthday you would have \$1,040 as expressed in the equation below:
\$1,000 + (1,000×0.04) = \$1,000 × (1 + 0.04) = \$1,040
Table 4.2.1 Interest-Bearing Account
Today Interest Rate Time (years) One Year from Now
1,000 0.04 1 1,040 = 1,000 × (1+0.04)
If you left that amount in the bank until your twenty-second birthday, you would have
1,040 + (1,040 × 0.04) = 1,040 × (1 + 0.04) =
[1,000 × (1 + 0.04)] × (1 + 0.04) =
1,000 × (1+0.04)2 = 1,081.60
To generalize the computation, if your present value (PV), is your value today, r is the rate at which time affects value or discount rate (in this case, your interest rate), and if t is the number of time periods between you and your liquidity, then the future value (FV) of your wealth is expressed in the following equation:
FV = PV × (1+r)t
In this case, 1,000 × (1.04)1 = 1,040 and 1,000 × (1+r)2 = 1,081.60. Table 4.2.2 illustrates how present value, the interest rate, and time equate to future value.
Table 4.2.2 Future Value
Today Interest Rate Time (years) Equation
1,000 0.04 1 1,040 = 1,000 × (1+0.04)¹
1,000 0.04 2 1,081.60 = 1,000 × (1+0.04)²
PV r t FV = PV × (1+r)t
Assuming there is little chance that your grandparents will not be able to give this gift, there is negligible risk. Your only cost of not having liquidity now is the opportunity cost of having to delay consumption or not earning the interest you could have earned.
The cost of delayed consumption is largely derived from a subjective valuation of whatever is consumed, or its utility or satisfaction. The more value you place on having something, the more it “costs” you not to have it, and the more time that you are without it affects its value.
Assuming that if you had the money today you would save it, by having to wait until your twenty-first birthday to receive it—and not having it today—you miss out on the \$40 it could have earned.
So, what would that nominal \$1,000 (that future value that you get one year from now) actually be worth today? The rate at which time affects your value is 4 per cent because that’s what having a choice (to spend or invest it) could earn for you if only you had received the \$1,000. That’s your opportunity cost; that’s what it costs you to not have liquidity. Since PV × (1+r)t = FV, then PV = FV/[(1+r)t], so PV = 1,000/[(1.04)1]= 961.5385.
Your gift is worth \$961.5385 today (its present value). If your grandparents offered to give you your twenty-first birthday gift on your twentieth birthday, they could give you \$961.5385 today, which would be the equivalent value to you of getting \$1,000 one year from now.
It is important to understand the relationships between time, risk, opportunity cost, and value. This equation describes that relationship:
PV × (1+r)t = FV
The r is more formally called the “discount rate” because it is the rate at which your liquidity is discounted by time, and it includes not only opportunity costs, but also risk. (On some financial calculators, r is displayed as I or i.)
The t is how far away you are from your liquidity over time.
Studying this equation yields valuable insights into the relationship it describes. Looking at the equation, you can observe the following relationships:
The more time (t) separating you from your liquidity, the more time affects value. The less time separating you from your liquidity, the less time affects value (as t decreases, PV increases).
As t increases, the PV of your FV liquidity decreases.
As t decreases, the PV of your FV liquidity increases.
The greater the rate at which time affects value (r), or the greater the opportunity cost and risk, the more time affects value. The less your opportunity cost or risk, the less your value is affected.
As r increases, the PV of your FV liquidity decreases.
As r decreases, the PV of your FV liquidity increases.
Table 4.2.3 presents examples of these relationships.
Table 4.2.3 Present Values, Interest Rates, Time, and Future Values
Today Interest Rate Time (years) Future Value
Example A 1,000 0.04 1
1,040
= PV × 1.04%
Greater effect
r increases
1,000 0.10 1
1,100
= PV × 1.10%
More time
t increases
1,000 0.04 3
1,124.86
= PV × 1.04³%
Less effect
r decreases
1,000 0.01 1
1,010
= PV × 1.01%
Less time
t decreases
1,000 0.04 0.5
1,019.80
= PV × 1.040.5%
Example B
961.54
= FV/1.04%
0.04 1 1,000
Greater effect
r increases
909.09
= FV⁄1.10%
0.10 1 1,000
More time
t increases
889.00
= FV⁄1.04³%
0.04 3 1,000
Less effect
r decreases
990.10
= FV⁄1.01%
0.01 1 1,000
Less time
t decreases
980.58
= FV⁄1.040.5%
0.04 0.5 1,000
The strategy implications of this understanding are simple yet critical. All things being equal, it is more valuable to have liquidity (get paid, or have positive cash flow) sooner rather than later and give up liquidity (pay out, or have negative cash flow) later rather than sooner.
If possible, accelerate incoming cash flows and decelerate outgoing cash flows: get paid sooner, but pay out later. Or, as Popeye’s pal Wimpy used to say, “I’ll give you 50 cents tomorrow for a hamburger today.”
Please see the following TVM tables developed by Jodi Letkiewicz (York University), in order to practice calculating future value and present value. A sample of the first TVM table—Future Value of a Lump Sum (\$1 at the end of t periods)—is illustrated below. Remember that FV = PV × (1+r)t.
TVM Table 1: Future Value of a Lump Sum (\$1 at the end of t periods)
t 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937
11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531
12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975
15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772
16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950
17 1.1843 1.4002 1.6528 1.9479 2.2920 2.6928 3.1588 3.7000 4.3276 5.0545
18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.9960 4.7171 5.5599
19 1.2081 1.4568 1.7535 2.1068 2.5270 3.0256 3.6165 4.3157 5.1417 6.1159
20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.6610 5.6044 6.7275
View the complete TVM tables in PDF format at the following four links:
TVM Table 1: Future Value of a Lump Sum (\$1 at the end of t periods)
TVM Table 2: Present Value of a Lump Sum (\$1)
TVM Table 3: Present Value of a Series of Payments (Annuity) (\$1)
TVM Table 4: Future Value of a Series of Payments (Annuity) (\$1)
Key Takeaways
1. To relate a present (liquid) value to a future value, you need to know:
• what the present value is or the future value will be,
• when the future value will be, and
• the rate at which time affects value: the costs per time period, or the magnitude of the effect of time on value.
2. The relationship of present value (PV), future value (FV), risk and opportunity cost (the discount rate, r), and time (t), may be expressed as: PV × (1 + r)t = FV.
3. The above equation yields valuable insights into these relationships:
• The more time (t) creates distance from liquidity, the more time affects value.
• The greater the rate at which time affects value (r), or the greater the opportunity cost and risk, the more time affects value.
• The closer the liquidity, the less time affects value.
• The less the opportunity cost or risk, the less value is affected.
4. To maximize value, get paid sooner and pay later.
Exercises
1. In your financial planning journal, identify a future cash flow. Calculate its present value and then calculate its future value based on the discount rate and time to liquidity. Repeat the process for other future cash flows you identify. What pattern of relationships do you observe between time and value?
2. Try the Time Value of Money calculator at Money-Zine. How do the results compare with your calculations in Exercise 1?
3. View the TeachMeFinance.com animated audio slide show on “The Time Value of Money” (3:00) by Mark McCracken. This slide show will walk you through an example of how to calculate the present and future values of money. How is each part of the formula used in that lesson equivalent to the formula presented in this text?
4. To have liquidity, when should you increase positive cash flows and decrease negative cash flows, and why?
4.3 VALUING A SERIES OF CASH FLOWS
Learning Objectives
1. Discuss the importance of the idea of the time value of money in financial decisions.
2. Define the present value of a series of cash flows.
3. Define an annuity.
4. Identify the factors you need to know to calculate the value of an annuity.
5. Discuss the relationships of those factors to the annuity’s value.
6. Define a perpetuity.
It is quite common in finance to value a series of future cash flows (CF), perhaps a series of withdrawals from a retirement account, interest payments from a bond, or deposits for a savings account. The present value of the series of cash flows is equal to the sum of the present value of each cash flow, so valuation is straightforward: find the present value of each cash flow and then add them up.
Often, the series of cash flows is such that each cash flow has the same future value. When there are regular payments at regular intervals and each payment is the same amount, that series of cash flows is an annuity. Most consumer loan repayments are annuities, as are, typically, installment purchases, mortgages, retirement investments, savings plans, and retirement plan payouts. Fixed-rate bond interest payments are an annuity, as are stable stock dividends over long periods of time. You could think of your paycheque as an annuity, as are many living expenses, such as groceries and utilities, for which you pay roughly the same amount regularly.
To calculate the present value of an annuity, you need to know:
• the amount of the future cash flows (the same for each),
• the frequency of the cash flows,
• the number of cash flows (t), and
• the rate at which time affects value (r).
Almost any calculator and the many readily available software applications can do the math for you, but it is important for you to understand the relationships between time, risk, opportunity cost, and value.
If you win the lottery, for example, you are typically offered a choice of payouts for your winnings: a lump sum or an annual payment over twenty years.
The lottery agency would prefer that you took the annual payment because it would not have to give up as much liquidity all at once; it could hold on to its liquidity longer. To make the annual payment more attractive for you—it isn’t, because you would want to have more liquidity sooner—the lump-sum option is discounted to reflect the present value of the payment annuity. The discount rate, which determines that present value, is chosen at the discretion of the lottery agency.
Say you win \$10 million. The lottery agency offers you a choice: take \$500,000 per year over twenty years or take a one-time lump-sum payout of \$6.7 million. You would choose the alternative with the greatest value. The present value of the lump-sum payout is \$6.7 million. The value of the annuity is not simply \$10 million, or \$500,000 × 20, because those \$500,000 payments are received over time and time affects liquidity and thus value. So, the question is: What is the annuity worth to you?
Your discount rate or opportunity cost will determine the annuity’s value to you, as Table 4.3.1 shows.
Table 4.3.1 Lottery Present Value with Different Discount Rates
CF Rate (r) in Per Cent Time (t) in Years PV
500,000 0.0200 20 8,175,717
500,000 0.0400 20 6,795,163
500,000 0.0600 20 5,734,961
500,000 0.0800 20 4,909,074
500,000 0.1000 20 4,256,782
500,000 0.1200 20 3,734,722
500,000 0.1400 20 3,311,565
500,000 0.0416 20 6,700,000
As expected, the present value of the annuity is less if your discount rate—or opportunity cost or next-best choice—is more. The annuity would be worth the same to you as the lump-sum payout if your discount rate were 4.16 per cent.
In other words, if your discount rate is about 4 per cent or less—if you don’t have more lucrative choices than earning 4 per cent with that liquidity—then the annuity is worth more to you than the immediate payout. You can afford to wait for that liquidity and collect it over twenty years because you have no better choice. On the other hand, if your discount rate is higher than 4 per cent, or if you feel that your use of that liquidity would earn you more than 4 per cent, then you have more lucrative things to do with that money and you want it now: the annuity is worth less to you than the payout.
For an annuity, as when relating one cash flow’s present and future value, the greater the rate at which time affects value, the greater the effect on the present value. When opportunity cost or risk is low, waiting for liquidity doesn’t matter as much as when opportunity costs or risks are higher. When opportunity costs are low, you have nothing better to do with your liquidity, but when opportunity costs are higher, you may sacrifice more by having no liquidity. Liquidity is valuable because it allows you to make choices. After all, if there are no more valuable choices to make, you lose little by giving up liquidity. The higher the rate at which time affects value, the more it costs to wait for liquidity, and the more choices pass you by while you wait for liquidity.
When risk is low, it is not really important to have your liquidity firmly in hand any sooner because you’ll have it sooner or later anyhow. But when risk is high, getting liquidity sooner becomes more important because it lessens the chance of not getting it at all. The higher the rate at which time affects value, the more risk there is in waiting for liquidity and the more chance that you won’t get it at all.
As r increases, the PV of the annuity decreases.
As r decreases, the PV of the annuity increases.
You can also look at the relationship of time and cash flow to annuity value in Table 4.3.2 “Lottery Payout Present Values.” Suppose your payout was more (or less) each year, or suppose your payout happened over more (or fewer) years.
Table 4.3.2 Lottery Payout Present Values
CF Rate Time PV
500,000 0.0400 20 6,795,163
500,000 0.0200 20 8,175,717
500,000 0.0600 20 5,734,961
750,000 0.0400 20 10,192,745
250,000 0.0400 20 3,397,582
500,000 0.0400 30 8,646,017
500,000 0.0400 10 4,055,448
As seen in Table 4.3.2, the amount of each payment or cash flow affects the value of the annuity because more cash means more liquidity and greater value.
As CF increases, the PV of the annuity increases.
As CF decreases, the PV of the annuity decreases.
Although time increases the distance from liquidity, with an annuity, it also increases the number of payments because payments occur periodically. The more periods in the annuity, the more cash flows and the more liquidity there is, thus increasing the value of the annuity.
As t increases, the PV of the annuity increases.
As t decreases, the PV of the annuity decreases.
It is common in financial planning to calculate the FV of a series of cash flows. This calculation is useful when saving for a goal where a specific amount will be required at a specific point in the future (e.g., saving for university, a wedding, or retirement).
It turns out that the relationships between time, risk, opportunity cost, and value are predictable going forward as well. Say you decide to take the \$500,000 annual lottery payout for twenty years. If you deposit that payout in a bank account earning 4 per cent, how much would you have in twenty years? What if the account earned more interest? Less interest? What if you won more (or less) so the payout was more (or less) each year?
What if you won \$15 million and the payout was \$500,000 per year for thirty years; how much would you have then? Or if you won \$5 million and the payout was only for ten years? Table 4.3.3 shows how future values would change.
Table 4.3.3 Lottery Payout Future Values
CF Rate Time PV FV
500,000 0.0400 20 6,795,163 14,889,039
500,000 0.0200 20 8,175,717 12,148,685
500,000 0.0600 20 5,734,961 18,392,796
750,000 0.0400 20 10,192,745 22,333,559
250,000 0.0400 20 3,397,582 7,444,520
500,000 0.0400 30 8,646,017 28,042,469
500,000 0.0400 10 4,055,448 6,003,054
Going forward, the rate at which time affects value (r) is the rate at which value grows, or the rate at which your value compounds. It is also called the rate of compounding. The bigger the effect of time on value, the more value you will end up with because more time has affected the value of your money while it was growing as it waited for you. So, looking forward at the future value of an annuity:
As r increases, the FV of the annuity increases.
As r decreases, the FV of the annuity decreases.
The amount of each payment or cash flow affects the value of the annuity because more cash means more liquidity and greater value. If you were getting more cash each year and depositing it into your account, you’d end up with more value.
As CF increases, the FV of the annuity increases.
As CF decreases, the FV of the annuity decreases.
The more time there is, the more time can affect value. As payments occur periodically, the more cash flows there are, and the more liquidity there is. The more periods in the annuity, the more cash flows, and the greater the effect of time, thus increasing the future value of the annuity.
As t increases, the FV of the annuity increases.
As t decreases, the FV of the annuity decreases.
There is also a special kind of annuity called a perpetuity, which is an annuity that goes on forever (i.e., a series of cash flows of equal amounts occurring at regular intervals that never ends). It is hard to imagine a stream of cash flows that never ends, but it is actually not as rare as it sounds. The dividends from a share of corporate stock are a perpetuity, because in theory, a corporation has an infinite life (as a separate legal entity from its shareholders or owners) and because, for many reasons, corporations like to maintain a steady dividend for their shareholders.
The perpetuity represents the maximum value of the annuity, or the value of the annuity with the most cash flows and therefore the most liquidity and therefore the most value.
Life Is a Series of Cash Flows
Once you understand the idea of the time value of money, and its use for valuing a series of cash flows, and the idea of annuities in particular, you won’t believe how you ever got through life without them. These are the fundamental relationships that structure so many financial decisions, most of which involve a series of cash inflows or outflows. Understanding these relationships can be a tool to help you answer some of the most common financial questions about buying and selling liquidity, because loans and investments are so often structured as annuities and certainly take place over time.
Loans are usually designed as annuities, with regular periodic payments that include interest expense and principal repayment. Using these relationships, you can see the effect of a different amount borrowed (PVannuity), interest rate (r), or term of the loan (t) on the periodic payment (CF).
For example, as seen in Table 4.3.4 “Mortgage Calculations,” if you get a \$250,000 (PV), thirty-year (t), 6.5 per cent (r) mortgage, the monthly payment will be \$1,577 (CF). If the same mortgage had an interest rate of only 5.5 per cent (r), your monthly payment would decrease to \$1,423 (CF). If it were a fifteen-year (t) mortgage, still at 6.5 per cent (r), the monthly payment would be \$2,175 (CF). If you can make a larger down payment and borrow less—say \$200,000 (PV)—then with a thirty-year (t), 6.5 per cent (r) mortgage your monthly payment would be only \$1,262 (CF).
Table 4.3.4 Mortgage Calculations
CF Rate (r) Time (t) PV
1,577 0.0054 360 250,000
1,423 0.0046 360 250,000
2,175 0.0054 180 250,000
1,262 0.0054 360 200,000
Note that in Table 4.3.4, the mortgage rate is the monthly rate—that is, the annual rate divided by twelve (months in the year), or r / 12, and that t is stated as the number of months, or the number of years × 12 (months in the year). That is because the mortgage requires monthly payments, so all the variables must be expressed in units of months. In general, the periodic unit used is defined by the frequency of the cash flows and must agree for all variables. In this example, because you have monthly cash flows, you must calculate using the monthly discount rate (r) and the number of months (t).
Saving to reach a goal—to provide a down payment on a house, or a child’s education, or retirement income—is often accomplished by a plan of regular deposits to an account for that purpose. The savings plan is an annuity, so these relationships can be used to calculate how much would have to be saved each period to reach the goal (CF), or given how much can be saved each period, how long it will take to reach the goal (t), or how a better investment return (r) would affect the periodic savings, or the time needed (t), or the goal (FV).
For example, if you want to have \$1 million (FV) in the bank when you retire, and your bank pays 3 per cent (r) interest per year, and you can save \$10,000 per year (CF) toward retirement, can you afford to retire at age sixty-five? You could if you start saving at age eighteen, because with that annual saving at that rate of return, it will take forty-seven years (t) to have \$1,000,000 (FV). If you could save \$20,000 per year (CF), it would only take thirty-one years (t) to save \$1,000,000 (FV). If you are already forty years old, you could do it if you save \$27,428 per year (CF) or if you can earn a return of at least 5.34 per cent (r). See Table 4.3.5.
Table 4.3.5 Retirement Savings Calculations
CF Rate (r) Time (t) PV FV
10,000 0.0300 47 250,000 1,000,000
20,000 0.0300 31 400,000 1,000,000
27,428 0.0300 25 477,606 1,000,000
20,000 0.0534 25 272,621 1,000,000
As you can see, the relationships between time, risk, opportunity cost, and value are some of the most important relationships you will ever encounter in life, and understanding them is critical to making sound financial decisions.
Financial Calculations
Modern tools make it much easier to do the math. Widely available calculators, spreadsheets, and software have been developed to be very user friendly.
Financial calculators have the equations relating the present and future values, cash flows, the discount rate, and time embedded, for single amounts or for a series of cash flows, so that you can calculate any one of those variables if you know all the others.
Personal finance software packages usually come with a planning calculator that performs a similar function. These tools are usually presented as a “mortgage calculator” or a “loan calculator” or a “retirement planner,” and they are set up to answer common planning questions such as, “How much do I have to save every year for retirement?” or, “What will my monthly loan payment be?”
Spreadsheets also have the relevant equations built in, as functions or as macros. There are also stand-alone software applications that may be downloaded to a mobile device, such as a smartphone. They are useful in answering planning questions, but they lack the ability to store and track your situation in the way that a more complete software package can.
The calculations are discussed here not so that you can perform them—you have many tools to choose from that can do that more efficiently—but so that you can understand them, and most importantly, so that you can understand the relationships that they describe.
Key Takeaways
1. The idea of the time value of money is fundamental to financial decisions.
2. The present value of a series of cash flows is equal to the sum of the present value of each cash flow.
3. A series of cash flows is an annuity when there are regular payments at regular intervals and each payment is the same amount.
4. To calculate the present value of an annuity, you need to know:
• the amount of the identical cash flows (CF),
• the frequency of the cash flows,
• the number of cash flows (t), and
• the discount rate (r) or the rate at which time affects value.
5. The calculation for the present value of an annuity yields valuable insights.
• The more time (t), the more periods and the more periodic payments—that is, the more cash flows, and so the more liquidity and the more value.
• The greater the cash flows, the more liquidity and the more value.
• The greater the rate at which time affects value (r) or the greater the opportunity cost and risk or the greater the rate of discounting, the more time affects value.
6. The calculation for the future value of an annuity yields valuable insights.
• The more time (t), the more periods and the more periodic payments—that is, the more cash flows, and so the more liquidity and the more value.
• The greater the cash flows, the more liquidity and the more value.
• The greater the rate at which time affects value (r) or the greater the rate of compounding, the more time affects value.
7. A perpetuity is an infinite annuity.
Exercises
1. In your financial planning journal, identify and record all your cash flows. Calculate the present value of each. Then calculate the future value. Which cash flows give you the greatest liquidity or value?
2. How can you determine if a lump-sum payment or an annuity will have greater value for you?
4.4 USING FINANCIAL STATEMENTS TO EVALUATE FINANCIAL CHOICES
Learning Objectives
1. Define pro forma financial statements.
2. Explain how pro forma financial statements can be used to project future scenarios for the planning process.
Now that you understand the relationship of time and value, especially looking forward, you can begin to think about how your ideas and plans will look as they happen. More specifically, you can begin to see how your future will look in the mirror of your financial statements. Projected or pro forma financial statements can show the consequences of your choices. To project future financial statements, you need to be able to envision the expected results of all the items on them. This can be difficult, for there can be many variables that may affect your income and expenses or cash flows, and some of them may be unpredictable. Predictions always contain uncertainty, so projections are always, at best, educated guesses. Still, they can be useful in helping you to see how the future may look.
For example, we can glimpse Brittany’s projected cash flow statements and balance sheets for each of her choices, along with their possible outcomes. Brittany can actually project how her financial statements will look after each choice is followed.
When making financial decisions, it is helpful to be able to think in terms of their consequences on the financial statements, which provide an order to our summary of financial results. For example, in previous chapters, Brittany was deciding how to decrease her debt. Her choices were to continue to pay it down gradually as she does now; to get a second job to pay it off faster; or to go to Vegas, hit it big (or lose big), and eliminate her debt altogether (or wind up with even more). Brittany can look at the effects of each choice on her financial statements as seen in Table 4.4.1.
Table 4.4.1 Potential Effects on Brittany’s Financial Statements
Choices Income Statement Cash Flow Statement Balance Sheet
Continue No new effects No new effects
↓Debt
↑Net worth
Second job ↑Income No new effect (increased cash flow from wages is used to pay debt)
↓Debt faster
↑Net worth faster
Vegas: Win
↑Expenses
(for the trip)
No new effect (increased cash flow from winnings is used to pay debt)
Eliminate debt
↑Net worth
Vegas: Lose
↑Expenses
(for the trip)
↓Net cash flow
↑Debt
↓Net worth
Looking more closely at the actual numbers on each statement gives us a much clearer idea of Brittany’s situation. Beginning with the income statement, income will increase if she works a second job or goes to Vegas and wins, while expenses will increase (travel expense) if she goes to Vegas at all. Assume that her second job would bring in an extra \$20,000 income and that she could win or lose \$100,000 in Vegas. Any change in gross wages or winnings (losses) would have a tax consequence; if she loses in Vegas, she will still have income taxes on her salary. See Table 4.4.2.
Table 4.4.2 Brittany’s Pro Forma Income Statements
Continue Second Job Vegas: Win Vegas: Lose
For the Year Ending 12/31/18 12/31/18 12/31/18 12/31/18
Gross wages 44,650 64,650 144,650 (55,350)
Income taxes and deductions 8,930 12,930 28,930
Disposable income 35,720 51,720 115,720 (55,350)
Rent 10,800 10,800 10,800 10,800
Food 3,900 3,900 3,900 3,900
Car expenses 3,600 3,600 3,600 3,600
Clothing 1,800 1,800 1,800 1,800
Cell phone 1,200 1,200 1,200 1,200
Internet and cable TV 1,200 1,200 1,200 1,200
Entertainment, travel, etc. 2,700 2,700 3,700 3,700
Total living expenses 25,200 25,200 26,200 26,200
Car loan interest 240 240 240 240
Student loan interest 4,240 4,240 4,240 4,240
Total interest expenses 4,480 4,480 4,480 4,480
Net income 6,040 22,040 85,040 (86,030)
While Vegas yields the largest increase in net income or personal profit if Brittany wins, it creates the largest decrease if she loses; it is clearly the riskiest option. The pro forma cash flow statements (shown in Table 4.4.3) reinforce this observation.
Table 4.4.3 Brittany’s Pro Forma Cash Flow Statements
Continue Second Job Vegas: Win Vegas: Lose
For the Year Ending 12/31/18 12/31/18 12/31/18 12/31/18
Cash from gross wages 44,650 64,650 44,650 44,650
Cash paid for:
Income taxes and deductions (8,930) (12,930) (8,930) (8,930)
Rent (10,800) (10,800) (10,800) (10,800)
Food (3,900) (3,900) (3,900) (3,900)
Car expenses (3,600) (3,600) (3,600) (3,600)
Clothing (1,800) (1,800) (1,800) (1,800)
Cell phone (1,200) (1,200) (1,200) (1,200)
Internet and cable TV (1,200) (1,200) (1,200) (1,200)
Entertainment, travel, etc. (2,700) (2,700) (3,700) (3,700)
Car loan interest (240) (240) (240) (240)
Student loan interest (4,240) (4,240) (4,240) (4,240)
Operating cash flow 6,040 22,040 5,040 5,040
Cash from gambling 0 0 100,000 (100,000)
Cash for repayment of car loan (2,160) (2,160) (2,700) (2,160)
Cash for repayment of student loan (3,480) (19,000) (53,000) (7,760)
Proceeds from new loan 0 0 0 104,880
Financing cash flows (5,640) (21,160) 44,300 (5,040)
Net cash flow 400 880 49,340 0
If Brittany has a second job, she will use the extra cash flow, after taxes, to pay down her student loan, leaving her with a bit more free cash flow than she would have had without the second job. If she wins in Vegas, she can pay off both her car loan and her student loan and still have an increased free cash flow. However, if she loses in Vegas, she will have to secure more debt to cover her losses. Assuming she borrows as much as she loses, she will have a small negative net cash flow and no free cash flow, and her other assets will have to make up for this loss of cash value.
So, how will Brittany’s financial condition look in one year? That depends on how she proceeds, but the pro forma balance sheets, as seen in Table 4.4.4, provide a glimpse.
Table 4.4.4 Brittany’s Pro Forma Balance Sheets
Continue Second Job Vegas: Win Vegas: Lose
12/31/19 12/31/19 12/31/19 12/31/19
Assets
Car 5,000 5,000 5,000 5,000
Savings 650 1,130 49,590 0
Total assets 5,650 6,130 54,590 5,000
Liabilities
Car loan 540 540 0 540
Student loan 45,240 34,000 0 45,240
New loan 0 0 0 104,880
Total liabilities 45,780 34,540 0 150,660
Net worth (40,130) (28,410) 54,590 (145,660)
If Brittany has a second job, her net worth increases but is still negative, as she has paid down more of her student loan than she otherwise would have, but it is still larger than her asset value. If she wins in Vegas, her net worth can be positive; with her loan paid off entirely, her asset value will equal her net worth. However, if she loses in Vegas, she will have to borrow more, her new debt quadrupling her liabilities and decreasing her net worth by that much more.
Table 4.4.5 provides a summary of the critical “bottom lines” from each pro forma statement and most clearly shows Brittany’s complete picture for each alternative.
Table 4.4.5 Brittany’s Pro Forma Bottom Lines
Continue Second Job Vegas: Win Vegas: Lose
12/31/19 12/31/19 12/31/19 12/31/19
Net income 6,040 22,040 85,040 (86,030)
Net cash flow 400 880 49,340 (4,880)
Net worth (40,130) (28,410) 54,590 (145,660)
Going to Vegas creates the best and the worst scenarios for Brittany, depending on whether she wins or loses. While the outcomes for continuing or getting a second job are fairly certain, the outcome in Vegas is not; indeed, there are two possible outcomes. The Vegas choice has the most risk or the least certainty.
The Vegas alternative also has strategic costs: if she loses, her increased debt and its obligations—more interest and principal payments on more debt—will further delay her goal of building an asset base from which to generate new sources of income. In the near future, or until her new debt is repaid, she will have even fewer financial choices.
The strategic benefit of the Vegas alternative is that if she wins, she can eliminate debt, begin to build her asset base, and have even more choices (by eliminating debt and freeing cash flow).
The next step for Brittany would be to try to assess the probabilities of winning or losing in Vegas. Once she has determined the risk involved—given the consequences now illuminated in the pro forma financial statements—she would have to decide if she can tolerate that risk, or if she should reject that alternative because of its risk.
Key Takeaways
Pro forma financial statements show the consequences of financial choices in the context of the financial statements.
Exercises
1. What are pro forma financial statements based on?
2. What are the strategic benefits of making financial projections on pro forma statements? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.04%3A_Evaluating_Choices-_Time_Risk_and_Value.txt |
INTRODUCTION
Seeing the value of reaching a goal is often much easier than seeing a way to reach that goal. People often resolve to somehow improve themselves or their lives. While they are not lacking sincerity, determination, or effort, they nevertheless fall short for want of a plan, a map, a picture of why and how to get from here to there.
Pro forma financial statements provide a look at the potential results of financial decisions. They can also be used as a tool to plan for certain results. When projected in the form of a budget, a projection of the financial requirements and consequences of a plan, tables become not only an estimated result, but also an actual strategy or plan, a map illustrating a path to achieve a goal. Later, when you compare actual results to the original plan, you can see how shortfalls or successes can point to future strategies.
Budgets are usually created with a specific goal in mind: to cut living expenses, to increase savings, or to save for a specific purpose such as education or retirement. While the need to do such things may be brought into sharper focus by the financial statements, the budget provides an actual plan for doing so. It is more a document of action than of reflection.
As such, a budget is meant to be dynamic, a reconciliation of “facts on the ground” and “castles in the air.” While financial statements are summaries of historic reality—that is, of all that has already happened and is “sunk”—budgets reflect the current realities that define one’s next choices. A budget should never be merely followed, but should constantly be revised to reflect new information.
Elder Rose Bird’s mother taught her how to budget in order to reconcile “facts on the ground” and “castles in the air.” When she was living on her own in Prince Albert, Saskatchewan, her mother came over from North Battleford, Saskatchewan, to visit her. Her mother asked for her money, so Elder Bird put it on the table. She then grabbed envelopes and asked her daughter how much her rent, utilities, food, and smokes cost her on a monthly basis. She marked a number of envelopes, divided up Elder Bird’s money, and put aside an envelope with the appropriate amount inside for each expense. Elder Bird’s mother said, “Whatever money you have left, then you can go to bingo” (personal communication, June 10, 2017). After dealing with the “facts on the ground,” namely her monthly expenses, she put aside a bit for the “castles in the air,” her wishes, dreams, and goals (Elder Bird, Video 2).
According to the Building Native Communities financial literacy curriculum, written by the First Nations Development Institute (FNDI) and First Nations Oweesta Corporation (FNOC), budgeting and savings have always been critical skills exemplified by First Nations people:
For years, our people have understood and practiced the present-day concepts of budgeting and savings. We managed our resources through conservation so that they lasted throughout the year by saving additional supplies for future use.
Consider the planning done by the Canadian Bands, Nit Nat and Sooke, when they prepared for one of their women to marry. They saved for one year to provide a feast and gifts for all guests at the ceremony. Traditionally, gifts included blankets, canoes, dried fish, and many kinds of animal skins. . . . The wedding ceremony required a lot of preparation and planning. Our people also saved for the purpose of acquiring goods that we could not produce ourselves. By producing more than the community needed, we had goods to trade. For instance, the Northwest Coastal Indians traded a wide variety of products, including smoked or dried fish and venison, as well as tools made from elk, deer, fish, or other indigenous animals. . . . Our people have successfully practiced resource management skills for generations. Now we call upon their example to strengthen our own abilities. (FNDI and Oweesta, 2016, p. 1)
Elder Florence Allen and Elder Margaret Reynolds also spoke of the budgeting and savings skills demonstrated by their families (Elder Reynolds, Video 1).
As stated by FNDI and FNOC, budgeting and savings are and have always been core skills that allow individuals and families to contribute to the economy and the community. They allow individuals and families to make informed financial decisions that ensure that they are in control of their money and not controlled by it.
As Elder Florence Allen stated, “money has a purpose and you’re always the boss of it and it’s never the boss of you because if it becomes the boss of you, you become obsessed about it and you hoard it and you are not as kind” (personal communication, June 10, 2017). Budgeting and savings help you to be the boss of your money; these skills help you to know what is coming, what is going out, and what is available for rainy days. When talking about her parents, Elder Florence Allen said, “they only went as far as the money went. . . . We never suffered because of that. . . . Life is good when you know you can work with that money and not allow that money to take over your life” (Elder Allen, Video 1).
5.1 THE BUDGET PROCESS
Learning Objectives
1. Trace the budget process.
2. Discuss the relationships of goals and behaviours.
3. Demonstrate the importance of conservatism in the budget process.
4. Show the importance of timing in the budget process.
The budget process is an infinite loop similar to the larger financial planning process. It involves:
• defining goals and gathering data;
• forming expectations and reconciling goals and data;
• creating the budget;
• monitoring actual outcomes and analyzing variances;
• adjusting budget, expectations, or goals; and
• redefining goals.
Chart 5.1.1 The Budget Process
A review of your financial statements or your current financial condition—as well as your own ideas about how you are and could be living—should indicate immediate and longer-term goals. It may also point out new choices. For example, an immediate goal may be to lower your housing expense. In the short-term, you could look for an apartment with lower rent, but in the long run, it may be more advantageous to own a home. This long-term goal may indicate a need to start a savings plan for a down payment.
The process of creating a budget can be instructive. Creating a budget involves projecting realistic behaviour. Your assumptions may come from your actual past behaviour based on accurate records that you have gathered. If you have been using personal finance software, it has been keeping those records for you; if not, a thorough review of your chequebook and investment statements will reveal that information. Financial statements are useful summaries of the information you need to create a budget.
According to the Building Native Communities (BNC) curriculum, “Every year our ancestors estimated their needs based on what they used in previous years . . . our ancestors compared the available harvest to their current needs . . . and planned what portion of the harvest to set aside for their future needs” (FNDI and FNOC, 2015, p. 15).
After formulating realistic expectations based on past behaviour and current circumstances, you still must reconcile your future behaviour with your original expectations. For example, you may recognize that greater sacrifices need to be made, or that you must change your behaviour, or even that your goals are unattainable and should be more realistic—perhaps based on less desirable choices.
On the other hand, this can be a process of happy discovery: goals may be closer or require less sacrifice than you may have thought.
Whether it results in sobering dismay or ambitious joy, the budget process is one of reconciling your financial realities to your financial dreams. How you finance your life determines how you can live your life, so budgeting is really a process of mapping out a life strategy. You may find it difficult to separate the emotional and financial aspects of your goals, but the more successfully you can do so, the more successfully you will reach your goals.
A budget is a projection of how things should work out, but there is always some uncertainty. If the actual results are better than expected, if incomes are more or expenses less, expectations can be adjusted upward as a welcome accommodation to good fortune. On the other hand, if actual results are worse than expected, if incomes are less or expenses more, not only the next budget, but also current living choices may have to be adjusted to accommodate that situation. Those new choices are less than preferred or you would have chosen them in your original plan.
To avoid unwelcome adjustments, you should be conservative in your expectations so as to maximize the probability that your actual results will be better than expected. Thus, when estimating, you would always underestimate the income items and potential gains and overestimate the expense items and potential losses.
You will also need to determine a time period and frequency for your budget process: annually, monthly, or weekly. The timing will depend on how much financial activity you have and how much discipline or guidance you want your budget to provide. You should assess your progress at least annually. In general, you want to keep a manageable amount of data for any one period, so the more financial activity you have, the shorter your budget period should be. Since your budget needs to be monitored consistently, you don’t want to be flooded with so much data that monitoring becomes too daunting a task. On the other hand, you want to choose an ample period or time frame to show meaningful results. Choose a time period that makes sense for your quantity of data or level of financial activity.
Key Takeaways
1. A budget is a process that mirrors the financial planning process.
2. The process of creating a budget can suggest goals, behaviours, and limitations.
3. For the budget to succeed, goals and behaviours must be reconciled.
4. Budgets should be prepared conservatively. Overestimate costs. Underestimate earnings.
5. The appropriate time period is one that is short enough to limit the amount of data, and long enough to capture meaningful data.
Exercises
1. In your financial planning journal, begin your budgeting process by reviewing your short- and long-term goals. What will it take to achieve those goals? What limitations and opportunities do you have for meeting them? Then gather your financial data and choose a time period and frequency for checking your progress.
2. Read “Making a Budget” from the Financial Consumer Agency of Canada, then answer the following questions. Why is a budget so important in personal financial planning? What kinds of problems can you resolve by creating a personal budget? What kinds of goals can you attain through changes to your personal budget?
REFERENCES
First Nations Oweesta Corporation and First Nations Development Institute. (2016). Building Native Communities (5th Ed). Retrieved from:
5.2 CREATING THE COMPREHENSIVE BUDGET
Learning Objectives
1. Describe the components of the comprehensive budget and their purposes.
2. Describe the components of an operating budget.
3. Discuss the sources of recurring income and expenses.
4. Identify the factors in the operating budgeting process.
5. Identify the factors in the capital budgeting process.
Gathering data and creating a budget—with some goals already in mind—are the initial steps in the process. Understanding the format or shape of the budget will help guide you to the kind of information you need. A comprehensive budget—that is, a budget covering all aspects of financial life—will include a projection of recurring incomes and expenses and of nonrecurring expenditures. (Nonrecurring income or “windfalls” should not be counted on, but rather “budgeted for” conservatively.) Recurring incomes would be earnings from wages, interest, or dividends. Recurring expenditures may include living expenses, loan repayments, and regular savings or investment deposits. Nonrecurring expenditures may be for capital improvements such as a new roof for your house or for purchases of durable items such as a refrigerator or a car. These are purchases that would not be made each period. A comprehensive budget diagram is shown in Chart 5.2.1.
Chart 5.2.1 Comprehensive Budget Diagram
Another distinction in recognizing recurring and nonrecurring items is the time frame for each. Recurring items need to be taken care of repeatedly and are therefore considered in the short term, while the items on the capital budget may allow for long-term planning because they happen less frequently. The different time horizons for planning for recurring and nonrecurring items may allow for different strategies to reach those different goals.
A comprehensive budget is a compilation of an operating budget for short-term goals involving recurring items, and a capital budget for long-term goals involving nonrecurring items.
Operating Budget: Recurring Incomes and Expenditures
Using Financial History
Recurring incomes and expenditures are usually the easiest to determine and project, as they happen consistently and have an immediate effect on your everyday living. An income statement shows incomes and expenses; cash flow statements show actual cash expenditures. Recurring incomes and expenditures are planned in the context of short-term lifestyle goals or preferences.
Look at a time period large enough to capture relevant data. Some incomes and expenditures recur reliably but only periodically or seasonally. For example, you may pay the premium on your auto insurance policy twice per year. It is a recurring expense, but it happens in only two months of the year, so you would have to look at expenditures over enough months to see it. Or your heating or cooling expenses may change seasonally, affecting your utility expenses in some months more than in others.
The time period you choose for a budget should be long enough to show intermittent items as recurring and nonrecurring items as unusual, yet short enough to follow and to manage choices within the period. For personal budgets, a month is the most common budget period to use, since most living expenses are paid at least monthly. However, it is best to use at least one full year’s worth of data to get a reasonable monthly average and to see seasonal and periodic items as they occur.
Some items may recur, but not reliably: either their frequency or their amount is uncertain. Taking a conservative approach, you should include the maximum possible amount of uncertain expenses in your budget. If income occurs regularly but the amount is uncertain, conservatively include the minimum amount. If income actually happens irregularly, it may be better just to leave it out of your budget—and your plans—since you can’t “count” on it.
Recall Jeff from Chapter 2. He works on contract as a graphics designer, tutors on the side, does house painting in the summer, and buys and sells sports memorabilia on the Internet. In 2016, he bought an older house with a \$200,000 fixed-rate mortgage at 3.02 per cent. He does not have health or dental benefits through his work, so he purchases health and dental insurance every year to cover the cost of prescription medication, physiotherapy, and other unexpected health costs. Every year, he deposits \$1,000 into his RRSP and uses some capital for home improvements. He used a car loan to buy his car. Whatever cash is left over after he has paid his bills is saved in a high interest savings account and invested in his tax-free savings account. At the end of 2018, he is trying to draw up a budget for 2019. Since he bought the house, he has been keeping pretty good financial records as shown in Table 5.2.1.
Remember that on a cash flow statement, described in Chapter 3, negative and positive numbers indicate direction of flow. A negative number is cash flowing out, and a positive number is cash flowing in. Conventionally, negative numbers appear in parentheses. The following two tables (5.2.1 and 5.2.2) are not cash flow tables, but the cash flow format has been used in order to clearly indicate the direction of flow.
Table 5.2.1 Jeff’s Financial Data, 2015–2018
2015
Actual
2016
Actual
2017
Actual
2018
Actual
Incomes
Contract Earnings 32,000 33,500 35,000 36,500
Tutoring 3,000 4,000 2,500 2,000
Memorabilia Sales 2,500 950 2,650 5,300
House Painting 10,000 11,000 4,500 10,250
Interest Income 180 192 173 146
Total Income 47,680 49,642 44,823 54,196
Payroll/Income Taxes (8,000) (8,375) (8,750) (9,125)
Disposable Income 39,680 41,267 36,073 45,071
Living Expenses
Groceries (3,120) (3,120) (3,120) (3,120)
Car (Fuel) (1,688) (1,875) (2,813) (1,523)
Car (Service, etc.) (350) (350) (350) (350)
Car (Insurance) (800) (800) (800) (800)
Electricity (780) (780) (780) (780)
Phone/Cable/Internet (1,500) (1,188) (1,188) (1,068)
Heat (1,240) (1,200) (1,990) (1,125)
Health and Dental Insurance (840) (840) (840) (840)
Medical 0 0 (600) (200)
Travel/Entertainment (3,000) (3,000) (3,000) (3,000)
Car Loan Payment (3,600) (5,400) (5,400) (5,400)
Mortgage Interest (11,433) (11,281) (11,120) (10,950)
Property Tax (3,450) (3,450) (3,450) (4,350)
Total Living Expenses (31,801) (33,284) (35,451) (33,506)
Income after Living Expenses 7,879 7,983 622 11,565
Interest Expense 0 0 0 0
Capital Expenditures/Investment
Mortgage Principal (2,573) (2,725) (2,886) (3,056)
Free Cash Flow 5,306 5,258 (2,264) 8,509
RRSP Deposit (1,000) (1,000) (1,000) (1,000)
Home Improvement (4,200) (5,327) 0 (4,146)
High Interest Savings Account
deposit/(withdrawal)
106 (1,069) (3,264) 3,363
Line of Credit
draw on/(pay off)
0 0 0 0
Net Cash Flow 0 0 0 0
Line of Credit Balance 0 0 0 0
Tax-Free Savings Account Balance 6,400 5,778 4,878 7,336
Jeff has five sources of income—some more constant, some more reliable, and some more seasonal. His graphics design job provides a steady, year-round income. House painting is a seasonal, although fairly reliable, source of income; in 2017, it was less because Jeff fell from a ladder and was unable to paint for two months. He had to spend money on crutches and the rental of a leg scooter. Tutoring is a seasonal source of income, which decreased in 2017. Memorabilia trading is a year-round, but unpredictable source of income. In 2019, he made some very lucrative trades, but in 2016 he made almost none. Interest income depends on the balance in the high interest savings account. He would include his graphics design, painting, and interest incomes in his budget, but should be conservative about including his tutoring or trading incomes.
Jeff’s expenses are reliable and easily predictable, with a few exceptions. His accident in 2017 increased his medical expenses for that year. The cost of gas for his car and heating expense vary with the weather and the highly volatile price of oil; in 2017, those expenses were unusually high. Jeff’s property tax increased in 2018, but is unlikely to do so again for several years.
Using New Information and “Micro” Factors
Along with your known financial history, you would want to include any new information that may change your expectations. As with any forecast, the more information you can include in your projections, the more accurate it is likely to be.
Jeff knows that his tutoring income will likely increase due to a decrease of available tutors where he lives. He just received some new graphics design contracts so he will receive a modest increase in his earnings and has just traded in his car and gotten a new loan for a “new” used car.
The personal or micro characteristics of your situation influence your expectations, especially if they are expected to change. Personal factors such as family structure, health, career choice, and age have significant influence on financial choices and goals. If any of those factors is expected to change, your financial situation should be expected to change as well, and that expectation should be included in your budget projections.
For example, if you are expecting to increase or decrease the size of your family or household, that would affect your consumption of goods and services. If you anticipate a change of job or career, that will affect your income from wages. A change in health may result in working more or less and thus changing your income from wages. There are many ways that personal circumstances can change, and they can alter your financial expectations, choices, and goals. All these projected changes need to be included in the budget process.
Using Economics and “Macro” Factors
Macro factors affecting your budget come from the context of the wider economy, so understanding how incomes and expenses are created is useful in forming estimates. Incomes are created when labour or capital (liquidity or assets) is sold. The amount of income created depends on the quantity sold and on the price.
The price of labour depends on the relative supply and demand for labour reflected in unemployment rates. The price of liquidity depends on the relative supply and demand for capital reflected in interest rates. Unemployment rates and interest rates in turn depend on the complex dynamics of the wider economy.
The economy tends to behave cyclically. If the economy is in a period of contraction or recession, demand for labour is lower, competition among workers is higher, and wages cannot be expected to rise. As unemployment rises, especially if you are working in an industry that is cyclically contracting along with the economy, wages may become unreliable or increasingly risky if there is risk of losing your job. Interest rates are, as a rule, more volatile and thus more difficult to predict, but generally tend to fall during a period of contraction and rise in a period of expansion. A budget period is usually short so that economic factors will not vary widely enough to affect projections over that brief period. Still, those economic factors should inform your estimates of potential income.
Expenses are created when a quantity of goods or services is consumed for a price. That price depends on the relative supply of, and demand for, those goods and services, and also on the larger context of price levels in the economy. If inflation or deflation is decreasing or increasing the value of our currency, then its purchasing power is changing and so is the real cost of expenses. Again, as a rule, the budget period should be short enough so that changes in purchasing power won’t affect the budget too much; still, these changes should not be ignored. Price levels tend to change much quicker than wage levels, so it is quite possible to have a rise in prices before a rise in wages, which decreases the real purchasing power of your paycheque.
If you have a variable rate loan—that is, a loan for which the interest rate may be adjusted periodically—you are susceptible to interest rate volatility. You should be aware of that particular macro factor when creating your budget.
Macroeconomic factors are difficult to predict, as they reflect complex scenarios, but news about current and expected economic conditions is easily available in the media every day. A good financial planner will also be keeping a sharp eye on economic indicators and forecasts. You can gain a pretty concrete idea of where the economy is in its cycles and how that affects you just by seeing how your paycheque meets your living expenses (e.g., filling up your car with gas or shopping for groceries). Chart 5.2.2 suggests how personal history, along with micro and macroeconomic factors, can be used to make projections about items in your budget.
Using his past history, current information, and understanding of current and expected macroeconomic factors, Jeff has put together the budget shown in Table 5.2.2.
Table 5.2.2 Jeff’s 2019 Budget
2015
Actual
2016
Actual
2017
Actual
2018
Actual
2019
Budget
Incomes
Contract Earnings 32,000 33,500 35,000 36,500 41,000
Tutoring 3,000 4,000 2,500 2,000 4,000
Memorabilia Sales 2,500 950 2,650 5,300 1,500
House Painting 10,000 11,000 4,500 10,250 10,417
Interest Income 180 192 173 146 49
Total Income 47,680 49,642 44,823 54,196 56,966
Payroll/Income Taxes (8,000) (8,375) (8,750) (9,125) (9,500)
Disposable Income 39,680 41,267 36,073 45,071 47,466
Living Expenses
Groceries (3,120) (3,120) (3,120) (3,120) (3,120)
Car (Fuel) (1,688) (1,875) (2,813) (1,523) (1,523)
Car (Service, etc.) (350) (350) (350) (350) (350)
Car (Insurance) (800) (800) (800) (800) (800)
Electricity (780) (780) (780) (780) (780)
Phone/Cable/Internet (1,500) (1,188) (1,188) (1,068) (1,068)
Heat (1,240) (1,200) (1,990) (1,125) (1,200)
Health and Dental Insurance (840) (840) (840) (840) (840)
Medical 0 0 (600) (200) (240)
Travel/Entertainment (3,000) (3,000) (3,000) (3,000) (3,000)
Car Loan Payment (3,600) (5,400) (5,400) (5,400) (5,988)
Mortgage Interest (11,433) (11,281) (11,120) (10,950) (10,764)
Property Tax (3,450) (3,450) (3,450) (4,350) (4,350)
Total Living Expenses (31,801) (33,284) (35,451) (33,506) (34,023)
Income after Living Expenses 7,879 7,983 622 11,565 13,443
Interest Expense 0 0 0 0 (521)
Capital Expenditures/Investment
Mortgage Principal (2,573) (2,725) (2,886) (3,056) (3,236)
Free Cash Flow 5,306 5,258 (2,264) 8,509 9,686
RRSP Deposit (1,000) (1,000) (1,000) (1,000) (1,000)
Home Improvement (4,200) (5,327) 0 (4,146) (15,000)
High Interest Saving Account
deposit/(withdrawal)
106 (1,069) (3,264) 3,363 (3,157)
Line of Credit
draw on/(pay off)
0 0 0 0 3,157
Net Cash Flow 0 0 0 0 0
Line of Credit Balance 0 0 0 0 3,157
Tax-Free Savings Account Balance 6,400 5,778 4,878 7,336 7,500
To project incomes, Jeff relied on his newest information to estimate his wages and tutoring income. He used the minimum income from the past four years for memorabilia sales, which is conservative and reasonable given its volatility. His painting income is less volatile, so his estimate is an average, excluding the unusual year of his accident.
Jeff expects his expenses for 2019 to be what they were in 2018, since his costs and consumption are not expected to change. However, he has adjusted his dental expenses and his car lease payments on the basis of new knowledge.
The price of gas and heating oil has been extraordinarily volatile during this period (2015–2018), affecting Jeff’s gas and heating expenses, so he bases his estimates on what he knows about his expected consumption and the price. He knows he drives an average of about 16,704 kilometres per year and that his car, a fairly modern, fuel efficient vehicle, gets slightly under 8 litres per 100 kilometres which is equivalent to around 35 miles per gallon. He estimates his gas expense for 2019 by guessing that since oil prices are similar to what they were in 2018, gas will cost, on average, what it did then, which was about \$1.14 per litre. He will buy, on average,
1,336 litres per year (16,704 kilometres/100 km x 8 litres), so his total expense will be \$1,523. Jeff also knows that he uses 1,895 litres of heating oil each year. Estimating heating oil prices at the previous year’s levels, his cost will be about the same as it was then, or \$1,200.
Jeff knows that the more knowledge and information he can bring to bear on his budget, the more accurate and useful his estimates are likely to be.
Capital Budget: Capital Expenditures and Investments
Income remaining after the deduction of living expenses and debt obligations, or free cash flow, is cash available for capital expenditures or investment. Capital expenditures are usually part of a long-term plan of building an asset base. Investment may also be part of a longer-term plan to build an asset base or to achieve a specific goal, such as financing education or retirement. Net cash flow is the gain or loss of funds over a period after all operation expenses, debts, and investment activities are paid for.
Long-term strategies are based on expected changes to the micro factors that shape goals. For example, you want to save for retirement because you anticipate aging and not being as willing or able to sell labour. Expanding or shrinking the family structure may create new savings goals or a change in housing needs that will indicate a change in asset base (e.g., buying or selling a house).
Some changes will eliminate a specific goal. A child finishing university, for example, ends the need for education savings. Some changes will emphasize the necessity of a goal, such as a decline in health underscoring the need to save for retirement. As personal factors change, you should reassess your longer-term goals and the capital expenditure toward those goals because long-term goals, and thus capital expenditures, may change with them.
While many personal factors are relatively predictable over the long term (e.g., you will get older, not younger), the macroeconomic factors that will occur simultaneously are much harder to predict. Will the economy be expanding or contracting when you retire? Will there be inflation or deflation? The further (in time) you are from your goals, the harder it is to predict those factors and the less relevant they are to your budgeting concerns. As you get closer to your goals, macro factors become more influential in the assessment of your goals and your progress toward them.
Since long-term strategies happen over time, you should use the relationships between time and value to calculate capital expenditures and progress toward long-term goals. Long-term goals are often best reached by a progression of steady and even steps. For example, a savings goal is often reached by a series of regular and steady deposits; and those regular deposits form an annuity. Knowing how much time there is and how much compounding there can be to turn your account balance (the present value of this annuity) into your savings goal (its future value), you can calculate the amount of the deposits into the account. This can then be compared to your projected free cash flow to see if such a deposit is possible. You can also see if your goal is too modest or too ambitious, and should be adjusted in terms of the time to reach a goal or the rate at which you do.
A capital expenditure may be a one-time investment, like a new roof. It may also be a step toward a long-term goal, like an annual savings deposit. That goal should be assessed with each budget, and that “step” or capital expenditure should be reviewed. Chart 5.2.3 shows the relationship of factors used to determine the capital budget.
Jeff’s 2019 budget (shown in Table 5.2.2) projects a drop in income and disposable income, and a rise in living expenses, which will leave him with less free cash flow for capital expenditures or investments. He knows that his house needs a new roof (estimated cost = \$15,000) and was hoping to have that done in 2019. However, that capital expenditure would create negative net cash flow, even if he also uses the savings from his high interest savings account. Jeff’s budget shows that both his short-term lifestyle preferences (projected income and expenses) and progress toward his longer-term goals (property improvement and savings) cannot be achieved without some changes and choices. What should those changes and choices be?
Key Takeaways
1. A comprehensive budget consists of an operating budget and a capital budget.
2. The operating budget accounts for recurring incomes and expenses.
3. Recurring incomes result from selling labour and/or liquidity.
4. Recurring expenses result from consumption of goods and/or services.
5. Recurring incomes and expenses satisfy short-term lifestyle goals and create free cash flow for capital expenditures.
6. The capital budget accounts for capital expenditures or nonrecurring items.
7. Capital expenditures are usually part of a longer-term plan or goal.
8. Projecting recurring incomes and expenses involves using: financial history, new information and microeconomic factors, and macroeconomic factors.
9. Different methods may be used to project different incomes and expenses depending on the probability, volatility, and predictability of quantity and price.
10. Projecting capital expenditures involves using the following: new information and microeconomic factors; macroeconomic factors, although these are harder to predict for a longer period, and therefore are less relevant; and the relationships described by the time value of money.
Exercises
1. Using Jeff’s budget sheet as a guide, adapt the budget categories and amounts to reflect your personal financial realities and projections. Develop an operating budget and a capital budget, distinguishing recurring incomes and expenses from nonrecurring capital expenditures. On what basis will you make projections about your future incomes and expenses?
2. How does your budget sheet relate to your income statement, your cash flow statement, and your balance sheet? How will you use this past history to develop a budget to reach your short- and long-term goals?
5.3 THE CASH BUDGET AND OTHER SPECIALIZED BUDGETS
Learning Objectives
1. Discuss the use of a cash budget as a cash management tool.
2. Explain the cash budget’s value in clarifying risks and opportunities.
3. Explain the purpose of a specialized budget, including a tax budget.
4. Demonstrate the importance of including specialized budgets in the comprehensive budget.
The Cash Budget
When cash flows are not periodic—that is, when they are affected by seasonality or a different frequency than the budgetary period—a closer look at cash flow management can be helpful. Although cash flows may be adequate to support expenses for the whole year, there may be timing differences. Cash flows from income may be less frequent than cash flows for expenses, for example, or may be seasonal while expenses are more regular. Most expenses must be paid on a monthly basis, and if some income cash flows occur less frequently or only seasonally, there is a risk of running out of cash in a specific month. When it comes to cash flows, timing is everything.
A good management tool is the cash budget, which is a rearrangement of budget items to show each month in detail. Irregular cash flows can be placed in the specific months when they will occur, allowing you to see the effects of cash flow timing more clearly. Jeff’s cash budget for 2019 is outlined in Table 5.3.1.
Table 5.3.1 Jeff’s Cash Budget
2019
January
2019 February 2019 March 2019 April 2019 May 2019 June 2019 July 2019 August 2019 September 2019 October 2019 November 2019 December
Incomes
Contract Earnings 3,417 3,417 3,417 3,417 3,417 3,417 3,417 3,417 3,417 3,417 3,417 3,417
Tutoring 333 333 333 333 555 555 0 0 333 333 333 555
Memorabilia Sales 79 79 79 79 79 79 79 79 79 79 79 79
House Painting 0 0 0 0 0 3,472 3,472 3,472 0 0 0 0
Interest Income 15 25 36 45 57 0 0 0 0 0 0 0
Total Income 3,844 3,854 3,865 3,874 4,108 7,523 6,968 6,968 3,829 3,829 3,829 4,051
Payroll/Income Taxes (792) (792) (792) (792) (792) (792) (792) (792) (792) (792) (792) (792)
Disposable Income 3,052 3,062 3,073 3,082 3,316 6,731 6,176 6,176 3,037 3,037 3,037 3,259
Living Expenses
Groceries (260) (260) (260) (260) (260) (260) (260) (260) (260) (260) (260) (260)
Car (Fuel) (127) (127) (127) (127) (127) (127) (127) (127) (127) (127) (127) (127)
Car (Service, etc.) (29) (29) (29) (29) (29) (29) (29) (29) (29) (29) (29) (29)
2019
January
2019 February 2019 March 2019 April 2019 May 2019 June 2019 July 2019 August 2019 September 2019 October 2019 November 2019 December
Car (Insurance) 0 (400) 0 0 0 0 0 (400) 0 0 0 0
Electricity (65) (65) (65) (65) (65) (65) (65) (65) (65) (65) (65) (65)
Phone / Cable / Internet (89) (89) (89) (89) (89) (89) (89) (89) (89) (89) (89) (89)
Heat (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100)
Health and Dental Insurance (70) (70) (70) (70) (70) (70) (70) (70) (70) (70) (70) (70)
Medical (20) (20) (20) (20) (20) (20) (20) (20) (20) (20) (20) (20)
Travel/Entertainment (250) (250) (250) (250) (250) (250) (250) (250) (250) (250) (250) (250)
Car Loan Payment (499) (499) (499) (499) (499) (499) (499) (499) (499) (499) (499) (499)
Mortgage Interest (897) (897) (897) (897) (897) (897) (897) (897) (897) (897) (897) (897)
Property Tax 0 0 0 0 0 0 0 0 0 (4,350) 0 0
Total Living Expenses (2,406) (2,806) (2,406) (2,406) (2,406) (2,406) (2,406) (2,806) (2,406) (6,756) (2,406) (2,406)
2019
January
2019 February 2019 March 2019 April 2019 May 2019 June 2019 July 2019 August 2019 September 2019 October 2019 November 2019 December
Income after Living Expenses 646 256 667 676 910 4,325 3,770 3,370 631 (3,719) 631 853
Interest Expense 0 0 0 0 0 (526) (364) (214) (79) (88) (93) (114)
Capital Expenditures/Investment
Mortgage Principal (270) (270) (270) (270) (270) (270) (270) (270) (270) (270) (270) (270)
Free Cash Flow 376 (14) 397 406 640 3,529 3,163 2,886 282 (4,077) 268 469
RRSP Deposit 0 0 (1000) 0 0 0 0 0 0 0 0 0
Home Improvement 0 0 0 0 (15,000) 0 0 0 0 0 0 0
High Interest Savings Account
deposit/ (withdrawal)
376 (14) (603) 406 (6,210) 3,529 3,163 2,886 282 (4,077) 268 469
Line of Credit
draw on/(pay off)
0 0 0 0 10,525 (3,250) (3,000) (2,700) 180 100 415 417
Net Cash Flow 0 0 0 0 2,375 279 163 186 462 100 683 886
2019
January
2019 February 2019 March 2019 April 2019 May 2019 June 2019 July 2019 August 2019 September 2019 October 2019 November 2019 December
Line of Credit Balance 0 0 0 0 10,525 7,275 4,275 1,575 1,755 1,855 2,270 2,687
Tax-Free Savings Account Balance 7,336 7,336 7,336 7,336 7,200 7,100 7,150 7,200 7,300 7,350 7,400 7,500
Jeff’s original annual budget (Table 5.2.2 “Jeff’s 2019 Budget”) shows that although his income is enough to cover his living expenses, it does not produce enough cash to support his capital expenditures—specifically, to fix the roof. If he must make the capital expenditure this year, he can finance it with a line of credit: a loan where money can be borrowed as needed, up to a limit, and paid down as desired, and interest is paid only on the outstanding balance.
The cash budget (Table 5.3.1) shows a more detailed and slightly different story. Because of Jeff’s seasonal incomes, if he has the roof fixed in May, he will need to borrow \$10,525 in May (before he has income from painting). Then he can pay that balance down until September, when he will need to extend it again. By the end of the year, his outstanding debt will be a bit more than originally shown, but his total interest expense will be a bit less as the loan balance (and therefore the interest expense) will be less in some of the months that he has the loan.
The cash (monthly) budget shows a different story than the annual budget because of the seasonal nature of Jeff’s incomes. Since he is planning the capital expenditures before he begins to earn income from painting, he actually has to borrow more—and assume more risk—than originally indicated.
The cash budget may show risks, but also remedies that otherwise may not be apparent. In Jeff’s case, it is clear that the capital expenditure cannot be financed without some external source of capital, most likely a line of credit. He would have to pay interest on that loan, creating an additional expense. That expense would be in proportion to the amount borrowed and the time it is borrowed for. In his original plan, the capital expenditure occurred in May, and Jeff would have had to borrow about \$10,525, paying interest for the next seven months. Delaying the capital expenditure until October, however, would cost him less, because he would have to borrow less and would be paying interest in fewer months.
Delaying the capital expenditure until October would also allow the high interest savings account to build value—Jeff’s seasonal income would be deposited during the summer—which would finance more of the capital expenditure. He could borrow less and his interest expense would be lower because he has borrowed less and because he can wait until October to borrow, thus paying interest for only three months of the year.
Timing matters for cash flows because you need to get cash before you spend it, but also because time affects value, so it is always better to have liquidity sooner and hang onto it longer. A cash budget provides a much more detailed look at these timing issues, and the risks—and opportunities—of cash management that you may otherwise have missed.
Other Specialized Budgets
A cash flow budget is a budget that projects a specific aspect of your finances—in this case, the cash flows. Other kinds of specialized budgets focus on one particular financial aspect or goal. A specialized budget is ultimately included in the comprehensive budget, as it is a part of total financial activity. It usually reflects one particular activity in more detail, such as the effect of owning and maintaining a particular asset or of pursuing a particular activity. You create a budget for that asset or that activity by segregating its incomes and expenses from your comprehensive budget. It is possible to create such a focused budget only if you can identify and separate its financial activity from the rest of your financial life. If so, you may want to track an activity separately that is directly related to a specific goal.
For example, suppose you decide to take up weekend backpacking as a recreational activity. You are going to try it for two years, and then decide if you want to continue. Aside from assessing the enjoyment that it gives you, you want to be able to assess its impact on your finances. Typically, weekend backpacking requires specialized equipment and clothing, travel to a hiking trail or campground, and perhaps lodging and meals: capital investment (in the equipment) and then recurring expenses. You may want to create a separate budget for your backpacking investment and expenses in order to assess the value of this new recreational activity.
One common type of specialized budget is a tax budget, including activities—incomes, expenses, gains, and losses—that have direct tax consequences. A tax budget can be useful in planning for or anticipating an event that will have significant tax consequences—for example, income from self-employment; the sale of a long-term asset such as a stock portfolio, business, or real estate.
While it can be valuable to isolate and identify the effects of a specific activity or the progress toward a specific goal, that activity or that goal is ultimately just a part of your larger financial picture. Specialized budgets need to remain a part of your comprehensive financial planning.
Key Takeaways
1. The cash flow budget is an alternative format used as a cash management tool that provides:
• more detailed information about the timing and amounts of cash flows, and
• a clearer view of risks and opportunities.
2. Specialized budgets focus on a specific asset or activity.
3. A tax budget is commonly used to track taxable activities.
4. Eventually, specialized budgets need to be included in the comprehensive budget to have a complete perspective.
Exercises
1. When is a cash flow budget a useful alternative to a comprehensive budget?
2. Create a specialized budget and a tax budget from your comprehensive budget.
5.4 BUDGET VARIANCES
Learning Objectives
1. Define and discuss the uses of budget variances.
2. Identify the importance of budget-monitoring activities.
3. Analyze budget variances to understand their causes, including possible changes in micro or macro factors.
4. Analyze budget variances to see potential remedies and to gauge their feasibility.
A budget variance occurs when the actual results of your financial activity differ from your budgeted projections. Since your expectations were based on knowledge from your financial history, micro- and macroeconomic factors, and new information, if there is a variance, it is because your estimate was inaccurate or because one or more of those factors changed unexpectedly. If your estimate was inaccurate—perhaps you had overlooked or ignored a factor—knowing that can help you improve. If one or more of those factors has changed unexpectedly, then identifying the cause of the variance creates new information with which to better assess your situation. At the very least, variances will alert you to the need for adjustments to your budget and to the appropriate choices.
Once you have created a budget, your financial life continues. As actual data replace projections, you must monitor the budget compared to your actual activities so that you will notice any serious variances or deviations from the expected outcomes detailed in the budget. Your analysis and understanding of variances constitute new information for adjusting your current behaviour, preparing the next budget, or perhaps realistically reassessing your behaviour or original goals.
The sooner you notice a budget variance, the sooner you can analyze it and, if necessary, adjust for it. And the sooner you correct the variance, the less it costs. For example, perhaps you have had a little trouble living within your means, so you have created a budget to help you do so. You have worked out a plan so that total expenses are just as much as total income. In your original budget, you expected to have a certain expense for putting gas in your car, which you determined by knowing the mileage that you drive and the current price of gas. You are following your budget and going along just fine. Suddenly, the price of gas goes way up. So does your monthly expense. That means you’ll have to:
• spend less for other expenses in order to keep your total expenses within your budget,
• lower your gas expense by driving less, and/or
• increase your income to accommodate this larger expense.
In the short term, monitoring your gas expense alerts you to the fact that you need to change your financial behaviour by driving less, spending less on other things, or earning more. In the long run, if you find this increased expense intolerable, you will make other choices to avoid it. For example, perhaps you would buy a more fuel-efficient car, or change your lifestyle to necessitate less driving. The number and feasibility of your choices will depend on the elasticity of your demand for that particular budget item. But if you hadn’t been paying attention—that is, if you had not been monitoring your budget against the real outcomes that were happening as they were happening—you would not have been aware that any change was needed, and you would have found yourself with a surprising budget deficit.
It bears repeating that once you have discovered a significant budget variance, you need to analyze what caused it so that you can address it properly.
Income results from the sale of labour (wages) or liquidity (interest or dividends). If income deviates from its projection, it is because:
• a different quantity of labour or liquidity was sold at the expected price (e.g., you had fewer house-painting contracts than usual but kept your rates the same),
• the expected quantity of labour or liquidity was sold at a different price (e.g., you had the usual number of contracts but earned less from them), or
• a different quantity of labour or liquidity was sold at a different price (e.g., you had fewer contracts and charged less in order to be more competitive).
Expenses result from consuming goods or services at a price. If an expense deviates from its projected outcome, it is because:
• a different quantity was consumed at the expected price (e.g., you did not use as much gas),
• the expected quantity was consumed at a different price (e.g., you used as much gas but the price of gas fell), or
• a different quantity was consumed at a different price (e.g., you used less gas and bought it for less).
Isolating the cause of a variance is useful because different causes will dictate different remedies or opportunities. For example, if your gas expense has increased, is it because you are driving more miles or because the price of gas has gone up? You can’t control the price of gas, but you can control the amount you drive. Isolating the cause allows you to identify realistic choices. In this case, if the variance is too costly, you will need to address it by somehow driving shorter distances.
If your income falls, is it because your hourly wage has fallen or because you are working fewer hours? If your wage has fallen, you need to try to increase it either by negotiating with your employer or by seeking a new job at a higher wage. Your success will depend on demand in the labour market and on your usefulness as a supplier of labour.
If you are working fewer hours, it may be because your employer is offering you less work or because you choose to work less. If the problem is with your employer, you may need to renegotiate your position or find a new one. However, if your employer is buying less labour because of decreased demand in the labour market, that may be due to an industry or economic cycle, which may affect your success in making that change.
If it is your choice of hours that has caused the variance, perhaps that is due to personal factors—you are aging or your dependents require more care and attention—that need to be resolved to allow you to work more. Or perhaps you could simply choose to work more.
Identifying why you are straying from your budget is critical to identifying remedies and choices. Putting those causes in the context of the micro- and macroeconomic factors that affect your situation will make your feasible choices clearer. Chart 5.4.1 below shows how these factors can combine to cause a variance.
After three months, Jeff decides to look at his budget variances to make sure he’s on track. His actual results for the January–March 2019 period are detailed in the following table.
Table 5.4.1 Jeff’s Actual Income and Expenditures, January–March 2019
2019 January Actual 2019 February Actual 2019 March Actual
Incomes
Contract earnings 3,417 3,417 3,417
Tutoring 500 500 500
Memorabilia Sales 450 360 1,200
House Painting 0 0 0
Interest Income 15 25 30
Total Income 4,382 4,302 5,147
Payroll/Income Taxes (792) (792) (792)
Disposable Income 3,590 3,508 4,355
Living Expenses
Groceries (260) (260) (260)
Car (Fuel) (127) (127) (127)
Car (Service, etc.) (29) (29) (29)
Car (Insurance) 0 (400) 0
Electricity (65) (65) (65)
Phone/Cable/Internet (89) (89) (89)
Heat (200) (200) (200)
Health and Dental Insurance (70) (70) (70)
Medical (20) (20) (20)
Travel/Entertainment 0 0 0
Car (Loan Payment) (499) (499) (499)
Mortgage Interest (897) (897) (897)
Property Tax 0 0 0
Total Living Expenses (2,256) (2,656) (2,256)
Income after Living Expenses 1,334 852 2,099
Interest Expense 0 0 0
Capital Expenditures/Investment
Mortgage Principal (270) (270) (270)
Free Cash Flow 1,064 582 1,829
RRSP Deposit 0 0 (1,000)
Home Improvement 0 0 0
High Interest Savings Account
deposit/(withdrawal)
1,064 582 829
Line of Credit
draw on/(pay off)
0 0 0
Net Cash Flow 0 0 0
Line of Credit Balance 0 0 0
Tax-Free Savings Account Balance 7,336 7,436 7,529
How will Jeff analyze the budget variances he finds? In his case, the income variances are positive. He has picked up a couple of tutoring clients who have committed to lessons through the end of the school year in June; this new information can be used to adjust income. His memorabilia business has done well; the volume of sales has not increased, but the memorabilia market seems to be up and prices are better than expected. The memorabilia business is cyclical: economic expansion and increases in disposable incomes enhance that market. Given the volatility of prices in that market, however, and the fact that there has been no increase in the volume of sales (Jeff is not doing more business, just more lucrative business), Jeff will not make any adjustments going forward. Interest rates have remained steady, so he will not adjust his expected interest income.
His expenses are as expected. The only variance is the result of Jeff’s decision to cut his travel and entertainment budget for this year (i.e., giving up his vacation) to offset the costs of the roof. He is planning that capital expenditure for October, which will actually make it cheaper to do.
Table 5.4.2 Jeff’s Adjusted Cash Budget for 2019, January-June
2019 January Actual 2019 February Actual 2019 March Actual 2019 April 2019 May 2019 June
Incomes
Contract earnings 3,417 3,417 3,417 3,417 3,417 3,417
Tutoring 500 500 500 500 500 500
Memorabilia Sales 450 360 1,200 700 650 500
House Painting 0 0 0 0 0 3,472
Interest Income 13 24 31 39 53 66
Total Income 4,380 4,301 5,148 4,656 4,620 7,955
Payroll/Income Taxes (792) (792) (792) (792) (792) (792)
Disposable Income 3,588 3,509 4,356 3,864 3,828 7,163
Living Expenses
Groceries (260) (260) (260) (260) (260) (260)
Car (Fuel) (127) (127) (127) (127) (127) (127)
Car (Service, etc.) (29) (29) (29) (29) (29) (29)
Car (Insurance) 0 400 0 0 0 0
Electricity (65) (65) (65) (65) (65) (65)
Phone/Cable/Internet (89) (89) (89) (89) (89) (89)
Heat (200) (200) (200) 0 0 0
Health and Dental Insurance (70) (70) (70) (70) (70) (70)
Medical (20) (20) (20) (20) (20) (20)
Travel/Entertainment 0 0 0 0 0 0
Car Loan Payment (499) (499) (499) (499) (499) (499)
Mortgage Interest (897) (897) (897) (897) (897) (897)
Property Tax 0 0 0 0 0 0
Total Living Expenses (2,256) (2,656) (2,256) (2,256) (2,256) (2,256)
Income after Living Expenses 1,332 853 2,100 1,608 1,572 4,907
Interest Expense 0 0 0 0 0 0
Capital Expenditures/Investment
Mortgage Principal (270) (270) (270) (270) (270) (270)
Free Cash Flow 1,062 583 1,830 1,338 1,302 4,637
RRSP Deposit 0 0 (1000) 0 0 0
Home Improvement 0 0 0 0 0 0
High Interest Savings Account
deposit/(withdrawal)
1,062 583 830 1,338 1,302 4,637
Line of Credit
draw on/(payoff)
0 0 0 0 0 0
Net Cash Flow 0 0 0 0 0 0
Line of Credit Balance 0 0 0 0 0 0
Tax-Free Savings Account Balance 7,336 7,345 7,450 7,500 7,037 7,069
Table 5.4.3 Jeff’s Adjusted Cash Budget for 2019, July-December
2019 July 2019 August 2019 September 2019 October 2019 November 2019 December
Incomes
Contract earnings 3,417 3,417 3,417 3,417 3,417 3,417
Tutoring 0 0 250 500 500 300
Memorabilia Sales 400 450 300 500 900 100
House Painting 3,472 3,472 0 0 0 0
Interest Income 111 153 192 200 20 36
Total Income 7,400 7,492 3,967 4,617 4,844 3,853
Payroll/Income Taxes (792) (792) (792) (792) (792) (792)
Disposable Income 6,608 6,700 3,175 3,825 4,050 3,061
Living Expenses
Groceries (260) (260) (260) (260) (260) (260)
Car (Fuel) (127) (127) (127) (127) (127) (127)
Car (Service, etc.) (29) (29) (29) (29) (29) (29)
Car (Insurance) 0 (400) 0 0 0 0
Electricity (65) (65) (65) (65) (65) (65)
Phone/Cable/Internet (89) (89) (89) (89) (89) (89)
Heat 0 0 0 (100) (100) (200)
Health and Dental
Insurance
(70) (70) (70) (70) (70) (70)
Medical (20) (20) (20) (20) (20) (20)
Travel/Entertainment 0 0 0 0 0 0
Car Loan Payment (499) (499) (499) (499) (499) (499)
Mortgage Interest (897) (897) (897) (897) (897) (897)
Property Tax 0 0 0 (4,350) 0 0
Total Living Expenses (2,056) (2,456) (2,056) (6,506) (2,156) (2,156)
Income after Living Expenses 4,552 4,244 1,119 (2,681) 1,894 905
Interest Expense 0 0 0 0 0 0
Capital Expenditures/Investment
Mortgage Principal (270) (270) (270) (270) (270) (270)
Free Cash Flow 4,282 3,974 849 (2,951) 1,624 635
RRSP Deposit 0 0 0 0 0 0
Home Improvement 0 0 0 (15,000) 0 0
High Interest Savings Account
deposit/(withdrawal)
4,282 3,974 849 (17,951) 1,624 635
Line of Credit
draw on/(pay off)
0 0 0 0 0 0
Net Cash Flow 0 0 0 0 0 0
Line of Credit Balance 0 0 0 0 0 0
Tax-Free Savings Account Balance 7,345 7,554 8,702 9,541 9,836 9,988
With these adjustments, it turns out that Jeff can avoid new debt and still support the capital expenditure of the new roof. The increased income that Jeff can expect, and his decreased expenses (if he can maintain his resolve), can finance the project and still leave him with a bit of savings in his high interest savings account.
This situation bears continued monitoring, however. Some improvements are attributable to Jeff’s efforts (cutting back on entertainment expenses, giving up his vacation, cultivating new tutoring clients). But Jeff has also benefited from macroeconomic factors that have changed to his advantage (rising memorabilia prices), and those factors could change again to his disadvantage. He has tried to be conservative about making adjustments going forward, but he should continue to keep a close eye on the situation, especially as he gets closer to making the relatively large capital expenditure in October.
Sometimes a variance cannot be “corrected” or is due to a micro- or macroeconomic factor beyond your control. In that case, you must adjust your expectations to reality, which may mean adjusting expected outcomes or even your ultimate goals.
Variances are also measures of the accuracy of your projections: what you learn from them can improve your estimates and your budgeting ability. The unexpected can always occur, but the better you can anticipate what to expect, the more accurate—and useful—your budget process can be.
Key Takeaways
1. Recognizing and analyzing variances between actual results and budget expectations identifies potential problems, and identifies potential remedies.
2. The more frequently the budget is monitored, generally the sooner adjustments may be made, and the less costly adjustments are to make.
3. Budget variances for incomes and expenses should be analyzed to see if they are caused by a difference in: actual quantity, actual price, or both actual quantity and actual price.
4. Variances also need to be analyzed in the context of micro and macro factors that may change.
Exercises
You are working fewer hours, which is reducing your income from employment and causing a budget variance. If the choice is yours, what are some microeconomic factors that could be causing this outcome? If the choice is your employer’s, what are some macroeconomic factors that could be sources of the variance? What are your choices for increasing income? Alternatively, what might you change in your financial behaviour, budget, or goals to your improve outcomes?
5.5 BUDGETS, FINANCIAL STATEMENTS, AND FINANCIAL DECISIONS
Learning Objectives
1. Describe the budget process as a financial planning tool.
2. Discuss the relationships between financial statements and budgets.
3. Demonstrate the use of budgets in assessing choices.
4. Identify factors that affect the value of choices.
Whatever type of budget you create, the budget process is one aspect of personal financial planning and therefore a tool to make better financial decisions. Other tools include financial statements, assessments of risk and the time value of money, macroeconomic indicators, and microeconomic or personal factors. These tools’ usefulness stems from their ability to provide a clearer view of “what is” and “what is possible.” It puts your current situation and your choices into a larger context, giving you a better way to think about where you are, where you’d like to be, and how to go from here to there.
Jeff has to decide whether to go ahead with the new roof. Assuming the house needs a new roof, his decision is really only about his choice of financing. An analysis of Jeff’s budget variances has shown that he can actually pay for the roof with the savings in his high interest savings account. This means his goal is more attainable (and less costly) than in his original budget. This favourable outcome is due to his efforts to increase income and reduce expenses, and to macroeconomic changes that have been to his advantage. So, Jeff can make progress toward his long-term goals of building his asset base; he can continue saving for retirement with deposits to his retirement account; and he can continue improving his property with a new roof on his house.
Because Jeff is financing the roof with the savings from his high interest savings account, he can avoid new debt and thus additional interest expense. He will lose the interest income from his high interest savings account (which is not that significant
), but the increases from his tutoring and sales income will offset the loss. Jeff’s income statement will be virtually unaffected by the roof. His cash flow statement will show unchanged operating cash flow, a large capital expenditure, and use of savings.
Jeff can finance this increase of asset value (his new roof) with another asset: his high interest savings account. His balance sheet will not change substantially—value will just shift from one asset to another—but the high interest savings account earns a minimal income, which the house does not, although there may be a gain in value when the house is sold in the future.
Moreover, Jeff will be moving value from a very liquid high interest savings account to a not-so-liquid house, decreasing his overall liquidity. Looking ahead, this loss of liquidity could create another opportunity cost: it could narrow his options. Jeff’s liquidity will be pretty much depleted by the roof, so future capital expenditures may have to be financed with debt. If interest rates continue to rise, that will make financing future capital expenditures more expensive, perhaps causing Jeff to delay those expenditures or even cancel them.
However, Jeff also has a very reliable source of liquidity in his earnings—his paycheque, which can offset this loss. If he can continue to generate free cash flow to add to his savings, he can restore his high interest savings account and his liquidity. Having no dependents makes Jeff more able to assume the risk of depleting his liquidity now and relying on his income to restore it later.
The opportunity cost of losing liquidity and interest income will be less than the cost of new debt and new interest expense. That is because interest rates on loans are always higher than interest rates on savings. Banks always charge more than they pay for liquidity. That spread, or difference between those two rates, is the bank’s profit, so the bank’s cost of buying money will always be less than the price it sells for. The added risk and obligation of new debt could also create opportunity cost and make it more difficult to finance future capital expenditures. So financing the capital expenditure with an asset rather than with a liability is less costly, both immediately and in the future, because it creates fewer obligations and more opportunities, less opportunity cost and less risk.
The budget and the financial statements allow Jeff to project the effects of this financial decision in the larger context of his current financial situation and ultimate financial goals. His understanding of opportunity costs, liquidity, the time value of money, and personal and macroeconomic factors also helps him evaluate his choices and their consequences. Jeff can use this decision and its results to inform his next decisions and his ultimate horizons.
Financial planning is a continuous process of making financial decisions. Financial statements and budgets are ways of summarizing the current situation and projecting the outcomes of choices. Financial statement analysis and budget variance analysis are ways of assessing the effects of choices. Personal factors, economic factors, and the relationships of time, risk, and value affect choices as their dynamics—how they work and bear on decisions—affect outcomes.
Key Takeaways
1. Financial planning is a continuous process of making financial decisions.
2. Financial statements are ways of summarizing the current situation.
3. Budgets are ways of projecting the outcomes of choices.
4. Financial statement analysis and budget variance analysis are ways of assessing the effects of choices.
5. Personal factors, economic factors, and the relationships of time, risk, and value affect choices, as their dynamics affect outcomes.
Exercises
Analyze Jeff’s budget as a financial planning tool for making decisions in the following situations. For each of the situations below, create a new budget showing the projected effects of Jeff’s decisions.
1. A neighbour and co-worker suggest that he and Jeff commute to work together.
2. Jeff wants to give up tutoring and put more time into his memorabilia business. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.05%3A_Financial_Plans-_Budgets.txt |
INTRODUCTION
The design of a tax system reflects the society’s view of both the government’s responsibilities toward its citizens and of its citizens toward their government. It is an important source of revenue for all governments, and it is largely used to pay for public programs and services.
The federal and provincial governments were granted the authority to make laws under the Constitution Act, 1867. Provinces and territories may assign some law-making authority to municipalities. Since federal, provincial or territorial, and municipal governments can all enact different tax laws, “this leads to a complex and diverse system of taxation in Canada” (Wadden, 2016, p. 128).
The authority of the federal government to make laws pertaining to “Indians, and lands reserved for Indians” has been questioned by Indigenous peoples, many of whom argue that there is no foundation for this in the treaties (Wadden, 2016, p. 128). This brings into question the Indian Act itself and its authority to define the rights of Indigenous peoples. Section 35 of the Constitution Act, 1982 recognizes the inherent Aboriginal right of self-government. The Indian Act will become less relevant as more Indigenous communities move toward self-government (Wadden, 2016).
Please go to the Financial Consumer Agency of Canada’s webpage 8.1.3 What taxes you pay for an illustration of the total amount of revenue that governments in Canada collect from each type of tax.
According to the CBC, in the 2013–2014 fiscal year, the Canadian government spent \$276.8 billion, “and 80 per cent of it, or \$219.9 billion, came from tax revenue” (CBC, 2015).
Many people tend to focus on taxes only in the lead-up to the April 30 deadline to file personal income tax. But successful financial planning requires an effective tax strategy throughout the whole year, as well as a basic understanding of the tax rules and regulations. As Kapoor et al. (2015) point out, there are common goals related to tax planning:
• knowing the current tax laws and regulations that affect you,
• maintaining complete and appropriate tax records, and
• making employment, purchase, and investment decisions that leave you with the greatest after tax cash flows and net wealth. (p. 172)
Manny Jules, the chief commissioner and one of the creators of the First Nations Tax Commission, an institution that helps securitize property tax revenues and oversee the bylaw approval process, suggests that “taxation is a mechanism to promote the economic independence, and stability of Aboriginal communities” (Wadden, 2016, p. 126). Jules believes that taxation is a fundamental government power that can help bands advance by creating a better, more accountable system, one that helps them to generate their own revenue; “otherwise, you’re always depending on someone else to do something for you” (Gerson, 2012). Taxation is an important means for Indigenous governments to generate their own independent revenues instead of relying on federal transfer funds or “Indian monies” under the Indian Act. Indigenous governments have wide discretion to apply tax revenues to their own priorities. During the past twenty-five years, many Indigenous governments in Canada “have enacted laws imposing direct taxes within their reserves or settlement lands. Aboriginal government taxes may include real property tax, sales tax, income tax and certain provincial-type commodity taxes” (INAC, 2014).
We will review the different types of taxes utilized by Indigenous, federal, provincial or territorial, and municipal governments throughout this chapter.
REFERENCES
CBC. (2015). “Where do tax dollars go when they leave your wallet?” CBC News, Mar. 2. Retrieved from: http://www.cbc.ca/news/multimedia/wh...llet-1.2974570.
Financial Consumer Agency of Canada. (2017). “What taxes you pay.” Retrieved from: https://www.canada.ca/en/financial-c...taxes-1/4.html.
Gerson, J. (2012). “Taxes the key to healthy aboriginal communities, Kamloops band chief says.” National Post, May 26. Retrieved from: http://nationalpost.com/news/canada/...and-chief-says.
Indigenous and Northern Affairs Canada. (2014). “Fact Sheet—Taxation by Aboriginal Governments.” Retrieved from: https://www.aadnc-aandc.gc.ca/eng/11.../1100100016435.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Wadden, W. (2016). “An Introduction to Taxation.” In Keith G. Brown, Mary Beth Doucette, and Janice Esther Tulk, eds., Indigenous Business in Canada, 125–145. Sydney, NS: Cape Breton University Press.
6.1 SOURCES OF TAXATION AND KINDS OF TAXES
Learning Objectives
1. Identify the levels of government that impose taxes.
2. Define the different kinds of incomes, assets, and transactions that may be taxed.
3. Compare and contrast progressive and regressive taxes.
Any government that needs to raise revenue and has the legal authority to do so may tax. Tax jurisdictions reflect government authorities. Taxation is used by governing bodies to fund public services such as “water, sewer, roads, garbage collection, education, and health care” (Wadden, 2016, p. 125).
In Canada, federal, provincial or territorial, and municipal governments impose taxes. Many Indigenous governments also impose taxes. Individuals and businesses in Canada must pay the following taxes: property tax, income tax, and sales tax. Similarly, in many countries there are national, provincial or state, county, and municipal taxes. Regional economic alliances, such as the European Union, may also levy taxes. The following are common taxes paid by people in Canada every year:
• Income taxes on employment and other income that you receive
• Sales taxes such as the Goods and Services Tax (GST) or Harmonized Sales Tax (HST) and the Provincial Sales Taxes (PST)
• Property taxes, usually charged by local governments on the value of land and buildings
• Customs duties or tariffs on certain imported and exported products
• Contributions by employers and employees to social security plans such as the Employment Insurance (EI) system, the Canada Pension Plan (CPP), the Québec Pension Plan (QPP), or the Québec Parental Insurance Plan
• Health services taxes charged in some provinces for access to the provincial health-care system
• Other taxes such as motor vehicle licences and natural resource taxes. (FCAC, 2017)
Governments tax income because it is a way to tax broadly based on the ability to pay. Most adults have an income from some source, even if it is a government distribution. Those with higher incomes should be able to pay more taxes, and, in theory, they should be willing to do so, for they have been more successful in or have benefited more from the economy that the government protects.
According to the Financial Consumer Agency of Canada, the following are definitions of different types of taxes:
Tax: A compulsory financial contribution imposed by law to raise government revenue.
Tariff: A charge (or list of charges) imposed by a government on imports or exports.
Duty: A specific tax imposed by law on imports or exports (same as tariffs).
Fee: A payment for services or for a particular privilege. (FCAC, 2017)
Income tax is usually a progressive tax: the higher the income or the more to be taxed, the greater the tax rate. The percentage of income that is paid in tax increases as income rises. Those income categories are called tax brackets.
Income tax is the main source of revenue for the federal government and is a direct tax on the income of individuals and businesses. Income tax can be levied by the federal, provincial or territorial, and Indigenous governments. The Income Tax Act provides the federal government with the authority to collect income tax. Through tax-collection agreements with most of the provinces and territories, the federal government has the authority to collect provincial or territorial income taxes on their behalf. First Nations Personal Income Tax Administration agreements have been entered into by a number of First Nations with the Government of Canada. According to Wadden (2016), these agreements allow self-governing First Nations “to exercise their power of direct taxation, to impose taxes on the income of individuals, and to enter into tax-collection agreements with Canada to collect taxes payable under the First Nations Tax Act” and remit them back to the applicable First Nation (p. 134).
With regard to the federal and provincial or territorial governments, your income, minus the deductions for which you qualify, must be calculated in order to arrive at a taxable income. You are taxed first by the federal government and then by your provincial or territorial government.
In Canada, we operate under a marginal tax rate system. Marginal tax is the amount of tax paid on an additional dollar of income. Unlike the flat tax rate, where you pay the same rate of tax no matter what your income, a marginal tax rate system increases the tax rate as income rises. Knowing one’s marginal tax rate can help you make effective long-term financial decisions.
For example, if you know you will be taxed at a much higher rate because you will be earning significantly more income in the coming year, you might want to consider investing in an RRSP. However, this strategy only makes sense if you can reasonably assume that you will be earning a much lower income in retirement and therefore paying a lower income tax in retirement. (Please see Chapter 11 for more information on RRSPs.)
The rate at which you are taxed is categorized into tax brackets and is determined by the government. Table 6.1.1 shows an overview of 2018 federal tax brackets.
Table 6.1.1 Canadian Income Tax Brackets in 2018
If your taxable income was between Federal Marginal Tax Rate
\$0-\$46,605 15%
\$46,606 up to \$93,208 20.5%
\$93,208 up to \$144,489 26%
\$144,489 up to \$205,842 29%
\$205,842 and up 33%
Data Source: Canada Revenue Agency, 2018. Table created by Bettina Schneider, 2018.
Federal tax and tax for all provinces and territories (except Quebec) is calculated the same way. Marginal tax rates calculate the amount of combined federal and provincial taxes payable on the next dollar of income. To calculate your combined federal and provincial tax bill in each province and territory as of June 15, 2018, you can use the 2018 Personal tax calculator found on Ernst & Young’s website.
For a list of provincial and territorial tax rates, please visit the Government of Canada’s webpage, Provincial and territorial tax rates for 2018.
Tax is levied on income from many sources:
• wages (selling labour),
• interest, dividends, and gains from investment (selling capital),
• self-employment (operating a business or selling a good or service),
• property rental,
• royalties (rental of intellectual property), and
• “other” income such as alimony, gambling winnings, or prizes.
A sales tax or consumption tax taxes the consumption financed by income. In Canada, sales taxes are imposed by the federal and provincial governments. Sales taxes are said to be more efficient and fair in that consumption reflects income (income determines one’s ability to consume and therefore one’s level of consumption). Consumption is also hard to hide, making sales tax a good way to collect taxes based on one’s ability to pay. Consumption taxes typically tax all consumption, including nondiscretionary items such as food, clothing, and housing. Opponents of sales tax argue that it is a regressive tax, because those with lower incomes must use a higher percentage of their incomes on nondiscretionary purchases than higher-income people do. In Canada, there are three types of sales taxes:
1. Provincial Sales Tax (PST): currently collected in British Columbia, Saskatchewan, Manitoba, and Quebec.
2. Goods and Services Tax (GST): a value-added tax (general consumption tax) levied by the federal government on most products except for essentials such as groceries, rent, and medical services. GST is an example of an excise tax, an indirect tax imposed on the sale of a particular product.
3. Harmonized Sales Tax (HST): also a value-added tax that is a single, blended combination of PST and GST, collected by Ontario, New Brunswick, Newfoundland and Labrador, Nova Scotia, and Prince Edward Island.
Sales tax is an example of an indirect tax because it involves an intermediary that collects tax from a person or organization and remits it to the entity that is imposing it (Wadden, 2016, p. 128). The seller (the taxation body) collects the tax from the buyer.
The value-added tax (VAT) or GST is a consumption tax, but it differs from the sales tax, which is paid only by the consumer as an end user. With a VAT or GST, the value added to the product is taxed at each stage of production. Governments use a VAT or GST instead of a sales tax to spread the tax burden among producers and consumers, and thus to reduce incentive to evade the tax. A consumption tax is a regressive tax. When travelling abroad, you should be aware that a VAT may add substantially to the cost of a purchase (i.e. a meal, accommodations, etc.).
Excise taxes are taxes on specific consumption items such as alcohol, cigarettes, motor vehicles, fuel, or highway use. In some provinces, excise taxes are justified by the discretionary nature of the purchases and may be criticized as exercises in “social engineering”—using the tax code to dictate social behaviours. For example, people addicted to nicotine or alcohol tend to purchase cigarettes or liquor even if an excise tax increases their cost and are therefore a reliable source of tax revenue.
Property taxes are used primarily by local—municipal, provincial or territorial, state, and county—governments, and are most commonly imposed on real property (land and buildings), but also on personal assets such as vehicles and boats. Property values theoretically reflect wealth (accrued income) and thus one’s ability to pay taxes. Property values are also a matter of public record (real property is deeded, whereas boats or automobiles are licensed), which allows more efficient tax collection. First Nations property may be taxed under bylaws passed by band councils, which may have authority under section 83 of the Indian Act or the 2005 First Nations Fiscal and Statistical Management Act. Most of these bylaws exempt property that is owned by band members (Wadden, 2016).
First Nations and Tax Exemptions
First Nations individuals and businesses are subject to the same tax rules as other Canadian residents unless income is eligible for tax exemption under section 87 of the Indian Act and paragraph 81(1)(a) of the Income Tax Act. As of 2011, 55 per cent of the 1.4 million Indigenous people in Canada followed the same tax rules as other Canadians (Sagan, 2015). Exemption is meant to protect the property of those living on reserves. Those who have moved off reserve do not qualify for section 87 tax exemptions. EI premiums are mandatory deductions that on-reserve employers must make while CPP contributions are not. On-reserve employers can provide their employees with optional CPP coverage; however, they are not required to deduct CPP from non-taxable income (CRA, 2018). If goods are bought on, or delivered to, a reserve, they are also tax exempt. Section 87 of the Indian Act does not apply to First Nations that have self-government agreements.
The following factors are considered by the Canada Revenue Agency (CRA) with regard to employment income tax exemption:
• Name
• Address
• Whether address is located on reserve
• Whether the individual is registered or entitled to be registered under the Indian Act
• Proportion of duties that are performed on reserve
• Residence is also a factor (CRA, 2017)
Furthermore, according to Sagan (2015), businesses and self-employed individuals can be tax exempt if they meet several factors outlined by the CRA, including:
• Where the business or person carries out revenue-generating activities
• Where its customers are located
• Whether or not an office or books and records are kept on a reserve (Sagan, 2015)
Section 87 of the Indian Act states that the following property, although subject to section 83 and section 5 of the First Nations Fiscal Management Act, is exempt from taxation:
• The interest of an Indian or a band in reserve lands or surrendered lands; and
• The personal property of an Indian or a band situated on reserve (Indian Act, 1985).
According to section 90, “certain items of personal property are protected from taxation or seizure by deeming that the property is situated on the reserve” (Wadden, 2016, p. 135). Currently, Métis and Inuit are not eligible to use the tax exemptions noted in the Indian Act. Tax exemptions are granted only to those individuals who meet the definition of “Indian” under the Act. Section 2 defines an Indian as “a person who pursuant to this Act is registered as an Indian or is entitled to be registered as an Indian” (Wadden, 2016, pp. 136–137). Those who have been removed from the Indian Register, or from a band list, may apply to be added. According to the CBC, “tax exemption for First Nations serves in part to protect aboriginal land and ‘to make sure tax does not erode the use of Indian property on reserves’ ” (Sagan, 2015).
Whitecap Dakota First Nation levies a variety of different taxes on reserve that status and non-status First Nations must pay. Chief Darcy Bear believes First Nations communities that levy their own taxes “are following in the tradition of the ‘sharing model’ that’s always been a part of First Nations culture” (Sagan, 2015). According to Chief Bear, “If your best hunter killed 10 buffalo, he doesn’t eat 10 buffalo himself. He shares with the whole community” (Sagan, 2015). Chief Bear believes it is important to generate income through taxation so a First Nation can invest in its people (Sagan, 2015).
The following information, taken directly from the Indigenous and Northern Affairs Canada webpage Facts Sheet—Taxation by Aboriginal Governments, highlights the different types of First Nations government taxes currently in place:
• First Nations Sales Tax (FNST) (levied only by Indian Act bands): A tax that applies to on-reserve sales of alcoholic beverages, motor fuels or tobacco products.
• First Nations Goods and Services Tax (FNGST) (levied by Indian Act bands or Aboriginal self-governments): A tax on the consumption that occurs within reserve or settlement lands.
• First Nations Personal Income Tax (FNPIT) (levied only by Aboriginal self-governments): To date, fourteen self-governing Aboriginal groups have enacted personal income tax laws and concluded related tax administration agreements with Canada.
• Real Property Tax under the Indian Act or the First Nations Fiscal Management Act: section 83 of the Indian Act provides a power for Indian Act bands to make bylaws for the taxation of land or interest in land in the reserve.
• Self-Government Agreements: The area of tax powers is also generally one of the subject matters addressed in self-government negotiations. Following the conclusion of self-government negotiations, many final agreements provide the Aboriginal government with the authority to impose direct taxes (e.g., real property tax, sales tax) on their citizens/members within their reserves or settlement lands.
• Provincial-Type Taxes (Indian Act bands or Aboriginal Self-Governments): The federal government has repeatedly expressed its willingness to facilitate tax administration agreements between Indian Act bands and provinces or territories. In 2006, the First Nations Goods and Services Tax Act was amended to enable the council of an Indian Act band that is listed in Schedule II to that Act to enact a law that imposes a direct tax like a particular provincial tax, if that province agrees and is also listed in the Schedule. A number of Indian Act bands and provinces have concluded such agreements. (INAC, 2016)
In August 2017, the Prime Minister announced that Indigenous and Northern Affairs Canada (INAC) would be dissolved and two new departments—Crown-Indigenous Relations and Northern Affairs Canada, and Indigenous Services Canada—would take INAC’s place over time, after engagement with Indigenous peoples and others.
As you can see, there are a number of different taxes that exist in Canada. It is critical to understand which taxes apply to you so you can develop a taxation strategy that will help you to be successful in your financial planning.
Key Takeaways
1. Governments at all levels use taxes as a source of financing.
2. Taxes may be imposed on the following:
• Incomes from wages, interest, dividends, and gains (losses), and rental of real or intellectual property.
• Consumption of discretionary and nondiscretionary goods and services.
• Wealth from asset ownership.
3. Taxes may be progressive, such as the income tax, in which you pay proportionally more taxes the more income you have, or regressive, such as a sales tax, in which you pay proportionally more taxes the less income you have.
Exercises
1. The T1 tax form is what individual Canadians use to complete their personal income tax return. Please review the video “Preparing T1 Returns – Reporting income and inputting T-slips on the T1 tax return (Part 2 of 5)” (12:47) by CanadianTaxAcademy.com on how to complete a T1 General form. After watching this video, try completing the T1 General form.
2. Examine the tax returns that you filed last year. Alternatively, estimate your tax return based on your present financial situation. On what incomes were you (or would you be) taxed? What tax bracket were you (or would you be) in? How did (or would) your provincial, federal, and other tax liabilities differ? What other types of taxes did you (or would you) pay, and to which government jurisdictions?
3. There are six types of tax: property, consumption, value-added or goods and services tax, income tax, excise tax, and sales tax. Match the type of tax to the description below:
• Tax on the use of vehicles, gasoline, alcohol, cigarettes, highways, etc.
• Tax on purchases of both discretionary and nondiscretionary items
• Tax on wages, earned interest, capital gain, and the like
• Tax on home and land ownership
• Tax on purchases of discretionary items
• Tax on items during their production as well as upon consumption
4. In your financial planning journal, record all the types of taxes you will be paying next year and to whom. How will you plan for paying these taxes? How will your tax liabilities affect your budget?
REFERENCES
Canada Revenue Agency. (2017). “Canadian income tax rates for individuals—current and previous years.” Retrieved from: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html.
Canada Revenue Agency. (2018). “Canadian income tax rates for individuals—current and previous years.” Retrieved from: https://www.canada.ca/en/revenue-age...ous-years.html.
Canada Revenue Agency. (2018). Payroll: Indian Employees. Retrieved from: https://www.canada.ca/en/revenue-age...employees.html.
Financial Consumer Agency of Canada. (2017). “What taxes you pay.” Retrieved from: https://www.canada.ca/en/financial-c...taxes-1/4.html.
Indigenous and Northern Affairs Canada. (2016). “Fact Sheet—Taxation by Aboriginal Governments.” Retrieved from: https://www.aadnc-aandc.gc.ca/eng/11.../1100100016435.
Sagan, A. (2015). “First Nations pay more tax than you think.” CBC News, Mar. 2. Retrieved from: http://www.cbc.ca/news/business/taxe...hink-1.2971040.
Wadden, W. (2016). “An Introduction to Taxation.” In Keith G. Brown, Mary Beth Doucette, and Janice Esther Tulk, eds., Indigenous Business in Canada, 125–145. Sydney, NS: Cape Breton University Press.
6.2 THE CANADIAN FEDERAL INCOME TAX PROCESS
Learning Objectives
1. Identify the taxes most relevant for personal financial planning.
2. Identify taxable incomes and the schedules used to report them.
3. Calculate deductions and credits.
4. Compare methods of tax payment.
The Canadian government relies most on income tax to provide for various types of government services. Income tax is the most relevant tax to consider for personal financial planning, as everyone has some sort of income over a lifetime. Most provinces and territories model their tax systems on the federal model or base their tax rates on federally defined income.
Taxable Entities
There are three taxable entities in the federal system: the individual or family unit, the corporation, and the trust. Personal financial planning focuses on your decisions as an individual or family unit, but other tax entities can affect individual income. Corporate profit may be distributed to individuals as a dividend, for example, which then becomes the individual’s taxable income. Likewise, funds established for a specific purpose may distribute money to an individual that is taxable as individual income. A trust, for example, is a legal arrangement whereby control over property is transferred to a person or organization (the trustee) for the benefit of someone else (the beneficiary). In Canada, the estate pays the taxes owed to the government, not the beneficiaries.
Peace Hills Trust (PHT) is considered Canada’s first and largest First Nation trust company. It is owned by the Samson Cree Nation of Maskwacis, Alberta, and has its head office in Maskwacis, Alberta. PHT was established in 1980 in order to serve “the financial needs of First Nations and their members, corporations, institutions and associations both on and off reserve” (PHT, 2017). It currently offers a wide range of financial and retail banking to more than twenty thousand personal and business customers, from both Indigenous and non-Indigenous backgrounds, in most regions of Canada through a network of eight regional offices and electronic services (PHT, 2017). As PHT states, “First Nation trusts have evolved a great deal over recent years. Now they may include impact benefit arrangements and economic development structures that provide growth and educational opportunities for First Nations” (PHT, n.d.).
While Canadian tax rules do not allow spouses to file joint income tax returns, couples in Canada can reduce the total amount of taxes they have to pay. If you choose to use tax preparation software, it may include an option to prepare a “coupled” return that maximizes your benefits while still generating two separate returns.
All taxable entities, including non-residents who receive income from sources in Canada, have to file a declaration of incomes and pay any tax obligations annually. Under Canada’s tax system, what you pay in income tax is based on your residency status.
But not everyone who files a tax return actually pays taxes. For example, individuals with low incomes and tax exempt, non-profit corporations typically do not. All potential taxpayers nevertheless must declare income and show their obligations to the government. For the individual, that declaration is filed on the T1 General form, which can be accessed on the Canada Revenue Agency website.
Income
For individuals, the first step in the process is to calculate total income. Income may come from many sources, and each income must be calculated and declared. Some kinds of income have a separate form or schedule to show their more detailed calculations. The following schedules are the most common for reporting incomes separately by source.
Interest and Dividend Income
Interest income is income from selling liquidity. For example, the interest that your savings account, guaranteed investment certificate, and bonds earn in a year is income. You essentially are earning interest from lending cash to a bank, a government, or a corporation (though not all your interest income may be taxable). Dividend income, on the other hand, is income from investing in the stock market. Dividends are your share of corporate profits as a shareholder, distributed in proportion to the number of shares of corporate stock you own.
Employment Income
Employment income is payment received for personal effort, including salaries, wages, commissions, tips, bonuses, and taxable employee benefits.
Business Income
Business income is income from any sole proprietorship, partnership, corporation, or profession. For sole proprietors and partners in a partnership, business income is the primary source of income. Many other individuals rely on wages, but have a small business on the side for extra income. Business expenses can be deducted from business income, including, for example, business use of your car and home. If expenses are greater than income, the business is operating at a loss. Business losses can be deducted from total income, just as business income adds to total income.
The tax laws distinguish between a business and a hobby that earns or loses money. The CRA defines a business as “any activity that you do for profit,” and any profit from your hobby is considered business income (Ward, 2017). In addition, the self-employed must pay estimated income taxes in quarterly installments based on expected income depending on your earnings. According to the CRA, quarterly income tax installments are required if your net tax owing will be above the threshold for your province or territory and/or if your net tax owing in previous years was above the threshold for your province or territory.
Adam is thinking about turning his hobby into a business. He has been successful at selling his artwork at different tradeshows and online. He thinks he has found a large enough market to support a business enterprise. As a business, he would be able to deduct the costs of website promotion, his art sales trips, his home office, and shipping, which would reduce the taxes he would have to pay on his business income. Adam decides to enroll in online courses on becoming an entrepreneur, how to write a business plan, and how to find capital for a new venture.
Capital Gains (or Losses)
Gains or losses from investments derive from changes in asset value during ownership between the asset’s original cost and its market value at the time of sale. If you sell an asset for more than you paid for it, you have a gain. If you sell an asset for less than you paid for it, you have a loss. Capital losses are subtracted from capital gains in the same calendar year, and 50 per cent of the resulting amount is taxable, which means less tax is paid on capital gains than on income. Recurring gains or losses from investment are from returns on financial instruments such as stocks and bonds. One-time gains or losses, such as the sale of a home, are also reported.
When you invest in financial assets, such as stocks, bonds, mutual funds, property, or equipment, be sure to keep good records by noting the date when you bought them and the original price. These records establish the cost basis of your investments, which is used to calculate your gain or loss when you sell them.
Rental and Royalty Income; Income from Partnerships and Trusts
Rental or royalty income is income earned from renting an asset, either real property or a creative work such as a book or a song. This can be a primary source of income, although many individuals rely on wages and have some rental or royalty income on the side. Home ownership may be made more affordable, for example, if the second half of a duplex can be rented for extra income. Rental expenses can also be deducted from rental income, which can create a loss from rental activity rather than a gain. Unlike a business, which must become profitable to remain a business for tax purposes, rental activities may generate losses year after year. Such losses are a tax advantage, as they reduce total income. In Canada, any capital gained on a home (house, condominium, or a share in a co-operative housing corporation) is tax exempt as long as it is your primary residence. The revenue sale of a rental home is subject to capital gains tax.
Partnerships are alternative business structures for a business with more than one owner. For example, partnerships are commonly used by professional practices, such as accounting firms, law firms, medical practices, and the like, as well as by family businesses.
The partnership is not a taxable entity, but the share of its profits distributed to each owner is taxable income for the owner and must be declared.
Other Taxable and Non-Taxable Income
Other taxable income includes spousal support, retirement fund distributions from pension plans and RRSPs, as well as payments from government plans such as the Canada Pension Plan, Employment Insurance, or Old Age Security.
According to the CRA, income that is not taxed by the Canadian government and does not have to be reported as income includes the following:
• any GST/HST credit, Canada child benefit, or Canada child tax benefit payments, including those from related provincial and territorial programs;
• child assistance payments and the supplement for handicapped children paid by the province of Quebec;
• compensation received from a province or territory if you were a victim of a criminal act or a motor vehicle accident;
• most lottery winnings;
• most gifts and inheritances;
• amounts paid by Canada or an ally (if the amount is not taxable in that country) for disability or death due to war service;
• most amounts received from a life insurance policy following someone’s death;
• most payments of the type commonly referred to as strike pay you received from your union, even if you perform picketing duties as a requirement of membership;
• elementary and secondary school scholarships and bursaries;
• post-secondary school scholarships, fellowships, and bursaries are not taxable if you received them in 2016 for your enrollment in a program that entitles you to claim the full-time education amount in 2015 or 2016, or if you will be considered a full-time qualifying student for 2017. (CRA, 2018)
Note, however, that income earned on any of the above amounts (such as interest you earn when you invest lottery winnings) is taxable.
Any amount contributed to a Tax-Free Savings Account (TSFA) as well as any income earned in the TSFA (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn. For more information, see RC4466 Tax-Free Savings Account (TFSA), Guide for Individuals (CRA, 2018).
More information on completing your tax return can be found on the Canada Revenue Agency website.
Deductions and Credits
Deductions are tax breaks created by government that allow individuals to reduce their overall taxable income by deducting certain expenditures.
Other deductions involve financial choices that the government encourages by providing an extra incentive in the form of a tax break. For example, one can deduct investment interest on borrowed money for the purpose of earning income from a business or property; this deduction is meant to encourage investment.
Deductions are also created for expenditures that may be considered nondiscretionary, such as court-ordered child support, spousal support, or medical expenses that you are required to pay. You have to read the instructions carefully in order to know what expenditures qualify as deductions. The following list provides examples of common deductions permitted in the calculation of net income:
• Contributions to deferred income plans such as registered pension plans, individual pension plans, and RRSPs are deductible. Income from these plans is taxed later down the road when withdrawals are made. Contributions to a tax-free savings account or a registered education savings plan (RESP) are not tax-deductible.
• Union and profession dues
• Child-care expenses
• Disability supports
• Moving expenses
• Other deductions include deductible business investment losses, spousal and child support payments, interest paid on loans (excluding loans for RRSP and RESP contributions), and employment expenses if, for example, one’s employer requires the employee to pay for travel or other costs of employment.
For a list of medical expenses that are tax-deductible, please visit the CRA webpage Lines 330 and 331 – Eligible medical expenses you can claim on your tax return.
Some deductions require an additional form to calculate specifics, such as unreimbursed employee or job-related expenses and investment interest. Once deductions are subtracted from total income, net income can be determined. Additional deductions and losses from previous years can be carried forward to determine taxable income once net income has been calculated. The final step in determining your taxable income is to factor in tax rates and tax credits.
A tax credit directly reduces the amount of tax you’ll pay versus a deduction which reduces your overall taxable income. A tax credit can be viewed as a deduction from the tax that is owed. Each taxpayer receives the same tax relief with a tax credit no matter the tax bracket one falls into as long as the credit can be used. Credits can be in the form of refundable credits or non-refundable credits. Refundable credits can be fully refunded if used. Even if you don’t owe any tax, you will still receive what is owed through the tax credit. An example of a refundable tax credit is the Working Income Tax Credit which provides tax relief for eligible working low-income individuals and families. In terms of nonrefundable tax credits, all taxpayers can claim a basic non-refundable tax credit, known as the personal amount, which can reduce your tax liability. If any portion from the non-refundable tax credit remains after your taxable income reaches zero, it is automatically forfeited by the taxpayer. Each province and territory also sets a personal amount for provincial or territorial taxes. A tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from his or her taxable income, and reduces the total tax bill of an individual.
Deductions reduce taxable income, while credits reduce taxes owed.
Deductions and credits are some of the more disputed areas of the tax code. Because of the depth of dispute about them, they tend to change more frequently than other areas of the tax code. As a taxpayer, you want to stay alert to changes that may be to your advantage or disadvantage. Usually, such changes are phased in and out gradually so you can include them in your financial planning process. For more information on deductions and credits, visit the Canadian government webpage Deductions, credits, and expenses.
Payments and Refunds
Once you have calculated your tax obligation for the year, you can compare that to any taxes you have paid during the year and calculate the amount still owed or the amount to be refunded to you.
You pay taxes during the tax year by having them withheld from your paycheque if you earn income through wages, or by making quarterly estimated tax payments if you have other kinds of income. When you begin employment, you fill out a form (Form TD1) that determines the taxes to be withheld from your regular pay. You may adjust this amount, within limits, at any time. If you have both wages and other incomes, but your wage income is your primary source of income, you may be able to increase the taxes withheld from your wages to cover the taxes on your other income, and thus avoid having to make estimated payments. However, if your non-wage income is substantial, you will have to make estimated payments to avoid a penalty and/or interest. The self-employed must pay estimated income taxes in quarterly installments based on expected income depending on your earnings. According to the CRA, quarterly income tax installments are required if your net tax owing will be above the threshold for your province or territory and/or if your net tax owing in previous years was above the threshold for your province or territory (CRA, 2017).
The government requires that taxes are withheld or paid quarterly during the tax year because it uses tax revenues to finance its expenditures, so it needs a steady and predictable cash flow. Steady payments also greatly decrease the risk of taxes being uncollectible. Provincial, territorial, and local income taxes must also be paid during the tax year and are similarly withheld from wages or paid quarterly.
If you have paid more during the tax year than your actual obligation, then you are due a refund of the difference. You may have that amount directly deposited to a bank account, or the government will send you a cheque.
If you have paid less during the tax year than your actual obligation, then you will have to pay the difference, and you may have to pay a penalty and/or interest, depending on the size of your payment.
The deadline for filing income tax returns and for paying any necessary amounts is April 30, following the end of the tax year on December 31. If you are self-employed, or the spouse or common-law partner of someone who is, the deadline to file your income tax and benefit return is June 15, although any balance owing is due April 30. You may file to request an extension of that deadline. Should you miss a deadline without filing for an extension, you will owe penalties and interest, even if your actual tax obligation results in a refund. It really pays to get your return in on time.
Key Takeaways
1. The most relevant tax for financial planning is the income tax, as it affects the taxpayer over an entire lifetime.
2. Different kinds of income must be defined and declared on specific income schedules and are subject to tax.
3. Deductions reduce taxable income.
4. Credits reduce tax obligations.
5. Payments are made throughout the tax year through withholdings from wages or quarterly payments.
Exercises
1. Do you have to file a tax return for the current year? Why or why not? (Identify all the factors that apply.) Which tax form(s) should you use?
2. Go to the Government of Canada webpage Income Tax Folio S1-F2-C3, Scholarships, Research Grants and Other Education Assistance to find answers to the following questions:
• Is financial aid for university subject to federal income tax?
• Can federal and provincial or territorial education grants be taxed as income?
• Are student loans taxable?
• When is a scholarship tax exempt?
• Do you have to be in a degree program to qualify for tax exemption?
• Can the amount of a scholarship used for tuition be deducted?
• Can living expenses while on scholarship be deducted?
• Is the income and stipend from a teaching fellowship or research assistantship tax exempt?
REFERENCES
Canada Revenue Agency. (2018). “Amounts that are not taxed.” Retrieved from: https://www.canada.ca/en/revenue-age...hat-taxed.html.
Peace Hills Trust. (2017). “Corporate Profile.” Retrieved from: https://www.peacehills.com/Personal/...porateProfile/.Peace Hills Trust. (n.d.). Peace Hills Trust 35th Anniversary (Brochure).
Ward, S. (2017). “Do You Have to Declare Hobby Income in Canada?” Retrieved from: https://www.thebalance.com/do-you-ha...canada-2947311.
6.3 RECORD KEEPING, PREPARATION, AND FILING
Learning Objectives
1. Identify sources of tax information.
2. Explain the importance of verifiable records and record keeping.
3. Compare sources of tax preparation assistance.
4. Trace the tax review process and its implications.
The CRA is responsible for the collection of tax revenues. To collect revenues, the CRA must inform the public of tax obligations and devise data collection systems that will allow for collection and verification of tax information so that collectible revenues can be verified. In other words, the CRA has to determine how to inform the public and collect taxes while also collecting enough information to be able to check that those taxes are correct.
To inform the public, the CRA has published numerous publications covering various aspects of the tax code. In addition, the CRA provides a website and telephone support to answer questions and assist in preparing tax filings.
By far, most income taxes from wages are collected through withholdings as earned. For most taxpayers, wages represent the primary form of income, and thus most of their tax payments are withheld or paid as wages are earned. Still, everyone has to file to summarize the details of the year’s incomes for the CRA and to calculate the final tax obligation. It is important that everyone file a tax return, even if an individual owes no money. Everyone needs to file a return in order to get, for example, the GST rebate, the Canada child benefit, or Old Age Security. For further information on the benefits of filing a return, see the CRA webpage Do you have to file a return?
Keeping Records
The individual filer must collect and report the information on tax forms and schedules. Fortunately, this is not as difficult as the volume of data would suggest. Employers are required to send Form T4 to each employee at the end of the year, detailing the total wages earned and taxes and contributions withheld. Depending on your tax situation, you may need to refer to other guides, or complete some schedules and other forms that have more detailed information. You can find this information on the webpage Other guides, schedules and forms you may need to complete your income tax and benefit return.
The system for filing tax information has purposeful redundancies. Where possible, information is collected independently from at least two sources so it can be verified. For example, your wage data is collected both from you and from your employer; your interest and dividend incomes are reported by both you and the bank or brokerage that paid them, and so on. Those redundancies, wherever practical, allow for a system of cross-references so that the CRA can check the validity of the data it receives.
Incomes may be summarized and reported to you, but only you know your expenses. Expenditures are important if they are allowed as deductions, such as job-related expenses, and so on, so data should be collected throughout the tax year. If you do nothing more than keep a chequebook, then you will have to go through it and identify the deductible expenses for the tax year. Financial software applications will make that task easier; most allow you to flag deductible expenses in your initial setup.
You should also keep receipts of purchases that may be deductible; credit or debit card statements and bank statements provide convenient backup proof of expenditures. Proof is needed in the event the CRA questions the accuracy of your return.
Tax Preparation and Filing
After you have collected the information you need, you fill out the forms. The tax code is based on the idea that citizens should create revenues for the government based on their ability to pay—and the tax forms follow that logic. Most taxpayers need to complete only a few schedules and forms to supplement their Form T1. Most taxpayers have the same kinds of taxable events, incomes, and deductions year after year, and file the same kinds of schedules and forms.
Many taxpayers prefer to consult a professional tax preparer. Professional help is useful if you have a relatively complicated tax situation: unusual sources of income or expenditures that may be deductible under unusual circumstances. Some taxpayers use a tax preparer simply to protect against making a mistake and having the error, however innocent, prove costly to fix. Fees for tax preparers depend on how complex your return is, the number of forms that need to be completed, and the type of professional you consult.
Professional tax preparers may be lawyers, accountants, personal financial planners, or tax consultants. You may have an ongoing relationship with your tax preparer, who may also be your accountant or financial planner working with you on other financial decisions. Or you may consult a tax preparer simply on tax issues. You may want your tax preparer to fill out and file the forms for you, or you may be looking for advice about future financial decisions that have tax consequences. Tax preparers may be independent practitioners who work during tax season, or employees of a national chain that provide year-round tax services.
There is no standard certification to be a professional tax preparer. A chartered public accountant (CPA) has specific training and experience in accounting. When looking for a tax preparer, your lawyer, accountant, or financial planner may be appropriate, or they may be able to make a recommendation. If your information is fairly straightforward, you may minimize costs by using a preparer who simply does taxes. If your situation involves more complications—especially involving other entities such as businesses or trusts, or unusual circumstances such as a gain—you may want to consult a professional with a range of expertise, such as an accountant or a lawyer who specializes in taxes. Many professionals also offer a “guarantee” that they will also help you if the information on your return is later questioned by the CRA.
Whether you prepare your tax return by yourself or with a professional, it is you who must sign the return and assume responsibility for its details. You should be sure to review your return with your tax preparer so that you understand and can explain any of the information found on it. You should question anything that you cannot understand or that seems contrary to your original information. You should also know your tax return because understanding how and why tax obligations are created or avoided can help you plan for tax consequences in future financial decisions.
You may choose to prepare the return yourself using a tax preparation software application. There are many available, and several are compatible with personal financial software applications, enabling you to download or transfer data from your financial software directly into the tax software. Software applications are usually designed as a series of questions that guide you through Form T1 and the supplemental schedules, filling in the data from your answers. Once you have been through the “questionnaire,” it tells you the forms it has completed for you, and you can simply print them out to submit by mail or “e-file” them directly to the CRA. Most programs also allow you to enter data into the individual forms directly.
Many tax preparation software packages are reviewed in the business press or online. Some popular programs are listed on thebalance.com website in the article “Top Canadian Tax Software Programs.”
Software can be useful in that it automatically calculates unusual circumstances, limitations, or exceptions to rules using your complete data. Some programs even prompt you for additional information based on the data you submit. Overlooking exceptions is a common error that software programs can help you avoid. The programs have all the forms and schedules, but if you choose to file hard-copy versions, you can download them directly from the CRA website, or you can call the CRA and request that they be sent to you. Once your return is completed, you must file it with the CRA, either by mail or by e-file, which has become increasingly popular.
Following Up
After you file your tax return it will be processed and reviewed by the CRA. If you are owed a refund, it will be sent; if you paid a payment, it will be deposited. The CRA reviews returns for accuracy, based on redundant reporting and its “sense” of your data. For example, the CRA may investigate any discrepancies between the wages you report and the wages your employer reports. As another example, if your total wages are \$23,000 and you show a charitable contribution of \$20,000, that contribution seems too high for your income—although there may be an explanation.
The CRA may follow up by mail or by a personal interview. It may just ask for verification of one or two items, or it may conduct a full audit—a thorough financial investigation of your return. In any case, you will be asked to produce records or receipts that will verify your reported data. Therefore, it is important to save a copy of your return and the records and receipts that you used to prepare it. The CRA recommends saving your tax data for six years in case the CRA decides to review your tax returns and/or audit your small business. The best protection against a possible audit is to have verification—a receipt or a bill or a cancelled cheque—for all the incomes and expenses that you report.
If you have a personal interview, your tax preparer may accompany you to help explain and verify your return. Ultimately, however, you are responsible for it. If you have made errors, and if those errors result in a larger tax obligation (if you owe more), you may have to pay penalties and interest in addition to the tax you owe. You may be able to negotiate a payment schedule with the CRA.
The CRA randomly chooses a certain number of returns each year for review and possible audit even where no discrepancies or unusual items are noticed. The threat of a random audit may deter taxpayers from cheating or taking shortcuts on their tax returns. Computerized record keeping has made it easier for both taxpayers and the CRA to collect, report, and verify tax data.
Filing Strategies
Most citizens recognize the need to contribute to the government’s revenues but want to avoid paying more than they need to. Tax avoidance is the practice of ensuring that you have no excess tax obligations. Strategies for minimizing or avoiding tax obligations are perfectly legal. However, tax evasion—fraudulently reporting tax obligations, for example, by understating incomes and gains or overstating expenses and losses—is illegal.
Timing can affect the value of taxable incomes. If you anticipate a significant increase in income—and therefore in your tax rate—in the next tax year, you may try to defer a deductible expense. Likewise, if you anticipate a decrease in income that will decrease your tax rate, you may want to defer receipt of income until the next year, when it will be taxed at a lower rate. In addition, some kinds of incomes are taxed at different rates than others, so how your income is created may have a bearing on how much tax it creates. The definition of expenses and the way you claim them can affect the tax one saves. For example, suppose you are a high school Cree or French teacher. You also tutor students privately. You buy Cree or French books to improve your own language skills and to keep current with the published literature. Are the costs of those books an unreimbursed employee expense related to your job as a teacher? Or are they an expense of your private tutoring business? They may be both, but you can only claim the expense once or in one place on your tax return.
Key Takeaways
1. Information about the tax code is available from the CRA.
2. Verifiable records must be kept for all taxable incomes and expenses or other taxable events and activities.
3. Professional tax assistance and tax preparation software are readily available.
4. The CRA reviews tax returns for errors and may follow up through an informal or formal audit process.
5. Tax avoidance is the legal practice of minimizing tax obligations.
6. Tax evasion is the illegal process of fraudulently presenting information used in calculating tax obligations.
7. Tax-avoidance strategies can involve the timing of incomes and/or expenses to take advantage of changing tax circumstances.
Exercises
1. Gather a current sample of the kind of records you will use to calculate your tax liability this year and to verify your tax return. List each type of record and identify exactly what information it will give you, your tax preparer, and the CRA about your tax situation. What additional records will you need that are not yet in your possession?
2. Use your spreadsheet program, or download a free one, to develop a document showing monthly cash flows for income and expenses to date for which you have written records. If you continue to develop this document for the remaining months, how will it help you prepare your tax returns?
3. Research how you can reduce your tax liability and/or avoid paying taxes when you file this year. Work with classmates to develop a tip sheet for students on tax avoidance.
6.4 TAXES AND FINANCIAL PLANNING
Learning Objectives
1. Trace the tax effects of life stages and life changes.
2. Identify goals and strategies that provide tax advantages.
3. Identify tax advantages that may be useful in pursuing your goals.
4. Discuss the relationship of tax considerations to financial planning.
You may anticipate significant changes in income or expenses based on a change of job or career, or a change of life stage or lifestyle. Not only may the amounts of income or expenses change, but the kinds of incomes or expenses may change as well. Planning for those changes in relation to tax obligations is part of personal financial planning.
Tax Strategies and Life Stages
Tax obligations change more broadly as your stage of life changes. Although everyone is different, there is a typical pattern to aging, earning, and taxes, as shown in the following table.
Table 6.4.1 Life Stages and Tax Implications
Young
Adulthood
Middle
Adulthood
Older
Adulthood
Retirement
Source of Income Wages
Wages/
Investments
Wages/
Investments
Investments
Asset Base None/Low Accumulating Growing Depleting
Taxable Income Low Higher Highest Lower
Deductions, Credits Low Higher High Low
In young adulthood, you rely on income from wages, and you usually have yet to acquire an asset base, so you have little income from interest, dividends, or capital gains. Your family structure does not include dependents, so you have few deductions but also low taxable income.
As you progress in your career, you can expect wages, expenses, and dependents to increase. You are building an asset base by buying a home, possibly saving for your children’s education, or saving for retirement. Because those are the kinds of assets encouraged by the government, they not only build wealth, but also create tax advantages—for example, an RRSP or an RESP.
In older adulthood, you may begin to build an asset base that can no longer provide those tax advantages that are limited or may create taxable income such as interest, dividends, or rental income. In retirement, most people can anticipate a significant decrease in income from wages and a significant increase in reliance on incomes from investments, such as interest, dividends, and gains. Some of those assets may be retirement savings accounts, such as an RRSP, that created tax advantages while growing, but will create tax obligations as income is drawn from them.
Generally, you can expect your income to increase during the middle years of adult life, but that is when many people typically have dependents and deductions such as job-related expenses to offset increased tax obligations. As you age, and especially when you retire, you can expect less income and also fewer deductions.
The bigger picture is that at the stages of your life when income is increasing, so are your deductions and tax credits, which tend to decrease as your income decreases. Although your incomes change over your lifetime, your tax obligations change proportionally, so they remain relative to your ability to pay.
The tax consequences of such changes should be anticipated and considered as you evaluate choices for financial strategies. Because the tax code is a matter of law it does change, but because it is also a matter of politics, it changes slowly and only after much public discussion. You can usually be aware of any tax code changes far enough in advance to incorporate them into your planning.
Tax Strategies and Personal Financial Planning
Tax advantages are sometimes created for personal financial strategies as a way of encouraging certain personal goals. In Canada, for example, home ownership, retirement savings, and education are seen as personal goals that benefit society as well as the individual. In most cases, tax advantages are created to encourage progress toward those goals.
Retirement saving is encouraged, so some savings plans such as a registered retirement savings plan (RRSP) or a registered pension plan (RPP) create tax advantages. For example, an RPP is a pension plan that has been set up by your employer, and registered by the CRA, in order to provide you with a pension upon retirement. You can deduct the total of your RPP contributions to reduce your taxable income. Income from this plan will be taxed at a later date.
There are also retirement savings strategies that do not create tax advantages, such as saving outside of a tax-advantaged account. A tax-free savings account (TFSA) is a flexible investment account that can help you meet both your short- and long-term goals. Your investment income in a TFSA—interest, dividends, or capital gains—is not taxed, even when withdrawn. This tax-free compound growth means that your money grows more quickly inside a TFSA than in a taxable account. In addition to the investment income earned, any amount contributed to the TFSA is not taxed when it is withdrawn. However, initial contributions to a TFSA are not deductible for income tax purposes. The following are important facts about contributions to your TFSA:
• The current contribution limit is \$5,500 per year; contributions to your RRSP/RPP do not limit your TFSA contribution.
• Any unused room can be carried forward.
• You can contribute up to your TFSA contribution limit. A tax applies to all contributions exceeding your TFSA contribution limit.
• Withdrawals will be added to your TFSA contribution room at the beginning of the following year.
• You can replace the amount of the withdrawal in the same year only if you have available TFSA contribution room.
• Direct transfers must be completed by your financial institution. (Government of Canada, 2016)
A registered education savings plan (RESP) is an education savings account registered with the Government of Canada. It is an investment vehicle used by parents to save for their children’s post-secondary education in Canada. The key advantage of an RESP is the access it provides to the Canada Education Savings Grant (CESG) no matter what your family income. This grant is 20 per cent of any eligible contributions in an RESP account; the maximum annual grant by the government is \$500. There are currently no annual contribution limits; however, you can receive the grant only on the first \$2,500 in contributions per year, and the lifetime contribution limit is \$50,000 (Government of Canada, 2017).
Although contributions are not tax-deductible, all investment income generated in the RESP is tax-free as long as it remains in the plan (Government of Canada, 2016). Once the recipient withdraws the money from the plan, he or she will be taxed. However, many students have little or no income and therefore the student would pay little to no tax on the withdrawal.
RESPs also provide access to the Canada Learning Bond, which is an important benefit for low-income families. The Canada Learning Bond is money that the Government of Canada deposits into an RESP for Canadian residents born on or after January 1, 2004, in order to help low-income families save for a child’s education after high school. The government deposits can be up to a maximum of \$2,000 and will not affect any other benefits that you or an eligible child receives (Government of Canada, 2018).
Planning Your Strategy
Where you have a choice, it makes sense to use a strategy that will allow you to make progress toward your goal and realize a tax advantage. Your enthusiasm for the tax advantage should not define your goals, however. Taxes affect the value of your alternatives, so recognizing tax implications should inform your choices without defining your goals.
Unanticipated events such as lottery winnings, casualty and theft losses, or medical expenses can also have tax consequences. They are often unusual events (and therefore unanticipated) and may be unfamiliar and financially complicated. In those circumstances, it may be wise to consult an expert.
Your financial plans should reflect your vision for your life. You will want to be aware of tax advantages or disadvantages so that you can make the most tax-advantageous decisions. Like any costs, you want to minimize your tax costs of living and of life events, but tax avoidance is only a means to an end. You should make your life choices for better reasons than avoiding taxes.
Key Takeaways
1. Tax strategies may change as life stages and family structure changes.
2. Some personal finance goals may be pursued in a more or less tax-advantaged way, so you should evaluate the tax effects on your alternatives.
3. Tax strategies are a means to an end—that is, to achieving your personal finance goals with a minimum of cost.
Exercises
1. Review your list of personal financial goals. For each goal, how does the Canadian tax code help or hinder you in achieving it?
2. Investigate tax strategies that would benefit you in your present life stage. What tax strategies would benefit you in your next life stage? Share your findings and strategies with others in your life stage.
REFERENCES
Government of Canada. (2016). “Registered Education Savings Plans (RESPs).” Retrieved from: https://www.canada.ca/en/revenue-age...ans-resps.html.
Government of Canada. (2017). “Information about Registered Education Savings Plans (RESPs). Retrieved from: https://www.canada.ca/en/employment-...resp/info.html
Government of Canada. (2018). “Canada Learning Bond—Overview.” Retrieved from: https://www.canada.ca/en/employment-...ning-bond.html. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/01%3A_Learning_Basic_Skills_Knowledge_and_Context/1.06%3A_Taxes_and_Tax_Planning.txt |
• 2.1: Financial Management
This chapter focuses on financing consumption using current earnings and/or credit, and financing longer-term assets with debt.
• 2.2: Consumer Strategies
This chapter discusses purchasing decisions, starting with recurring consumption, and then goes into detail on the purchase of a car, a more significant and longer-term purchase both in terms of its use and financing.
• 2.3: Buying a Home
This chapter applies the ideas developed in the previous chapter to what, for most people, will be the major purchase: a home. The chapter discusses its role both as a living expense and an investment, as well as the financing and financial consequences of the purchase.
02: Achieving Your Financial Goals
INTRODUCTION
Financial management is about managing the financing for consumption and investment. You have two sources for money: yourself or someone else. You need to decide when to use whose money and how to do so as efficiently as possible so as to maximize benefit and minimize cost. As with all financial decisions, you also need to think about the strategic consequences of your decisions and how they might impact your future.
You can use your own money as a source of financing if your income is at least equal to your living expenses. If it is more, you have a budget surplus that can be saved and used as a source of future financing while earning income at the same time. If your own income is less than the expenses, you have a budget deficit that will require another external source of financing—someone else’s money—that will add an expense. Ideally, you want to avoid the additional expense of borrowing and instead create the additional income from saving. The budgeting techniques discussed in Chapter 5 “Financial Plans: Budgets” are helpful in seeing this picture more clearly.
Your ability to save will vary over your lifetime, as your family structure, age, career choice, and health will change. Those “micro” factors determine your income and expenses and thus your ability to create a budget surplus and your own internal financing. Likewise, your need to use external financing, such as credit or debt, will vary with your income, expenses, and ability to save.
At times, unexpected change can turn a budget surplus into a budget deficit (e.g., a sudden job loss or increased health expenses), and a saver can reluctantly become a borrower. Being able to recognize that change and understand the choices for financing and managing cash flow will help you create better strategies.
Financing can be used to purchase a long-term asset that will generate income, reduce expense, or create a gain in value, and it may be useful when those benefits outweigh the cost of the debt. The benefit of long-term assets is also influenced by personal factors. For example, a house may be more useful, efficient, and valuable when families are larger.
Macroeconomic factors, such as the economic cycle, employment levels, and inflation, should bear on your financing decisions as well. Your incomes and expenses are affected by the economy’s expansion or contraction, especially as it affects your own employment or earning potential. Inflation or deflation, or an expected devaluation or appreciation of the currency, affects interest rates as both lenders and borrowers anticipate using or returning money that has changed in value.
Financial management decisions become more complicated when the personal and macroeconomic factors become part of the decision-making process, but the result is a more realistic evaluation of alternatives and a better strategy that leaves more choices open in the future. Financial management decisions, however, are difficult not because of their complexity, but because the way you finance your assets and expenses (i.e., lifestyle) determines the life that you live.
7.1 YOUR OWN MONEY: CASH
Learning Objectives
1. Identify the cash flows and instruments used to manage income deposits and expense payments.
2. Explain the purpose of cheque balancing.
Most people use a chequing account as their primary means of managing cash flows for daily living. Incomes from wages and perhaps from investments are deposited into this account, and expenses are paid from it. The actual deposit of paycheques and the writing of cheques, however, has been made somewhat obsolete as more cash flow services are provided electronically.
When incoming funds are distributed regularly, such as a paycheque or a government distribution, direct deposit is preferred. For employers and government agencies, it offers a more efficient, timely, and secure method of distributing funds. For the recipient, direct deposit is equally timely and secure, and can allow for a more efficient dispersal of funds to different accounts. For example, you may have some of your paycheque directly deposited to a savings account, while the rest is directly deposited to your chequing account to pay living expenses. Because you never “see” the money that is saved, it never passes through the account that you “use,” so you are less likely to spend it.
Withdrawals or payments have many electronic options. Automatic payments may be scheduled to take care of a periodic payment (i.e., same payee, same amount) such as a mortgage or car payment. They may also be used for periodic expenses of different amounts—for example, utility or telephone expenses. A debit card may be used to directly transfer funds at the time of purchase; money is withdrawn from your account and transferred to the payee’s with one quick swipe at checkout. An ATM (automated teller machine) card offered by a bank allows for convenient access to the cash in your bank accounts through instant cash withdrawals.
The bank clears these transactions as it manages your account, providing statements of your cash activities, usually monthly and online. When you reconcile your record keeping (i.e., your chequebook or software accounts) with the bank’s statement, you are balancing your chequing account. This ensures that your records and the bank’s records are accurate and that your information and account balance are up to date and consistent with the bank’s. Banks do make mistakes, and so do you, so it is important to check and be sure that the bank’s version of events agrees with yours.
Key Takeaways
1. A chequing account is the primary cash flow management tool for most consumers, providing a way to pay for expenses and store cash until it is needed.
2. Balancing your chequebook reconciles your personal records with the bank’s records of your chequing account activity.
Exercises
1. In your personal finance journal, inventory in detail all the vehicles you use for managing your cash flows. Include all your accounts that are mediated through banks and finance companies. Also, list your cards issued by banks, such as debit or ATM cards, and identify any direct deposits and automatic payments that are made through your savings and chequing accounts. How might you further enhance your cash management through the use of banking tools?
2. Does your bank offer online banking services, such as electronic bill payment? View your bank and others online to learn more about Internet banking. What products and services do online branches and banks offer? Do you (or would you) use those products and services? Why or why not? Discuss online banking with classmates. What do they identify as the main benefits and risks of electronic banking?
7.2 YOUR OWN MONEY: SAVINGS
Learning Objectives
1. Identify the markets and institutions used for saving.
2. Compare and contrast the instruments used for saving.
3. Analyze a savings strategy in terms of its liquidity and risk.
When incomes are larger than expenses there is a budget surplus, and that surplus can be saved. You could keep it in your possession and store it for future use, but then you have the burden of protecting it from theft or damage. More important, you create an opportunity cost. Because money trades in markets and liquidity has value, your alternative is to lend that liquidity to someone who wants it more than you do at the moment and is willing to pay for its use. Money sitting idle is an opportunity cost.
The price that you can get for your money has to do with supply and demand for liquidity in the market, which in turn has to do with a host of other macroeconomic factors. It also has a lot to do with time, opportunity cost, and risk. If you are willing to lend your liquidity for a long time, then the borrower has more possible uses for it, and increased mobility increases its value. However, while the borrower has more opportunity, you (the seller) have more opportunity cost because you give up more choices over a longer period of time. That also creates more risk for you, since more can happen over a longer period of time. The longer you lend your liquidity, the more compensation you need for your increased opportunity cost and risk.
Savings Markets
The markets for liquidity are referred to as the money markets and the capital markets. The money markets are used for relatively short-term, low-risk trading of money, whereas the capital markets are used for relatively long-term, higher-risk trading of money. The different time horizons and risk tolerances of the buyers, and especially the sellers, in each market create different ways of trading or packaging liquidity.
When individuals are saving or investing for a long-term goal (e.g., education or retirement), they are more likely to use the capital markets; their longer time horizon allows for greater use of risk to earn return. Saving to finance consumption relies more on trading liquidity in the money markets because there is usually a shorter horizon for the use of the money. Also, most individuals are less willing to assume opportunity costs and risks when it comes to consumption, thus limiting the time that they are willing to lend liquidity.
When you save, you are the seller or lender of liquidity. When you use someone else’s money or when you borrow, you are the buyer of liquidity.
Savings Institutions
For most individuals, access to the money markets is done through a bank. A bank functions as an intermediary or “middleman” between the individual lender of money (the saver) and the individual borrower of money.
For the saver or lender, the bank can offer the convenience of finding and screening the borrowers, and of managing the loan repayments. Most important, a bank can guarantee the lender a return: the bank assumes the risk of lending. For the borrowers, the bank can create a steady supply of surplus money for loans (from the lenders), and arrange standard loan terms for the borrowers.
Banks create other advantages for both lenders and borrowers. Intermediation allows for the amounts loaned or borrowed to be flexible and for the maturity of the loans to vary. That is, you don’t have to lend exactly the amount someone wants to borrow for exactly the time she or he wants to borrow it. The bank can “disconnect” the lender and borrower, creating that flexibility. By having many lenders and many borrowers, the bank diversifies the supply of and demand for money, and thus lowers the overall risk in the money market.
The bank can also develop expertise in screening borrowers to minimize risk and in managing and collecting the loan payments. In turn, that reduced risk allows the bank to attract lenders and diversify supply. Through diversification and expertise, banks ultimately lower the cost of lending and borrowing liquidity. Since they create value in the market (by lowering costs), banks remain as intermediaries or middlemen in the money markets.
In Canada, there are currently five banks and the National Bank of Canada, often referred as the Big Six, which account for more than 90 per cent of the total banking assets in Canada. The National Bank of Canada is headquartered in Montreal, Quebec, and the five banks are headquartered in Toronto, Ontario. The five banks are classified as Schedule I domestic banks, which are banks that are Canadian-owned and have no more than 10 per cent of voting shares controlled by a single interest. These banks are: Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Scotiabank, and Toronto-Dominion.
Unlike the United States, which has hundreds of banks—some with only a few branches—Canada has a much smaller number of banks, many with hundreds of branches throughout the country. Schedule II banks may be domestically owned or foreign-controlled and do not meet the 10 per cent limit (Ebert, Griffin, Starke, and Dracopoulos, 2017). Schedule III banks are branches of foreign institutions that are authorized under the Bank Act to do banking in Canada. These foreign institutions are subject to certain restrictions that Schedule I and II banks are not subject to. Bank of America and Capital One are examples of such institutions.
Credit unions, or caisses populaires, function similarly, but are co-operative membership organizations, with depositors as members. Credit unions also tend to be more community-oriented in their overall mission. For example, Conexus Credit Union promotes financial well-being, its key priority, through its Community Investment Program. In partnership with non-profit and charitable organizations, credit unions support financial literacy education programs, capital projects, and programs that address basic human needs with regard to education, food, shelter, and health services. Another difference between banks and credit unions is that banks are federally regulated, while credit unions are regulated by the provinces or territories.
In addition to banks, other kinds of intermediaries for savers include pension funds, life insurance companies, and investment funds. They focus on saving for a particular long-term goal. To finance consumption, however, most individuals primarily use banks or credit unions.
Some intermediaries have moved away from the “bricks-and-mortar” branch model and now operate as online banks, either entirely or in part. There are cost advantages for the bank if it can use online technologies in processing saving and lending. Those cost savings can be passed along to savers in the form of higher returns on savings accounts or lower service fees. Most banks offer online and, increasingly, mobile account access via cell phone or smartphone. Intermediaries operating as finance companies offer similar services.
The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown corporation of the Government of Canada that protects eligible deposits at each of its member financial institutions up to a maximum of \$100,000 (principal and interest combined) per depositor per insured category in case of a failure. There is no need to apply for this insurance or file a claim; coverage is free and automatic as long as deposits are paid in Canada and in Canadian currency. The CDIC does not cover foreign currency deposits, including U.S. dollars. If deposits are made at a branch or office of a CDIC member institution in Canada, that institution is eligible for CDIC coverage (CDIC, 2018a). Similar protection is provided to customers of credit unions. A provincial deposit insurer is present in each of Canada’s ten provinces and protects provincial credit unions; these provincial deposit insurers can be found on the CDIC website on the webpage Provincial deposit insurers. Currently, there is no credit union legislation in place in the Yukon, Northwest Territories, and Nunavut.
Eligible deposits covered by the CDIC include:
• Savings accounts,
• Chequing accounts,
• Term deposits (such as GICs) with original terms to maturity of five years or less,
• Debentures issued to evidence deposits by CDIC member institutions (other than banks),
• Money orders and bank drafts issued by CDIC members,
• Cheques certified by CDIC members. (CDIC, 2018b)
Member institutions include banks, federally regulated credit unions, as well as loan and trust companies and associations governed by the Cooperative Credit Associations Act. The CDIC is funded by premiums paid by its member institutions and does not receive public funds to operate (CDIC, 2018c).
The above-mentioned institutions are examples of deposit-type institutions.
The following are examples of non-depository institutions that also provide a variety of financial services: life insurance companies, investment companies, mortgage and loan companies, pawnshops, and cheque-cashing outlets (Kapoor et al., 2015).
Non-depository institutions provide non-depository credit, such as real estate credit, international trade financing, short-term inventory credit and loans, working capital credit, and agricultural credit and loans. Essentially, they make direct loans or extend credit through funds from sources other than deposits from the public.
Cheque-cashing centres are examples of a non-depository financial institution that offer financial services that are often utilized by those who are unable to open up accounts at depository institutions, largely because of their past financial history, those who wish to take advantage of their extended business hours, and those who wish to have immediate access to their funds. Some are critical of these centres because of the fees associated with them. Many centres charge an average fee of 3 to 5 per cent of the cheque amount. Long term, the fees charged by these centres are generally far more expensive than a traditional chequing account at a depository institution.
A pawnshop is an example of a non-depository institution that offers loans in exchange for personal property as a form of collateral. The personal property may be repurchased if the loan is repaid in an agreed-upon time frame at its initial price plus interest. The personal property “may be liquidated by the pawn shop through a pawnbroker or second-hand dealer through sales to customers” (BusinessDictionary, 2018).
Indigenous Financial Institutions
Historically, Indigenous communities and businesses in Canada have had a lack of access to debt financing due to a number of issues such as limited collateral, the challenge of using on-reserve assets as collateral, and a lack of local financial institutions. Equity financing has also been hampered by limited personal resources, a lack of access to venture capital and community funds, and the inability of family and friends to invest (Cooper, 2016). According to Cooper (2016), “perceived risk underlies most of these issues. In many cases this perception is shaped by a lack of accurate information about the governance and fiscal capacity of Aboriginal communities. . . . As a result, Aboriginal individuals and communities in Canada have been placed at a disadvantage to the rest of Canadian society” (pp. 163–164).
Instead of selling bonds or other large loans to capital markets, “Aboriginal entrepreneurs, businesses and governments rely more on financial institutions, such as banks, credit unions, and other structures to access capital” (Cooper, 2016, p. 165). Therefore, Indigenous financial institutions, banks, and credit unions play a critical role in closing the gap that has existed between Indigenous and mainstream communities with regard to access to capital. Many mainstream financial institutions and government initiatives, such as Aboriginal Business Canada, have also attempted to close the “capital gap” in recent years.
Below are some examples of Indigenous financial institutions that have been established in order to assist Indigenous communities, entrepreneurs, and governments in accessing capital.
First Nations Bank of Canada got its start with the Saskatchewan Indian Equity Foundation (SIEF). SIEF was established as an Aboriginal capital corporation in the mid-1980s. During the early 1990s, the settlement of land claims under the Treaty Land Entitlement Framework Agreement (TLEFA) in Saskatchewan was taking place. Many banks began to show an interest in working with First Nations to manage their money because of these land claims. Seeing an opportunity, a proposal was submitted by SIEF to the Federation of Saskatchewan Indian Nations (FSIN)—now called the Federation of Sovereign Indigenous Nations—to create the First Nations Bank of Canada (Schneider, 2009).
In 1996, SIEF, the FSIN, and Toronto-Dominion (TD) launched the First Nations Bank of Canada (Cooper, 2016). The founders of First Nations Bank (FNB) had a vision to develop a federally chartered bank serving Indigenous and non-Indigenous people, corporations, and governments throughout Canada. The bank offers these customers a full range of personal and business banking services, including loans, mortgages, investments (registered and non-registered), transaction accounts, and cash management. The bank is primarily focused on providing financial services to the Indigenous marketplace in Canada and “sees itself as an important step toward Aboriginal self-sufficiency” (FNB, 2017a). Over 80 per cent of FNB is Indigenous owned and controlled; the bank now operates separately from TD (FNB, 2017b).
FNB is both an approved member of the CDIC and the Canadian Payments Association, and it is an approved mortgage lender with Canada Mortgage and Housing Corporation as well as the First Nations Market Housing Fund (FNB, 2017b). The bank is headquartered in Saskatoon, Saskatchewan.
Caisse Populaire Kahnawake and Me-Dian Credit Union are two examples of Indigenous credit unions in Canada. Caisse Populaire Kahnawake is located on reserve, twenty kilometres from Montreal. Kahnawake chose to open the credit union in the mid-1980s in order to develop their own source of capital for economic development purposes instead of being reliant on outside government (Cooper, 2016). Me-Dian was first established in 1978 as the Métis Credit Union of Manitoba, Canada’s first Indigenous credit union and first Indigenous full-service financial institution, and later changed its name to the Me-Dian Credit Union to include the entire Indigenous population; non-Indigenous people were welcomed as associate members in 2009 (Me-Dian Credit Union, 2021).
Aboriginal financial institutions (AFIs) were created in the late 1980s and early 1990s by Indigenous leaders, the Government of Canada, and a Native Economic Development Program initiative in order to address the lack of available capital to finance Indigenous small-business development. Within the last thirty years, over fifty AFIs have been established throughout Canada, resulting in over thirteen thousand full-time equivalent jobs and \$2.3 billion in developmental loans to Canadian Indigenous peoples (NACCA, 2016).
AFIs represent a network of loan corporations in Canada, structured as non-governmental financial institutions, which deliver a variety of Indigenous business and community development products and support services. AFIs offer developmental lending and their products are inclusive of small business loans to Indigenous small businesses engaged in all sectors of the Canadian economy. The National Aboriginal Capital Corporation (NACCA) serves the AFI network by supporting AFI capacity development and Indigenous business development in order to enhance “social and economic self-reliance and sustainability for Indigenous peoples and communities nationwide” (NACCA, 2016, p. 5). AFIs are generally composed of three different institutional structures:
1. Aboriginal Capital Corporations (inclusive of Métis Capital Corporations);
2. Aboriginal Community Future Development Corporations; and
3. Aboriginal Developmental Lenders
For more information on these different types of AFIs, go to the website of the National Aboriginal Capital Corporations Association.
Saving Instruments
Banks offer many different ways to save your money until you use it for consumption. The primary difference among the accounts offered to you is the price that your liquidity earns, or the compensation for your opportunity cost and risk, which in turn depends on the degree of liquidity that you are willing to give up. You give up more liquidity when you agree to commit to a minimum time or amount of money to save or lend.
For the saver, a demand deposit (e.g., chequing account) typically earns no or very low interest but allows complete liquidity on demand. Chequing accounts that do not earn interest are less useful for savings and therefore more useful for cash management. Some chequing accounts do earn some interest, but often require a minimum balance. Time deposits, or savings accounts, offer minimal interest or a bit more interest with minimum deposit requirements.
If you are willing to give up more liquidity, GICs offer a higher price for liquidity, but extract a time commitment enforced by a penalty for early withdrawal if they are considered non-redeemable GICs. Some GICs can be redeemed prior to maturity, but these GICs will offer a lower rate of interest compared to non-redeemable GICs (Kapoor et al., 2015, pp. 129). They are offered for different maturities and some have minimum deposits as well. Banks can also offer investments in money market mutual funds. A money market fund is a “combination savings-investment plan in which the investment company uses your money to purchase a variety of short-term financial instruments” (Kapoor et al., 2015, pp. 123–124). Examples of short-term financial instruments are securities such as stocks and bonds.
Compared to the capital markets, the money markets have very little risk, so money market funds are considered very low-risk investments.
As long as your money remains in your account, including any interest earned while it is there, you earn interest on that money. If you do not withdraw the interest from your account, it is added to your principal balance, and you earn interest on both. This is referred to as earning interest on interest, or compounding. The rate at which your principal compounds is the annual percentage rate (APR) that your account earns.
The rate of return is the yield, namely “the percentage of increase in the value of savings as a result of interest earned” (Kapoor et al., 2015, p. 130). For example, if you invest \$200 and earn 2 per cent annually, you will earn \$4 the first year. You can calculate the eventual value of your account by using the relationships of time and value that we looked at in Chapter 4 “Evaluating Choices: Time, Risk, and Value,” where FV = future value, PV = present value, r = rate, and t = time. The balance in your account today is your present value, PV; the APR is your rate of compounding, r; the time until you will withdraw your funds is t. Your future value depends on the rate at which you can earn a return or the rate of compounding for your present account and can be determined using the following formula:
FV = PV × (1+r)t
If you are depositing a certain amount each month or with each paycheque, that stream of cash flows is an annuity. You can use the annuity relationships discussed in Chapter 4 to project how much the account will be worth at any point in time, given the rate at which it compounds. Many financial calculators can help you make those calculations.
Ideally, you would choose a bank’s savings instrument that offers the highest APR and most frequent compounding. However, interest rates change, and banks with savings plans that offer higher yields often require a minimum deposit, minimum balance, and/or a maintenance fee. Also, your interest from savings is taxable, as it is considered income. As you can imagine, however, with monthly automatic deposits into a savings account with compounding interest, you can see your wealth can grow safely.
Savings Strategies
Your choice of savings instrument should reflect your liquidity needs. In the money markets all such instruments are relatively low risk, so return will be determined by opportunity cost.
You do not want to give up too much liquidity and then risk being caught short, because then you will have to become a borrower to make up that shortfall, which will create additional costs. If you cannot predict your liquidity needs or you know they are immediate, you should choose products that will least restrict your liquidity choices. If your liquidity needs are more predictable or longer term, you can give up liquidity without creating unnecessary risk and can therefore take advantage of products, such as GICs, that will pay a higher price.
Your expectations of interest rates will contribute to your decision to give up liquidity. If you expect interest rates to rise, you will want to invest in shorter-term maturities, so as to regain your liquidity in time to reinvest at higher rates. If you expect interest rates to fall, you would want to invest in longer-term maturities so as to maximize your earnings for as long as possible before having to reinvest at lower rates.
One strategy to maximize liquidity is to diversify your savings in a series of instruments with differing maturities. If you are using GICs, the strategy is called GIC laddering. For example, suppose you have \$12,000 in savings earning 0.50 per cent annually. You have no immediate liquidity needs, but would like to keep \$1,000 easily available for emergencies. If a one-year GIC is offering a 1.5 per cent return, the more savings you put into the GIC, the more return you will earn, but the less liquidity you will have.
A “laddering” strategy allows you to maximize return and liquidity by investing \$1,000 per month by buying a one-year GIC. After twelve months, all your savings are invested in twelve GICs, each earning 1.5 per cent. But because one GIC matures each month, you have \$1,000 worth of liquidity each month. You can keep the strategy going by reinvesting each GIC as it matures. Your choices are shown in Table 7.2.1.
Table 7.2.1 GIC Laddering Strategy
\$ Invested in GICs Liquid Earnings Interest Rate
Savings Strategy 0 12,000 60 0.50%
Savings Strategy 11,000 1,000 165 1.50%
Savings Strategy 12,000 0 180 1.50%
GIC Laddering Strategy 12,000 1,000 180 1.50%
A laddering strategy can also reflect expectations of interest rates. If you believe that interest rates or the earnings on your money will increase, then you don’t want to commit to the currently offered rates for too long. Your laddering strategy may involve a series of relatively short-term (less than one year) instruments. On the other hand, if you expect interest rates to fall, you would want to weight your laddering strategy to longer-term GICs, keeping only your minimum liquidity requirement in the shorter-term GICs.
The laddering strategy is an example of how diversifying maturities can maximize both earnings and liquidity. In order to save at all, however, you have to choose to save income that could otherwise be spent, suffering the opportunity cost of everything that you could have had instead. Saving is delayed spending, often seen as a process of self-denial.
One saving strategy is to create regular deposits into a separate account such that you might have a chequing account from which you pay living expenses and a savings account in which you save.
This is easier with direct deposit of wages since you can have a portion of your disposable income go directly into your savings account. Saving becomes effortless, while spending actually requires a more conscious effort.
Some savings accounts need to be “segregated” because of different tax consequences—a retirement or education account, for example. In most cases, however, separating accounts by their intended use has no real financial value, although it can create a psychological benefit. Establishing a savings vehicle has a very low cost, if any, so it is easy to establish as many separate funds for saving as you find useful.
Key Takeaways
1. Banks serve to provide the consumer with excess cash by having their cash earn money through savings until the consumer needs it.
2. Banking institutions include retail, commercial, and investments banks.
3. Consumers use retail institutions, including the following:
• savings banks,
• mutual savings banks,
• Aboriginal financial institutions, and
• credit unions.
4. Savings instruments include the following:
• demand deposit accounts,
• time deposit accounts,
• guaranteed income certificates, and
• money market fund accounts.
5. A savings strategy can maximize your earnings from savings.
Exercises
1. What are the benefits and drawbacks of guaranteed income certificates and money market funds for saving? Compared to savings accounts, what are their implications for liquidity and risk? What are their implications for cost and return? What advice would you give to someone who saved by keeping money in a piggy bank?
2. You have \$10,000 to deposit. You want to save it, earning interest by loaning its use in the money market to your bank. You anticipate you will need to replace your washing machine within the year, however, so you don’t want to surrender all your liquidity all at once. What is the best way to save your money that will give you the greatest increase in wealth without too much risk and while still retaining some liquidity? Explain your reasons for your choice of a solution.
3. What Aboriginal financial institutions are located within your province or territory or are closest to where you live? Pick one and identify what banking services they offer.
4. Go online to experiment with compound interest calculators (for example, at moneychimp.com or WebMath.com). Use real numbers based on your actual or projected savings. For example, based on what you have in savings now, how much could you have in five years? To see the effects of compounding, compare your results with the same calculation for simple interest (rather than compounded interest), using the simple interest calculator at WebMath.com.
REFERENCES
BusinessDictionary. (2018). “Pawn Shop.” Retrieved from: http://www.businessdictionary.com/de...pawn-shop.html.
Canadian Credit Union Association. (2017). “2017 Credit Union Community and Economic Impact Report.” Retrieved from: https://www.ccua.com/~/media/CCUA/me...R_FF.PDF?la=en.
Canadian Deposit Insurance Corporation. (2018a). “About Deposit Insurance.” Retrieved from: http://www.cdic.ca/en/about-di/Pages/default.aspx.
Canadian Deposit Insurance Corporation. (2018b). “What We Cover.” Retrieved from: http://www.cdic.ca/en/about-di/what-...s/default.aspx.
Canadian Deposit Insurance Corporation. (2018c). “About Us.” Retrieved from: http://www.cdic.ca/en/about-cdic/Pages/default.aspx.
Cooper, T. (2016). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp. 161–176. Sydney, NS: Cape Breton University Press.
Ebert, R. J., R. W. Griffin, F. A. Starke, G. Dracopoulos. (2017). Business Essentials (8th Ed.). Toronto: Pearson Canada.
First Nations Bank of Canada. (2017a). “Who We Are: FNBC at A Glance.” Retrieved from: https://www.fnbc.ca/AboutUs/WhoWeAre/FNBCataGlance/.
First Nations Bank of Canada. (2017b). “Who We Are.” Retrieved from: https://www.fnbc.ca/AboutUs/WhoWeAre/.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
National Aboriginal Capital Corporation Association. (2016). “NACCA Annual Report 2015-16.” Retrieved from: https://nacca.ca/wp-content/uploads/...Report-WEB.pdf.
Schneider, B. (2009). Reclaiming economic sovereignty: Native and Aboriginal financial institutions (unpublished PhD diss.). University of California, Davis.
7.3 OTHER PEOPLE’S MONEY: CREDIT
Learning Objectives
1. Identify the different kinds of credit used to finance expenses.
2. Analyze the costs of credit and their relationships to risk and liquidity.
3. Describe the credit rating process and identify its criteria.
4. Identify common features of a credit card.
5. Discuss remedies for credit card trouble.
6. Summarize government’s role in protecting lenders and borrowers.
The term “credit” derives from the Latin verb credere (to believe). It has several meanings as a verb in common usage—to recognize with respect, to acknowledge a contribution—but in finance, it generally means to allow delayed payment. According to Kapoor et al. (2015), credit is defined as “an arrangement to receive cash, goods, or services now and pay for them in the future” (p. 144).
Credit is not a new concept among Indigenous peoples in Canada. Trading posts, in what is present-day Canada, were largely established by the Hudson’s Bay Company in the late 1600s and throughout the 1700s and 1800s.
According to the Encyclopedia of Saskatchewan, Indigenous families would gather at trading posts in the fall, expecting the arrival of traders from the east with new stocks of goods. Indigenous families would obtain many of their supplies on credit and would then depart for their wintering grounds. These families would usually not return until the spring. It was at this time that they would bring winter furs to pay off their debts from the previous fall and would trade any remaining merchandise for other goods (Russell, 2006). Credit was used as a tool by Indigenous people in Canada to help meet their needs when cash wasn’t always on hand.
As pointed out by Oweesta and First Nations Development Institute, traditional resource management teaches us that our actions today affect the resources that we will have available in the future. For example, “hunting practices demonstrated an understanding of the costs and benefits of working within the natural cycle. The benefit of fresh meat year-round did not justify the cost” (FNOC and FNDI, 2016, p. 74).
When it comes to credit, traditional resource management also teaches us that we must not overextend ourselves and purchase goods that we are not able to repay in “the spring” (FNOC and FNDI, 2016, p. 74). Credit might provide us the benefit of fresh meat (i.e., various non-necessities and luxury items) all year long, but it is not worth the excessive interest payments that will arise if you don’t have the resources to pay off those interest charges on a monthly basis.
Kinds of Credit
Credit is issued either as installment credit or as revolving credit. Installment credit is a form of credit used to purchase consumer durables, usually issued by one vendor, such as a department store, for a specific purchase. The vendor screens the applicant and extends credit, bearing the default risk, or risk of nonpayment. Payments are made until that amount is paid for. Payments include a portion of the cost of the purchase and the cost of the credit itself, or interest.
Installment credit is an older form of credit that became popular for the purchase of consumer durables (i.e., furniture, appliances, electronics, or household items) after the First World War. This form of credit expanded as mass production and invention made consumer durables such as radios and refrigerators widely available. (Longer-term installment purchases for bigger-ticket assets, such as a car or property, are considered debt.)
Revolving credit extends the ability to delay payment for different items from different vendors up to a certain limit. Such credit is lent by a bank or finance company, typically through a charge card or a credit card. The charge card balance must be paid in full in each period or credit cycle, while the credit card balance may not be, requiring only a minimum payment.
While both the charge card and many credit cards operate on a line of unsecured credit that has been extended to you by the card’s issuer and both assess similar fees, such as annual fees, late fees, or foreign transaction fees, there are two key distinctions.
First, credit cards typically have a pre-set spending limit while charge cards do not, which allows charge card holders to put all their expenses on one card and take advantage of rewards points if these are offered on the card.
The other important difference (mentioned above) is that charge cards require customers to pay in full every month or face a fee, which can be as high as 30 per cent of the balance. However, paying interest on your balance is not required.
A charge card tends to be a good choice for those who travel frequently or have a lot of regular expenses for business. The card holder benefits from a much higher spending limit than a traditional credit card (Engen, 2013).
It is important to note that some credit cards are secured. For some consumers, this might be their only choice.
The credit card is a more recent form of credit, as its use became widely practical only with the development of computing technology. The first charge card was the Diners’ Club card, issued in 1950. The first credit card was the Bank Americard (now called Visa), issued by Bank of America in 1958, which was later followed by MasterCard in 1966. Retailers can also issue revolving credit (e.g., a store account or credit card) to encourage purchases.
Credit cards are used for convenience and security. Merchants around the world accept credit cards as a method of payment because the issuer (the bank or finance company) has assumed the default risk by guaranteeing merchants’ payment. Use of a credit card abroad also allows consumers to incur less transaction cost.
This universal acceptance allows a consumer to rely less on cash, so consumers can carry less cash, which is therefore less likely to be lost or stolen. Credit card payments also create a record of purchases, which is convenient for later record keeping. When banks and finance companies compete to issue credit, they often offer gifts or rewards to encourage purchases. In some situations, such as when it comes to purchasing airline tickets or hotel reservations, it’s difficult to complete the transaction without a credit card.
Credit cards create security against cash theft, but they also create opportunities for credit fraud and even for identity theft. A lost or stolen credit card can be used to extend credit to a fraudulent purchaser. It can also provide personal information that can then be used to assume your financial identity, usually without your knowing it. You should therefore, handle your credit cards carefully and be aware of publicized fraud alerts. Failure to do so may leave you responsible for purchases you did not make—or enjoy. Currently, there are a number of bank apps that can be utilized to review your credit card transactions in real time in order to ensure against cash theft or credit fraud, such as the TD MySpend app. Look to see if your bank has such an app.
Costs of Credit
Credit has become a part of modern transactions, largely enabled by technology, and a matter of convenience and security. It is easy to forget that credit is a form of borrowing and thus has costs. Understanding those costs helps you manage them.
Because consumer credit is all relatively short term, its cost is driven more by risk than by opportunity cost—that is, the risk of default or the risk that you will fail to repay the amounts advanced to you. The riskier the borrower, the fewer the sources of credit. The fewer sources of credit available to a borrower, the more credit will cost.
Measuring Risk: Credit Ratings and Reports
How do lenders know who the riskier borrowers are?
Credit rating agencies specialize in evaluating borrowers’ credit risk or default risk for lenders. That evaluation results in a credit score, which lenders use to determine their willingness to lend and their price.
If you have ever applied for consumer credit (a revolving, installment, or personal loan) you have been evaluated and given a credit score. The information you write on your credit application form, such as your name, address, income, and employment, is used to research the factors for calculating your credit score, also known as a FICO (Fair Isaac Corporation) score after the company that developed it.
In Canada, there are currently two major credit rating agencies: Equifax Canada and TransUnion. Each calculates your score a bit differently, but the process is similar. They assign a numerical value to five characteristics of your financial life and then compile a weighted average score. Scores range from 300 to 900; the higher your score, the less risky you appear to be. Although a number of factors can determine credit scores, the following five factors are most heavily weighted when determining your credit score:
1. your payment history,
2. amounts you currently owe,
3. the length of credit history,
4. new credit issued to you, and
5. the types of credit you have received.
The rating agencies give your payment history the most weight, because it indicates your risk of future defaults. Do you pay your debts? How often have you defaulted in the past? CIBC has recently partnered with Fintech Borrowell and Equifax Canada to provide Canadians unlimited free access to their credit score, which will be updated quarterly, through CIBC mobile banking. The purpose of this app is to not only provide clients with access to their credit score, but also to improve their financial well-being and understanding with additional information that is provided on “factors that affect their credit score and advice on how to improve it” (CIBC, 2017).
CIBC recently conducted research that indicates “the majority of Canadians recognize the importance of knowing their credit score to safeguard against fraud, yet more than two-thirds do not know their credit score (69 per cent). Two-in-five (45 per cent) say they have no idea where to obtain their credit score” (CIBC, 2017). The credit available to you is reflected in the amounts you currently owe or the credit limits on your current accounts. These show how dependent you are on credit and whether or not you are able to take on more credit. It is important to keep your credit balance low because the lower your outstanding credit balances, the more points are awarded in terms of your credit score.
The length of your credit history shows how long you have been using credit successfully; the longer you have been doing so, the less risky a borrower you are and the higher your score becomes. Credit rating agencies pay more attention to your more recent credit history and also look at the age and mix of your credit accounts, which show your consistency and diversification as a borrower.
The credit rating process is open to manipulation and misinterpretation. Many people are shocked to discover, for example, that simply cancelling a credit card, even for a dormant or unused account, lowers their credit rating by shortening their credit history and decreasing the diversity of their accounts. Yet it may make sense for a responsible borrower to cancel a card. Credit reports may also contain errors that you should correct by disputing the information.
You should know your credit score. Even if you haven’t applied for new credit, you should check on it annually. Each of the credit rating agencies is required to provide your score once a year for free and to correct any errors that appear—and they do—in a timely way. If you should find an error in your report, you should contact the agency immediately and follow up until the report is corrected.
Beware of any other websites called “annual credit report” as these may be impostors. It is important to review your score regularly to check for those errors. Knowing your score can help you to make financing decisions because it can help you to determine your potential costs of credit. It can also alert you to any credit or identity theft of which you otherwise are unaware.
Please visit the webpage Credit report and score basics on the Government of Canada website for more information.
If you wish to protest your credit score or ask for more information, you can contact the credit reporting agency regarding their dispute resolution process. After an investigation, if you do not agree with an item, you can visit either the TransUnion or Equifax websites for more information on how you can add an explanatory statement to your report.
Identity theft is a growing problem. Financial identity theft occurs when someone poses as you by using your personal information, such as your social insurance, driver’s licence, bank account, or credit card numbers. The impostor uses your identity to either access your existing accounts (withdrawing funds from your chequing account or buying things with your credit card) or establish new accounts in your name.
The best protection is to be careful how you give out public information. Convenience encourages more and more transactions by telephone and Internet, but you still need to be sure of whom you are talking to before giving out identifying data.
As careful as you are, you cannot protect yourself completely. Checking your credit report regularly can therefore flag any unfamiliar or unusual activity carried out in your name. If you suspect that your personal information has been breached, you can ask the credit reporting agencies to issue a fraud alert. Fraud alert messages notify potential credit grantors to verify your identification by contacting you before extending credit in your name in case someone is using your information without your consent. That way, if a thief is using your credit to establish new accounts (or buy a home, a car, or a boat) you will know it. If a stronger measure is needed, you can order a credit freeze that will prevent anyone other than yourself from accessing your credit file.
Using a Credit Card
Credit cards issued by a bank or financing company are the most common form of revolving credit. This often has costs only after a repayment deadline has passed. For example, credit cards offer a grace period between the time of the credit purchase or “charge” and the time of payment, assuming your beginning balance is zero. If you pay before interest is applied, you are using someone else’s money to make your purchases at no additional cost. In that case, you are using the credit simply as a cash management tool.
Credit cards are effective as a cash management tool. They can be safer to use than cash, especially for purchasing pricier items. Payment for many items can be consolidated and made monthly, with the credit card statement providing a detailed record of purchases. If you carry more than one card, you might use them for different purposes. For example, you might use one card for personal purchases and another for work-related expenses. Credit cards also make it convenient to buy on impulse, which may cause problems.
Problems arise if you go beyond using your card as a cash management tool and use it to extend credit or to finance your purchases past the payment deadline. At that point, interest charges begin to accrue. Typically, that interest is expensive—perhaps only a few percentage points per month, but compounding to a large APR.
Credit card APRs today may start with 0 per cent for introductory offers and range from as low as 8.99 per cent (fixed rate) to between 20 to 23 per cent on popular credit cards (Barnea, 2017). These rates may be fixed or variable, but in any case, when you carry a balance from month to month, this high interest is added to what you owe.
As an example, if your credit card charges interest of 1.5 per cent per month, that may not sound like much, but it is an annual percentage rate of 18 per cent (1.5 per cent per month × 12 months per year). To put that in perspective, remember that your savings account is probably earning only around 1 to 3 per cent per year. Consumer credit is thus an expensive way to finance consumption. Consumers tend to rely on their cards when they need things and lack the cash, and this can quickly lead to credit card debt.
Choosing a Credit Card
You should shop around for credit just as you would shop around for anything that you might purchase with it, comparing the features and the costs of each credit card.
Features of the credit include the credit limit (or how much credit will be extended), the grace period, purchase guarantees, liability limits, and consumer rewards. Some cards offer a guarantee for purchases; if you purchase a defective item, you can have the charge “stopped” and removed from your credit card bill. Liability limits involve your responsibilities should your card be lost or stolen.
Consumer rewards may be offered by some credit cards, usually by rewarding “points” for dollars of credit. The points may then be cashed in for various products. Sometimes the credit card is sponsored by a certain retailer and offers rewards redeemable only through that store. A big sponsor of rewards has been the airline industry, commonly offering “frequent flyer miles” through credit cards as well as actual flying. Be aware, however, that many reward offers have limitations or conditions on redemption. In the end, many people never redeem their rewards.
Creditors charge fees for extending credit. There is the APR on your actual credit, which may be a fixed or adjustable rate. It may be adjustable based on the age of your balance—that is, the rate may rise if your balance is over sixty days or ninety days. There may also be a late fee charged in addition to the actual interest. The APR may also adjust as your balance increases, so that even if you stay within your credit limit, you are paying a higher rate of interest on a larger balance.
There are also fees on cash advances and on balance transfers (i.e., having other credit balances transferred to this creditor). These can be higher than the APR and can add a lot to the cost of those services. You should be aware of those costs when making choices. For example, it can be much cheaper to withdraw cash from an ATM using your bank account’s debit card than using a cash advance from your credit card.
Many credit cards charge an annual fee just for having the card, regardless of how much it is used. Many do not, however, and it is worth looking for a card that offers the features that you want with no annual fee.
How you will use the credit card will determine which features are important to you and what costs you will have to pay to get them. If you plan to use the credit card as a cash management tool and pay your balance every month, then you are less concerned with the APR and more concerned about the annual fee, or the cash advance charges. If you sometimes carry a balance, then you are more concerned with the APR.
It is important to understand the costs and responsibilities of using credit—and it is very easy to overlook them.
The Financial Consumer Agency of Canada’s credit card comparison tool helps consumers compare the features of different cards, including interest rates, annual fees, and rewards. Go to the Credit Card Comparison Tool on the Government of Canada’s website to find the card that best suits your needs.
Installment Credit
Retailers also may offer credit, usually as installment credit for a specific purchase, such as a flat screen TV or baby furniture. The cost of that credit can be hard to determine, as the deal is usually offered in terms of “low, low monthly payments of only” or “no interest for the first six months.” To find the actual interest rate you would have to use the relationships of time and value. Ideally, you would pay in as few installments as you could afford and would pay all the installments in the shortest possible time.
Retailers usually offer credit for the same reason they offer home delivery—as a sales tool—because most often, customers would be hesitant or even unable to make a durable goods purchase without the opportunity to buy it over time. For such retailers, the cost of issuing and collecting credit and its risk are the operating costs of sales. The interest on installment credit offsets those sales costs. Some retailers sell their installment receivables to a company that specializes in the management and collection of consumer credit, including the repossession of durable goods.
Personal Loans
Aside from installment credit and rotating credit, another source of consumer credit is a short-term personal loan arranged through a bank, credit union, or finance company. Personal loans used as credit are all-purpose loans that may be “unsecured”—that is, nothing is offered as collateral—or “secured.” Personal loans used as debt financing are discussed in the next section. Personal loans used as credit are often costly and difficult to secure, depending on the size of the loan and the bank’s risks and costs (screening and paperwork).
A personal loan may also be made by a private financier who holds personal property as collateral, such as a pawnbroker in a pawnshop. Typically, such loans are costly, usually result in the loss of the property, and are used by desperate borrowers with no other sources of credit. Today, many “financiers” offer personal loans online at very high interest rates with no questions asked to consumers with bad credit. This is a contemporary form of “loan sharking,” or the practice of charging a very high and possibly illegal interest rate on an unsecured personal loan. Some loan sharks have been known to use threats of harm to collect what is owed.
One form of high-tech loan sharking is the “payday loan,” which offers very short-term personal loans of small amounts at high interest rates. The amount you borrow, usually between \$500 and \$1,500, is directly deposited into your chequing account overnight, but you must repay the loan with interest on your next payday. The loan thus acts as an advance payment of your wages or salary, so when your paycheque arrives, you have already spent a large portion of it, and maybe even more because of the interest you have to pay. As you can imagine, many victims of repeated payday loans fall behind in their payments, cannot meet their fixed living expenses on time, and end up ever deeper in debt.
Payday lending is often viewed as a form of predatory lending; this type of lending is often characterized by excessive interest rates, unnecessary charges, and highly questionable terms. Some predatory lenders will charge interest rates as high as 59.9 per cent, just short of the 60 per cent legal limit in Canada. Payday lenders such as Money Mart (interest rate — 59.9 per cent) and Easyfinancial (interest rate – 46.9 per cent) are examples of predatory lenders (Freeman, 2015). The total fees result in an APR equivalent cost of over 300 per cent. In 2006, the federal government introduced legislation allowing provinces to lower the legal limit if they created a regulatory system to govern the industry. Bill C-26 (2006) exempts payday lenders from prosecution under Section 347 and defers regulation of these lenders to the provinces.
Personal loans are the most expensive way to finance recurring expenses, and they almost always create more expense and risk—both financial and personal—for the borrower.
Credit Trouble and Protections
As easy as it is to use credit, it is even easier to get into trouble with it. Because of late fees and compounding interest, if you don’t pay your balance in full each month, it quickly multiplies and becomes more difficult to pay. It doesn’t take long for the debt to overwhelm you.
According to the Advanced Planning Insurance Group (2018), the following are five warning signs of overindebtedness to watch for:
1. You are spending more than 20 per cent of your after-tax earnings on debt. Total up all you owe, excluding your mortgage (e.g., student loans, car payments, and credit card bills). Now total up how much of your after-tax income is dedicated to servicing this debt.
2. You are paying for daily essentials with credit instead of cash. Consequently, you are close to the credit limits on your cards. Credit cards charge notoriously high interest rates, which is exacerbated by compounding when credit cards are not paid off monthly. This can also increase your actual gross cost of goods purchased.
3. You are deferring important expenditures. You may need maintenance work (on your car, your home, and your teeth) as you struggle to get by.
4. You seem to spend your paycheque the day you get it. This may be a sign that you’re also overspending, an activity that leads to debt.
5. You are not differentiating between “good” versus “bad” debt. Good debt is money borrowed for productive purposes to help generate wealth over time (through such things as education, building a small business, or purchasing real estate). Fancy cars, expensive vacations, restaurant meals, and overindulgent gift giving may indicate a lifestyle that is, for many, beyond the average household’s paycheque.
If you should become overindebted, the first thing to do is to try to devise a realistic budget that includes a plan to pay off the balance. Contact your creditors and explain that you are having financial difficulties and that you have a plan to make your payments. Don’t wait for the creditor to turn your account over to a debt collector such as a collection agency, a company that intervenes to recover money owed by people in debt. It is better to be proactive in trying to resolve the debt. Creditors—the people to whom money is owed—pay collection agencies to recover what is owed to them. If money is owed to a company or a supplier, and payments have not recently been made by an individual or company, that company or supplier can turn the file over to a collection agency.
In Canada, only a first party lender, debt buyer, or lawyer can collect money. Provincially, a licensed collection agency can collect consumer or commercial debt, and these agencies are subject to provincial laws (Priority Credit Recovery, 2017). You can refer to the Office of Consumer Affairs (OCA) on the Innovation, Science and Economic Development Canada website for helpful tips and information on how to deal with collection agencies.
Too much debt can create serious stress in your life and threaten your well-being and your future. You may want to use a credit counsellor to help you create a budget and negotiate with creditors. Many counselling agencies are non-profit organizations that can also help with debt consolidation and debt management. Some “counsellors” are little more than creditors trying to sell you more credit, however, so be careful about checking their credentials before you agree to any plan. You do not need more credit, but more realistic credit.
As a last resort, you may file for personal bankruptcy, which may relieve you of some of your debts, but will blemish your credit rating for six years, making it very difficult—and expensive—for you to use any kind of credit or debt. A second bankruptcy will stay on your credit report for fourteen years (Bankruptcy Canada, 2013). Each allows you to keep some assets, and each holds you to some debts. But the process gets complicated, and you will want legal assistance.
In Canada, insolvency—that is, “the inability to pay debts when they are due because of liabilities that far exceed the value of assets”—falls under the Bankruptcy and Insolvency Act and is governed by the Office of the Superintendent of Bankruptcy (Kapoor et al., 2015, p. 53).
A consumer proposal “is a maximum five-year plan for paying creditors all or a portion of a debt owed. To be eligible for this type of insolvency protection application, you must be insolvent and be less than \$250,000 in debt (excluding a mortgage on your principal residence)” (Kapoor et al., 2015, p. 192). A Licensed Insolvency Trustee (LIT) is a qualified, experienced, federally regulated professional who administers a consumer proposal, which is a legally binding process, and can help guide you and get you discharged from your debt. One must work with a trustee if they are filing either a consumer proposal or for bankruptcy. The LIT works with you “to develop a ‘proposal’ to pay creditors a percentage of what is owed to them, or extend the time you have to pay off the debts, or both. The term of a consumer proposal cannot exceed five years. Payments are made through the LIT, and the LIT uses that money to pay each of your creditors” (Government of Canada, 2015). See the Office of the Superintendent of Bankruptcy on the Government of Canada website for information on how to file a consumer proposal or for bankruptcy as an individual.
The effects of a bankruptcy can last longer than your debts would have, however, so it should never be seen as an “out,” but rather as a last resort.
Modern laws and regulations governing the extension and use of credit and debt try to balance protection of the lender and of the borrower. They try to ensure that credit or debt is used for economic purposes and not to further social or political goals. They try to balance borrowers’ access to credit and debt as tools of financial management with the rights of property owners (lenders).
Many provinces have their own legislation and oversight. These bankruptcy rules focus on personal bankruptcy exemptions.
If you feel that your legal rights as a borrower or lender have been ignored and that the offender has not responded to your direct, written notice, there are local, provincial, and national agencies and organizations that offer assistance. There are also organizations that help borrowers manage credit and debt.
Laws and regulations can govern how we behave in the credit and debt markets, but not whether we choose to participate as a lender or as a borrower: whether we use credit to manage cash flow or to finance a lifestyle, whether we use debt to finance assets or lifestyle, and whether we save. Laws and regulations can protect us from each other, but they cannot protect us from ourselves.
Key Takeaways
1. Credit is used as a cash management tool or as a method of short-term financing for consumption.
2. Credit may be issued as revolving credit (credit cards), installment credit, or personal loans.
3. Credit can be a relatively expensive method of financing.
4. Credit accounts differ by the following features:
• credit limit,
• grace period,
• purchase guarantees,
• liability limits, and
• consumer rewards.
5. Credit accounts charge fees, such as the following: annual percentage rate, late fees, balance transfer fees, and cash advance fees.
6. Credit remedies include the following: renegotiation, debt consolidation, debt management, and bankruptcy.
7. Modern laws governing the uses of credit and debt try to balance protection of borrowers and lenders.
Exercises
1. Read the Maclean’s article “Drowning in debt is the new normal in Canada,” by Scott Terrio, on personal credit card debt in Canada. Record in your personal finance journal all the facts that pertain especially to you in your present financial situation. What facts did you find most surprising or most disturbing? Share your observations about these data with your classmates.
2. Investigate online the sources and processes of debt consolidation. Sample debt consolidation businesses offering “free” advice and services. Visit the Financial Consumer Agency of Canada’s website and read the webpage Getting help from a credit counsellor. When seeking advice about your credit, why might you want to use an adviser or consumer centre?
3. What is your credit rating or credit score? Apply for your credit reports from Equifax Canada or TransUnion.
REFERENCES
Advanced Planning Insurance Group. (2018). “What are the warning signs of over indebtedness?” Retrieved from: https://www.advancedplanning.ca/libr...r-indebtedness.
Bankruptcy Canada. (2013). “How does bankruptcy affect my credit rating?” Retrieved from: https://bankruptcy-canada.com/bankru...credit-rating/.
Barnea, A. (2017). “Credit card interest rates in Canada are way too high.” Montreal Gazette, July 10. Retrieved from: http://montrealgazette.com/opinion/o...e-way-too-high.
CIBC. (2017). “CIBC introduces free mobile credit score for clients – a first for a major Canadian Bank.” Retrieved from: http://www.newswire.ca/news-releases...re-for-clients—a-first-for-a-major-canadian-bank-625905414.html.
Engen, R. (2013). “Charge cards vs. credit cards: What’s the difference?” Toronto Star, June 30. Retrieved from: https://www.thestar.com/business/per...ifference.html.
First Nations Oweesta Corporation and First Nations Development Institute. (2016). Building Native Communities (5th Ed). Retrieved from: http://www.firstnations.org/system/f...thEd_Small.pdf.
Freeman, S. (2015). “Borrow \$10,000, Owe \$25,000: The Face Of Predatory Lending in Canada.” Huffington Post, July 31. Retrieved from: http://www.huffingtonpost.ca/2015/07...n_7898598.html.
Government of Canada. (2015). “You owe money—Consumer Proposals.” Retrieved from: https://www.ic.gc.ca/eic/site/bsf-os...g/br02051.html.
Kapoor, J., L. Dlabay, L., R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Me-Dian Credit Union. (2021). History. Retrieved from: https://www.mediancu.mb.ca/history
Priority Credit Recovery Inc. (2017). “Comparison—Collecting Debt in Canada.” Retrieved from: https://www.collectdebtincanada.com/comparison.php.
Russell, D. (2006). “Fur Trade Posts.” Encyclopedia of Saskatchewan. Retrieved from: http://esask.uregina.ca/entry/fur_trade_posts.html.
7.4 OTHER PEOPLE’S MONEY: AN INTRODUCTION TO DEBT
Learning Objectives
1. Define debt and identify its uses.
2. Explain how default risk and interest rate risk determine the cost of debt.
3. Analyze the appropriate uses of debt.
Debt is something, often a sum of money, that is owed or due. One often has the ability to delay payment over several periods when taking on debt. Credit creates debt—either short- or long-term debt—in order to finance the purchase of assets. Credit is a cash management tool used to create security and convenience, whereas debt is an asset management tool used to create wealth. Debt also creates risk.
The two most common uses of debt by consumers are car loans and mortgages. They are discussed much more thoroughly in Chapter 8 “Consumer Strategies” and Chapter 9 “Buying a Home.” But before you get into the specifics, it is good to know some general ideas about debt.
Usually, the asset financed by the debt can serve as collateral for the debt, lowering the default risk for the lender. However, that security is often outweighed by the amount and maturity of the loan, so default risk remains a serious concern for lenders. Whatever concerns lenders will be included in the cost of debt, and so these things should also concern borrowers.
Lenders face two kinds of risk: default risk, or the risk of not being paid, and interest rate risk, or the risk of not being paid enough to outweigh their opportunity cost and make a profit from lending. Your costs of debt will be higher than the lender’s cost of risk. When you lower the lender’s risk, you lower your cost of debt.
Costs of Debt
Default Risk
Lenders try to protect themselves against default risk by screening applicants to determine their probability of defaulting. Along with the scores provided by credit rating agencies, lenders evaluate loan applicants on “the five C’s”: character, capacity, capital, collateral, and conditions.
Character is an assessment of the borrower’s attitude toward debt and its obligations, which is a critical factor in predicting timely repayment. To deduce “character,” lenders can look at your financial stability, employment history, residential history, and repayment history on prior loans.
Capacity represents your ability to repay by comparing the size of your proposed debt obligations to the size of your income, expenses, and current obligations. The larger your income is in relation to your obligations, the more likely it is that you are able to meet those obligations.
Capital is your wealth or asset base. You use your income to meet your debt payments, but you could use your asset base or accumulated wealth as well if your income falls short. Also, you can use your asset base as collateral.
Collateral insures the lender against default risk by claiming a valuable asset in case you default. Loans to finance the purchase of assets, such as a mortgage or car loan, commonly include the asset as collateral—the house or the car. Other loans, such as a student loan, may not specify collateral but instead are guaranteed by your general wealth.
Conditions refer to the lender’s assessment of the current and expected economic conditions that are the context for this loan. If the economy is contracting and unemployment is expected to rise, that may affect your ability to earn income and repay the loan. Also, if inflation is expected, the lender can expect that 1) interest rates will rise and 2) the value of the currency will fall. In this case, lenders will want to use a higher interest rate to protect against interest rate risk and the devaluation of repayments.
Interest Rate Risk
Because debt is long term, the lender is exposed to interest rate risk, or the risk that interest rates will fluctuate over the maturity of the loan. A loan is issued at the current interest rate, which is “the going rate” or current equilibrium market price for liquidity. If the interest rate on the loan is fixed, then that is the lender’s compensation for the opportunity cost or time value of money over the maturity of the loan.
If interest rates increase before the loan matures, lenders suffer an opportunity cost because they miss out on the extra earnings that their cash could have earned had it not been tied up in a fixed-rate loan. If interest rates fall, borrowers will try to refinance or borrow at lower rates to pay off this now higher-rate loan. Then the lender will have its liquidity back, but it can only be re-lent at a newer, lower price and create earnings at this new and lower rate. So the lender suffers the opportunity cost of the interest that could have been earned.
Why should you, the borrower, care? Because lenders will have you cover their costs and create a loan structured to protect them from these sorts of risks. Understanding their risks (looking at the loan agreement from their point of view) helps you to understand your debt choices so you can use them to your advantage.
Lenders can protect themselves against interest rate risk by structuring loans with a penalty for early repayment to discourage refinancing or by offering a floating-rate loan, a loan for which the interest rate “floats” or changes, usually periodically and relative to a benchmark rate such as the prime rate. In contrast, the interest rate of a fixed-rate loan remains the same until the loan is paid back. The prime rate is the rate that banks charge their very best (least risky) borrowers. The floating-rate loan shifts some interest rate risk onto the borrower, for whom the cost of debt would rise as interest rates rise. The borrower would still benefit, and the lender would still suffer from a fall in interest rates, but there is less probability of early payoff should interest rates fall. Mainly, the floating-rate loan is used to give the lender some benefit should interest rates rise. The real rate of return is what the investor receives as an annual percentage return on an investment once changes in prices, due to inflation or other external effects, are taken into account.
Borrowers may be better off having a fixed-rate loan and having stable and predictable payments over the life of the loan. The better or more creditworthy a borrower you are, the better the terms and structure of the loan you may negotiate.
Uses of Debt
Debt should be used to finance assets rather than recurring expenses, which are better managed with a combination of cash and credit. The maturity of the financing (credit or debt) should match the useful life of the purchase. In other words, you should use shorter-term credit for consumption and longer-term debt for assets.
If you finance consumption with longer-term debt, then your debt will outlive your expenses: you will be continuing to pay for something long after it is gone. If you finance assets with short-term debt, you will be making very high payments, both because you will be repaying over a shorter time and so will have fewer periods in which to repay and because your cost of credit is usually higher than your cost of debt; for example, annual credit card rates are typically higher than mortgage rates.
However, borrowers may be tempted to finance asset purchases with credit in order to avoid the more difficult screening process of debt. Given the more significant investment of time and money in debt, lenders screen potential borrowers more rigorously for debt than they do for credit. The transaction costs for borrowing with debt are therefore higher than they are for borrowing with credit. Still, the higher costs of credit should be a caution to borrowers.
The main reason not to finance expenses with debt is that expenses are expected to recur, and therefore the best way to pay for them is with a recurring source of financing, such as income. The cost of credit can be minimized if it is used merely as a cash management tool, but if it is used as debt—and if interest costs are allowed to accrue—then it becomes a very costly form of financing because it creates a new expense (interest) and further obligates future income. In turn, that limits future choices, creating even more opportunity cost.
Credit is more widely available than debt and it is therefore a tempting source of financing. It is a costlier financing alternative, however, in terms of both interest and opportunity costs.
Student Loans
Unlike grants, which do not have to be paid back, student loans are borrowed money and are legal obligations that have to be repaid once you complete your education. It is important that students understand the financial implications of taking out a loan for their education. How much will you have to repay once you graduate?
The Government of Canada provides lower interest rates than commercial lenders because the federal government subsidizes student loan rates. The two main student loan programs in Canada fall under federal or provincial and territorial jurisdiction. The federal program—the Canada Student Loans Program (CSLP)—can be accessed by both full- and part-time students. The provincial and territorial programs offer either integrated or stand-alone loans. Integrated loans mean that students not only have to apply to their province of residence in order to access federal and provincial student loans, but also have to go through the National Student Loans Service Centre in order to manage and repay the loan. Integrated loans exist in Ontario, British Columbia, New Brunswick, Newfoundland and Labrador, and Saskatchewan. All other provinces and territories, except the Yukon, offer stand-alone loans, which means that students apply to one place for assistance, but have to manage and repay two separate loans (Kapoor et al., 2015).
For more information on Canada Student Loans, the Repayment Assistance Plan, the National Student Loan Service Centre, provincial and territorial student financial aid offices, and how to manage and reduce student loan debt, visit the Student Loans webpage on the Government of Canada website.
Key Takeaways
1. Debt is an asset management tool used to create wealth.
2. Costs of debt are determined by the lender’s costs and risks, such as default risk and interest rate risk.
3. Default risk is defined by the borrower’s ability to repay the interest and principal.
4. Interest rate risk is the risk of a change in interest rates that affects the value of the loan and the borrower’s behaviour.
5. Debt should be used to purchase assets, not to finance recurring expenses.
Exercises
1. Identify and analyze your debts. What assets secure your debts? What assets do your debts finance? What is the cost of your debts? What determined those costs? What risks do you undertake by being in debt? How can being in debt help you build wealth?
2. Are you considered a default risk? How would a lender evaluate you based on “the five C’s” of character, capacity, capital, collateral, and conditions? Write your evaluations in your personal finance journal. How could you plan to make yourself more attractive to a lender in the future?
3. Use the Loan Repayment Estimator on the Government of Canada website to estimate the monthly payments you will need to make to repay your Canada Student Loan or other government student loans. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/02%3A_Achieving_Your_Financial_Goals/2.01%3A_Financial_Management.txt |
INTRODUCTION
Aiden, Riley, and Athena are all students at the local university. All are living at home to save money while in school, and all are working at least one job to pay tuition. Between their paycheques and financial aid, they can get by, but not by much.
Aiden loves nothing more than to get lost in the world of games; he is hoping that his degree in digital media will lead to a career developing games and applications for a growing market. Whenever he can, he upgrades his laptop and smartphone with the latest killer apps.
Living in a city with public transportation, none of them needs a car. Riley, however, loves to ride his bike whenever possible and keeps a bike in his parents’ garage. Riley is a whiz not only in engineering, but also in mechanics. He has helped to fix a number of his friend’s bikes over the years and is considering opening up a part-time business that would focus on bike repairs.
Athena is hoping to become an entrepreneur and is getting a head start by joining the campus business club. Wanting to make a good impression, Athena is careful to maintain a fashionable yet professional wardrobe.
All three are consumers and will be all their lives. All three make consumption decisions based on their financial and strategic goals, on their personal tastes and lifestyle, and on their professional aspirations. Their choices are very different and have different financial consequences. Everyone needs strategies that help guide their purchasing decisions.
8.1 CONSUMER PURCHASES
Learning Objectives
1. Trace the pre-purchase, purchase, and post-purchase steps in consumer purchases.
2. Demonstrate the use of product-attribute scoring in identifying the product.
3. Compare and contrast features of different consumer markets.
4. Analyze financing choices and discuss their impact on purchasing decisions.
5. Discuss the advantages of consumer strategies using branding, timing, and transaction costs.
6. Identify common consumer scams, strategies, and remedies.
Consumer purchases refer to items used in daily living (e.g., clothing, food, electronics, appliances). They are the purchases that most intimately frame your life: you live with these items and use them every day; they are an expression of your tastes and lifestyle choices, and as such, they reflect your priorities. Maybe you take pride in your car or your clothes or your kitchen appliances or your latest, coolest whatever. Or maybe you spend whatever you can on travel or on your passion for hiking. Those very personal tastes will frame your spending choices.
Consumer purchases should fit into your budget. By making an operating budget, you can plan to consume and to finance your consumption without creating extra costs of borrowing. You can plan to live within your income. At times, you may have unexpected changes (loss of a job or change in the family) that put your nondiscretionary needs temporarily beyond your means. Ideally, you would want to have a cushion to tide you over until you can adjust your spending to fit your income.
A budget can also show you just how fast some “small luxuries” can add up. Stopping for a latte on your way to work or school every day (\$4.95) adds up to \$25 per week, or about \$1,300 per year. That money may be better used to finance a bigger-ticket item that you then would not have to finance with debt. With the budget to help you put expenses into perspective, you can make better purchasing decisions.
Purchasing decisions are always limited by your available income, and that means making choices. Your choices of what, where, when, and even how to buy will affect the amount that you spend and the utility (the joy or regret) that you ultimately get out of your purchase.
Shopping is a process. You decide what you want, then have to make more specific decisions:
• Should you buy more (and pay more) but get a cheaper unit price?
• Should you buy locally or remotely, via catalogue or Internet?
• Should you pay more for a well-known brand or buy generic?
• Should you look for a guarantee or warranty or consider long-term repair costs?
• Should you consider resale value?
• Should you pay cash or use credit? If you pay through credit, is it store credit, your own credit card, or a loan?
Each of these decisions creates a trade-off. For example, it may be more convenient—and quicker—to shop locally, but there may be lower prices and a better selection of products online. Or you may find lower prices online, but have a harder time getting repairs done if you haven’t bought locally.
Some of your purchases involve few conscious decisions—for example, groceries—because you buy them repeatedly and often. Other purchases involve more decisions because they are made less often and involve costlier items such as a car. When you have to live with your decision for years instead of days, you tend to make it more carefully.
The decision process can be broken down into the following steps:
1. Before you buy, or “pre-purchase,” identify
• the product: compare attributes;
• the market: compare price, delivery (return), and convenience; and
• the financing.
2. As you buy, negotiate
• attributes: colour, delivery, and style;
• price and purchase costs; and
• payment.
3. After you buy, or “post-purchase,” consider
• maintenance; and
• how to address dissatisfaction.
Before You Buy: Identify the Product
What do you want? What do you want it to do for you? What do you want to gain by having it or using it or wearing it or eating it or playing with it? You buy things hoping to solve a need in your life. The more specifically you can define that need, the more accurately you can identify something to fill it. If your purchase is inappropriate for your need, you will not be happy with it, no matter how good it is. And because your budget is limited, you want to minimize your opportunity cost and buyer’s remorse or regret at not making a better purchase in order to use your limited income most efficiently.
Sometimes you can identify a need, but have no idea of the kinds of products that may fill it. This is especially true for infrequent needs or purchases. For example, you may decide you need to get away and take a long weekend. To do it cheaply, you decide to go hiking and camping. To make it more fun, you decide to go to an area where you’ve never been before. You may not be aware of the camping options available in that area, however, or of equally cheap alternatives such as hostels, bed and breakfasts, or other accommodations. When you find that you have a range of choices, you can compare them and choose one that offers the most satisfaction.
Once you have identified the product, you can compare the attributes of those products. What characteristics do you require or want? How are you going to use the product? For example, do you need cooking facilities, access to a shower, a safe but scenic location, opportunities to meet other hikers, and so on? What attributes are important to you and what are available?
Aiden is looking for a new computer keyboard, a hot gaming keyboard that can also be comfortable for writing college papers. He begins to research keyboards and finds over five hundred models from over fifty brands with different designs, attributes, and functions offered at a range of prices. He decides to try to filter his choices by looking only at gaming keyboards, which narrows it down to about eighty models.
Noticing that most of the keyboards range in price from \$25 to \$50, he decides to look in the \$50 to \$100 range, figuring he’ll get a slightly higher-end product, but not an outrageously expensive one. This narrows his search to about twenty-five models.
None of the models has all the attributes that Aiden desires. It’s a trade-off: he can have some features, but not others. He decides to try to organize his research by creating a table ranking the product attributes in order of importance, and then scoring each model on each attribute (on a scale of one to ten), eventually coming up with an overall score for each model. Table 8.1.1 shows scoring for three models.
Table 8.1.1 Aiden’s Product-Attribute Scoring
VTK TKG GBY
Attribute Weight (%)
Backlit 25 8 2 10 2.5 9 2.25
Wireless 25 9 2.25 10 2.5 0 0
Programmable G-keys 25 2 0.5 10 2.5 5 1.25
Game panel 8 7 0.56 1 0.08 5 0.4
Touch 5 8 0.4 1 0.05 10 0.5
Media controls 5 7 0.35 1 0.05 10 0.5
Ergonomic design 5 7 0.35 1 0.05 10 0.5
Warranty 2 0 0 0 0 10 0.2
Weighted Average Score 100 6.34 7.72 5.55
Multiplying each attribute’s weight by its score gives its weighted score, then adding up each weighted score gives the total score for the product. Based on this attribute analysis, Aiden would choose TKG, which has the highest overall score.
In the case of an asset purchase, you may eventually think of reselling the item, so the ease and/or costs of doing so may factor into your pre-purchase evaluation. You may decide to go with a “better” product—a more recognizable or popular brand, for example—that may have a higher resale value. You also need to consider the market for used or pre-owned products; if there is one, how liquid the market is, or how easy it is to use. If the market is not very liquid, then the transaction costs of selling in the used product market may be significant, and you may be disappointed with the result.
The more choices you have, the better your chances of finding satisfaction. The more products there are to satisfy your need, and the more attributes those products offer, the more likely you are to find what “works” for you. Sometimes you need to be a bit creative in thinking about your alternatives, especially with limited resources.
Sources of product information include the manufacturer, retailer, and other consumers. By law, certain information must be provided for certain products. For example, food ingredients must be labelled, and perishable products dated. Appliances almost always come with operating and care instructions that can give you an idea of their ongoing maintenance costs as well as operating features.
The Internet has made it easy to research products online and to become a much better-informed consumer. You can do lots of research online, even if you actually purchase locally. A feature of many online stores and consumer discussions is product reviews, where consumers give feedback on their satisfaction with the product. Such reviews can balance the information from the manufacturer and retailer, who want primarily to encourage consumers to buy.
Other sources of information are magazines and trade journals (such as Consumer Reports, both in print and online), which have articles and ratings on products as well as ads. Your research may also involve actual or virtual window shopping, like going to stores to examine the products you are thinking of buying.
Before You Buy: Identify the Market
Your market may be local, national, or international, with advantages and disadvantages to each. Generally, a larger market (more vendors) will offer more variation and selection of product attributes.
As with any market, the real determinant of how your market works is competition. The more vendors there are, the more they compete for your business, and the more likely you will find options for purchasing convenience, product attributes, and price.
In markets where vendors are so plentiful that your problem is filtering rather than finding information, there are middlemen to provide that service. An example is the budget travel businesses, where there are websites that make it convenient to research and buy flights, rental cars, and hotel accommodations. Middlemen, or brokers, exist in markets where they can add value to your purchasing process, either by providing information in the pre-purchase stage or by providing convenience during the purchase. The more they can reduce the cost of a “bad” decision (e.g., a difficult flight schedule, an expensive car rental, an uncomfortable hotel accommodation), the more valuable they are. They can add more value in markets where you have too little or too much information or less familiarity with products or vendors. Generally, the more expensive the product or the less frequent the purchase, the more likely you will find a middleman to make it easier.
Some products—such as durable goods and some consumer goods like textbooks, vintage clothing, and yard sale goods—have a “new” and a “used” market. Evaluating the quality of a used or pre-owned product can require more research, information, and expertise, because the effect of its past use on its future value can be hard to estimate. Used products are almost always priced less than new products, unless they have become “collectibles” that can store value. The trade-off is that used products offer less reliable or predictable future performance and may lack attributes of newer models.
Different kinds of stores often offer the same products at different prices. Convenience stores, for example, typically charge higher prices than grocery stores, but—as their name suggests—may be in more convenient locations and open at more convenient hours. Smaller boutique stores cannot always realize the economies of scale in administrative costs or in inventory management that are available to a larger store or a chain. For those reasons, prices tend to be higher at a smaller store. Boutiques often offer more amenities and a higher level of customer service to be competitive. You may also shop at a specialty store when you need a certain level of expertise or assistance in making a purchase.
Co-operative stores are owned and managed collectively and may provide goods or services that would not otherwise be available. Shopping is usually open to anyone, but members are eligible for discounts, depending on their participation in the store’s operations or management. The members own the store, so they can forgo corporate profits for consumer discounts.
Increasingly, merchandise of all kinds may be bought directly from the manufacturer, often through a catalogue or online. The shopping experience is very different (you can’t try on the sweater or see how the keyboard feels), but if you are well informed about the product, you may be comfortable buying it. Internet shopping has become a great convenience to those who are too busy or too far away to visit stores.
Auctions are becoming increasingly popular, as well, especially online auctions at eBay and similar sites. Auctions are open negotiations between buyers and sellers and offer dynamic pricing. They also offer uncertainty, as the price and even the eventual purchase are risky—you may lose the auction and not get the item. Auctions are used most often for resales and for assets such as homes, cars, antiques, art, and collectibles. The popularity of online auctions has led to more buyers, bringing more competition and thus higher prices.
Before You Buy: Identify the Financing
Most consumer purchases are for consumable goods or services and are budgeted from current income. You pay by using cash or a debit card or, if financed, by using a credit card for short-term financing. Such purchases—food, clothing, transportation, and so on—should be covered by recurring income because they are recurring expenses. You need to be able to afford them. As you read in Chapter 7 “Financial Management,” consumers who use debt to finance consumption can quickly run into trouble because they add the cost of debt to their recurring expenses, which are already greater than their recurring income.
Unless financed by savings, durable goods such as appliances, household wares, or electronics are often bought on credit, as they are costlier items infrequently purchased. Assets such as a car or a home may be financed using long-term debt such as a car loan or a mortgage, although they also require some down payment of cash.
The use of middlemen or brokers to find and buy an item also contributes to the cost of a purchase because of the fees you pay for the service.
Products and preferred financing sources are shown in Table 8.1.2.
Table 8.1.2 Products and Preferred Financing Sources
Consumer Goods Durable Goods Assets
Cash, Debit, Income
Savings
Credit
Debt
As You Buy: The Purchase
Having done your homework and made your choice, you are ready to purchase. In some cases, you may be able to make specific arrangements with vendors as to convenience, price, delivery, and even financing.
In Western cultures, prices for consumer goods are usually not negotiable; consumers expect to pay the price on the price tag. In many other cultures, however, bargaining over price is common and expected, which often surprises travellers abroad.
Durable goods and asset purchases typically offer more purchase options than consumer goods, usually as an incentive to buyers. Vendors may offer free delivery or free installation, product guarantees, or financing arrangements such as “no payments for six months” or “zero per cent financing.” Offers may be enhanced periodically to “move the merchandise,” when prices may also be discounted. Sales, “special offers,” or “low, low prices” may be used to sell merchandise that is about to be replaced by a newer model. If those product cycles are seasonal and predictable, you may be able to schedule your purchase to take advantage of discounts.
Or you may decide to wait and pay full price for the newer model to avoid purchasing a product that is about to become outdated.
The more the purchase process allows for negotiation, the more possibility there is for consumers to enhance satisfaction. However, the negotiation process can go the other way too: it allows more opportunity for the vendor to negotiate an advantage. The better-informed consumer is more likely to negotiate a more satisfying purchase, so it is important to be thorough in your pre-purchase research.
A purchase may have transaction costs such as sales tax or delivery charges. For higher-priced products such as durables and assets, those transaction costs can add up, so you should factor them into the overall cost of your purchase.
Financing costs can also be significant if debt financing is used. Debt is long term and is a significant commitment as well. It may pay to compare financing rates and terms just as you would for the product itself, or you may be able to use financing costs as a negotiating chip in your price negotiations.
Now you can enjoy your purchase. Some products require maintenance and periodic repair to remain useful. You should research those additional costs before buying, because after the purchase you are committed to those activities.
If you are not satisfied due to a product defect, you can contact the retailer or manufacturer. If there is a warranty, the retailer or manufacturer will either fix the defect or replace the item. Many manufacturers and retailers will do so, even if there is no warranty, to maintain good customer relations and enhance their brand’s reputation. An Internet search will usually turn up contact information for a product’s customer service team.
There are also federal and provincial consumer protection laws that cover a seller’s responsibilities after a sale. In Canada, the Office of Consumer Affairs has the most direct responsibility for consumer issues. Contact information can be found on the Canadian Consumer Handbook webpage Federal, Provincial and Territorial Consumer Affairs Offices. Locally, you can also contact your chamber of commerce or Better Business Bureau for more information.
You can also resort to the judicial system for compensation. For limited claims, you can file in small claims court. Claim limits vary by province. Small claims court is a less formal and costly process than filing a suit. At the other end of the spectrum is the class action suit in which many plaintiffs pursue the same complaint, sharing the costs and the awards of the lawsuit.
Consumer Strategies
The advertising industry is proof of the importance of “branding.” Customer brand loyalty is a real phenomenon.
Producers go to great expense to brand their products. When in doubt, consumers tend to choose a familiar brand. Once disappointed by a brand, consumers tend to avoid it. For some products, there are alternative private-label or store-label brands, applied to many products, but sold by one store or chain. The store brand is usually a cheaper alternative and often, although not always, of comparable quality. This is a widespread practice in the food industry with grocery store brands. Shopping for the store brand can often yield significant savings.
Consider the story of Maria. Maria’s purchase comes with a two-year manufacturer’s guarantee, but the salesperson is encouraging her to buy an extended warranty. She is already paying more than she wanted to for a high-quality machine, and the extended warranty adds nearly a hundred dollars to the purchase price. She decides to forgo the extra protection, reasoning that most repairs, if needed after two years, would cost less than that anyway.
An offer of a warranty with purchase can be valuable if it lowers the expected maintenance or repair costs of the product. Sometimes a product is offered with a warranty at a higher price; sometimes you can purchase an optional warranty for an additional cost. If the cost of a malfunction is low, then the warranty is probably not worth it.
Price advantage can sometimes come through timing. Seasonally updated products or models can force retailers to discount old inventory to get it off the shelves before the new inventory arrives. Automobiles, for example, have a one-year product cycle, as do many desktop computers and peripherals.
Some products, such as calendars or tax preparation software, are naturally dated, and so may be discounted as they near their expiration date. However, that is because they have less and less usefulness and may not be worth buying at all.
Commodities prices can fluctuate depending on the season or the weather, and although you may not have a choice of when to buy home heating oil, some products do offer you a choice. Tomatoes in January are more expensive than in August, for example; eating fresh foods seasonally can produce savings.
Price can also be affected by transaction costs, or the costs of making the purchase. They can be included in the price or may be listed separately. Larger and more expensive items tend to have more transaction costs, such as delivery and storage. Sales tax, which is a percentage of the price, may be required, and the higher the item’s price, the more sales tax you will pay. Asset purchases also involve a legal transfer of ownership and often the costs of acquiring financing, which add to their costs. Sometimes, to entice a purchase, the seller may agree to bear some or all of the transaction costs.
Retailers change prices based on buyers’ needs. They practice price discrimination, or the practice of charging a different price for the same product, when different consumers have different need of a product. Airlines are a classic example: they charge less for a ticket bought weeks in advance than for the same flight if the ticket is bought the day before. Someone who purchases weeks ahead is probably a leisure traveller, has more flexibility, and is more sensitive to price. Someone who books a day ahead is probably a business traveller, has little flexibility, and is not as sensitive to price. The business traveller, in this case, is willing to pay more, so the airline will charge that person more.
Retailers also offer discounts, sales, or “deals” to attract consumers who otherwise would not be shopping. Sometimes these are seasonal and predictable, such as in January, when sales follow the big holiday shopping season. Sometimes sales are not sales at all, but rather are “discounted” prices relative to new, higher, prices that will soon take effect. Quantity discounts—a lower unit price for a higher volume purchased—may be available for customers buying larger quantities, although sometimes the opposite is true—that is, the smaller package offers a smaller unit price. While it may be cheaper to buy a year’s worth of toilet paper at one time, you then create storage costs and sacrifice liquidity, which you should weigh against your cost savings.
In short, sellers want to sell and will use price to make products more attractive. As a buyer, you need to recognize when that attraction offers real value.
Scams: Caveat Emptor (Buyer Beware)
Unfortunately, the world of commerce includes people with less-than-honourable intentions. You likely have been taken advantage of once or twice or have fallen victim to a scam, or a fraudulent business activity or swindle. Technology has made it easier for con artists to steal from more people, contacting them by telephone or by email. The details of these scams vary, but the pattern is much the same: the fraud sets up a scenario that requires the victim to send money or to divulge financial or personal information, such as bank account details, social insurance number (federal identification), or credit card numbers, which can then be used to access accounts.
Here are some typical scams reported by the Canadian Competition Bureau:
• subscription traps/free trial scams
• business supplies/directory scams
• cheque cashing/online classifieds/money transfer job scams
• fraudulent health products or cures
• prize lottery scams
• work-at-home job opportunity scams
• antivirus scams
• continuity and premium text messaging scams. (Competition Bureau, 2015a)
The best way to protect yourself from scams is to be as informed as possible. Do your homework. If you feel like you are in over your head, call on a friend or family member to help you or to speak for you in negotiations. There are a number of non-profit and government agencies that you can ask about the legitimacy of an idea or an arrangement. Review the Competition Bureau’s webpage Fraud Facts—Recognize, Reject, Report Fraud.
There are also some proven ways to try to protect yourself:
1. Never give anyone personal and/or financial information when solicited by telephone or Internet. Legitimate business interests do not do that. When in doubt, contact the organization to verify the caller’s identity.
2. Get a second opinion, especially when advised to do costly repairs.
3. Check the credentials of prospective workers or service providers; most are certified, licensed, or recognized by a professional organization or trade group (e.g., auto mechanics may be endorsed by the Canadian Automobile Association).
4. If you have doubts about a professional’s credentials, such as an accountant, doctor, or architect, call the local professional society or trade group and ask about previous complaints lodged against him or her.
5. Get a written estimate, specifying the work to be done, the materials to be used, the estimated labour costs, the estimated completion date, and the estimated total price. Ask the vendor to provide proof of insurance. (Competition Bureau, 2015b)
If you do get “scammed,” it is your civic duty to complain to your federal, provincial, or territorial consumer affairs offices; it is the only way to stop and expose such frauds and to keep others from becoming victims. And remember, as the saying goes, “If it sounds too good to be true, it probably is.”
Key Takeaways
1. The consumer purchase process involves:
pre-purchase: identifying the product, the market, and the financing;
• purchase: negotiating the purchase price and terms of sale; and
• post-purchase: ensuring satisfaction.
2. Attribute scoring can be used to help identify the product.
3. A product may be sold in different markets that may affect the cost of the purchase.
4. Financing choices can affect the cost of the purchase.
5. Strategies such as maximizing the advantages of branding, timing, and transaction costs can benefit customers.
6. There are common features of scams and also legal protections and remedies.
Exercises
1. Identify the last three items (consumer goods and durable goods) you purchased. Alternatively, select any three items you purchased during the last two months. Choose diverse items and analyze each item in terms of the following factors:
• Why did you buy that item? How did you decide what to get?
• What attributes proved most important in narrowing your choices? Create an attribute analysis chart for each item (see Table 8.1.1 “Aiden’s Product-Attribute Scoring”).
• Where did you get your information about the item?
• Where did you go to buy the item?
• In what kind of market did you make your purchase?
• Where did the money come from for your purchase?
• How much did you pay for the item and how did you pay for it?
• How would you rate your satisfaction with your purchase?
• If or when you purchase that type of item again, what might you do differently?
2. In your personal finance journal, record your favourite strategies for making purchases. Include a specific recent example of how you used each strategy. Your strategies may relate to bargain shopping, high-end shopping, warranties, store brands, coupons, discounts, rebates, seasonal shopping, expiry shopping, bulk buying, co-operative buying, special sales, or other practices. Share your consumer success stories with classmates and add at least one new idea to your list.
3. Have you ever been the victim of a consumer scam? What scams have you been exposed to that you managed to avoid? Describe your experiences in your personal finance journal. How informed are you about your rights as a consumer in your province and as a citizen of Canada? For example, what are your rights in returning unwanted purchases and recalled items? In moving? In buying food? In having access to electricity?
REFERENCES
Competition Bureau. (2015a). “Common Scams.” Retrieved from: http://www.competitionbureau.gc.ca/e.../03234.html#s1.
Competition Bureau. (2015b). “Fraud Prevention.” Retrieved from: http://www.competitionbureau.gc.ca/e...g/h_00122.html.
8.2 A MAJOR PURCHASE: BUYING A CAR
Learning Objectives
1. Show how the purchasing process (e.g., identifying the product, the market, and the financing) may be applied to a car purchase.
2. Explain the advantages (and disadvantages) of leasing versus borrowing as a form of financing.
3. Analyze all the costs associated with car ownership.
Many adults will buy a car several times during their lifetimes. A car is a major purchase. Its price can be as much as or more than one year’s disposable income. Its annual operating costs can be substantial, including the cost of fuel, legally mandated insurance premiums, and registration fees, as well as maintenance and perhaps repairs and storage (parking). A car is not only a significant purchase, but also an ongoing commitment.
In Canada, people spend a considerable amount of time in their cars, commuting to work, driving their children to school and various activities, driving to entertainment and recreational activities, and so on. Most people want their car to provide not only transportation, but also comforts and conveniences. You can apply the purchasing model, described in this chapter, to the car purchase.
First, you identify the need: What is your goal in owning a car? What needs will it fulfill? Here are some further questions to consider:
• What kind of driving will you use the car for? Will you depend on it to get you to work, or will you use it primarily for weekend getaways?
• Do you need carrying capacity (for passengers or “stuff”) or hauling capacity?
• Do you live in a metropolitan area where you will be driving shorter distances at lower speeds and often idling in traffic?
• Do you live in a more rural area where you will be driving longer distances at faster speeds?
• Do you live in a climate where winter or a rainy season would make traction and storage an issue?
• How much time will you spend in the car every day?
• How many kilometres will you drive each year?
• How long do you expect to keep the car?
• Do you expect to resell or trade in the car?
Your answers to these questions will help you identify the product you want.
Identify the Product
Answering these questions can help identify the attributes you value in a car, based on how you will use it. Cars have many features to compare. The most critical (in no particular order) are shown in Table 8.2.1.
Table 8.2.1 Automobile Attributes and Relevance
Automobile Attribute Relevance
Fuel or Energy Efficiency Determine the cost and convenience of operating the car, a major component of your annual operating expenses. Energy efficiency may also relate to growing demand for “green” cars or hybrids. An environmentally friendly car may in itself be an attribute you care about when deciding to buy a car.
Size and “Horsepower” Determined by your need to carry passengers and “stuff”. Size may also refer to engine size, which affects fuel or energy efficiency.
Condition New, floor model, or used. Physical condition and odometer reading on trade-ins are major attributes on the used car market.
Performance Quality Usually described in terms of the car’s acceleration, but also in terms of the availability of four-wheel drive and the quality of steering system, braking system, suspension, and transmission—all of which affect the ease and utility of driving the car and its expected maintenance and repair costs.
Entertainment Features As more people spend more time in their cars, features such as DVD players and monitors have joined radios, bluetooth connectivity, and cup holders as desirable features. Plug-in capacity for cell phones and laptops has also become a critical feature for many consumers.
Navigation Features Innovations such as real-time GPS systems with digital road maps are rapidly becoming standard.
Safety Features Many safety features are mandated, but distinctive safety features are offered, including, for example, electronic locking systems, built-in security alarms, built-in child restraints, and reverse sonar.
Appearance and Comfort For some buyers the color, shape, and fitting of a car and its interior are important attributes.
Reliability Reliability refers to expected performance over time in all conditions, as well as to future maintenance and repair costs.
Make Some buyers prefer particular brands or styles of car and remain loyal to them.
All these attributes affect price, and you may think of others. Product-attribution scoring can help you identify the models that most closely fit your goals.
Mary lives on a reserve in a rural area; she drives about 46,619 kilometres per year, commuting to her job as an accountant at the corporate headquarters of an auto parts chain and taking her kids to school. She is also a pretty good car mechanic and does basic maintenance herself.
Miguel lives in the city. He walks, bikes, or takes a bus to his job as a market researcher for an ad agency, but keeps a car to visit his parents in the suburbs. He drives about 12,950 kilometres per year, often crawling in traffic. Miguel does limited maintenance on his vehicle.
Miguel and Mary would rate these attributes very differently, and their scoring of the same models would have very different results.
Mary may value fuel efficiency more, as she drives more (and so purchases more fuel). Driving often and with her children, she may rank size, safety, and entertainment features higher than Miguel would, who is in his car less frequently and alone. Mary relies on the car to get to work, so reliability would be more important for her than for Miguel, who drives only for recreational visits. But Mary also knows that she can maintain and repair some things herself, which makes that less of a factor.
Car attributes are widely publicized by car dealers and manufacturers.
You can visit dealerships in your area or manufacturers’ websites. Using the Internet is a more efficient way of narrowing your search. Specialized print and online magazines, such as Car and Driver, Road and Track, and Edmunds.com, offer detailed discussions of model attributes and their actual performance. Consumer Reports also offers ratings and reviews and also provides data on frequency of repairs and annual maintenance costs.
You want to be sure to consider not only the price of buying the car, but also the costs of operating it. Fuel, maintenance, repair, insurance, and registration may all be affected by the car’s attributes, so you should consider operating costs when choosing the product. For example, routine repairs and maintenance are more expensive for some cars. A more fuel-efficient car can significantly lower your fuel costs. A more valuable car will cost more to insure. Moreover, the costs of fuel, maintenance, insurance, and registration will be ongoing expenses—you want to buy a car you can afford and afford to drive.
If you are buying a new car, you know its condition and so you can predict annual maintenance and repair costs and the car’s longevity by the history for that model. Depending on how long you expect to own the car, you may also be concerned with its predicted resale value.
Used cars are generally less expensive than new. A used car has fewer kilometres left in it. Its condition is less certain: you may not know how it has been driven or its repair and maintenance history. This makes it harder to predict annual maintenance and repair costs. Typically, since it is already used when you buy it, you expect little or no resale value. You can gain a significant price savings in the used car market, and there are good used cars for sale. You may just have to look a bit harder to find one.
The Canadian Black Book publishes guidebooks on used-car values. Items to inspect in your exterior, interior, and engine checks are outlined in Table 8.2.2.
Table 8.2.2 Used Car Buyer’s Checklist
Exterior Interior Engine
• Alignment
• Doors
• Lights
• Mirrors
• Paint
• Panels, bumpers, trim
• Shocks
• Windshields and windows
• Carpets and upholstery
• Instruments and controls
• Trunk
• Seats
• Safety features
• Comfort
• Belts and hoses
• Battery
• Exhaust
• Fluids
• Idling
• Driving
Data Source: National Automobile Dealers Association, 2009
A car’s exterior and interior conditions can indicate past accidents, repairs, or lack of maintenance that may increase future operating expenses, or just driving habits that have left a less attractive or less comfortable vehicle.
Services like Carfax provide research on a vehicle’s history based on its VIN (vehicle identification number), including any incidence of accidents, flooding, frame damage, or airbag deployment, the number and type of owners (was it a rental or commercial vehicle?), and the number of kilometres. All these events affect your expectations of the vehicle’s longevity, maintenance and repair costs, resale value, and operating costs, which can help you calculate its value and usefulness.
Unless you are an expert yourself, you should always have a trained mechanic inspect a used vehicle before you buy it. With cars, as with any item, the better informed you are, the better you can do as a consumer. Given the cost of a car and its annual expense, there is enough at stake with this purchase to make you cautious.
Identify the Market
New cars are sold through car dealerships. The dealer has a contract with the manufacturer to sell its cars in the retail market. Dealers may also offer repair and maintenance services as well as parts and accessories made especially for the models it sells.
New car dealers may also resell cars that they get as trade-ins, especially of the same models they sell new. Used car dealers typically buy cars through auctions of corporate, rental, or government cars.
Individuals selling a used car can also do so through networking—in an online auction such as eBay, a virtual bulletin board such as VarageSale or Kijiji, or the bulletin board in the local college snack bar. Dealers will have more information about the market, especially about the supply of cars and price levels for them.
Some people prefer a new car, with its more advanced features and more certain quality, but a used car may be a viable substitute for many purchasers. Many people buy used cars while their incomes are lower, especially in the earlier stages of their adult (working) life. As income rises and concern for convenience, reliability, and safety increases with age and family size, consumers may move into the new car market.
While they are two very different markets, the markets for new and used cars are related. Supply of and demand for new cars affect price levels in the new car market, but also in the used car market. For example, when new car prices are high, more buyers seek out used cars, and when they are low, used car buyers may turn to the new car market.
Demand for cars is affected by macroeconomic factors such as business cycles and inflation. If there is a recession and a rise in unemployment, incomes drop; demand for new cars will therefore fall. Many people will decide to keep driving their current vehicle until things pick up, unwilling to purchase a long-term asset when they are uncertain about their job and paycheque. That slowing of demand may lower car prices, but will also lower the resale or trade-in value of the current vehicle. For first-time car buyers, that may be a good time to buy.
If there is inflation, it will push up interest rates because the price of borrowing money rises with other prices. Since many people borrow when purchasing a car, that will make the borrowing, and so the purchase, costlier, which will discourage demand.
When the economy is expanding, on the other hand, and inflation and interest rates are low, demand for new cars rises, pushing up prices. In turn, prices are kept in check by competition. As demand for new cars rises, demand for used cars may fall, causing the supply of used cars to rise as more people trade in their cars to buy a new one. They trade them in earlier in the car’s life, so the quality of the used cars on the market rises. This may be a good time to buy a used car.
Identify the Financing: Loans and Leases
The cost of a car is significant. Car purchases usually require financing through a loan or a lease. Each may require a down payment, which you would take out of your savings. That creates an opportunity cost of losing the return you could have earned on your savings. You also lose liquidity: you are taking cash, a liquid asset, and trading it for a car, a not-so-liquid asset. (See the FCAC webpage Financing a car for more information.)
Your opportunity cost and the cost of decreasing your liquidity are costs of buying the car. You can reduce those costs by borrowing more (and putting less money down), but the more you borrow, the higher your costs of borrowing. If you trade in a vehicle, dealers will often use the trade-in value as the down payment and will sell the car to you with “no money down.”
Car loans are available from banks, credit unions, consumer finance companies, and the manufacturers themselves. Be sure to shop around for the best deal, as rates, maturity, and terms can vary. If you shop for the loan before shopping for the car, then the loan negotiation is separate from the car purchase negotiation. Both may be complex deals, and there are many trade-offs to be made. The more separate—and simplified—each negotiation is, the more likely you will be happy with the outcome.
Loans differ by interest rate, or APR, and by the time to maturity. Both will affect your monthly payments. A loan with a higher APR will cost you more and, all things being equal, will have a higher monthly payment. A loan with a longer maturity will reduce your monthly payment, but if the APR is higher, it will actually cost you more. Loan maturities may range from one to five years; the longer the loan, the more you risk ending up with a loan that’s worth more than your car.
Rebecca buys a used Saturn for \$6,000, with \$1,000 cash down from savings and a loan at 7.2 APR, on which she pays \$115 a month for forty-eight months. She could have gotten a twenty-four-month loan, but wanted to have smaller monthly payments. After only twenty-five months, she totals her car in a chain collision but luckily escapes injury. Now she needs another car. The Saturn has no trade-in value, her insurance benefit won’t be enough to cover the cost of another car, and she still has to pay off her loan regardless. Rebecca is out of luck, because her debt outlived her asset. If your debt outlives your asset, your ability to get financing when you go to replace that vehicle will be limited, because you still have the old debt to pay off and now are looking to add a new debt—and its payments—to your budget. Rebecca will have to use more savings and may have to pay more for a second loan, if she can get one, increasing her monthly payments or extending her debt over a longer period of time.
An alternative to getting a car loan is leasing a car. Leases are a common way of financing a car purchase. A lease is a long-term rental agreement with a buyout option at maturity. Typically, at the end of the lease—usually three or four years—you can buy the car outright for a certain amount, or you can give it back (and buy or lease another car), which removes the risk of having an asset that outlives its financing. Leases specify the number of kilometres that you can drive the car in a year before incurring additional costs. Leases also specify the monthly payment and requirements for routine maintenance that will preserve the car’s value.
So, lease or borrow? The price of the car should be the same regardless of how it is financed—the car should be worth what it’s worth, no matter how it is paid for. The cost of borrowing, in percentage terms, is the interest rate or APR of the loan. The costs of leasing, in dollars, are the down payment, the lease payments, and the buyout. Since the price of the car itself is the same in either case, the present value of all the lease costs should be the same as the price of the car. You can use what you know about the time value of money to calculate the discount rate that produces that price; that is the equivalent annual cost of the lease, in percentage terms.
For example, you want to buy a car with a price of \$19,000. You can get a car loan with an APR of 6.5 per cent from your bank. You are offered a lease requiring a down payment of \$2,999, monthly payments of \$359 for three years, and a final buyout of \$5,000. The APR of the lease is actually 5.93 per cent, which would make it the cheaper financing alternative.
In general, the longer you intend to keep the car, the less sense it makes to lease. If you typically drive a car “into the ground,” until it costs more to repair than replace it, then you are better off borrowing and spreading the costs of financing over a longer period. On the other hand, if you intend to keep the car only for the term of the lease and not to exercise the buyout option, then it is usually more cost effective to lease. You also need to consider whether or not you are likely to stay within the kilometre limits of the lease, as the penalties can add significantly to your costs.
Some people will say that they like to borrow and then “own” in order to have an asset that can store value or “build equity.” Given the unpredictable nature of the used car market, however, a car is really not an asset that can be counted on to store value. Thinking of a car as something that you will use up (although over several years) rather than as an asset you can preserve or save will help you make better financial decisions.
When you are buying a car, you want to minimize the cost of both the car and the financing. If you are purchasing the car and the financing from the same dealer, you should be careful to discuss them separately. Car dealers who offer loans and leases as well as cars often combine the three discussions, offering a break on the financing to make the car more affordable, or offering a break on the car to make the financing more affordable. To complicate matters further, they may also offer a rebate on a certain model or with a certain lease. The more clearly you can separate which costs belongs to which—the car or the financing—the more clearly you can understand and minimize your costs.
Purchase and Post-Purchase
A car purchase requires significant pre-purchase activities. Once you have identified and compared appropriate car attributes, a seller, and financing options, all you have to do is drive away, right? Not quite.
Car purchases are one instance where the buyer is expected to haggle over price. The sticker price is the manufacturer’s suggested retail price (MSRP) for that vehicle model with those features. Dealers negotiate many of the factors that ultimately determine the value of the purchase: the optional features of the car, the warranty terms, service discounts on routine maintenance, financing terms, rebates, trade-in value for your old car, and so on.
As more of these factors are discussed at once, the negotiation becomes more and more complex. You can help yourself by keeping the negotiations as simple as possible: negotiate one thing at a time, settle on that, and then negotiate the next factor. Keep track of what has been agreed to as you go along. When each factor has been negotiated, you will have the package deal.
Your ability to get a satisfying deal rests on your abilities as a negotiator. For this reason, many people who find that process distasteful or suspect that their skills are lacking find the car-purchasing process distasteful. Dealers know this, and some will try to attract customers by being more transparent about their own costs and about prices.
As with any product in any market, the more information you have, the better you can negotiate. The more thorough your pre-purchase activities, the more satisfying your purchase will be.
While you own the car, you will maximize the benefits enjoyed by operating the vehicle safely and by keeping it in good condition. Routine maintenance (e.g., replacing fluids, rotating tires) can ensure the quality and longevity of your vehicle. New cars come with owner’s manuals that detail a schedule of service requirements and good driving practices for your vehicle. You will be required to keep the car legally insured and registered with the province or territory where you reside, and you must maintain a valid licence to drive.
New cars, and some used cars, are sold with a warranty, which is a promise about the quality of the product, made for a certain period of time. The terms and covered repair costs may vary. You should understand the terms of the warranty, especially if something covered should need servicing, so that you know what repairs you may be charged for. The manufacturer, and sometimes the seller, issues the warranty. If you have questions about the warranty after purchasing, it may be best to contact the manufacturer directly.
If you are dissatisfied with your purchase (and the fault seems to be with the car), your first step should be a conversation with your dealer. If the problem is not addressed, you can contact the automobile company directly; its website will provide you with a customer service contact. If the dealer and the manufacturer refuse to make good, you should contact your provincial or territorial consumer affairs office.
Key Takeaways
1. The purchase process may be applied to a car purchase.
2. Attribute scoring may be helpful to identify the product.
3. Cars are commonly financed through a loan or a lease.
4. A warranty guarantees minimal satisfaction with performance attributes.
Exercises
1. Perform an attribute analysis for your next new or used car. Go online to research cars with the attributes you have prioritized, and find where you could buy what you want locally. Then research the dealership, including a quick check at the Better Business Bureau website or your local chamber of commerce to learn if there have been many consumer complaints. Comparison shop by referring to the Canadian Red Book or the Canadian Black Book. After researching the product, the market, and the price, visit a dealership, preferably with a classmate or partner, for the experience of getting information and practising your negotiation skills (but without making any commitments, unless you really are in the market for a car at this time).
2. How will you finance a car? First identify a sample of new or used cars you would like to own, and for each choice calculate what your down payment, monthly loan payments, and term of payment would be. How much would you need to buy a car and where would that money come from? How much could you afford to pay each month and for how long? How could you modify your budget to accommodate car payments?
3. For a car you would like to drive, calculate and compare what it would cost you to buy it and to lease it. Use the Vehicle Lease or Buy Calculator on the Government of Canada website. What would be the advantages of owning the car? What would be the advantages of leasing it? For your lifestyle, needs, and uses of a vehicle, should you buy or lease? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/02%3A_Achieving_Your_Financial_Goals/2.02%3A_Consumer_Strategies.txt |
INTRODUCTION
Buying a home may be the biggest purchase you ever make. Unlike most other consumer purchases, a home is expected to be more than a living space; it is also often viewed as an asset that stores and increases value. A house, then, often has a dual financial role as both a nest and a nest egg.
However, it must be noted that a house does not always increase in value. Depending on how they save and invest their money, many people who choose to rent and often save and invest the difference between their rent and what they would have had to pay as a mortgage payment do just as well as or better than their peers who build equity in a home.
A house can be costly to maintain. There are substantial annual operating expenses for repairs and maintenance, insurance, and taxes. Maintenance is critical if one wishes to preserve a home’s value. Insurance is also required if you wish to protect that value. Homeowners must pay taxes for community services that help to enhance and secure a home’s value.
A house purchase is typically financed with debt that creates a significant monthly expense in your budget—the mortgage payment. A mortgage is a long-term debt that obligates your cash flows for a long time, perhaps even reducing your choices of careers and your mobility.
Your choice of home, whether you own or rent, reflects personal factors in your life. These factors include your personal tastes, your age and stage of life, your family size and circumstances, your health, and your career choices. These factors are reflected in your decision to own or rent a home, as well as in the location, size, and use of your home.
9.1 IDENTIFY THE PRODUCT AND THE MARKET
Learning Objectives
1. Describe the different building structures for residential dwellings.
2. Describe the different ownership structures for residential dwellings.
3. Identify the factors used by lenders to evaluate borrowers for mortgage credit.
4. Identify the components of the mortgage affordability calculation and calculate estimated mortgage affordability.
5. Identify the components of a buyer’s inspection checklist.
6. Explain the potential effects of business cycles, unemployment, and inflation on the housing market.
7. Analyze the effects of the demand for housing financing on the housing market.
Renting a Home
If you have already decided on a goal of home ownership, you have already compared the costs and benefits of the alternative, which is renting. Renting requires relatively few initial legal or financial commitments. The renter signs a lease that spells out the terms of the rental agreement: term, rent, terms of payments and fees, restrictions such as pets or smoking, and charges for damages. A renter is usually required to give the landlord a security deposit to cover the landlord’s costs of repairs or cleaning, as necessary, when the tenant moves out. If the deposit is not used, it is returned to the departing tenant and, in most cases, the deposit with interest should be provided to tenants when they move out. Some general advantages and disadvantages of renting and owning are shown in Table 9.1.1.
Table 9.1.1 Renting versus Owning
Advantage Disadvantage
Renting
• Limited financial obligation
• Limited maintenance expenses
• More liquidity
• More mobility
• No equity growth or store of value
• Lifestyle limitations (e.g., pets, smoking)
• Decorating/renovating limitations
• Less-predictable housing expense
Owning
• Store of value and possible equity growth
• Lifestyle choices
• Decorating/renovating choices
• Pride of ownership
• More-predictable housing expenses
• Substantial financial obligation
• Significant annual expenses
• Less liquidity
• Less mobility
The choice of whether to rent or own follows the pattern of life stages. People rent early in their adult lives because they typically have fewer financial resources and put a higher value on mobility, usually to keep more career flexibility. Since incomes are usually low, the tax advantages of ownership don’t have much benefit.
As family size grows, the quality of life for dependents typically takes precedence, and a family looks for the added space and comfort of a house and its benefits as an investment. This is the mid-adult stage of accumulating assets and building wealth. As income rises, the tax benefit becomes more valuable too. Often, in retirement, with both incomes and family size smaller, older adults will downsize to a condo, an apartment, or a smaller house, shedding responsibilities and financial commitments. Home ownership decisions vary: some people do not want the responsibilities of ownership, while some just want to own their home.
Finding an apartment or house to rent is much like finding a home in terms of assessing its attributes, comparing choices, and making a choice. Landlords, property managers, and agents all rent properties and use various media to advertise an available space. Since the rent for an apartment is a regular expense, financed from current income (not long-term debt), you need to find only the apartment and not the financing, which simplifies the process considerably.
Assessing Attributes
Once you decide to own your home, you must choose which home to own.
There are single- and multiple-unit dwellings, for example. A multiple-unit dwelling can be used to create rental income or to house extended family members, but this choice imposes the responsibilities of being a landlord and also limits privacy.
There are previously owned, new, and custom-built homes. Previously owned homes may require some renovation to make them comfortably modern and convenient. New and custom-built homes typically have more modern features and conveniences and require less maintenance and repair expense. Custom-built homes are built to the homeowners’ specifications.
Mobile homes are large trailers fitted with utilities connections and they can be installed on permanent sites and used as residences. A mobile home may also be situated in a trailer park or mobile home community in which the owner rents a lot. Mobile homes are often referred to as manufactured homes, and other examples of manufactured homes are prefabricated or modular homes, which are moved to a foundation site by trailer and then assembled.
In a condominium, the homeowner owns a unit in a multiple-unit dwelling, but the common areas of the building are owned and managed by the condominium owners’ association. Condo owners pay a fee to cover the costs of overall building maintenance and operating expenses for common areas.
Co-operative housing is a unit in a building or complex owned by a non-profit association or a corporation for the residents’ use. Residents do not own the units, but rather own shares in the co-operative association, which entitles them to the right to dwell in its housing units.
Personal factors such as your age, family size, health, and career help you to answer some of the following key questions:
• How large should the house be? How many bedrooms and bathrooms?
• Which rooms are most important: kitchen, family room, or home office?
• Do you need parking or a garage?
• Do you need storage space?
• Do you need disability accommodation?
• Do you want outside space: a yard, patio, or deck?
• How important is privacy?
• How important is energy efficiency and other “green” features?
• How important are design features and appearance?
• How important is location and environmental factors?
• How important is proximity to work? Schools? Shopping? Family and friends?
After ranking the importance of such attributes, you can use an attribute-scoring matrix to score your choices. After understanding exactly what you are looking for in a home, you should begin to think about how much house you can afford.
Canada Mortgage Housing Corporation
The Canada Mortgage Housing Corporation (CMHC) is a Canadian government agency and Canada’s authority on housing. According to the CMHC, the agency aims to “contribute to the stability of the housing market and financial system, provide support for Canadians in housing need, and offer objective housing research and advice to Canadian governments, consumers and the housing industry” (CMHC, 2017a).
Many of the resources that are provided throughout this chapter are derived from the CMHC website and are important to review before you set out to purchase a home.
Assessing Affordability
Before looking for a house that offers what you want, you need to identify a price range that you can afford. Most people use financing to purchase a home, so your ability to access financing or get a loan will determine the price range of the house you can buy. Since your home and your financing are long-term commitments, you need to be careful to try to include future changes in your thinking.
For example, Tamiko and Anthony are both twenty-five years old, newly married, and looking to buy their first home. Both work and earn good incomes. The real estate market is strong, especially with mortgage rates relatively low. They buy a two-bedroom condo in a new development as a starter home.
Fast forward five years. Tamiko and Anthony are expecting their second child; while the couple is happy about the new baby, neither can imagine how they will all fit in their already cramped space. They would love to sell the condo and purchase a larger home with a yard for the kids, but the real estate market has slowed, mortgage rates have risen, and a plant closing last year has driven up unemployment in their area. Tamiko hasn’t worked outside the home since their first child was born two years ago; they are just getting by on one salary and a new baby will increase their expenses—making it even more difficult to think about financing a larger home.
A lender will look at your income, your current debts, and your credit history to assess your ability to afford a mortgage. As discussed in Chapter 7 “Financial Management,” your credit score is an important tool for the lender, who may also request verification of employment and income from your employer.
Before looking for a home, the CMHC recommends reviewing its guide Homebuying Step by Step.
As Tamiko and Anthony consider buying a home, an important first step is identifying how much they can afford to spend on homeownership in order to ensure they have enough money to cover all of their other expenses, such as food, clothing, and other debts and payments.
According to the CMHC, there are two rules Canadians should follow in order to assess whether they can comfortably manage a home and to verify whether a lender will approve them. The first affordability rule is to determine your gross debt service (GDS). To figure out your GDS, you must determine the principal and interest that make up your monthly mortgage payment, as well as taxes and heating expenses. The acronym “PITH” (principal, interest, taxes, and heating) can help people to remember these expenses. A condominium purchase must also take into consideration half of the monthly condominium fees. GDS is determined by adding up your total monthly PITH payments and calculating what percentage of your average gross monthly household income is made up of PITH payments (CMHC, 2016). GDS ratios are calculated by using the following equation:
Gross debt service (GDS) = PI + T + H x 100%
GI
GDS should not be more than 35 per cent of your gross monthly income. The CMHC online Debt Service Calculator can help you to compare your monthly debt payments and housing expenses to your gross household income.
The second affordability rule is to calculate your total debt service (TDS) in order to determine how much of your gross income is already going toward debt payments. TDS is the percentage of your income needed to cover all of your debts. The ratio for this is the same as that of the GDS, except all of your monthly payments, such as car payments, credit cards, and any loans, must be considered (CMHC, 2016). TDS ratios are calculated by using the following equation:
Total debt service (TDS) = PI + T + H + D x 100%
GI
For lenders to consider you for a mortgage, your TDS should not be more than 42 per cent of your gross monthly income.
In order to calculate GDS and TDS, the CMHC webpage Calculating GDS/TDS provides information on what inputs are used to calculate a borrower’s debt service ratios.
If you would like to determine the monthly mortgage payments (principal and interest) of a home by inputting different down payments, house prices, and interest rates, the CMHC’s Mortgage Calculator should be of assistance.
These kinds of calculations give both you and your lender a much clearer idea of what you can afford, and they are part of the pre-approval process for a mortgage. You may want to sit down with a potential lender and have this discussion before you do any serious house hunting so that you have a price range in mind before you shop.
Searching for a Home
After understanding exactly what you are looking for in a home and what you can afford, you can organize your efforts and begin your search.
Typically, buyers use a realtor, real estate agent, or broker who has to be licensed to trade real estate in Canada and realty listings to identify homes for sale. A realtor is a person or business that serves as an agent for the sale and purchase of buildings and land. A real estate broker is a manager of a brokerage firm who supervises real estate agents. Brokers are given broker’s licences by provincial real estate associations when they have completed additional training for their added responsibilities. Brokers add value to your search by providing information about the house and property, the neighbourhood and its schools, recreational and cultural opportunities, and costs of living. A real estate agent serves as an intermediary between people selling a property and those who want to buy real estate, and they are often employed by a real estate broker in a registered real estate brokerage.
Remember, though, that the broker or its agent, while helping you gather information and assess your choices, is working for the sellers and will be compensated by the seller when a sale is made. Consider paying for the services of a buyer’s agent, a fee-based real estate broker who works for the buyer to identify choices independently of the purchase. The real estate industry is regulated by provincial, territorial, and federal laws as well as by self-regulatory bodies, and real estate agents must be licensed to operate.
Increasingly, sellers are marketing their homes directly to save the cost of using a broker. A real estate broker typically takes a negotiable amount of the purchase price, often in the range of 3 to 7 per cent, from which it pays a commission to the real estate agent, which is then split with the buyer’s agent. Some brokers will charge a flat rate. There is no set rate of commission for real estate agents nationally or in individual provinces and territories and the rate is often negotiable (Tersigni, 2017). “For sale by owner” sites on the Internet can make the exchange of housing information easier and more convenient for both buyers and sellers. For example, websites such as comfree.com serve home sellers and buyers directly. Keep in mind, however, that sellers acting as their own brokers and agents are not licensed or regulated and may not be knowledgeable about federal and provincial laws governing real estate transactions, potentially increasing your risk.
Mortgage Pre-Approval and Qualifying for a Mortgage
Mortgages can be obtained from several types of lenders, such as:
• banks,
• credit unions or caisses populaires,
• mortgage companies,
• insurance companies,
• trust companies, and
• loan companies.
It is important to talk to several lenders during the pre-approval process to make sure you’re getting the best rates and conditions for your mortgage needs. A pre-payment penalty can be charged if you switch lenders after signing a mortgage contract, so it is important that you are comfortable with and understand the terms and condition of your mortgage contract.
Mortgage lenders look at one’s finances (GDS and TDS) in order to determine the maximum amount of a mortgage they will lend you, what tentative interest rate they will charge, and what your estimated mortgage payments will be. But the pre-approval, while it represents the maximum amount you may get, does not guarantee you will receive that mortgage loan amount (FCAC, 2017).
In order to get pre-approved, the FCAC (2017) provides an overview of the information (your total assets and debts) required by your lender or mortgage broker (an intermediary between a borrower and a lender who determines the borrower’s ability to secure financing), including:
• identification,
• proof of employment,
• proof you can pay for the down payment and closing costs,
• information about your other assets, such as a car, cottage, or boat, and
• information about your debts or financial obligations.
Proof of employment may require that you provide:
• proof of current salary or hourly pay rate (for example, a current pay stub and a letter from your employer),
• your position and length of time with the organization, and
• notices of assessment from the CRA for the past two years, if you’re self-employed.
Proving that you can pay the down payment may require that you provide recent financial statements from bank accounts or investments.
Your lender or mortgage broker will also require an overview of your debts or financial obligations, which may include:
• credit card balances and limits, including those on store credit cards,
• child or spousal support amounts,
• car loans or leases,
• lines of credit,
• student loans, and
• other loans.
The FCAC recommends asking the following questions when getting pre-approved:
• how long the lender or broker will guarantee the pre-approved rate
• whether you automatically get the lowest rate if interest rates go down while you’re pre-approved
• if the pre-approval can be extended (FCAC, 2017).
Even if you’ve been pre-approved, you could be refused a mortgage by your chosen lender. A lender will need to verify that your property meets certain standards; this is determined by each lender and therefore varies. If you are turned down for a mortgage, it is important to ask about other options that are available (FCAC 2017).
Home Inspection
After you narrow your search, receive mortgage pre-approval, and choose a prospective home, you have the home inspected to assess its condition and project the cost of any repairs or renovations. Home inspections are strongly recommended before signing a purchase agreement or as a condition of the agreement. A standard home inspection checklist, based on information from Desjardins Insurance, is shown in Table 9.1.2.
Table 9.1.2 Standard Home Inspection Checklist
Inside Outside
Kitchen
• Check countertops, sinks, cupboard doors for damage
• Ensure range hood exhaust fan works properly
• Check pipes under sink for leaks
• Check sink water flow
Driveway, Grounds
• Check for large cracks or uneven portions of driveway
• Check for standing water
Floors, Walls, Ceilings
• Check for cracks, damage, water spots
• Walk across all floors—ensure minimum unevenness, squeaking
Exterior Surfaces
• Check for cracks, decay in siding
• Check for stains or paint flaking on exterior surfaces
Bathrooms
• Check faucet water flow and pressure
• Ensure sink, shower, tub drains properly, toilet functions properly
• Check for cracked/loose tiles
• Ensure cabinets and plumbing under sink in good condition
Roof
• Shingles: check for rot, cracks, curling, loss of granulation, broken or missing shingles
• Ensure that gutters and chimney are in good condition
Windows, Doors
• Ensure windows and doors open/close properly
• Check for cracked/broken glass or damaged screens in windows
• Inspect weather-stripping for damage
Miscellaneous Items
• Ensure that automatic garage door operates properly
• Make sure outside foundation is in good condition (straight, no large cracks)
• Ensure smoke/carbon monoxide detectors installed as per provincial regulations
Basement
• Check for large cracks/stains in exposed foundation
• Check for water leaks on ceiling/floor
• No decay/damage in structural wood
Attic
• Check for structural and water damage
• Ensure proper insulation and ventilation
Plumbing
• Check for damaged/leaking pipes
• Check for rust on water heater
• Locate all water shut-off valves (remember: to prevent frozen pipes in winter, close inside valves that supply outside hose bibs)
Electrical
• Ensure main electrical panel is easily accessible
• Ensure all wiring is in good condition, no exposed splices
• Ensure there are CFGI (ground fault circuit interrupter) outlets in kitchen and bathrooms
Data Source: Desjardins Insurance, 2016; table created by Bettina Schneider, 2018
As with a car, it is best to hire a professional (a structural engineer, contractor, or licensed home inspector) to do the home inspection. A professional will be able to spot not only potential problems but also evidence of past problems that may have been fixed improperly or that may recur—for example, water in the basement or leaks in the roof. If there are problems, you will need an estimate for the cost of fixing them. If there are significant and immediate repair or renovation costs projected by the home’s condition, you may try to reduce the purchase price of the property by those costs. You don’t want any surprises after you buy the house, especially costly ones.
You will also want to do a title search, as required by your lender, to verify that there are no liens or claims outstanding against the property. For example, the previous owners may have had a dispute with a contractor and never paid his bill, and the contractor may have filed a lien or a claim against the property that must be resolved before the property can change hands. There are several other kinds of liens—for example, a tax lien, which is imposed to secure payment of overdue taxes.
A lawyer or a title search company can do the search, which involves checking the municipal or town records where a lien would be filed. A title search will also reveal if previous owners have deeded any rights—such as development rights or water rights, for example, or grants of right-of-way across the property—that would diminish its value.
Identifying the Market
Housing costs are determined by the price of the house and by the price of the debt (i.e., the interest rate payments) that finances the house. House prices are determined by forces of supply and demand, which in turn are determined by macroeconomic circumstances.
When the economy is contracting and incomes are decreasing, and especially if unemployment rises and incomes become uncertain, buyers are hesitant to add the significant financial responsibility of new debt to their budgets. They tend to continue with their present arrangements or may try to move into cheaper housing, downsizing to a smaller house, an apartment, or condo to decrease operating expenses. When the economy is expanding, on the other hand, expectations of rising incomes may encourage buyers to be bolder with their purchasing decisions.
A house represents not only a housing expense but also an investment that can serve as a store of wealth. In theory, if a contraction creates a market with declining asset values, investors will seek out alternative investments, abandoning that market. In other words, if house prices decline, the house’s value as an investment will decline. Investors will seek other assets in which to store wealth to avoid the opportunity cost of making an investment that does not generate returns.
Housing markets are local, however. If the local economy is dominated by one industry or by one large employer, the housing market will be sensitive to the fate of that industry or employer. If a location has value independent of the local economy, such as value as a vacation or retirement location, that value can offset local concerns. In that case, housing prices may be less sensitive to the local economy.
Since a house is an investment, the homebuyer is concerned about its expected future value. Future value is not easy to predict, however, as housing markets have some volatility. In extreme periods, for example between 2004 and 2009 in the United States, there was extreme volatility. Thus, depending on how long you intend to own the home, it may or may not be realistic to try to predict price trends based on macroeconomic cycles or factors. Some areas may seem to be always desirable, but a severe economic shock or boom can affect prices in those areas as well. While a house may be used to store value, it may not generate a real increase in wealth.
Since the early 2000s, however, housing prices have soared. Many economists attribute this to a sustained period of low mortgage rates and slow economic growth. In recent years, many have been concerned that Canada is close to the level at which America’s housing bubble topped out in 2006. In the United States, the housing bubble burst in 2007 as the economy slumped into a recession. Housing demand and prices fell, even with low mortgage rates, creating a real buyer’s market. Many economists attribute the severity of the slump to the banking crisis that froze the credit markets, because most housing purchases were financed with debt.
Ability to buy a house rests on the ability to finance the purchase, to provide a down payment, and to borrow. That ability is determined by the buyer’s personal situation (e.g., stability of employment or income, credit history) and by macroeconomic events such as interest rate levels, expected inflation, and liquidity in the credit markets. If interest rates and inflation are low and there is liquidity in the credit markets, it will be easier for buyers to borrow than if inflation and interest rates are high and the credit market is liquid. Demand for housing thus relies on the availability of credit for the housing market.
Key Takeaways
1. Different building structures are:
• single-unit or multiple-unit dwellings or mobile homes, and
• previously owned, new, or custom built.
2. Different ownership structures include:
• conventional ownership,
• condominium, and
• co-operative housing.
3. The buyer’s inspection checklist includes:
• structural elements,
• exterior elements,
• systems for plumbing, electrical, heating/cooling, and
• outdoor buildings and features.
4. Lenders assess income, current debts, and credit history to determine the borrower’s creditworthiness.
5. A mortgage affordability estimate uses an estimate of PITH and other debt payments as a percentage of gross monthly income and of the down payment as a percentage of the purchase price.
6. Housing prices may be affected by business cycles as they affect
• unemployment and income levels, and
• inflation, which affects not only the cost of houses but also interest rates and the cost of home financing.
7. Housing prices are affected by the availability of home financing, which in turn depends on:
• interest rates and inflation, and
• liquidity in the credit markets.
Exercises
1. Perform an attribute analysis of your projected wants and needs as a homeowner. Begin by prioritizing the following personal and microeconomic factors in terms of their importance to you in deciding when to buy a home:
• How large should the house be? How many bedrooms and bathrooms?
• Which rooms are most important: kitchen, family room, or home office?
• Do you need parking or a garage?
• Do you need storage space?
• Do you need disability accommodation?
• Do you want outside space: a yard, patio, or deck?
• How important is privacy?
• How important is energy efficiency or other “green” features?
• How important are design features and appearance?
• How important is location and environmental factors?
• How important is proximity to work? Schools? Shopping? Family and friends?
2. In your journal, describe hypothetically your first or next home that you think you would like to own, including its location and environment. Predict how much you think it might cost to own such a home in your province. Then look through realty news and ads to find the asking prices for homes or housing units similar to the one you described. How accurate is your prediction?
3. Discuss with classmates the ins and outs of being a tenant and the ins and outs of being a landlord. Develop a comparison chart of benefits, drawbacks, and risks.
4. Do you live in a dorm or at home with parents or other relatives? What needs to happen for you to have a place of your own? Research websites that aid students in finding independent housing. Develop a flexible plan and timetable for finding and financing a place of your own and record it in your personal finance journal.
5. Investigate the real estate market in your area. How do local housing availability and pricing differ from other cities, towns, and provinces or territories? How stable or volatile is your real estate market? Is it a buyer’s market or a seller’s market, and what does that mean? To what local factors do you attribute the differences you find? Share your findings with classmates.
6. Identify and analyze the macroeconomic factors that are affecting your local real estate market. In what ways or to what extent does your local economy reflect macroeconomic factors in the national economy?
REFERENCES
Canada Mortgage and Housing Corporation. (2016). “Housing for Newcomers.” Retrieved from: https://www.cmhc-schl.gc.ca/newcomer...10-10-002.html.
Canada Mortgage and Housing Corporation. (2017a). “About CMHC.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/about/.
Canada Mortgage and Housing Corporation. (2017b). “What CMHC Does.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/...wedo/index.cfm.
Canada Mortgage and Housing Corporation. (2017c). “History of CMHC.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/...t/hi/index.cfm.
Desjardins Insurance. (2016). “4 Important Home Inspection Tips and a Checklist.” Retrieved from: https://dgidirect.ca/general-tips/4-...ips-checklist/.
Financial Consumer Agency of Canada. (2017). “Getting pre-approved and qualifying for a mortgage.” Retrieved from: https://www.canada.ca/en/financial-c...gage.html#toc1.
Tersigni, J. (2017). “How Much Are Real Estate Commission Rates in Canada?” MoneyWise, May 31. Retrieved from: https://www.ratesupermarket.ca/blog/...ons-in-canada/.
9.2 IDENTIFY FINANCING
Learning Objectives
1. Define the effects of the down payment on other housing costs.
2. Calculate the monthly mortgage payment, given its interest rate, maturity, and principal balance.
3. Distinguish between a fixed-rate, variable-rate, and an adjustable-rate mortgage and explain their effects on the monthly payment and interest rate.
4. Distinguish between a rate cap and a payment cap, and explain their uses and risks.
5. Identify potential closing costs.
6. Define First Nations housing on reserve.
Just as your house may be your most significant purchase, your mortgage may be your most significant debt. The principal may be many times one year’s disposable income and may need to be paid over fifteen or thirty years. The house secures the loan, so if you default or miss payments, the lender may foreclose on your house or claim ownership of the property, evict you, and resell the house to recover what you owe.
Banks, credit unions, finance companies, and mortgage finance companies sell mortgages. They profit by lending and competing for borrowers. It makes sense to shop around for a mortgage, as rates and terms (i.e., the borrowers’ costs and conditions) may vary widely. The Internet has made it easy to compare; a quick search of “mortgage rates” yields many websites that provide national and provincial averages, lenders in your area, comparable rates and terms, and free mortgage calculators.
Keep in mind that the costs discussed in this chapter, associated as they are with various kinds of mortgages, may change. The real estate market, government housing policies, and government regulation of the mortgage financing market may change at any time. So when it is time for you to shop for a mortgage, be sure you are informed of current developments.
Down Payment
Mortgages require a down payment, or a percentage of the purchase price paid in cash upon purchase. Most buyers use cash from savings, the proceeds of a house they are selling, or a family gift.
In Canada, the minimum down payment required is 5 per cent if the home costs \$500,000 or less. If the price of the home is greater than \$500,000, one will need a minimum of 5 per cent down on the first \$500,000 and 10 per cent on the remainder (CMHC, 2018). The size of the down payment does not affect the price of the house, but how much you put down will affect the cost of the financing (a larger down payment = a smaller mortgage and lower monthly payments).
Buyers with a down payment between 5 and 20 per cent must be backed by mortgage insurance, which insures the lender against the costs of default. Mortgage loan insurance is mandatory for federally regulated lenders in Canada when the buyer of a home puts down less than a 20 per cent down payment.
The CMHC is a public mortgage insurer and as such has “a mandate to provide service in all parts of the country and for a range of housing forms” (CMHC, 2017a). A conventional mortgage is a loan for no more than 80 per cent of the purchase price (or appraised value) of the property, and it must meet the 20 per cent down payment CMHC requires in order to not have to purchase mortgage insurance. A high ratio mortgage is a loan for more than 80 per cent of the purchase price (or appraised value) of the property. A high ratio mortgage must be insured by the CMHC, Genworth Financial Canada, or Canada Guarantee.
A significant portion of the CMHC’s mortgage loan insurance business is in markets or for housing options that are not served or less served by private mortgage insurers. In addition to being the primary insurer for housing in small and rural communities, the CMHC is the only insurer of mortgages for multi-unit residential properties, including large rental buildings, student housing, and nursing and retirement homes (CMHC, 2017a).
The down payment can offset the annual cost of the financing, but it creates opportunity cost and decreases your liquidity as you take money out of savings.
The Home Buyers’ Plan is an important source of money for a down payment. The Home Buyers’ Plan “is a program that allows you to withdraw up to \$25,000 in a calendar year from your RRSPs to buy or build a housing unit in Canada for yourself or for a relative with a disability” (Government of Canada, 2016).
Cash will also be needed for the closing costs or transaction costs of this purchase or for any immediate renovations or repairs. Those needs will have to be weighed against your available cash to determine the amount of your down payment. Expenses for moving, new furniture, and other related moving expenses should be considered as well.
Monthly Mortgage Payment
The mortgage payment is the ongoing cash flow obligation of the loan. While monthly mortgage payments are common, other options are available, such as biweekly and semi-monthly payments. If you don’t meet this payment, you are in default on the loan and may eventually lose the house with no compensation for the money you have already put into it. Your ability to make the monthly payment therefore determines your ability to keep the house.
The interest rate and the maturity (lifetime of the mortgage) determine the monthly payment amount. With a fixed-rate mortgage, the interest rate remains the same over the entire maturity of the mortgage, and so does the monthly payment. A variable-rate mortgage (VRM) requires a constant monthly payment, but the amount paid toward the principal balance will fluctuate as interest rates fluctuate. Lower interest rates mean that more of the monthly payment will go towards the principal balance, while higher interest rates mean that more of the payment is allocated to the interest. VRMs generally offer lower initial interest rates compared to fixed-rate mortgages, which are attractive to borrowers. However, borrowers, not lenders, are at risk if future interest rates increase. VRMs are more often issued outside of the United States. Conventional mortgages can be fixed-rate mortgages or variable rate.
A fixed-rate mortgage is structured as an annuity: regular periodic payments of equal amounts. Some of the payment is repayment of the principal and some is for the interest expense. As you make a payment, your balance gets smaller, and so the interest portion of your next payment is smaller, and the principal payment is larger. In other words, as you continue making payments, you are paying off the balance of the loan faster and faster and paying less and less interest.
Mortgage amortization is a schedule of interest and principal payments over the life of the loan—that is, the length of time it will take you to pay off your entire mortgage. The maximum amortization period on CMHC-insured mortgages is twenty-five years. The longer the maturity, the greater the interest rate, because the lender faces more risk the longer it takes for the loan to be repaid.
In the early years of the mortgage, your payments are mostly interest, while in the last years they are mostly principal.
With an adjustable-rate mortgage (ARM), the interest rate—and the monthly payment—can change. This differs from a variable-rate mortgage in which only the interest rate can change; only the amount paid towards the principal balance varies, not the actual monthly payment. If interest rates rise, the monthly payment will increase, and if they fall, it will decrease. A rate cap is a limit on an adjustable-rate mortgage. Most rate caps rise 1 to 2 per cent in a year and no more than 5 percentage points during the life of a loan (Kapoor et al., 2015). Homeowners with ARMs are at risk of seeing their monthly payment increase, but can limit this interest rate risk with a rate cap.
ARMs are much more commonly offered in the United States than in Canada. “80% of U.S. mortgages issued in recent years to sub-prime borrowers were adjustable-rate mortgages” (Kapoor et al., 2015). The sub-prime mortgage crisis in the United States came about due to an increase in mortgage foreclosures, largely sub-prime mortgages (loans given to less creditworthy borrowers). Many mortgage lenders and hedge funds in the United States failed due to this crisis. It also negatively impacted the global credit market as risk premiums increased and capital liquidity decreased (Kapoor et al., 2015). The global financial crisis, ignited by the sub-prime mortgage crisis in the United States, began in 2007, resulting in a recession in many parts of the world, including Canada. The Canadian recession of 2008–2009, while considered milder than what was experienced in the United States and Europe, was still harsh enough that a number of changes to mortgages—insured and uninsured—were made.
The Insured Mortgage Purchase Program (IMPP) was introduced by the federal government, which allowed banks to exchange “illiquid mortgage assets for bonds issued by the Canadian Mortgage and Housing Corporation. . . . Since CMHC debt is backed by the federal government, these assets were more readily accepted as collateral for short-term lending. This exchange did not affect the government’s risk exposure to the mortgage market: only mortgages that were already insured by the government were eligible for the IMPP” (Gordon, 2017).
A payment cap limits the amount by which the mortgage payment can increase or decrease. That sounds like it would protect the borrower, but if the payment is capped and the interest rate rises, more of the payment pays for the interest expense and less for the principal payment, so the balance is paid down more slowly. If interest rates are high enough, the payment may be too small to pay all the interest expense, and any interest not paid will add to the principal balance of the mortgage.
In other words, instead of paying off the mortgage, your payments may actually increase your debt, and you could end up owing more money than you borrowed, even though you make all your required payments on time. This is called negative amortization.
There are mortgages that combine fixed and variable rates—for example, offering a fixed rate for a specified period of time, and then an adjustable rate. Another type of mortgage is a split- or multi-rate (hybrid) mortgage that allows one to split the borrowed amount into three to five parts, each with different term lengths, rates, and rate types. A hybrid mortgage allows a borrower to take advantage of the low rates inherent in a variable-rate mortgage when different parts of the mortgage are renewed at different times.
As an asset, a house may be used to secure other types of loans. A home equity loan or a second mortgage allows a homeowner to borrow against any equity in the home. A home improvement loan is a type of home equity loan. A home equity line of credit (HELOC) allows the homeowner to secure a revolving line of credit, or a loan that is borrowed and paid down as needed, with interest paid only on the outstanding balance. The advantages of HELOCs are easy access to a line of credit and the ability to repay at any time without pre-payment penalties. The disadvantages of HELOCs are the fees attached to these loans and the fact that you could lose your home if you are unable to make your loan payments.
Do-it-yourself mortgages are for self-employed people who may often have inconsistent income. For such borrowers, there are two options: 1) apply for a stated income loan, which are based on the income the borrower reports (these loans are often riskier unless the applicant has a high credit score or can provide a large down payment), and 2) regular loans with income documentation, which requires applicants to provide one to two years of tax returns (Kapoor et al., 2015).
A reverse mortgage is designed to provide homeowners with high equity a monthly income in the form of a loan. A reverse mortgage essentially is a loan against your home that you do not have to pay back for as long as you live there. To be eligible for most reverse mortgages, you must own your home and be sixty years of age or older. A set payment schedule is not required, as it is with a traditional mortgage; you or your estate repays the loan when you sell the house or die. Reverse mortgages need to be considered with caution. For more information on what people need to think about when considering this choice, see the FCAC overview of Reverse mortgages on the Government of Canada website.
Closing Costs
Other costs of a house purchase are transaction costs—that is, costs of making the transaction happen that are not direct costs of either the home or the financing. These are referred to as closing costs, as they are paid at the closing, when the ownership and loan documents are signed and the property is actually transferred. The buyer pays these closing costs, including the appraisal fee, title insurance, and filing fee for the deed.
The lender will have required an independent appraisal of the home’s value to make sure that the amount of the mortgage is reasonable given the value of the house that secures it. The lender will also require a title search and contract for title insurance. The title company will research any claims or liens on the deed; the purchase cannot go forward if the deed may not be freely transferred. Over the term of the mortgage, the title insurance protects against flaws not found in the title and any claims that may result. The buyer also pays a fee to file the property deed with the township or municipality. There may also be a land transfer tax, a one-time tax levied by most provinces and territories that is the responsibility of the buyer. PST on the mortgage insurance and legal/notarial fees must also be paid in cash as part of the closing costs. For more information on closing costs in Canada, see the Royal Bank of Canada webpage Closing Costs.
Closings may take place in the office of the title company handling the transaction or at the registry of deeds. Closings also may take place in the lender’s offices, such as a bank, or an attorney’s office and usually are mediated between the buyer and the seller through their attorneys. Lawyers who specialize in real estate ensure that all legal requirements are met and all filings of legal documents are completed.
First Nations, Métis, and Inuit Housing
According to Chris Maracle, “First Nations have always owned and maintained their own homes. Prior to contact with European Canadians some First Nations lived in communal settings while others lived nomadic lives. One thing is certain: we owned the dwellings we lived in” (CREA, 2018, p. 3). Today, First Nations governments are responsible for providing and managing on-reserve housing. First Nations communities that receive annual funding from Indigenous Services Canada for on-reserve housing can use these funds for a variety of housing needs, such as:
• construction,
• lot servicing,
• renovation,
• maintenance,
• insurance,
• debt servicing,
• planning and managing their housing portfolio, and
• mould remediation. (INAC, 2016)
The Government of Canada also invests annually in other housing programs, such as the CMHC’s On-Reserve Non-Profit Housing Program and the First Nation Market Housing Fund.
Other Government of Canada departments have programs available to support housing on reserve. For example, the CMHC works closely with other federal partners, provinces and territories, and Indigenous organizations to attempt to address housing needs in Indigenous communities by funding different programs. The CMHC’s funding supports the following:
• the construction of new rental housing,
• the renovation of existing homes,
• ongoing subsidies for existing rental social housing, and
• an investment in capacity-building for First Nations people living on reserve. (CMHC, 2017b)
The CMHC also has an On-Reserve Non-Profit Housing Program, which assists First Nations in the following areas: the construction, purchase, rehabilitation, and administration of suitable, adequate, and affordable rental housing in First Nations communities. The CMHC provides a subsidy to the project to assist with its financing and operation (CMHC, 2017b).
According to Judith Sayers (2013), the following points regarding First Nations housing should be noted:
• Reserve housing systems vary across the country.
• Some First Nations provide homes to members if they can afford it.
• Others provide homes that are built by the First Nation with a mortgage and the mortgage is paid off with the rental moneys.
• Depending on the individual First Nation’s policy, rental homes can be transferred to the member to own after the mortgage is paid out.
In addition to the points mentioned, rent can be charged by First Nations and rental revenue can be used to construct new housing and “renovate, repair or maintain existing homes” (Kiedrowski, 2014). However, it is important to note that some may see the collection of rent as a threat to treaty rights. Some First Nations, such as Six Nations and Kahnawake, have revolving loan funds for members; these First Nations provide mortgages to members who want to build or buy (CREA, 2018). Despite restrictions within the Indian Act, First Nations and financial institutions have developed innovative financing options with regard to mortgages on reserve.
There are off-reserve housing supports as well that are available to all Indigenous peoples. Provinces and territories deliver the vast majority of federal housing investments in these cases. Indigenous housing providers off reserve also have access to the CMHC’s Affordable Housing Centre, “which works with the private, public and non-profit sectors to develop affordable housing solutions that do not require ongoing federal assistance” (CMHC, 2017b). According to the CMHC, the Investment in Affordable Housing, new federal funding that has been available since 2011, provides provincial and territorial governments “the flexibility to provide programs that meet their community’s housing needs” through agreements with the federal government (CMHC, 2017c). Support may be provided in the form of proposal development funding and/or seed funding to assist in getting projects started. Indigenous housing providers off reserve can also access the Direct Lending Program for federally assisted social housing projects.
An example of an off-reserve Indigenous housing provider is Namerind Housing Corporation in Regina, Saskatchewan, which has been 100 per cent Indigenous owned since 1977. Its mission “is to provide safe, affordable, quality housing and economic development opportunities for Indigenous People” (Namerind Housing Corporation, 2018). Silver Sage Housing Corporation is another Regina-based non-profit that provides affordable housing options to First Nations peoples living in urban centres.
An example of a Métis-owned housing corporation is the Métis Urban Housing Corporation, which provides “affordable, adequate, and appropriate rental housing for low and moderate income Aboriginal families within the urban centers of Alberta” (Métis Nation of Alberta, 2018).
The Nunavut Housing Corporation (NHC) delivers a public housing program in all twenty-five Nunavut communities, the majority of which are Inuit. Management agreements between the NHC and the Local Housing Organizations (LHOs) provide “the financial resources and professional support needed to provide ongoing public housing services” (NHC, 2015).
The CMHC also provides the Housing Internship Initiative for First Nations and Inuit Youth (HIIFNIY) for First Nations and Inuit youth who would like to pursue employment in the housing industry.
The CMHC supports Habitat for Humanity’s efforts to make its home ownership model available to more Indigenous people, and it is the founding national partner for Habitat for Humanity Canada’s Indigenous Housing Program (CMHC, 2017e).
Key Takeaways
1. The percentage of the purchase price paid up front as the down payment will determine the amount that is borrowed. That principal balance on the mortgage, in turn, determines the monthly mortgage payment.
2. A larger down payment may make the monthly payment smaller but creates the opportunity cost of losing liquidity.
3. A fixed-rate mortgage is structured as an annuity; the monthly mortgage payment can be calculated from the mortgage rate, the maturity, and the principal balance on the mortgage.
4. A fixed-rate mortgage has a fixed mortgage rate and fixed monthly payments.
5. An adjustable-rate mortgage may have an adjustable mortgage rate and/or adjustable payments.
6. A rate cap or a payment cap may be used to offset the effects of an adjustable-rate mortgage on monthly payments.
7. Closing costs are transaction costs such as an appraisal fee, title search and title insurance, filing fees for legal documents, transfer taxes, and sometimes realtors’ commissions.
Exercises
1. You are considering purchasing an existing single-family house for \$200,000 with a 20 per cent down payment and a twenty-five-year, fixed-rate mortgage at 5.5 per cent. What would be your monthly mortgage payment? When should you consider an adjustable-rate mortgage? Why should you be cautious about adjustable-rate mortgages?
2. Do you presently rent or own your home or apartment? What are your housing costs? What percentage of your income is taken up in housing costs? If your housing is costing you more than a third of your income, what could you do to reduce that cost? Record your alternatives in your personal finance journal.
3. As a prospective homeowner, what would be your estimated PITH? Would a bank consider that you qualify for a mortgage loan at this time? Why or why not? What criteria do lenders use to determine your eligibility for a home mortgage?
4. Can you afford a mortgage now? How much of a mortgage could you afford? Answer these questions using the Mortgage Calculator found on the CMHC website. If you cannot afford a mortgage now, how would your personal situation and/or budget need to change to make that possible? Establish home affordability as a goal in your financial planning. Write in your personal finance journal how and when you expect you will reach that goal.
5. Read about the closing process in the following article from the Real Estate Wire, “Eight Steps to Closing the Purchase of Your New Home.” Who attends the closing? What legal documents are processed at the closing?
6. Re-review local real estate, condo, or apartment listings in the price range you have now determined is truly affordable for you. For learning purposes, choose a home you would like to own and clip the ad with photo to put in your personal finance journal. Record the purchase price, the down payment you would make, the mortgage amount you would seek, the current interest rates on a mortgage loan for fixed- and variable-rate mortgages for various periods or maturities, the type of mortgage you would prefer, the rate and maturity you would seek, the amount of monthly mortgage payments you would expect to make, and the names of lenders you would consider approaching first.
REFERENCES
Canada Mortgage and Housing Corporation. (2017a). “Mortgage Loan Insurance.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/...whwedo_004.cfm.
Canada Mortgage and Housing Corporation. (2017b). “First Nations Housing.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/...whwedo_002.cfm.
Canada Mortgage and Housing Corporation. (2017c). “Affordable Housing in Canada’s North.” Retrieved from: https://www.cmhc-schl.gc.ca/en/inpr/...afhoce_022.cfm.
Canada Mortgage and Housing Corporation. (2018). “What is CMHC Mortgage Loan Insurance.” Retrieved from: https://www.cmhc-schl.gc.ca/en/corp/...whwedo_005.cfm.
Canadian Real Estate Association (CREA). (2018). First Nations Homeownership. Retrieved from: https://www.crea.ca/wp-content/uploa...eownership.pdf.
Gordon, S. (2017). “Recession of 2008–09 in Canada.” Retrieved from: https://www.thecanadianencyclopedia....809-in-canada/.
Government of Canada. (2016). “What is the Home Buyers’ Plan (HBP)?” Retrieved from: https://www.canada.ca/en/revenue-age...yers-plan.html.
Indigenous and Northern Affairs Canada. (2016). “Roles and responsibilities in First Nations housing.” Retrieved from: http://www.aadnc-aandc.gc.ca/eng/147.../1476905026701.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Kiedrowski, J. (2014). “Rents on reserves.” National Post, October 20. Retrieved from: https://nationalpost.com/opinion/joh...ts-on-reserves.
Métis Nation of Alberta. (2018). “Métis Urban Housing Corporation (MUHC).” Retrieved from: http://albertametis.com/affiliates/m...ation-housing/.
Namerind Housing Corporation. (2018). “About Namerind.” Retrieved from: http://www.namerindhousing.ca/about-namerind.
Nunavut Housing Corporation. (2015). “Public Housing.” Retrieved from: http://www.nunavuthousing.ca/home.
Sayers, J. (2013). “Private Property Ownership On Reserve: A Strange Concept.” First Nations BC Knowledge Network. Retrieved from: https://fnbc.info/blogs/judith-sayer...trange-concept.
9.3 PURCHASING AND OWNING YOUR HOME
Learning Objectives
1. Identify the components of a purchase and sale agreement.
2. Explain the importance of a capital budget in determining capital spending priorities.
3. Identify the financing events you may encounter during the maturity of a mortgage.
4. Define the borrower’s and the lender’s responsibilities to the mortgage.
5. Explain the consequences of default and foreclosure.
The Purchase Process
Now that you’ve chosen your home and determined the financing, all that’s left to do is sign the papers, right? Not quite.
Once you have found a house, you will make an offer to the seller, who will then accept or reject your offer. If the offer is rejected, you may try to negotiate with the seller or you may decide to forgo this purchase. If your offer is accepted, you and the seller will sign a formal agreement, often called a purchase and sale agreement or a residential form of offer to purchase, specifying the terms of the sale. When the purchase and sale agreement is signed, you will be required to pay a non-refundable deposit, also known as earnest money, which counts toward your down payment.
The purchase and sale agreement might include the following terms and conditions:
• A legal description of the property, including boundaries, with a site survey contingency;
• The sale price and deposit amount;
• A mortgage contingency, stating that the sale is contingent on final approval of your financing;
• The closing date and location, mutually agreed upon by buyer and seller;
• Conveyances or any agreements made as part of the offer—for example, an agreement as to whether the kitchen appliances are sold with the house;
• A home inspection contingency specifying the consequences of a home inspection and any problems that it may find, if not already completed and included in the price negotiation;
• Possession date, usually the closing date; and
• A description of the property insurance policy that will cover the home until the closing date.
Any problems with the property must be legally disclosed, and the method of doing so varies by province.
After the purchase and sale agreement is signed, any conditions that it specified must be fulfilled before the closing date. If those conditions are the seller’s responsibility, you will want to be sure that they have been fulfilled before closing. Read all the documents before you sign them and get copies of everything you sign. Do not hesitate to ask questions. You will live with your mortgage, and your house, for a long time.
Capital Expenditures
A house and property need care; even a new home will have repair and maintenance costs. These costs are now a part of your living expenses or operating budget.
If you have purchased a home that requires renovation or repair, you will decide how much of the work you can do immediately and how much can be done on an annual basis. A capital budget is helpful to project these capital expenditures and plan the income or savings to finance them. You can prioritize these costs by their urgency and by how they will be done.
For example, Sally and Chris just closed on an older home and are planning renovations. During the home inspection, they learned that the old stone foundation would need some work. They would also like to install more energy-efficient windows, paint the walls, and strip and refinish the old wood floors.
Their first priority should be the foundation on which the house rests. The windows should be the next on the list, as they will not only provide comfort but also reduce the heating and cooling expenses. Cosmetic repairs such as painting and refinishing can be done later. The walls should be done before the the floors (in case any paint drips on the floors).
Renovations should increase the resale value of your home. It is tempting to customize renovations to suit your tastes and needs, but too much customization will make it more difficult to realize the value of those renovations when it comes time to sell. You will have a better chance of selling at a higher price if there is more demand for it, if it appeals to as many potential buyers as possible. The more customized or “quirky” it is, the less broad its appeal may be.
Early Payment
Two financing decisions may come up during the life of a mortgage: early payment and refinancing. Some mortgages have an early payment penalty, also referred to as “closed mortgages”—whereby the borrower is fined for repaying the loan before it is due—but most do not. If your mortgage does not have an early payment penalty—this is often referred to as an “open mortgage”—you may be able to pay it off early (before maturity), either with a lump sum or by paying more than your required monthly payment and having the excess payment applied to your principal balance.
If you are thinking of paying off your mortgage with a lump sum, then you are weighing the value of your liquidity, the opportunity cost of giving up cash, against the cost of the remaining interest payments. The cost of giving up your cash is the loss of any investment return you may otherwise have from it.
You also need to weigh the use of your cash to pay off the mortgage versus other uses of that cash. For example, suppose you have some money saved and you are thinking of paying down the mortgage. However, you also know that you will need a new car in two years. If you use that money to pay down the mortgage now, you won’t have it to pay for the car two years from now. You could get a car loan to buy the car, but the interest rate on that loan will be higher than the rate on your mortgage. If paying off your mortgage debt forces you to use more expensive debt, then it is not worth it.
One way to pay down a mortgage early without sacrificing too much liquidity is by making a larger monthly payment. The excess over the required amount will be applied to your principal balance, which then decreases faster. Since you pay interest on the principal balance, reducing it more quickly would save you some interest expense. If you have had an increase in income, you may be able to do this fairly “painlessly,” but then again, there may be a better use for your increased income.
Over a mortgage as long as thirty years, that interest expense can be substantial—more than the original balance on the mortgage. However, that choice must be made in the context of the value of your alternatives.
Refinancing
You may think about refinancing your mortgage if better mortgage rates are available. Refinancing means borrowing a new debt or getting a new mortgage and repaying the old one. It involves closing costs: the lender will want an updated appraisal, a title search, and title insurance. It is valuable to refinance if the mortgage rate will be so much lower that your monthly payment will be substantially reduced. That in turn depends on the size of your mortgage balance.
If interest rates are low enough and your home has appreciated so that your equity has increased, you may be able to refinance and increase the principal balance on the new mortgage without increasing the monthly payment over your old monthly payment. If you do that, you are withdrawing equity from your house, but you are not allowing it to perform as an investment—that is, to store your wealth.
If you would rather take gains from the house and invest them differently, that may be a good choice. But if you want to take gains from the house and use those for consumption, then you are reducing the investment returns on your home. You are also using nonrecurring income to finance recurring expenses, which is not sustainable. There is also a danger that property value will decrease and you will be left with a mortgage worth more than your home.
Default, Foreclosure, and Fraud
If you have a change of circumstances—for example, you lose your job in an economic downturn, or you have unexpected health-care costs in your family—you may find that you are unable to meet your mortgage obligations as planned. A mortgage is secured by the property it financed. If you miss payments and default on your mortgage, the lender has recourse to foreclose on your property, evict you and take possession of your home, and then sell or lease it to recover its investment. Under normal circumstances, lenders incur a cost in repossessing a home, and usually lose money in its resale. It may be possible to renegotiate terms of your mortgage to forestall foreclosure. You may want to consult with a legal representative, or contact federal and/or provincial agencies for assistance.
You may believe you are having trouble meeting your mortgage obligations because they are not what you thought they would be. Lenders profit by lending. When you are borrowing it is important to understand the terms of your loan. If those terms will adjust under certain conditions, you must understand what could happen to your payments and to the value of your home. It is your responsibility to understand these conditions. However, the lender has a responsibility to disclose the lending arrangement and all its costs, according to federal and provincial laws (which vary by province). If you believe that not all the conditions and terms of your mortgage were fairly disclosed, you should contact local consumer advocacy groups that will help clarify the laws and explore any legal recourse you may have.
Just as your lender has a legal obligation to be forthcoming and clear with you, you have an obligation to be truthful. If you have misrepresented or omitted facts on your mortgage application, you can be held liable for mortgage fraud. For example, if you have overstated your income, misled the lender about your employment or your intention to live in the house, or have understated your debts, you may be prosecuted for mortgage fraud, intentional misrepresentation or omission of facts perpetrated by a borrower in the process of obtaining mortgage financing. Other forms of mortgage fraud are more elaborate, such as inflating the appraisal amount in order to borrow more.
During the recent housing bubble in the United States, mortgage fraud was aggravated by low interest rates that encouraged more borrowing and lending, often when it was less than prudent to do so.
Key Takeaways
1. The purchase and sale agreement details the conditions of the sale.
2. Conditions of the purchase and sale agreement must be met before the closing.
3. A capital budget can help you prioritize and budget for capital expenditures.
4. Early payment is the trade-off of interest expense versus the opportunity cost of losing liquidity.
5. Refinancing is the trade-off between lower monthly payments and closing costs.
6. Both borrowers and lenders have a responsibility to understand the terms of the mortgage.
7. Buyers, sellers, lenders, and brokers must be alert to predatory lending, real estate scams, and possible cases of mortgage fraud.
8. Default may result in the lender foreclosing on the property and evicting the former homeowner.
Exercises
1. According to this chapter, what information is included in a purchase and sale agreement?
2. Use the mortgage refinance calculator from Loans Canada to find out if you would save money by refinancing your real or hypothetical mortgage at this time. What factors should you take into consideration when deciding to refinance?
3. Sample consumer advocacy groups online at dmoztools.net. What kinds of help can you get through such organizations? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/02%3A_Achieving_Your_Financial_Goals/2.03%3A_Buying_a_Home.txt |
• 3.1: Personal Risk Management- Insurance
This chapter introduces the idea of incorporating risk management into financial planning. This chapter focuses on planning for the unexpected. It progresses from the more obvious risks to property to less obvious risks, such as the possible inability to earn due to temporary ill health, permanent disability, or death.
• 3.2: Personal Risk Management- Retirement and Estate Planning
This chapter focuses on planning for the expected: retirement, loss of income from wages, and the subsequent distribution of assets after death. Retirement planning discusses ways to develop alternative sources of income from capital that can eventually substitute for wages. Estate planning also touches on the considerations and mechanics of distributing accumulated wealth.
03: Protecting What Is Important to You
INTRODUCTION
Life is full of risks. You can try to avoid them or reduce their likelihood and consequences, but you cannot eliminate them. You can, however, pay someone to share them. That is the idea behind insurance.
There are speculative risks—that is, risks that offer a chance of loss or gain, such as developing a “killer app” or business idea that may or may not sell, or investing in a corporate stock that may or may not provide good returns. Such risks can be avoided simply by not participating. They are almost always uninsurable.
There are pure risks—accidental or unintentional events, such as a car accident or an illness. Pure risks are insurable because their probabilities can be calculated precisely enough for the risk to be quantified, which means it can be priced, bought, and sold.
Risk shifting is the process of selling risk to someone who then assumes the risk and its consequences. Why would someone buy your risk? Because in a large enough market, your risk can be diversified, which minimizes its cost.
Insurance can be purchased for your property and your home, your health, your employment, and your life. In each case, you weigh the cost of the consequence of a risk that may never actually happen against the cost of insuring against it. Deciding what and how to insure is really a process of deciding what the costs of loss would be and how willing you are to pay to get rid of those risks.
Risk management is the strategic trade-off of the costs of reducing, assuming, and shifting risks. The costs of insurance can also be lowered through risk avoidance or reduction strategies. Risk avoidance is accomplished by completely avoiding the risk through such measures as choosing not to smoke or avoiding an activity that might cause injury. Risk reduction reduces the risk of injury, loss, or illness. For example, installing an alarm system in your home may reduce homeowner’s insurance premiums because that reduces the risk of theft. Of course, installing an alarm system has a cost too. Risk assumption is when one assumes responsibility for a loss or injury instead of pursuing insurance. Risk assumption is often embraced when the potential loss is minimal, risk reduction strategies have been undertaken, insurance is too expensive, and/or when protection is difficult to obtain (Kapoor et al., 2015). First Nations people on reserve can be sued and can sue for personal injury or property damage. Indigenous governments need to protect their assets and their operations from risk. There are a number of insurance companies in Canada that serve primarily First Nations clients. The following are a few examples of such companies.
Kitsaki Management Limited Corporation is owned by the Lac La Ronge Indian Band and serves nearly ten thousand band members in northern Saskatchewan. First Nations Insurance Services Limited Partnership was established in 1987 to meet the needs of First Nations, their institutions, and businesses. It provides its clients with the following choice of benefits: life insurance, dependent life coverage, accidental death and dismemberment, short- and long-term disability, extended health, dental, vision, and an employee and family assistance program, pension services, and other benefits that can be passed on to their employees. Kitsaki will “never replace or duplicate Treaty Health Rights for any employee who has Treaty Status” (Kitsaki Management Limited Corporation, 2017).
Many Nations Financial Services’ (MNFS) coordinates its clients’ group life and health insurance coverage with the benefits their clients receive from the Department of Indigenous Services Canada and Non-Insured Health Benefits (NIHB). The NIHB is a national program that provides eligible First Nations and Inuit people with prescription drugs, over-the-counter medication, medical supplies and equipment, mental health counselling, dental care, vision care, and medical transportation (Government of Canada, 2018). For more information on non-insured health benefits for First Nations and Inuit peoples, please see the Government of Canada website Non-insured health benefits for First Nations and Inuit.
MNFS also attempts to ensure that non-taxable First Nations employees receive a higher level of disability income if they become disabled in order to be comparable to their pre-disability earnings (MNFS, 2014).
AFN Insurance Brokers has been in operation since 1998 as a nationally incorporated insurance brokerage that only serves First Nations across Canada to meet their specific needs.
10.1 INSURING YOUR PROPERTY
Learning Objectives
1. Describe the purpose of property insurance.
2. Identify the causes of property damage.
3. Compare the coverage and benefits offered by various homeowner’s insurance plans.
4. Analyze the costs of homeowner’s insurance.
5. Compare the kinds of auto insurance to cover bodily injury and property damage.
6. Explain the factors that determine auto insurance costs.
7. Analyze the factors used in determining the risks of the driver, the car, and the driving region.
Property insurance is ownership insurance: it ensures that the rights of ownership conferred upon you when you purchased your property will remain intact. Typically, property insurance covers loss of use from either damage or theft; loss of value, or the cost of replacement; and liability for any use of the property that causes damage to others or others’ property. For most people, insurable property risks are covered by insuring two kinds of property: car and home.
Loss of use and value can occur from hazards, which increase the likelihood of loss due to peril, which is the cause of possible loss. Examples of perils are fires, weather disasters, accidents, and the results of deliberate destruction such as vandalism or theft. One can choose named perils coverage, which provides coverage only for loss caused by the perils one chooses. All risks coverage applies to loss from all causes and is usually more expensive than a named perils insurance policy.
When replacement or repair is needed to restore usefulness and value, that cost is the cost of your risk. For example, if your laptop’s hard drive crashes, you not only have the cost of replacing or repairing it, but also the cost of being without your laptop for however long that takes. Insuring your laptop shares that risk (and those costs) with the insurer.
Liability is the risk that your use of your property will injure someone or something else. Ownership implies control of, and therefore responsibility for, property use.
For example, you are liable for your dog’s attack on a pedestrian and for your fallen tree’s damage to a neighbour’s fence. You are also liable for damage a friend causes while driving your car with your permission, and for injury to your invited guests who trip over your lawn ornament, fall off your deck, or leave your party drunk.
Legal responsibility can result from:
• negligence, or the failure to take necessary precautions;
• strict liability, or responsibility for intentional or unintentional events (strict liability is when you are liable by default—that is, the onus has shifted from the plaintiff to the defendant. For example, if you have a dangerous thing, like a wild animal, and it escapes, it is presumed to be your fault unless you can demonstrate some intervening cause that was not caused by your negligence); and
• vicarious liability, or responsibility for someone else’s use of your possessions or someone else’s activity for which you are responsible.
Home Insurance Coverage
Homeowner’s insurance insures both the structure and the personal possessions that make the house your home. Tenant’s or renter’s insurance protects your possessions even if you are not the owner of your dwelling. Tenant’s insurance policies will vary depending on the customer. Riders are exemptions included in policies that allow you to adapt your renter’s policy to fit your needs. For example, if you work from home, you might consider an at-home business endorsement rider, which provides additional coverage for certain business-related items such as a computer and other electronic items that can surpass your \$2,500 liability limit on business items. This rider could help to double your standard coverage at a low cost.
A deductible—a fixed sum of money—is required before an insurance company will pay a claim. As stated in Kapoor et al., “the amount of your deductible is often \$100, \$250, \$500, or \$1,000, and your insurance company will subtract that amount from your claim” (2015, p. 243). Thus, if you have to pay a \$500 deductible for a \$1,000 claim, then you will only receive \$500 for the claim. Policy premiums are often reduced when one agrees to pay a higher deductible. A policy costs less when you agree to pay a higher deductible because you are essentially sharing more of the risk with the insurance company. Higher deductibles also have other advantages for insurance companies. When people have to pay a higher deductible, they are more careful and, therefore, insurance companies have to process fewer claims (Kapoor et al., 2015).
You may not think you need insurance until you are the homeowner, but even when you don’t need to insure against possible damage or liability for your dwelling, you can still insure your possessions. Even if your furniture came from your aunt’s house or a yard sale, it could cost a lot to replace. Ed and Elizabeth were renting and had chosen to store artwork and a number of heirlooms in the basement of their home rental. Their landlord was negligent and had not cleaned the septic tank in years. The septic tank backed up in the basement of their home rental and most of their artwork and heirlooms were ruined. Luckily, they had tenant’s insurance that covered the replacement cost of most of their items.
If you have especially valuable possessions such as jewelry or fine musical instruments, you may want to insure them separately to get enough coverage for them. Such items are typically referred to as scheduled property and are insured as endorsements added on to a homeowner’s or renter’s policy. Items should be appraised by a certified appraiser to determine their replacement or insured value.
A good precaution is to have an up-to-date inventory of your possessions such as furniture, clothing, electronics, and appliances, along with photographs or video showing these items in your home. That inventory should be kept somewhere else, such as a safe deposit box. If the house suffered damage, you would then have the inventory to help you document your losses.
A homeowner’s policy covers damage to the structure itself as well as any outbuildings on the property and, in some cases, even the landscaping or infrastructure on the grounds, such as a driveway.
A homeowner’s policy does not cover:
• property of renters, or property kept in an apartment regularly rented;
• business property, even if the business is conducted on the residential premises; and
• most forms of accidental death (e.g., vehicle impact).
According to the Insurance Bureau of Canada, coverage can vary from one insurer to the next. Different policies exist to meet the different needs of insurers.
Home insurance covers the dwelling, contents, and personal liability of the policyholder, as well as his or her spouse or partner and children. The policy also covers:
• dependants under the age of eighteen; and
• dependants who are students enrolled and actually attending a school, college, or university and living in the household or temporarily living away from the insured principal residence.
If you share your home with a friend or relative, or rent out part of your residence, you must notify your insurance representative.
Home insurance also includes coverage for additional living expenses in the event that you are temporarily unable to live in your home due to an insured loss in certain circumstances.
Homeowners’ policies cover liability for injuries on the property and for injuries that the homeowner may accidentally inflict. You may also want to add an umbrella policy that covers personal liabilities such as slander, libel, and defamation of character, or the invasion of property. An umbrella policy may also extend over other assets, such as vehicles or rentals covered by other insurance carriers. If you participate in activities where you are assuming responsibilities for others, you may want such extended liability coverage available through your homeowners’ policy (also available separately).
Home Insurance Coverage: The Benefit
Home insurance policies automatically cover your possessions up to a certain percentage of the house’s insured value. You can buy more coverage if you think your possessions are worth more. The benefits are specified as either actual cash value or replacement cost. Actual cash value tries to estimate the actual market value of the item at the time of loss, so it accounts for the original cost less any depreciation that has occurred. Replacement cost is the cost of replacing the item. For most items, the actual cash value is less.
For example, say your policy insures items at actual cash value. You are claiming the loss of a ten-year-old washer and dryer that were ruined when a pipe burst and your basement flooded. Your coverage could mean a benefit of \$100 (based on the market price of ten-year-old appliances). However, to replace your appliances with comparable new ones could cost \$1,000 or more.
The actual cash value is almost always less than the replacement value, because prices generally rise over time and because items generally depreciate (rather than appreciate) in value. A policy that specifies benefits as replacement costs offers more actual coverage. Guaranteed replacement costs are the full cost of replacing your items, while extended replacement costs are capped at a certain percentage—for example, 125 per cent of actual cash value.
Home Insurance Coverage: The Cost
You buy home insurance by paying a premium to the insurance company. The insurance purchase is arranged through a broker, who may represent more than one insurance company. The broker should be knowledgeable about various policies, coverage, and premiums offered by different insurers.
The amount of the premium is determined by the insurer’s risk—the more risk, the higher the premium. Risk is determined by:
• the insured (the person buying the policy),
• the property insured, and
• the amount of coverage.
To gauge the risk of the insured, the insurer needs information about your personal circumstances and history, the nature of the property, and the amount of coverage desired for protection. This information is summarized in Table 10.1.1.
Table 10.1.1 Factors that Determine Insurance Premiums
Insured Property Coverage
• Employment
• Marital Status
• Criminal record
• Credit history
• Insurance claim history
• Age
• Size
• Location
• Proximity to fire/police services
• Building materials
• Number of occupants
• Heating system
• Actual cash value
• Replacement cost
• Endorsements for listed property
• Umbrella for personal liability
Insurers may offer discounts for enhancements that lower risks, such as alarm systems or upgraded electrical systems. You may also be offered a discount for being a loyal customer, for example, by insuring both your car and home with the same company. Be sure to ask your insurance broker about available discounts for the following:
• Multiple policies (with the same insurer),
• Sprinkler systems,
• Burglar and fire alarms,
• Long-time policyholder,
• Upgrades to plumbing, heating, and electrical systems,
• Age (insurers give discounts to people as young as age forty in some cases), and
• Credit scoring (quite new in Canada).
Premiums can vary, even for the same levels of coverage for the same items insured. You should compare policies offered by different insurers to shop around for the best premium for the coverage you want.
Insuring Your Car
If you own and drive a car, you must have car insurance. A car accident could affect not only you and your car, but also the health and property of others. An accident often involves a second party, and so legal and financial responsibility must be assigned and covered by both parties.
Conventionally, a victim or plaintiff in an accident is reimbursed by the driver at fault or by his or her insurer. Fault has to be established and the amount of the claim agreed to. In practice, this has often been done only through extensive litigation.
In Canada, the provincial governments of British Columbia, Manitoba, and Saskatchewan offer basic automobile insurance coverage. In Quebec, the provincial government and private insurers split auto insurance coverage. In all other provinces and territories, private insurers provide auto insurance. Public insurance requires just one price for coverage, while private insurance companies’ rates may vary. Manitoba, Ontario, Quebec, and Saskatchewan have adopted variations of no-fault insurance, in which an injured person’s own insurance covers his or her damages and injuries regardless of fault, and a victim’s ability to sue the driver at fault is limited. The person deemed responsible for the accident is responsible for the deductible payment. The goal of no-fault insurance is to lower the incidence of court cases, and thus the cost of legal action against a third party, and to speed up compensation for victims (Kapoor et al., 2015).
Auto Insurance Coverage
Auto insurance policies cover two types of consequences: bodily injury and property damage. Each cover three types of financial losses. Chart 10.1.1 shows these different kinds of automobile insurance coverage.
Chart 10.1.1 Automobile Insurance Coverage
Bodily injury liability refers to the financial losses of people in the other car that are injured in an accident you cause, including their medical expenses, loss of income, your legal fees, and other expenses associated with the automobile accident. Injuries to people in your car or to yourself are covered by the automobile owner’s policy. If the owner has given permission for someone else to operate his or her vehicle, the automobile owner’s policy will cover any liability claim. Accident Benefits cover the following benefits for people, including yourself, who were injured in your automobile accident: income replacement, medical, rehabilitation, and attendant car expenses, and death and funeral costs (Kapoor et al., 2015).
Uninsured motorist protection covers your injuries if the accident is caused by someone with insufficient insurance or by an unidentified driver.
Property damage liability covers the costs to other people’s property from damage that you cause, while collision covers the costs of damage to your own property. Collision coverage is limited to the market value of the car at the time. To reduce their risk, the lenders financing your car loan will require that you carry adequate collision coverage. Comprehensive physical damage covers your losses from anything other than a collision, such as theft, weather damage, acts of nature, or hitting an animal.
Auto Insurance Costs
As with any insurance, the cost of having an insurer assume risk is related to the cost of that risk. The cost of auto insurance is related to three factors that create risk: the car, the driver, and the driving environment—the region or rating territory.
The model, style, and age of the car determine how costly it may be to repair or replace, and therefore the potential cost of damage or collision. The higher that cost is, the higher the cost of insuring the car. For example, a 2017 luxury car will cost more to insure than a 2002 sedan. Also, different models have different safety features that may lower the potential cost of injury to passengers, and those features may lower the cost of insurance. Different models may come with different security devices or be more or less attractive to thieves, affecting the risk of theft.
The driver is an obvious source of risk as the operator of the car. Insurers use various demographic factors such as age, education level, marital status, gender, and driving habits to determine which kinds of drivers present more risk. Not surprisingly, young drivers (ages sixteen to twenty-four) of both sexes and elderly drivers (over seventy) are the riskiest. According to data compiled over a ten-year period, provincial police have said that twice as many males as females aged twenty-five to thirty-four die in auto accidents (Canadian Press, 2015).
Your driving history, and especially your accident claim history, along with your criminal record (or lack thereof) and credit score, can affect your premiums. In some provinces and territories, an accident claim can severely increase your cost of insurance over a number of years. Your driving habits—whether or not you use the car to commute to work, for example—can affect your costs as well. Some insurers offer credits or points that reduce your premium if you have a safe driving record or have passed a driver education course.
Where you live and drive also matters. Insurers use police statistics to determine rates of traffic accidents, auto theft, and vandalism, for example. If you are in an accident-prone area or higher-crime region, you may be able to offset those costs by installing safety and security features in your car.
Premium rates vary, so you should always shop around. You can shop through a broker or directly. Online discount auto insurers have become increasingly popular in recent years. Their rates may be lower, but the same cautions apply as for other high-stakes transactions conducted online.
Also, premiums are not the only cost of auto insurance. You should also consider the insurer’s reliability in addressing a claim. Chances are you rely on your car to get to school, to work, or for your daily errands or recreational activities. Your car is also a substantial investment, and you may still be paying off debt from financing your car. Losing your car to repairs and perhaps being injured yourself is no small inconvenience and can seriously disrupt your life. You want to be working with an insurer who will co-operate in trying to get you and your car back on the road as soon as possible.
Key Takeaways
1. Property insurance is to insure the rights of ownership and to protect against its liabilities.
2. Property damage can be caused by hazards or by deliberate destruction, such as vandalism or theft.
3. Homeowner’s policies insure structures and possessions for actual cash value or replacement cost; an umbrella policy covers personal liability.
4. The cost of homeowner’s insurance is determined by the individual taking out the policy, the property insured, and the extent of the coverage and benefits.
5. Auto insurance coverage insures bodily injury through:
• bodily injury liability,
• medical payments coverage, and
• uninsured motorist protection.
6. Auto insurance coverage insures property damage through:
• property damage liability,
• collision, and
• comprehensive physical damage.
7. Auto insurance costs are determined by the driver, the car, and the driving region.
8. The risk of the driver is determined by demographics, credit history, employment history, and driving record.
9. The risk of the car is determined by its cost; safety and security features may lower insurance costs.
10. The risk of the driving region is determined by statistical incident histories of accidents or thefts.
Exercises
1. In your personal finance journal, record or chart all the insurances you own privately or through a financial institution and/or are entitled to through your employer. In each case, consider the following questions: what is insured, who is the insurer, what is the term, what are the benefits, and what is your premium or deduction? Research online to find the details. Then analyze your insurance in relation to your financial situation. How does each type of insurance shift or reduce your risk or otherwise help protect you and your assets or wealth?
2. Conduct and record a complete inventory of all your personal property. State the current market value or replacement cost of each item. Then identify the specific items that would cause you the greatest difficulty and expense if they were lost, damaged, or stolen.
3. How would a tenant’s insurance policy help protect your property? What do such policies cover? How much would it cost you to insure against the loss of just your laptop or desktop computer?
4. How do auto insurance rates in your province or territory—which are based partly on the rates of accidents, injuries, and deaths in your respective province or territory—compare with rates in other provinces?
REFERENCES
Canadian Press. (2015). “OPP data shows twice as many men have died in crashes as women.” CBC News, Mar. 23. Retrieved from: http://www.cbc.ca/news/canada/kitche...omen-1.3005464.
Government of Canada. (2018). Benefits Information – Non-Insured Health Benefits. Retrieved from: https://www.canada.ca/en/indigenous-...formation.html.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Kitsaki Management Limited Corporation. (2017). “First Nations Insurance Services Limited Partnership.” Retrieved from: http://www.kitsaki.com/fninsurance.html.
Many Nations Financial Services. (2014). Group Health and Life Insurance. Retrieved from:
10.2 INSURING YOUR HEALTH AND INCOME
Learning Objectives
1. Discuss how health insurance is important when it comes to financial planning.
2. Describe the purposes, coverage, and costs of disability insurance.
3. Compare the appropriate uses of term life and whole life insurance.
4. Explain the differences among variable, adjustable, and universal whole life policies and the use of riders.
5. List the factors that determine the premiums for whole life policies.
As you have learned, assets such as a home or car should be protected from the risk of a loss of value, because assets store wealth, so a loss of value is a loss of wealth.
Your health is also valuable, and the costs of repairing it in the case of accident or illness are significant enough that it also requires insurance coverage. In addition, however, you may have an accident or illness that leaves you permanently impaired or even dead. In either case, your ability to earn income will be restricted or gone. Thus, your income should be insured, especially if you have dependents who would bear the consequences of losing your income. Disability insurance and life insurance are ways of insuring your income against some limitations.
Health Insurance
In Canada, provincial government health plans cover most basic medical procedures under the Medical Care Act. The following are examples of items either not covered or only partially covered by provincial health insurance plans:
• Semi-private or private hospital rooms
• Prescription drugs
• Eyeglasses
• Dental care
• Private nursing care
• Cosmetic surgery
• Physician testimony in court
Many people insure the above-mentioned items through private medical insurance companies. When travelling internationally, many people will also purchase travel insurance to cover health-care costs that are not fully covered by provincial health-care plans.
Health insurance pays for medical expenses incurred by the insured and reduces the financial burden of risk by “dividing losses among many individuals” (Kapoor et al., 2015, p. 274). Insurance companies establish rates and benefits by determining how many people within a certain population will become ill and how much their illness will cost (Kapoor et al., 2015). Health insurance can reimburse the insured for expenses incurred from illness or injury, or pay the care provider directly.
Group health insurance plans most commonly offer supplemental health insurance coverage and are most often sponsored by the employer, who pays most or part of the cost. Group health insurance plans vary depending on the provider and will likely not cover all of one’s health needs. Therefore, many will supplement their group insurance plans with individual health insurance.
Individual health insurance plans are tailored to an individual’s or family’s specific needs, particularly when group insurance plans do not suffice. Individual health insurance plans do require comparative shopping because coverage and cost can vary greatly from one provider to the next. “Make sure you have enough insurance, but don’t waste money by over insuring” (Kapoor et al., 2015).
Disability Insurance
Disability insurance is designed to insure your income should you survive an injury or illness impaired. The definition of “disability” is a variable feature of most policies. Some define it as being unable to pursue your regular work, while others define it more narrowly as being unable to pursue any work. Some plans pay partial benefits if you return to work part-time, and some do not. As always, you should understand the limits of your plan’s coverage.
The costs of disability insurance are determined by the features and/or conditions of the plan, including the following:
• Waiting period
• Amount of benefits
• Duration of benefits
• Cause of disability
• Payments for loss of vision, hearing, speech, or use of limbs
• Inflation-adjusted benefits
• Guaranteed renewal or non-cancelable clause
In general, the more of these features or conditions that apply, the higher your premium.
All plans have a waiting period from the time of disability to the collection of benefits. Most are between 30 and 90 days, but some are as long as 180 days. Generally, the longer the waiting period is, the less the premium.
Plans also vary in the amount and duration of benefits. Benefits are usually offered as a percentage of your current wages or salary. The more the benefits or the longer the insurance pays out, the higher the premium.
In addition, some plans offer benefits in the following cases, all of which carry higher premiums:
• Disability due to accident or illness
• Loss of vision, hearing, speech, or the use of limbs, regardless of disability
• Benefits that automatically increase with the rate of inflation
• Guaranteed renewal, which insures against losing your coverage if your health deteriorates
You may already have some disability insurance through your employer, although in many cases the coverage is minimal. Private medical insurance policies provide coverage for disability. Coverage varies depending on your premium, the company, and the details of your policy. There are provincial and federal programs available to the disabled. Employment insurance is a federal program that provides short-term payments for those who have contributed in the past. Both the Canada and Quebec Pension Plans also include a disability pension for those contributors with a severe or prolonged disability. You may also be eligible for workers’ compensation benefits from your province or territory, if the disability is due to an on-the-job accident (Kapoor et al., 2015). Other providers of disability benefits include the following:
• Veterans’ Affairs Canada (if you are a veteran)
• Automobile insurance (if the disability is due to a car accident)
• Labour unions (if you are a member)
• Civil service provisions (if you are a government employee)
You should know the coverage available to you and if you find it’s not adequate, supplement it with private disability insurance.
Life Insurance
Life insurance is a way of insuring that your income will continue after your death. If you have a spouse, children, parents, or siblings who are dependent on your income or care, your death would create new financial burdens for them. To avoid that, you can insure your dependents against your loss, at least financially.
There are many kinds of life insurance policies. Before purchasing one, you should determine what it is you want the insurance to accomplish for your survivors. This could include the following:
• Pay off the mortgage
• Put your kids through university
• Provide income so that your spouse can be home with the kids and not be forced out into the workplace
• Provide alternative care for your elderly parents or dependent siblings
• Cover the costs of your medical expenses and funeral
Your goals for your life insurance will determine how much benefit you need and what kind of policy you need. Weighed against that are its costs—the amount of premium that you pay and how that fits into your current budget. Consider the following scenario.
Sam and Saifina have two children, ages three and five. Saifina works as a credit analyst in a bank. Sam looks after the household and the children and Saifina’s elderly mother, who lives a couple of blocks away. He does her grocery shopping, cleans her apartment, does her laundry, and runs any errands that she may need done. Sam and Saifina live in a condo they bought, financed with a mortgage. They have established RESPs for each child, and they try to save regularly.
Sam and Saifina need to insure both their lives, because the loss of either would cause the survivors financial hardship. With Saifina’s death, her earnings would be gone, which is how they pay the mortgage and save for their children’s education. Insurance on her life should be enough to pay off the mortgage and fund their children’s university educations, while providing for the family’s living expenses, unless Sam returns to the workforce. With Sam’s death, Saifina would have to hire someone to keep house and care for their children, and also someone to keep her mother’s house and provide care for her. Insurance on Sam’s life should be enough to maintain everyone’s quality of living.
Term Insurance
Saifina’s income provides for three expenditures: the mortgage, education savings, and living expenses. While living expenses are an ongoing or permanent need, the mortgage payment and the education savings are not: eventually, the mortgage will be paid off and the children educated. To cover permanent needs, Saifina and Sam could consider permanent insurance, also known as whole life, straight life, or cash value insurance. To insure those two temporary goals of paying the mortgage and university tuitions, Saifina and Sam could also consider temporary or term insurance. Term insurance is insurance for a limited time period, usually one, five, ten, or twenty years. After that period, the coverage stops. It is used to cover financial needs for a limited time period—for example, to cover the balance due on a mortgage, or education costs. Premiums are lower for term insurance, because the coverage is limited. The premium is based on the amount of coverage and the length of the time period covered.
A term insurance policy may have a renewability option, so that you can renew the policy at the end of its term, or it may have a conversion option, so that you can convert it to a whole life policy and pay a higher premium. If it is a multi-year level term or straight term, the premium will remain the same over the term of coverage.
Decreasing term insurance pays a decreasing benefit as the term progresses, which may make sense in covering the balance due on a mortgage, which also decreases with payments over time. On the other hand, you could simply buy a one-year term policy with a smaller benefit each year and have more flexibility should you decide to make a change.
A return-of-premium (ROP) term policy will return the premiums you have paid if you outlive the term of the policy. On the other hand, the premiums on such policies are higher, and you may do better by simply buying the regular term policy and saving the difference between the premiums.
Term insurance is a more affordable way to insure against a specific risk for a specific time. It is pure insurance, in that it provides risk shifting for a period of time, but unlike whole life, it does not also provide a way to save or invest.
Whole Life Insurance
Whole life insurance is permanent insurance—that is, you pay a specified premium until you die, at which time your specified benefit is paid to your beneficiary. The amount of the premium is determined by the amount of your benefit and your age and life expectancy when the policy is purchased.
Unlike term insurance, where your premiums simply pay for your coverage or risk shifting, a whole life insurance policy has a cash surrender value or cash value that is the value you would receive if you cancelled the policy before you die. You can “cash out” the policy and receive that cash value before you die. In that way, the whole life policy is also an investment vehicle: your premiums are a way of saving and investing, using the insurance company as your investment manager. Whole life premiums are more than term life premiums because you are paying not only to shift risk, but also for investment management.
A variable life insurance policy has a minimum death benefit guaranteed, but the actual death benefit can be higher depending on the investment returns that the policy has earned. In that case, you are shifting some risk, but also assuming some risk of the investment performance.
An adjustable life policy is one where you can adjust the amount of your benefit, and your premium, as your needs change.
A universal life policy offers flexible premiums and benefits. The benefit can be increased or decreased without cancelling the policy and getting a new one (and thus losing the cash value, as in a basic whole life policy). Premiums are added to the policy’s cash value, as are investment returns, while the insurer deducts the cost of insurance (COI) and any other policy fees.
When purchased, universal life policies may be offered with a single premium payment, a fixed (and regular) premium payment until you die, or a flexible premium where you can determine the amount of each premium, so long as the cash value in the account can cover the insurer’s COI. Chart 10.2.1 shows the life insurance options.
So, is it term or whole life? When you purchase a term life policy, you purchase and pay for the insurance only. When you purchase a whole life policy, you purchase insurance plus investment management. You pay more for that additional service, so its value should be greater than its cost (in additional premiums). Whole life policies take some analysis to assess the real investment returns and fees, and the insurer is valuable to you only if it is a better investment manager than you could have otherwise. There are many choices for investment management. Thus, the additional cost of a whole life policy must be weighed against your choices among investment vehicles. If it’s better than your other choices, then you should buy the whole life. If not, then buy term life and save or invest the difference in the premiums.
Choosing a Policy
All life insurance policies have basic features, which then can be customized with a rider clause that adds specific benefits under specific conditions. The standard features include provisions that protect the insured and beneficiaries in cases of missed premium payments, fraud, or suicide. There are also loan provisions granted, so that you can borrow against the cash value of a whole life policy.
Riders are actually extra insurance that you can purchase to cover less-common circumstances. Commonly offered riders include:
• a waiver of premium payment if the insured becomes completely disabled;
• a double benefit for accidental death;
• guaranteed insurability allowing you to increase your benefit without proof of good health;
• cost of living protection that protects your benefit from inflation; and
• accelerated benefits that allow you to spend your benefit before your death if you need to finance long-term care.
Finally, you need to consider the settlement options offered by the policy: the ways that the benefit is paid out to your beneficiaries. The three common options are:
• as a lump sum, paid out all at once;
• in installments, paid out over a specified period; or
• as interest payments, so that a series of interest payments is made to the beneficiaries until a specified time when the benefit itself is paid out.
You would choose the various options depending on your beneficiaries and their anticipated needs. Understanding these features, riders, and options can help you to identify the appropriate insurance product for your situation. As with any purchase, once you have identified the product, you need to identify the market and the financing.
Many insurers offer many insurance products, usually sold through brokers or agents. Agents are paid on commission, based on the amount of insurance they sell. A captive agent sells the insurance of only one company, while an independent agent sells policies from many insurers. You want a licensed agent that is responsive and will answer questions patiently and professionally. If you die, this may be the person on whom your survivors will have to depend to help them receive their benefits in a troubling time.
You will have to submit an application for a policy and may be required to have a physical exam or release medical records to verify your physical condition. Factors that influence your riskiness are your family medical history, age and weight, and lifestyle choices such as smoking, drinking, and drug use. Your risks will influence the amount of your premiums.
Having analyzed the product and the market, you need to be sure that the premium payments are sustainable for you, that you can add the expense in your operating budget without creating a budget deficit.
Life Insurance as a Financial Planning Decision
Unlike insuring property and health, life insurance can combine two financial planning functions: shifting risk and saving to build wealth. The decision to buy life insurance involves thinking about your choices for both and your opportunity cost in doing so.
Life insurance is about insuring your earnings even after your death. You can create earnings during your lifetime by selling labour or capital. Your death precludes your selling labour or earning income from salary or wages, but if you have assets that can also earn income, they may be able to generate some or even enough income to ensure the continued comfort of your dependents, even without your salary or wages.
In other words, the larger your accumulated asset base, the greater its earnings, and the less dependent you are on your own labour for financial support. In that case, you will need less income protection and less life insurance. Besides life insurance, another way to protect your beneficiaries is to accumulate a large enough asset base with a large enough earning potential.
If you can afford the life insurance premiums, then the money that you will pay in premiums is currently part of your budget surplus and is being saved somehow. If it is currently contributing to your children’s education savings or to your retirement plan, you will have to weigh the value of protecting current income against insuring your children’s education or your future income in retirement. Or that surplus could be used toward generating that larger asset base.
These are tough decisions to weigh because life is risky. If you never have an accident or illness, and simply go through life earning plenty and paying off your mortgage and saving for retirement and educating your children, then are all those insurance premiums just wasted? No. Since your financial strategy includes accumulating assets and earning income to satisfy your needs now or in the future, you need to protect those assets and income, at least by shifting the risk of losing them through a chance accident. At the same time, you must make risk-shifting decisions in the context of your other financial goals and decisions.
Key Takeaways
1. Disability insurance insures your income against an accident or illness that leaves your earning ability impaired.
2. Disability insurance coverage and costs vary.
3. Life insurance is designed to protect dependents against the loss of your income in the event of your death.
4. Term insurance provides life insurance coverage for a specified period of time.
5. Whole life insurance provides life insurance coverage until the insured’s death.
6. Whole life insurance has a cash surrender value and thus can be used as an investment instrument as well as a way of shifting risk.
7. Variable, adjustable, and universal life policies offer more flexibility of benefits and premiums.
8. Riders provide more specific coverage.
9. Premiums are determined by the choice of benefits and riders and the risk of the insured, as assessed by medical history and lifestyle choices.
Exercises
1. Find out about workers’ compensation in your province or territory by visiting the website of the Association of Workers’ Compensation Boards of Canada. What does the Association of Workers’ Compensation Boards of Canada do? Find out what programs are available in your province for workers’ compensation covering industrial and workplace accidents. What information does the Canadian Centre for Occupational Health and Safety provide on the prevention of workplace illness and injury?
2. Find information about employment insurance at the following websites Employment and Social Development Canada and EI Regular Benefits—Overview to answer the following questions:
• What does it mean to be involuntarily unemployed?
• If you are involuntarily unemployed, does employment insurance replace your wages?
• Are you entitled to employment insurance if you choose to be unemployed temporarily?
• Does it matter what kind of a job you have or how much income you earn?
• Where does the money come from?
• If you have seasonal employment, can you collect unemployment to cover the off-season?
• If you are eligible, how long can you collect unemployment?
• Is the money you receive from unemployment compensation taxable?
REFERENCES
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/03%3A_Protecting_What_Is_Important_to_You/3.01%3A_Personal_Risk_Management-_Insurance.txt |
INTRODUCTION
While insurance is about protecting what you have, retirement and estate planning is about protecting what you may have in the future. Insuring what you have means finding the best way to protect it. Retirement planning, on the other hand, means finding the best way to protect the life that you’d like to be living after you stop earning income from employment. Estate planning involves protecting what you have even after your death.
Both types of planning aim to address some of the following questions, even if you really can’t answer them:
• What will my life be like when I retire?
• Will I have a spouse or partner?
• Will I have dependents?
• Will I have a home?
• Will I have a mortgage?
• Will I be disabled?
• Where will I live?
• What will I do?
• What would I like to do?
Planning, especially for retirement, should start as early as possible, allowing the most time for savings to occur and accrue. Ironically, that’s when it is hardest to try to imagine answers to these questions. Understanding the practical means to planning and saving for retirement can help you get started. If your plans are flexible, they can be adapted to the unexpected as it happens, which it inevitably will.
11.1 RETIREMENT PLANNING: PROJECTING NEEDS
Learning Objectives
1. Identify the factors required to estimate savings for retirement.
2. Estimate retirement expenses, length of retirement, and the amount saved at retirement.
3. Calculate relationships between the annual savings required and the time to retirement.
Retirement planning involves the same steps as any other personal planning: assess where you’d like to be and then determine how to get there from where you are. More formally, the first step is to define your goals, even if they are no more specific than “I want to be able to afford a nice life after I stop getting a paycheque.” But what is a “nice life,” and how will you pay for it?
It may seem impossible or futile to try to project your retirement needs so far from retirement given that there are so many uncertainties in life and retirement may be far away. But that shouldn’t keep you from saving. You can try to save as much as possible for now, with the idea that your plans will clarify as you get closer to your retirement, so whatever money you have saved will give you a head start.
Chris and Sam are young professionals in Regina, Saskatchewan. Their families live elsewhere in the province—Chris’s family lives in Prince Albert, and Sam’s family lives on a reserve forty-five minutes from Regina near Fort Qu’Appelle. Both Chris and Sam miss not having their families close by, especially now that they have young kids. Both would like to move closer to Sam’s reserve one day, but they have good jobs in Regina, so they agreed that for the time being, they would like to buy a second home near Sam’s reserve. They plan to go there a couple weekends each month and during holidays in order to spend more time with family. They have also discussed the possibility of Sam’s younger cousin, Jen, paying them a modest monthly rent to live there. This monthly rent would help them to pay for the cost of the home. Jen has agreed to stay with family when they visit during weekends and holidays. Chris and Sam are planning to use the value of their house in Regina to finance their second home. Now in their mid-thirties, Chris and Sam are planning to retire in thirty years. They hope to sell their home in Regina when they retire, for retirement income, and move to their second home.
As they plan, Chris and Sam need to project how much money they will need to have saved by the time they wish to retire. To do that, they need to project both their future capital needs (to buy their second home) and their future living expense in retirement. They also need to project how long they may live after retirement, or how many years’ worth of living expenses they will need, so that they won’t outlive their savings.
They know that they have thirty years over which to save this money. They also know, as explained in Chapter 4 “Evaluating Choices: Time, Risk, and Value,” that time affects value. Thus, Sam and Chris need to project the rate of compounding for their savings, or the rate at which time will affect the value of their money.
To estimate required savings, in other words, you need to estimate the following:
• Expenses in retirement
• The duration of retirement
• The return on savings in retirement
As difficult as these estimations seem, because it is a long time until retirement and a lot can happen in the meantime, you can start by using what you know about the present.
Estimating Annual Expenses
One approach is to assume that your current living expenses will remain about the same in the future. Given that, over the long run, inflation affects the purchasing power of your income, you factor in the effect inflation may have so that your purchasing power remains the same.
For example, say your living expenses are around \$25,000 per year and you’d like to have that amount of purchasing power in retirement as well. Assuming your costs of living remain constant, if you are thirty years from retirement, how much will you be spending on living expenses then?
The overall average annual rate of inflation in Canada in 2017 was about 1.53 per cent.
So, you would have to spend \$25,000 × (1 + 0.0153)30 = \$39,425 per year to maintain your standard of living thirty years from now. In this case, \$25,000 is the present value of your expenses, and you are looking for the future value, given that your expenses will appreciate at a rate of 1.53 per cent per year for thirty years.
As you can see, you would need a little more than two times your current spending to live the life you live now. Fortunately, your savings won’t be just “sitting there” during that time. They, too, will be compounding to keep up with your needs.
You may use your current expenses as a basis to project a more or less expensive lifestyle after retirement. You may anticipate expenses dropping with fewer household members and dependents, for example, after your children have grown. Or you may wish to spend more and live a more comfortable life, doing things you’ve always wanted to do. In any case, your current level of spending can be a starting point for your estimates.
Estimating Length of Retirement
How much you need to have saved to support your annual living expenses after retirement depends on how long those expenses continue or how long you’ll live after retirement. In Canada, life expectancy at age sixty-five has increased dramatically in the last century due to increased access to health care, medical advances, and healthier lives before age sixty-five.
If life expectancy continues to increase, in thirty years your life expectancy at age sixty-five could be twenty-eight to thirty years. In that case, your retirement savings will have to provide for your living expenses for as long as thirty years. Put another way, at age thirty-five you have thirty years to save enough to support you for thirty years after that.
Estimating the Amount Needed and Annual Savings for Retirement
You can use what you know about time and value (from Chapter 4) to estimate the amount you would need to have saved up by the time you retire. Your annual expenses in retirement are really a series of cash flows that will grow by the rate of inflation. At the same time, your savings will grow by your rate of return, even after you are making withdrawals to cover your expenses.
The amount you need at retirement varies with the expected rate of return on your savings. While you are retired, you will be drawing income from your savings, but your remaining savings will still be earning a return. The more return your savings can earn while you are retired, the less you have to have saved by retirement. The less return your savings can earn in retirement, the more you need to have saved before retirement.
The more your account can earn before you retire, the less you will have to contribute to it. On the other hand, the more you can contribute to it, the less it has to earn.
The time you have to save until retirement can make a big difference to the amount you must save every year. The longer the time you have to save, the less you have to save each year to reach your goal.
The longer the time you have to save, the sooner you start saving, and the less you need to save each year. Chris and Sam are already in their thirties, so they have thirty years to save for retirement. Had they started in their twenties and had forty years until retirement, they would not have to save so much each year. If they wait until they are around fifty, they will have to save a lot more each year. The more you have to save, the less disposable income you will have to spend on current living expenses, making it harder to save. Clearly, saving early and regularly is the superior strategy.
When you make these calculations, be aware that you are using estimates to determine the money you’ll need at retirement. You use the expected inflation rate, based on its historic average, to estimate annual expenses, historical statistics on life expectancy to estimate the duration of your retirement, and an estimate of future savings returns. Estimates must be adjusted because things change. As you progress toward retirement, you’ll want to re-evaluate these numbers at least annually to be sure you are still saving enough.
Key Takeaways
1. To calculate required savings, you need to estimate:
• expenses in retirement, based on lifestyle and adjusted for inflation;
• the duration of retirement, based on age at retirement and longevity; and
• the return on savings in retirement.
2. You must save more for retirement if:
• expenses are higher;
• duration of retirement is longer; and
• the return on savings in retirement is less.
3. Your annual savings for retirement also depends on the time until retirement; the longer the time that you have to save, the less you need to save each year.
Exercises
1. Write in your personal finance journal your ideas and expectations for your retirement. At what age do you want to retire? How many years do you have to prepare before you reach that age? Will you want to stop working at retirement? Will you want to have a retirement business or start a new career? Where and how would you like to live? How do you think you would like to spend your time in retirement? How much have you saved toward retirement so far?
2. Review the Financial Consumer Agency of Canada’s worksheet 10.6.1 Your retirement planning worksheet. What will you have saved for retirement by the time you retire? What will you need to live in retirement without income from employment? How old will you be when your retirement savings run out? Run several combinations of estimates to get an idea of how and why you should plan to save for retirement.
11.2 RETIREMENT PLANNING: WAYS TO SAVE
Learning Objectives
1. Compare and contrast employer, government, and individual retirement plans.
2. Explain the differences between a defined benefit pension plan and a defined contribution pension plan.
3. Summarize the structure and purpose of the Canada Pension Plan.
4. Identify retirement plans for the self-employed.
While knowing the numbers clarifies the picture of your needs, you must reconcile that picture with the realities that you face now. How will you be able to afford to save what you need for retirement?
There are several savings plans structured to help you save; some offer tax advantages, some don’t. But first you need to make a commitment to save.
Saving means not spending a portion of your disposable income. It means delaying gratification or putting off until tomorrow what you could have today. That is often difficult, as you have many demands on your disposable income. You must weigh the benefit of fulfilling those demands with the cost of not saving for retirement, even though benefit in the present is much easier to credit than benefit in the future. Once you resolve to save, however, employer, government, and individual retirement plans are there to help you.
Defined Benefit and Contribution Plans
Employers may sponsor pension or retirement plans for their employees as part of the employees’ total compensation. In Canada, a registered pension plan “is an arrangement by an employer or a union to provide pensions to retired employees in the form of periodic payments. The Income Tax Act provides deductions in respect of both employee and employer contributions. Contributions and investment earnings are tax-exempt until such time as benefits commence to be paid” (Government of Canada, 2016a). There are two kinds of employer-sponsored plans: defined benefit plans and defined contribution plans.
A defined benefit plan is a retirement plan funded by the employer, who promises the employee a specific benefit upon retirement. The employer can be a corporation, labour union, government, or other organization that establishes a retirement plan for its employees. In addition to (or instead of) a defined benefit plan, an employer may also offer a profit-sharing plan, a stock bonus plan, an employee stock ownership plan, or other plan. Each type of plan has advantages and disadvantages for employers and employees, but all are designed to give employees a way to save for the future and employers a way to attract and keep employees.
The payout for a defined benefit plan is usually an annual or monthly payment for the remainder of the employee’s life. In some defined benefit plans, there is also a spousal or survivor’s benefit. The amount of the benefit is determined by your wages and length of service with the company.
With a defined benefit plan your income in retirement is constant or “fixed,” and it is the employer’s responsibility to fund your retirement. This is both an advantage and a disadvantage for the employee. Having your employer fund the plan is an advantage, but having a fixed income in retirement is a drawback during periods of inflation when the purchasing power of each dollar declines. In some plans, that drawback is offset by automatic cost of living increases.
To avoid the responsibility for defined benefit plans, more and more employers are moving toward defined contribution retirement plans.
Under defined contribution plans, each employee has a retirement account, and both the employee and the employer may contribute to the account. The employer may contribute up to a percentage limit or offer to match the employee’s contributions, up to a limit. With a matching contribution, if employees choose not to contribute, they lose the opportunity of having the employer’s contribution as well as their own. The employee makes untaxed contributions to the account as a payroll deduction, up to a maximum limit specified by the tax code. The employer’s contributions are a tax-deductible expense and are not a taxable benefit to the plan member. After a certain period of time, the employee obtains the right to the employer’s contribution. Employers can allow employees to make the investment decisions for the employer contributions, or the decision may be left to the employer. Employees usually make the investment decisions for their own contributions.
Private pension plans (including pooled registered pension plans) provided to employees whose employment falls under federal jurisdiction or for pension plans established in the Yukon, the Northwest Territories, and Nunavut, are regulated and supervised by the Office of the Superintendent of Financial Institutions. Every province, except Prince Edward Island, “has its own laws and regulations that govern pension plans in industries that are not under federal jurisdiction” (Government of Canada, 2016a). Regulations pertain to withdrawals both in retirement and in special situations.
The employer offers a selection of investments, but the employee chooses how the funds in his or her account are diversified and invested. Thus, the employee assumes the responsibility—and risk—for investment returns. The employer’s contributions are a benefit to the employee. There is a considerable choice of investment options. These typically include:
• Guaranteed investment funds
• Canadian bond funds
• Canadian balanced funds
• Canadian equity funds
• International and/or global equity funds
Many defined benefit and contribution plans are structured with a vesting option that limits your claim on the retirement fund until you have been with the company for a certain length of time. For example, Paul’s employer has a defined benefit plan that provides for Paul to be 50 per cent vested after five years and fully vested after seven years. If Paul were to leave the company before he had worked there for five years, none of his retirement fund would be in his account. If he left after six years, half his fund would be kept for him; after ten years, all of it would be.
Employers can also make a contribution with company stock, which can create an undiversified account. A portfolio consisting only of your company’s stock exposes you to market risk should the company not do well, in which case, you may find yourself losing both your job and your retirement account’s value.
Employers are increasingly moving towards defined contribution plans versus defined benefit plans because they are concerned about investment risk as well as liquidity within the plan to pay active retirees versus contributing employees.
Canadian Government: Public Pensions
The Canadian government has three different retirement income systems. The first is Old Age Security (OAS), which provides a modest monthly pension starting at the age of sixty-five. The second system is the Canada Pension Plan (CPP), a retirement plan for all citizens offered by the federal government, except those living in Quebec who must contribute to the Quebec Pension Plan (QPP). The third level of the retirement income system is composed of private pensions and savings.
Canada Pension Plan and Quebec Pension Plan
The CPP and QPP is not an automatic benefit, but an entitlement. To qualify for benefits, you must work and contribute. The CPP and the QPP are closely coordinated so that your pension is protected no matter where you live in Canada. If you have contributed to both the CPP and the QPP, the amount you receive will take into consideration all contributions made to both plans. However, if you live in Quebec, you must apply for the QPP, and if you live elsewhere in Canada, you must apply for the CPP. Your benefit will be paid depending on your place of residence (Government of Canada, 2016a). Every person over the age of eighteen (with some exceptions) who works in Canada and earns more than the minimum amount per year (it is frozen at \$3,500) must contribute pensionable earnings to either the CPP or QPP. It is important to note that employers and First Nations workers on-reserve are not required to pay into the Canada Pension Plan. However, if a First Nation employer chooses to participate in the CPP, all employees must contribute to the CPP through payroll deductions. If people are self-employed or their First Nation employer decides not to participate in the CPP, they can still contribute by paying both the employee and the employer’s portions of the CPP contributions. Those who are employed off-reserve or are receiving taxable employment income must contribute to the CPP (Government of Canada, 2016b).
Maximum pensionable earnings are adjusted every January according to the increases in average wage. In 2018, the maximum amount was \$55,900. Employers pay half the required contributions and the employee pays the other half. If you are self-employed, you make the whole contribution, to a maximum contribution of \$5,187.60 as of 2018. Your contributions are based on your net business income after expenses (Government of Canada, 2018).
You can apply to begin collecting a monthly retirement pension from the federal government at the age of sixty if you have paid into the CPP. However, the earlier you begin collecting your pension before the age of sixty-five, the less you will receive on a monthly basis. If you begin collecting at age sixty, your pension payments could be reduced by as much as 36 per cent. If you collect after seventy, it could be as much as 42 per cent greater (Government of Canada, 2016c). The CPP has three different types of benefits: disability benefits (for disabled contributors and their children), a retirement pension, and survivor benefits (which include the death benefit, the surviving spouse’s pension, and the children’s benefit).
“CPP was designed to replace only 25 per cent of the salary from which you made your CPP contributions” (Kapoor et al., 2015, p. 421). Given this information, it is critical that you understand that CPP and other public pensions cannot meet all of your financial needs in retirement. You must combine private savings with public pensions in order to be prepared for retirement. A statement of your CPP contribution is available through the Service Canada website; this statement must be used as a personal finance tool in order to properly plan for retirement and set realistic goals (Kapoor et al., 2015).
The following recent changes to CPP will be implemented over the course of a number of years:
1. The annual payout target will increase from about 25 per cent of pre-retirement earnings to 33 per cent.
2. The maximum amount of income covered by the CPP will increase from \$54,900 to about \$82,700 when the program is fully phased in by 2025. Those who earn a higher income will be eligible to earn CPP benefits on a larger portion of their income (McFarland and McGugan, 2017).
3. Canadians who take time out of the workforce to raise children or due to disability will not see a decline in their retirement benefits. A drop-in provision has been introduced by the federal government that allows for a drop-in amount based on an average of previous years’ earnings. The formula assigns income to those during years without work because they have chosen to raise a child or because of disability (Canadian Press, 2017; Press, 2017).
4. Survivor benefits will be paid out to everyone, regardless of age, dependent children, or disability, beginning in 2019.
5. The death benefit, a one-time payment to, or on behalf of, the estate of a deceased CPP contributor, will be set for everyone at \$2,500, instead of being calculated based on a deceased’s earnings (Canadian Press, 2017).
Old Age Security, Guaranteed Income Supplement,and Spouse’s Allowance
According to the Government of Canada, the Old Age Security program is its largest pension program and is funded out of its general revenues; Canadians do not pay directly into it. OAS is available to seniors aged sixty-five and older who meet the Canadian legal status and residence requirements and the amount one receives is determined by how long one has lived in Canada after the age of eighteen.
OAS benefits are adjusted quarterly (in January, April, July, and October) if there are increases in the cost of living as measured by the Consumer Price Index. Seniors who have low income may be eligible to also receive the Guaranteed Income Supplement (GIS) and Spouse’s Allowance (SPA). The GIS is a monthly, non-taxable benefit for Old Age Security pension recipients who have a low income and are living in Canada. The SPA is also a benefit available to low-income individuals aged sixty to sixty-four who are the spouses or common-law partners of GIS recipients (Government of Canada, 2016d).
Seniors who have high income must pay back all or a portion of their OAS (line 113 of the tax return) as well as any net federal supplements (line 146) if their annual income exceeds a certain amount (TurboTax Canada, 2017).
Traditionally, many plans for public employees have been defined benefit plans providing annuities upon retirement.
Personal Retirement Plans
Registered Retirement Savings Plan
Any individual can save for retirement without a special “account,” but since the government would like to encourage retirement savings, it has created tax-advantaged accounts to help you do so. Because these accounts provide tax benefits as well as some convenience, it is best to use them first in planning for retirement, although their use may be limited.
A registered retirement savings plan (RRSP) is a personal investment vehicle that allows you to shelter your savings from income taxes. RRSPs allow you to shelter your money in a wide range of financial products: stocks, Canada Savings Bonds (CSBs) and treasury bills (T-Bills), corporate bonds, term deposits, guaranteed investment certificates (GICs), mutual funds, savings accounts, real estate, and so on. In the 2017 federal budget, the Government of Canada announced its decision to end the sale of CSBs as of November 1, 2017. Savings accounts, term deposits, and GICs are examples of guaranteed funds because you are ensured the return of your principal plus a guaranteed rate of return, and they are offered by most financial institutions. Mutual funds do not guarantee a rate of return or the return of your principal and are available through most financial institutions including investment dealers and life insurance companies. Life insurance and life annuity products, which are sold through life insurance companies, may also qualify as RRSP investments, but they might not be the best financial plan due to various restrictions on these types of investments (Kapoor et al., 2015).
An RRSP allows you to realize immediate tax benefits at a time when your income is generally highest. Your annual contribution can be deducted from your gross income at tax time, reducing the amount you pay in income tax that year. The income earned in your RRSP is not taxed until you begin to withdraw funds at retirement and will likely be taxed at a lower rate given that most people will be earning a reduced income compared to when they worked full-time. However, one will certainly be receiving taxable income and not everyone will be in a lower tax bracket upon retirement. Your RRSP investments can grow and are tax-sheltered until retirement. If one is paying little to no income tax, likely an RRSP is not needed. As mentioned above, an RRSP is best utilized when your income is generally highest. An additional advantage of the RRSP is that principal appreciation (interest, dividend income, or capital gain) is not taxed until the funds are withdrawn.
Types of RRSPs
The most common type of RRSP held by Canadians is a “regular” RRSP due to the fact that fees are minimal and it requires minimal management. However, because of the type of low-risk and low-return investments available within the regular RRSP, there is a limited return on investment. “Self-directed” RRSPs allow for greater scope of categories, such as cash, T-Bills, bonds (including CSBs), mortgages, mutual funds, and stocks (Kapoor et al., 2015). The fees are higher and require more management, but the return on investment is often higher. Spousal RRSPs are available to common-law couples and same-sex couples, and they allow one to contribute to an RRSP and name one’s spouse/partner as the beneficiary. This can be a useful type of RRSP when one spouse/partner does not participate in the labour market. However, this type of contribution will reduce one’s allowable contribution to his or her own plan.
As mentioned in Chapter 9 “Buying a Home,” you can use RRSP funds for a down payment on your first home under the Home Buyer’s Plan. Up to \$25,000 can be withdrawn as a loan from your RRSP; no interest is required on the loan and it must be paid back within fifteen years. A certain payment must be paid every year; if it is not, that amount due will be included in your income for that year.
RRSP funds, up to a maximum of \$20,000, can also be used for full-time training or educational purposes for you or your common-law partner or spouse under the Life-Long Learning Plan, up to \$10,000 per year. Withdrawals have to be paid within ten years. As with funds used for a down payment on a house, if a payment that is due is not made, it will be included in your income for the year it was due (Kapoor et al., 2015).
Contribution Limits
If you are already contributing to a registered pension plan, the CRA will calculate, along with the help of your employer, the allowable contribution using a pension adjustment. If you do not have an RPP, then you can contribute up to 18 per cent of your earned income or the stated maximum (Kapoor et al., 2015). You can exceed your contribution limit by \$2,000 without penalty, but anything beyond this amount will incur a 1 per cent fine. If you do not contribute the maximum contribution in a given year, you can carry forward your contribution shortfall and invest more in a year when you are able to.
Deregistering an RRSP
Cashing in or “deregistering” your RRSP must take place before the end of the calendar year of your seventy-first birthday. Upon deregistering an RRSP, you have a number of options:
1. Withdraw the funds and pay the income tax. If a lump-sum payment is withdrawn, it is likely a high marginal tax rate will apply. The tax consequences of doing this could be quite expensive.
2. Purchase a single-payment life annuity from an insurance company. This life annuity will allow you to receive a fixed level of payment on a regular basis for the rest of one’s lifetime and you only pay taxes on your annual income.
3. Purchase a fixed-term annuity from an insurance company that pays you an income for a fixed-term. Unlike life annuities, life expectancy or the pooling of funds with others is not taken into account.
4. Set-up a registered retirement income fund (RRIF) that allows you to withdraw a minimum amount from the RRSP and invest that money. That minimum amount increases over time. The amount and frequency of payments to your RRIF can be adjusted. Earnings in a RRIF are tax-free and amounts paid out of a RRIF are taxable upon receipt (Kapoor et al., 2015, pp. 440–442).
5. One could also choose a combination of the options mentioned above, such as withdrawing funds, buying an annuity, and putting the rest in a RRIF.
For more information regarding your options when deregistering an RRSP, see Options for your own RRSPs on the Government of Canada website.
Fixed-Term and Life Annuities
Fixed-term and life annuities can be purchased with a lump sum from any Canadian life insurance company; the lump sum can be from either registered or non-registered sources. Examples of registered funds used to purchase both fixed-term and life annuities are: individual RRSPs, locked-in RRSPs, RRIFs, pension plans, or deferred profit sharing plans. Fixed-term annuities specify to the insurance company how long the purchaser wishes this type of annuity to pay them. The insurance company is obligated to pay out all capital used to pay for this annuity. All income payments cease and the annuity contract ends once the payment period has ended. Fixed-term annuities are purchased when a guaranteed income is needed for a specific time period. Any guaranteed payments that have not been paid due to the death of the annuitant will be paid to a named beneficiary or his or her estate (Canadian Annuity Rates, 2018).
Life annuities can be purchased as either single life or joint life. “Single Life annuities pay a periodic income as long as the sole annuitant is alive. Joint Life annuities continue to pay as long as one of the two joint annuitants is alive” (Canadian Annuity Rates, 2018).
As mentioned in Chapter 6 “Taxes and Tax Planning,” a tax-free savings account (TFSA) is a flexible investment account where one’s investment income—interest, dividends, or capital gains—is not taxed, even when withdrawn. TFSAs are an increasingly popular investment strategy because your money grows more quickly inside a TFSA than in a taxable account due to tax-free compound growth. Through a TFSA, one can invest in various vehicles, such as GICs, bonds, mutual funds, stocks, and exchange-traded funds. Furthermore, eligibility for federal income-tested benefits (e.g., OAS), or credits (non-refundable tax credit for taxpayers sixty-five years and older) are not affected by investment gains within the TFSA or by withdrawals (Kapoor et al., 2015). The following are important facts about contributions to your TFSA:
• The current contribution limit is \$5,500 per year; contributions to your RRSP/RPP do not limit your TFSA contribution.
• Any unused room can be carried forward.
• You can contribute up to your TFSA contribution limit. A tax applies to all contributions exceeding your TFSA contribution limit.
• Withdrawals will be added to your TFSA contribution room at the beginning of the following year.
• You can replace the amount of the withdrawal in the same year only if you have available TFSA contribution room.
• Direct transfers must be completed by your financial institution (Government of Canada, 2016e; Government of Canada, 2016f).
The federal government introduced TFSAs in 2009. One can go back and contribute for every year since 2009 for a total of \$57,500 (2009–2012: \$5,000 per year; 2013–2014: \$5,500 per year; 2015: \$10,000; 2016–2018: \$5,500). Many different groups can benefit from TFSAs, and they should be considered as a viable retirement savings strategy for young and old as well as low- to high-income Canadians (Government of Canada, 2016e).
Key Takeaways
1. Retirement plans may be sponsored by employers, government, or individuals.
2. Defined benefit plans differ from defined contribution plans in that the benefit is a specified amount for which the employer is liable. In a defined contribution plan, the benefit is not specified, and the employee is responsible for the accumulation in the plan.
3. CPP is an entitlement financed by payroll taxes and designed to supplement employer retirement plans or individual retirement plans.
4. Examples of personal retirement plans are registered retirement savings plans and tax-free savings accounts.
Exercises
1. Do you participate in an employer-sponsored retirement savings plan? If so, what kind of plan is it, and what do you see as the benefits and drawbacks of participating? If you contribute to your plan, how did you decide how much to contribute? Could you contribute more? In searching for your next good job, what kind of retirement plan would you prefer to find in the new employer’s benefit package, and why?
2. As part of your planning, how can you estimate what you will need for your retirement income? Find this answer by going to the Canadian Retirement Income Calculator on the Government of Canada’s website.
REFERENCES
Canadian Annuity Rates. (2018). “Types of Canadian Annuities.” Retrieved from: https://annuitybrokers.ca/types-of-annuities/.
Canadian Press. (2017). “The Canada Pension Plan is getting more changes: Here are five things you need to know.” Financial Post, 2017. Retrieved from: http://business.financialpost.com/pe...a-pension-plan.
Government of Canada. (2016a). “About Registered Pension Plans (RPPs).” Retrieved from: https://www.canada.ca/en/revenue-age...lans-rpps.html.
Government of Canada. (2016b). “First Nations workers and the Canadian Pension Plan.” Retrieved from: https://www.canada.ca/en/employment-social-development/services/pension/reports/aboriginal.html.
Government of Canada. (2016c). “Canada Pension Plan—How much could you receive. Retrieved from: https://www.canada.ca/en/services/be...it/amount.html.
Government of Canada. (2016d). “Old Age Security.” Retrieved from: https://www.canada.ca/en/services/be...-security.html.
Government of Canada. (2016e). “Contributions, withdrawals, and transfers.” Retrieved from: https://www.canada.ca/en/revenue-age...transfers.html.
Government of Canada. (2016f). “Contributions.” Retrieved from: https://www.canada.ca/en/revenue-age...ributions.html.
Government of Canada. (2018). “CPP contribution rates, maximums and exemptions.” Retrieved from: https://www.canada.ca/en/revenue-age...xemptions.html
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
McFarland, J. and I. McGugan. (2017). “A new premium on retirement.” Globe and Mail, Nov. 12. Retrieved from: https://www.theglobeandmail.com/glob...ticle30551445/.
Press, J. (2017). “New CPP changes give survivors full benefits immediately.” Toronto Star, Dec. 13. Retrieved from: https://www.thestar.com/news/canada/...mediately.html.
TurboTax Canada. (2017). “Old Age Security (OAS) Clawback and Strategies to Help Reduce It.” Retrieved from: https://turbotax.intuit.ca/tips/old-...reduce-it-5554.
11.3 ESTATE PLANNING
Learning Objectives
1. Identify the purposes, types, and components of a will.
2. Describe the roles and types of trusts and gifts.
3. Identify which taxes to consider in estate planning.
Your estate includes everything you own. Other aspects of financial planning involve creating and managing your assets while you are alive. Estate planning is a way to manage your assets after your death. Age is not really a factor, because death can occur at any time, at any age, by any cause. Arranging for the disposition of your estate is not a morbid concern, but a kindness to those you leave behind. Death is a legal and financial event as well as an emotional one. Your loved ones will have to deal with the emotional aftermath of your loss and will appreciate your care in planning for the legal and financial outcomes of your death.
Legal Considerations
Provincial family law varies from province to province when it comes to the distribution of one’s estate. For example, British Columbia and Ontario consider common-law or same-sex unions when determining when one has matrimonial rights; this is particularly important for the purposes of distributing an estate without a will. While these provincial laws differ, the motive behind provincial laws is to fairly distribute your estate to those who are financially dependent on you at the time of your death. It is important that you make known your desires regarding the distribution of your estate so that it is not left up to the legal system to make sensitive decisions.
Wills
Elder Norma Jean Byrd emphasizes the importance of a will in order to plan for the future of loved ones (Video 4).
Since you won’t be here, you will need to leave a written document outlining your instructions regarding your estate. That is your will, your legal request for the distribution of your estate—that is, assets that remain after your debts have been satisfied. If you die intestate, or without a will, the laws of your province or territory of legal residence will dictate the distribution of your estate.
You can write your own will so long as you are a legal adult and mentally competent. The document has to be witnessed by two or three people who are not inheriting anything under the terms of the will, and it must be dated and signed and, in some provinces, notarized. A holographic will is handwritten, and as such, it may be more difficult to validate. A formal will is usually prepared on a typed or pre-printed form with the assistance of an attorney. A statutory will is a pre-printed form that you can buy from a store or in a software package. Online will-writing services, such as Canadian Legal Wills (legalwill.ca) or MakeYourWill.com (canada.makeyourwill.com), provide easy, affordable access to statutory wills. Consider, however, that a will is a legal document. Having yours drawn up by a lawyer may better insure its completeness and validity in court. A notarial will is only available in Quebec and must be signed in the presence of a notary, who keeps the original copy to share with heirs, and at least one witness (Kapoor et al., 2015).
Probate is the legal process of validating a will and administering the payment of debts and the distribution of assets by a probate court. The probate court process legally confirms the authority of the executor of an estate by granting the executor letters probate (or in Ontario, a certificate of estate trustee with a will). In Quebec, probates are not common because notarial wills do not require probate (Financial Post, 2013). Probate courts also distribute property in the absence of a will. However, probate is not required if the deceased:
• owned assets of little value, allowing for transfer without court supervision;
• owned assets jointly with or “payable on death” to another person;
• owned assets naming another person as beneficiary; or
• held all assets in a living trust (a legal entity for managing assets on behalf of beneficiaries).
Besides the details of “who gets what,” a will should name an executor, the person or persons who will administer the payment of your debts and the distribution of your remaining assets according to your wishes as expressed in your will. If you have legal dependents, you should name a guardian for them who will assume responsibility for providing for your children and managing the estate for them. A great deal of thought and consideration should be put into the selection of a guardian for your children to ensure you are choosing someone who has a similar parenting philosophy and who would be willing to accept responsibility for your children. You may also include a “letter of last instruction” stating the location of important documents, safe deposit keys, and bank accounts, and specifying your funeral arrangements.
You may change or rewrite your will at any time, but you should definitely do so as your life circumstances change, especially with events such as marriage or divorce, the birth of a child, and the acquisition of significant assets, such as a house. If the changes in your circumstances are substantial, you should create a new will.
There are several types of wills. A simple will leaves everything to a spouse.
It is possible that you will become mentally or physically disabled before you die and unable to direct management of your assets. To prepare for this possibility, you may create a living will with instructions for your care in that event. You may appoint someone, usually a spouse, child, or sibling, who would have power of attorney—that is, the right to act on your behalf, especially regarding financial and legal decisions. That power may be limited or unlimited (such as a “durable power of attorney”) and is restricted to certain acts or dependent on certain circumstances. The two major types of powers of attorney are ordinary and enduring. An ordinary power of attorney is no longer valid if the donor becomes mentally incompetent while an enduring power of attorney remains valid regardless (LawDepot, 2018).
An ethical will is a way for one to pass along values and beliefs as well as emotional and spiritual wishes (Kapoor et al., 2015).
Along with granting power of attorney, your living will may include a health-care proxy, requesting that medical personnel follow the instructions of a designated family member who expresses your wishes concerning your end-of-life treatment. Many people request, for example, that they not be revived or sustained if they cannot experience some quality of life. But be sure to update your living will, as over time your views may change and medical and technological advances may change our notions of what constitutes “quality of life.”
Trusts and Gifts
A trust is a legal entity created by a trustor, or grantor, who owns assets managed by a trustee or trustees for the benefit of a beneficiary or beneficiaries. A trust is often preferred to probating a will, which can be a costly and lengthy process that could make the contents of the probate a matter of public record. A testamentary trust may be established by a will so that beneficiaries who are unable to manage assets (minor children or disabled dependents) can benefit from the assets but have them managed for them. This type of trust becomes effective upon one’s death. A living trust is established while the grantor is alive. Unlike a will, it does not become a matter of public record upon your death. A spousal trust is a trust created for one’s spouse and “requires that 1) all income of the trust is paid to the spouse during the spouse’s lifetime, and 2) that none of the capital can be distributed to anyone else during your spouse’s lifetime” (Kapoor et al., 2015, p. 464).
Most trusts, whether testamentary or living, are created to avoid either the probate process or to avoid wills from becoming a public record. The probate process can be long and costly and therefore a burden for your executor, your beneficiaries (who may have to wait for their distributions), and your estate. Living trusts are also easier to change than the contents of a will.
Estates
An estate includes everything you own, such as property, life insurance, annuities, employee benefits, etc. Unlike the United States, Canada no longer has any form of estate or inheritance tax. However, there are three potential taxes that may be incurred at death:
• Income tax due to deemed disposition (Income Tax Act)
• Provincial probate taxes
• US estate tax (on your US assets)
Your primary objective is to see that your dependents are provided for by the distribution of your assets and that your assets are distributed as you would wish them to be were you still there to distribute them yourself.
Estate Services for First Nations Peoples
In Canada, under the Indian Act, the Department of Indigenous Services Canada (DISC) is required to manage the estates of First Nations people who lived on reserve upon their time of death as well as the estates of dependent adults or a minor. DISC will get involved in managing an estate if no one is identified in the will or if no other eligible person is willing and able to. If First Nations individuals live off-reserve upon their time of death, the province or territory where an individual lives will be responsible and provincial/territorial laws will apply. DISC will also assist First Nations people to administer the estates themselves (INAC, 2017).
DISC provides the following services as part of its Deceased Estates Service:
• appoints estate administrators or executors,
• approves wills so they can take effect,
• transfers reserve lands from the estate to the heirs or beneficiaries,
• if someone dies without a will, DISC will determine the heirs,
• if the family does not or cannot settle the estate, DISC will serve as administrator,
• if DISC is the administrator, it will distribute estate assets according to the will or the intestacy provisions of the Indian Act (INAC, 2017).
Key Takeaways
1. A will describes your wishes for the distribution of your assets (the estate) after your death.
2. Probate courts distribute assets in the absence of a will and administer wills in estates with assets valued above a certain (variable) dollar amount.
3. There are many kinds of wills, including:
• the holographic will
• the formal will
• the statutory will
• the notarial will
• the simple will
• the living will
• the ethical will
4. Living wills, with power of attorney and health-care proxy, provide medical directives, empower someone to manage your estate while you are still alive, and authorize someone to make decisions about your end-of-life care.
5. Trusts are used to provide the benefits of assets for beneficiaries without them assuming responsibility for asset management.
6. There are testamentary, living trusts, and spousal trusts. Setting up and administering trusts involves some considerable expense.
Exercises
1. Draft a holographic will or use a form for a statutory will. Start by reviewing your balance sheet, showing your assets, liabilities, net worth, and inventory of personal and household property. Think about how you would want your estate to be distributed upon your death. Identify an executor. For more information on writing a will, read the Canadian Living article “What you need to know about writing a will,” and visit formalwill.ca for free forms and advice.
2. Find out what kind of document your province or territory requires for a “last will and testament.” Also, consider drafting a living will. What should be in a living will?
REFERENCES
Financial Post. (2013). “To probate or not to probate.” Financial Post, Feb. 22. Retrieved from: http://business.financialpost.com/pe...not-to-probate.
Indigenous and Northern Affairs Canada. (2017). Estate services for First Nations people. Retrieved from: https://www.aadnc-aandc.gc.ca/eng/11.../1100100032361
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
LawDepot. (2018). “Power of Attorney—FAQ.” Retrieved from: https://www.lawdepot.ca/law-library/.../#.Wn_zk6IWCps. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/03%3A_Protecting_What_Is_Important_to_You/3.02%3A_Personal_Risk_Management-_Retirement_and_Estate_Planning.txt |
• 4.1: Investing
This chapter presents basic information about investment instruments and markets and explains the classic relationships of risk and return developed in modern portfolio theory.
• 4.2: Owning Stocks
This chapter look at investments commonly made by individual investors and their use in (and the risks of) building wealth as part of a diverse investment strategy.
• 4.3: Owning Bonds and Investing in Mutual Funds
This chapter look at investments commonly made by individual investors and their use in (and the risks of) building wealth as part of a diverse investment strategy.
• 4.4: Career Planning
This chapter brings the planning process full circle with a discussion on how to think about getting started—that is, deciding how to approach the process of selling your labour. The chapter introduces the idea of selling labour to employers in the labour market and explores how to search and apply for a job in light of its strategic as well as immediate potential.
04: Planning for the Future
INTRODUCTION
Saving to build wealth is investing. When people have too much money to spend immediately—that is, a surplus of disposable income—they become savers or investors. They transfer their surplus to individuals, companies, or governments that have a shortage or too little money to meet immediate needs. This is almost always done through an intermediary—a bank or broker—who can match up the surpluses and the shortages. If the capital markets work well, those who need money can get it, and those who can defer their need can try to profit from that. When you invest, you are transferring capital to those who need it on the assumption that they will be able to return your capital when you need or want it and that they will also pay you for its use in the meantime.
Investing happens over your lifetime. In your early adult years, you typically have little surplus to invest. Your first investments are in your home (although primarily financed with the debt of your mortgage) and then perhaps in planning for children’s education or for your retirement.
After a period of just paying the bills, making the mortgage, and trying to put something away for retirement, you may have the chance to accumulate wealth. Your income increases as your career progresses. You have fewer dependents (as children leave home), so your expenses decrease. You begin to think about your investment options. You have already been investing—in your home and retirement—but those investments have been prescribed by their specific goals.
You may reach this stage earlier or later in your life, but at some point, you begin to think beyond your immediate situation and look to increase your real wealth to ensure your future financial health. Investing is about that future.
Investment also goes beyond simply contributing one’s own individual wealth and financial health. The investments we make can contribute to the growth of businesses, organizations, and communities. The investment choices we make can have a significant economic and social impact in the world.
With regard to Indigenous communities in Canada, economic growth is fueled by investment. According to Chief Michael LeBourdais of the Whispering Pine/Clinton Indian Band, “investment can be generated from local residents through savings, through home equity or from outside sources. In Canada, private sector investment outweighs public sector investment by five to one. Three times as many jobs are created in the private sector as in the public sector” (Tulo Centre of Indigenous Economics, 2014, p. 6). Thus, attracting private investment to Indigenous business and economic development projects is an important part of economic growth. Many Indigenous entrepreneurs lack access to capital and rely heavily on personal and family support to help finance their businesses; “there is a growing need for ‘angel investors’ ” as well as other private investment options (Cooper, 2016). Furthermore, “investment creates jobs and business opportunities. This, in turn, builds the fiscal capacity of governments to support social improvements and build infrastructure. It also encourages a natural constituency for accountable, fiscally responsible government as the investment climate is enhanced. Indigenous governments must participate in federations and market systems to provide fiscal and economic opportunities for their governments and members” (Tulo Centre of Indigenous Economics, 2014, p. 7). Therefore, investing can help to increase your individual financial well-being, as well as the economic and social well-being of communities throughout the country.
Through the creation of the First Nations Fiscal and Statistical Management Act on March 23, 2005, the First Nations Finance Authority (FNFA), the First Nations Financial Management Board (FNFMB), and the First Nations Tax Commission (FNTC) were established. Canada’s First Nations and the Government of Canada worked together to support the creation of these new institutions in order to assist First Nations to better access capital markets and more investment opportunities. The FNFMB helps First Nations to build stronger community management and accountability frameworks, including best practices, standard-setting, and capacity-building, that enhance First Nations’ ability to participate in raising capital through the FNFA (Cooper, 2016). The FNTC, as mentioned in Chapter 6, helps First Nations use their property tax revenue to secure long-term borrowing and oversee the bylaw approval process, which provides greater investor certainty. As Cooper states, “the ability to successfully provide transparent, risk-related investment opportunities to private capital providers requires that First Nation communities undertake initiatives to enhance their ability to borrow. The practices and processes of the FNFA and the FNFMB are tools which can be of immediate assistance to the First Nations communities as they proceed to prepare themselves for dealing with private capital providers” (Cooper, 2016, p. 172).
How should you invest your money? This is a critical question that we must all ask ourselves as we reach that stage of our lives when we are ready to begin investing. Today, there are more and more options available to investors who wish to invest their money in socially responsible businesses. Furthermore, many businesses are focusing more on corporate social responsibility (CSR), which is focused on economic, social, and environmentally sustainable activities—and not only because they know it is the right thing to do, but also because it is good business. More and more companies are sharing their CSR record, which makes it easier for investors to research and make informed decisions.
12.1 INVESTMENTS AND MARKETS: A BRIEF OVERVIEW
Learning Objectives
1. Identify the features and uses of issuing, owning, and trading bonds.
2. Identify the uses of issuing, owning, and trading stocks.
3. Identify the features and uses of issuing, owning, and trading commodities and derivatives.
4. Identify the features and uses of issuing, owning, and trading mutual funds, including exchange-traded funds and index funds.
5. Describe the reasons for using different instruments in different markets.
Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to plan your investment goals and strategies.
You have looked at using the money markets to save surplus cash for the short term. By contrast, investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity.
The capital markets developed as a way for buyers to buy liquidity (i.e., raise capital). The two primary methods that have evolved into modern times are the bond and stock markets. Both are discussed in greater detail in Chapter 13 “Owning Stocks” and Chapter 14 “Owning Bonds and Investing in Mutual Funds,” but a brief introduction is provided here to give you a basic idea of what they are and how they can be used as investments.
Bonds and Bond Markets
Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest payments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make that large a loan, taking a large risk on only one borrower. In this case, the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds.
A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, provincial, municipal, and foreign) borrow by issuing bonds. The interest rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate: the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages. The Bank of Canada sets the prime rate.)
Bonds have many features other than the principal and interest; these include the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”—that is, redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders (the lenders). For example, the borrower (the bond issuer) may be required to keep a certain level of cash on hand, relative to his or her short-term debts, or may not be allowed to issue more debt until this bond is paid off.
Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets—that is, the relationship between the bond and its price is harder to determine.
Stocks and Stock Markets
Stocks or equity securities are shares of ownership: when you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, you buy a share of its future profits. You are literally sharing in the fortunes of the company.
Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares.
Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in Canada and around the world. Internationally, the best-known Canadian stock exchange is the Toronto Stock Exchange.
Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees.
Commodities and Derivatives
Commodities are resources or raw materials, including the following:
• agricultural products (food and fibres) such as soybeans, pork bellies, and cotton;
• energy resources such as oil, coal, and natural gas;
• precious metals such as gold, silver, and copper; and
• currencies, such as the dollar, yen, and euro.
Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term.
The answer was futures and forward contracts. Futures and forward contracts (or forwards) are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July 2018. If you know that you will want to have wheat in May of 2019, you could wait until May 2019 and buy the wheat at the market price, which is unknown in July 2018. Or you could buy it now, paying today’s price, and store the wheat until May 2019. Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat.
Alternatively, you could buy a futures contract for May 2019 wheat in July 2018. You would be buying May 2019 wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May 2019. The value of the futures contract to you is that you are removing the future price uncertainty without incurring any storage costs. In July 2018, the value of a contract to buy May 2019 wheat depends on what the price of wheat actually turns out to be in May 2019.
Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while futures contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange or the New York Mercantile Exchange.
When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer.
Futures and forward contracts proved so successful in shielding against some risk that they are now written for many more types of commodities, such as interest rates and stock market indices. More kinds of derivatives have been created as well, such as options. Options are the right, but not the obligation, to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities.
Derivatives such as forwards, futures, and options are used to hedge or protect against an existing risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors.
Mutual Funds, Index Funds, and Exchange-Traded Funds
A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment.
Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers. Chapter 14 section 4 “Mutual Funds” provides more information on portfolio management fees.
An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) 500 is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial corporations. An index fund is invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs.
Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans.
Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes. An exchange-traded fund (ETF) is a mutual fund that tracks an index or a commodity or a basket of assets, but is traded like stocks on a stock exchange. An ETF trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price.
The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years have seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models. The Internet also gives amateurs instantaneous access to information and accounts.
Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons.
For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time horizon, but rather a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, before time runs out.
Key Takeaways
1. Bonds are:
• a way to raise capital through borrowing, used by corporations and governments;
• an investment for the bondholder that creates return through regular, fixed, or floating interest payments on the debt and the repayment of principal at maturity; and
• traded on bond exchanges through brokers.
2. Stocks are:
• a way to raise capital through selling ownership or equity;
• an investment for shareholders that creates return through the distribution of corporate profits as dividends or through gains (losses) in corporate value; and
• traded on stock exchanges through member brokers.
3. Commodities are:
• natural or cultivated resources;
• traded to hedge revenue or production needs or to speculate on resources’ prices; and
• traded on commodities exchanges through brokers.
4. Derivatives are instruments based on the future, and therefore uncertain, price of another security, such as a share of stock, a government bond, a currency, or a commodity.
5. Mutual funds are portfolios of investments designed to achieve maximum diversification with minimal cost through economies of scale.
6. An index fund is a mutual fund designed to replicate the performance of an asset class or selection of investments listed on an index.
7. An exchange-traded fund is a mutual fund whose shares are traded on an exchange.
8. Institutional and individual investors differ in the use of different investment instruments and in using them to create appropriate portfolios.
Exercises
1. In your personal finance journal, record your experiences with investing. What investments have you made, and how much do you have invested? What stocks, bonds, funds, or other instruments described in this section do you have now (or have had in the past)? How were the decisions about your investments made, and who made them? If you have had no personal experience with investing, explain your reasons. What reasons might you have for investing (or not) in the future?
2. Please review the article “Stock Exchanges Around the World” found on Investopedia’s website. Roughly how many stock exchanges exist in the world? Which geographic region has the greatest number of exchanges?
3. Visit the Chicago Mercantile Exchange. What are some examples of commodities on the CME that theoretically could be part of your investment portfolio?
REFERENCES
Cooper, T. (2016). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp.161–176. Sydney, NS: Cape Breton University Press.
Tulo Centre of Indigenous Economics. (2014). Building a Competitive First Nation Investment Climate. Retrieved from: https://static1.squarespace.com/stat...lotextbook.pdf.
12.2 INVESTMENT PLANNING
Learning Objectives
1. Describe the advantages of the investment policy statement as a useful framework for investment planning.
2. Identify the process of defining investor return objectives.
3. Identify the process of defining investor risk tolerance.
4. Identify investor constraints or restrictions on an investment strategy.
Allison has a few hours to kill while her flight home is delayed. She loves her job as an analyst for a management consulting firm, but the travel is getting old. As she gazes at the many investment magazines and paperbacks on display and the several screens all tuned to financial news networks and watches people hurriedly checking their stocks on their mobile phones, she begins to think about her own investments. She has been paying her bills, paying back student loans, and trying to save some money for a while. Her uncle just died and left her a bequest of \$50,000. She is thinking of investing it since she is getting by on her salary and has no immediate plans for this windfall.
Allison is wondering how to get into some serious investing. There is no lack of information or advice about investing, but Allison isn’t sure how to get started.
Allison may not realize that there are as many different investment strategies as there are investors. The planning process is similar to planning a budget or savings plan. You determine where you are, where you want to be, and how to get there. One way to get started is to draw up an individual investment policy statement.
Investment policy statements are outlines of the investor’s goals and constraints, and they are popular with institutional investors such as pension plans, insurance companies, or non-profit endowments. Institutional investment decisions are typically made by professional managers operating on instructions from a higher authority, usually a board of directors or trustees. The directors or trustees may approve the investment policy statement and then leave the specific investment decisions up to the professional investment managers. The managers use the policy statement as their guide to the directors’ wishes and concerns.
This idea of a policy statement has been adapted for individual use, providing a helpful, structured framework for investment planning—and thinking. The advantages of drawing up an investment policy to use as a planning framework include the following:
• The process of creating the policy requires thinking through your goals and expectations and adjusting those to what is possible.
• The policy statement gives you an active role in your investment planning, even if the more specific details and implementation are left to a professional investment adviser.
• Your policy statement is portable, so even if you change advisers, your plan can go with you.
• Your policy statement is flexible; it can and should be updated at least once a year.
A policy statement is written in two parts. The first part lists your return objectives and risk preferences as an investor. The second part lists your constraints on investment. It is sometimes difficult to reconcile the two parts, so you may need to adjust your statement to improve your chances of achieving your return objectives within your risk preferences without violating your constraints.
Defining Return Objectives and Risk Tolerance
Defining return objectives is the process of quantifying the required annual return (e.g., 5 per cent, 10 per cent, etc.) necessary to meet your investment goals. If your investment goals are vague (e.g., to “increase wealth”), then any positive return will do. Usually, however, you have some specific goals—for example, to finance a child’s or grandchild’s education, to have a certain amount of wealth at retirement, to buy a sailboat on your fiftieth birthday, and so on.
Once you have defined goals, you must determine when they will happen and how much they will cost, or how much you will have to have invested to make your dreams come true. As explained in Chapter 4 “Evaluating Choices: Time, Risk, and Value,” the rate of return that your investments must achieve to reach your goals depends on how much you have to invest to start with, how long you have to invest it, and how much you need to fulfill your goals.
As in Allison’s case, your goals may not be so specific. Your thinking may be more along the lines of, “I want my money to grow and not lose value,” or, “I want the investment to provide a little extra spending money until my salary rises as my career advances.” In that case, your return objective can be calculated based on the role that these funds play in your life: safety net, emergency fund, extra spending money, or nest egg for the future.
However specific (or not) your goals may be, the quantified return objective defines the annual performance that you demand from your investments. Your portfolio can then be structured—you can choose your investments—such that it can be expected to provide that performance.
If your return objective is more than can be achieved given your investment and expected market conditions, then you know to scale down your goals, or perhaps find a different way to fund them. For example, if Allison wanted to stop working in ten years and start her own business, she probably would not be able to achieve this goal solely by investing her \$50,000 inheritance, even in a bull (up) market earning higher rates of return.
As you saw in Chapter 10 “Personal Risk Management: Insurance” and Chapter 11 “Personal Risk Management: Retirement and Estate Planning,” in investing there is a direct relationship between risk and return, and risk is costly. The nature of these relationships has fascinated and frustrated investors since the origin of capital markets, and it remains a subject of investigation, exploration, and debate. To invest is to take risk. To invest is to separate yourself from your money through actual distance—you literally give it to someone else—or through time. There is always some risk that what you get back is worth less (or costs more) than what you invested (a loss), or is less than what you might have had if you had done something else with your money (opportunity cost). The more risk you are willing to take, the more potential return you can make, but the higher the risk, the more potential losses and opportunity costs you may incur.
Individuals have different risk tolerances. Your risk tolerance is your ability and willingness to assume risk. Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.
Your willingness to take risk is shaped by your “personality,” your experiences, and your knowledge and education. Attitudes are shaped by life experiences, and attitudes toward risk are no different. Chart 12.2.1 shows how your level of risk tolerance develops.
Investment advisers may try to gauge your attitude toward risk by having you answer a series of questions on a formal questionnaire or by just talking with you about your investment approach. For example, an investor who says, “It’s more important to me to preserve what I have than to make big gains in the markets,” is relatively risk averse. The investor who says, “I just want to make a quick profit,” is probably more of a risk seeker.
Once you have determined your return objective and risk tolerance (i.e., what it will take to reach your goals and what you are willing and able to risk to get there) you may have to reconcile the two. You may find that your goals are not realistic unless you are willing to take on more risk. If you are unwilling or unable to take on more risk, you may have to scale down your goals.
Defining Constraints
Defining constraints is a process of recognizing any limitation that may impede or slow or divert progress toward your goals. The more you can anticipate and include constraints in your planning, the less likely they will throw you off course. Constraints include the following:
• Liquidity needs,
• Time available,
• Tax obligations,
• Legal requirements, and
• Unique circumstances.
Liquidity needs, or the need to use cash, can slow your progress from investing because you have to divert cash from your investment portfolio in order to spend it. In addition, you will have ongoing expenses from investing. For example, you will have to use some liquidity to cover your transaction costs such as brokerage fees and management fees. You may also wish to use your portfolio as a source of regular income or to finance asset purchases, such as the down payment on a home or a new car or new appliances.
While these may be happy transactions for you, for your portfolio they are negative events, because they take away value from your investment portfolio. Since your portfolio’s ability to earn returns is based on its value, whenever you take away from that value, you are reducing its ability to earn.
Time is another determinant of your portfolio’s earning power. The more time you have to let your investments earn, the more earnings you can amass. Or, the more time you have to reach your goals, the more slowly you can afford to get there, earning less return each year but taking less risk as you do. Your time horizon will depend on your age and life stage and on your goals and their specific liquidity needs.
Tax obligations are another constraint, because paying taxes takes value away from your investments. Investment value may be taxed in many ways (as income tax, capital gains tax, property tax, estate tax, or gift tax) depending on how it is invested, how its returns are earned, and how ownership is transferred if it is bought or sold.
Investors typically want to avoid, defer, or minimize paying taxes, and some investment strategies will do that better than others. In any case, your individual tax liabilities may become a constraint in determining how the portfolio earns to best avoid, defer, or minimize taxes.
Legalities also can be a constraint if the portfolio is not owned by you as an individual investor but by a personal trust or a family foundation. Trusts and foundations have legal constraints defined by their structure.
“Unique circumstances” refer to your individual preferences, beliefs, and values as an investor. For example, some investors believe in socially responsible investing (SRI), so they want their funds to be invested in companies that practise good corporate governance, responsible citizenship, fair trade practices, or environmental stewardship.
Some investors don’t want to finance companies that make objectionable products or by-products or have labour or trade practices reflecting objectionable political views. Divestment is the term for taking money out of investments. Grassroots political movements often include divestiture campaigns, such as student demands that their universities stop investing in companies that do business with nondemocratic or oppressive governments.
Socially responsible investment is the term for investments based on ideas about products or businesses that are desirable or objectionable. These qualities exist in the eye of the beholder, however, and vary among investors. Your beliefs and values are unique to you and to your circumstances in investing, and they may change over time. For more information on socially responsible investing in Canada, please go to the following websites:
Having mapped out your goals and determined the risks you are willing to take, and having recognized the limitations you must work with, you and/or your investment advisers can now choose the best investments. Different advisers may have different suggestions based on your investment policy statement. The process of choosing involves knowing what returns and risks investments have produced in the past, what returns and risks they are likely to have in the future, and how the returns and risks are related—or not—to each other.
Key Takeaways
1. The investment policy statement provides a useful framework for investment planning because:
• the process of creating the policy requires thinking through goals and expectations and adjusting those to the possible;
• the statement gives the investor an active role in investment planning, even if the more specific details and implementation are left to a professional investment adviser;
• the statement is portable, so that even if you change advisers your plans can go with you; and
• the statement is flexible; it can and should be updated at least once per year.
2. Return objectives are defined by the investor’s goals, time horizon, and value of the asset base.
3. Risk tolerance is defined by the investor’s ability and willingness to assume risk; comfort with risk-taking relates to personality, experience, and knowledge.
4. Constraints or restrictions to an investment strategy are the investor’s
• liquidity needs,
• time horizon,
• tax circumstances and obligations,
• legal restrictions, and
• unique preferences or circumstances.
5. Socially responsible investment and divestment are unique preferences based on beliefs and values about desirable or objectionable industries, products, or companies.
6. Your investment policy statement guides the selection of investments and development of your investment portfolio.
Exercises
1. Brainstorm with classmates expressions relating to investing, such as, “you gotta pay to play”; “you gotta play to win”; “no pain, no gain”; “it takes money to make money,” and so on. What does each of these expressions really mean? How do they relate to the concepts of investment risk and return on investment? In what ways are risks and returns in a reciprocal relationship?
2. Draft an individual investment policy statement as a guide to your future investment planning. What will be the advantages of having an investment policy statement? In your personal finance journal, record your general return objectives and specific goals at this time. What is a return objective?
3. What is your level of risk tolerance? How would you rate your risk tolerance on a five-point scale (with one indicating “most risk averse”)? In your personal finance journal, record how your asset base, time horizon, and liquidity needs define your ability to undertake investment risk. Then describe the personality characteristics, past experiences, and knowledge base that you feel help shape your degree of willingness to undertake risk. Now check your beliefs by using Sun Life Financial’s investment risk profiler on the webpage Calculate your risk profile. How do the results compare with your estimate? What conclusions do you draw from this test? What percentage of your investments do you now think you could put into stocks? What factor could you change that might enable you to tolerate more risk?
4. In your personal finance journal, record the constraints you face when it comes to reaching your investment goals. With what types of constraints must you reconcile with your investment planning? The more you need to use your money to live and the less time you have to achieve your goals, the greater the constraints in your investment planning. Revise your statement of goals and return objectives as needed to ensure it is realistic in light of your constraints.
5. In collaboration with classmates, conduct an online investigation into socially responsible investing. Review the websites noted in the section above on socially responsible investment. On the basis of your investigation, outline and discuss the different forms and purposes of SRI. Which form and purpose appeal most to you and why? What investments might you make, and what investments might you specifically avoid, to express your beliefs and values? Do you think investment planning could ever have a role in bringing about social change?
12.3 MEASURING RETURN AND RISK
Learning Objectives
1. Characterize the relationship between risk and return.
2. Describe the differences between actual and expected returns.
3. Explain how actual and expected returns are calculated.
4. Define investment risk and explain how it is measured.
5. Define the different kinds of investment risk.
You want to choose investments that will combine to achieve the return objectives and level of risk that’s right for you, but how do you know what the right combination will be? You can’t predict the future, but you can make an educated guess based on an investment’s past history. To do this, you need to know how to read or use the information available. Perhaps the most critical information to have about an investment is its potential return and susceptibility to types of risk.
Return
Returns are always calculated as annual rates of return, or the percentage of return created for each unit (dollar) of original value. If an investment earns 5 per cent, for example, that means that for every \$100 invested, you would earn \$5 per year (because \$5 = 5% of \$100).
Returns are created in two ways: the investment creates income or the investment gains (or loses) value. To calculate the annual rate of return for an investment, you need to know the income created, the gain (loss) in value, and the original value at the beginning of the year. The percentage return can be calculated as in Table 12.3.1.
Table 12.3.1 Calculating Percentage Return
[Income + Gain] / Original value = percentage rate of return
[Income + (Ending value – Original value)] / Original value = percentage rate of return
Note that if the ending value is greater than the original value, then ending value − (minus) original value > 0 (is greater than zero), and you have a gain that adds to your return. If the ending value is less, then ending value − (minus) original value < 0 (is less than zero), and you have a loss that detracts from your return. If there is no gain or loss, if ending value − (minus) original value = 0 (is the same), then your return is simply the income that the investment created.
For example, if you buy a share of stock for \$100, and it pays no dividend, and a year later the market price is \$105, then your return = [0 + (105 − 100)] / 100 = 5 / 100 = 5%. If the same stock paid a dividend of \$2, then your return = [2 + (105 − 100)] / 100 = 7 / 100 = 7%.
If the information you have shows more than one year’s results, you can calculate the annual return using what you learned in Chapter 4 “Evaluating Choices: Time, Risk, and Value” about the relationships of time and value. For example, if an investment was worth \$10,000 five years ago and is worth \$14,026 today, then \$10,000 × (1 + r)5 = \$14,026. Solving for r, the annual rate of return, you get 7 per cent. So, other factors being equal, the \$10,000 investment must have earned at a rate of 7 per cent per year to be worth \$14,026 five years later.
While information about current and past returns is useful, investment professionals are more concerned with the expected return for the investment—that is, how much it may be expected to earn in the future. Estimating the expected return is complicated because many factors (e.g., current economic conditions, industry conditions, and market conditions) may affect that estimate.
For investments with a long history, a strong indicator of future performance may be past performance. Economic cycles fluctuate, and industry and firm conditions vary, but over the long run, an investment that has survived has weathered all those storms. So, you could look at the average of the returns for each year. There are several ways to do the math, but if you look at the average return for different investments of the same asset class or type (e.g., stocks of large companies) you could compare what they have returned, on average, over time.
If the time period you are looking at is long enough, you can reasonably assume that an investment’s average return over time is the return you can expect in the next year. For example, if a company’s stock has returned, on average, 9 per cent per year over the last twenty years, then if next year is an average year, that investment should return 9 per cent again. Over the eighteen-year span from 1990 to 2008, for example, the average return for the S&P 500 was 9.16 per cent. Unless you have some reason to believe that next year will not be an average year, the average return can be your expected return. The longer the time period you consider, the less volatility there will be in the returns, and the more accurate your prediction of expected returns will be.
Returns are the value created by an investment, through either income or gains. Returns are also your compensation for investing, for taking on some or all of the risk of the investment, whether it is a corporation, government, parcel of real estate, or work of art. Even if there is no risk, you must be paid for the use of liquidity that you give up to the investment (by investing).
Returns are the benefits from investing, but they must be larger than its costs. There are at least two costs to investing: the opportunity cost of giving up cash and giving up all your other uses of that cash until you get it back in the future, and the cost of the risk you take—the risk that you won’t get it all back.
Risk
Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility—that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard deviation (showing the greatest variance from the average) have higher volatility and are the riskier investments.
An investment may do better or worse than its average. Standard deviation can therefore be used to define the expected range of investment returns. For the S&P 500, for example, the standard deviation from 1990 to 2008 was 19.54 per cent. So, in any given year, the S&P 500 is expected to return 9.16 per cent, but its return could be as high as 67.78 per cent or as low as −49.46 per cent, based on its performance during that specific period.
What risks are there? What would cause an investment to unexpectedly over or underperform? Starting from the top (the big picture) and working down, there are
• economic risks,
• industry risks,
• company risks,
• asset class risks, and
• market risks.
Economic risks are risks that something will upset the economy as a whole. The economic cycle may swing from expansion to recession, for example; inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are cyclical, growing when the economy grows and contracting when the economy contracts.
Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes. They also tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast food chains typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes.
Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate.
Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them more or less vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labour relationships are, and so on.
The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include:
• corporate stock or equities (shares in public corporations, either domestic or foreign);
• bonds or the public debts of corporations or governments;
• commodities or resources (e.g., oil, coffee, or gold);
• derivatives or contracts based on the performance of other underlying assets;
• real estate (both residential and commercial); and
• fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars).
Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short-, intermediate-, or long-term, depending on the maturity date.
Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds more or less valuable, for example, or more or less able to create valuable returns. In addition, changes in a market can affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in 1929, 1987, and 2008, all stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less efficient or less liquid—that is, there is less trading and less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. The loss in market efficiency further affects the value of assets traded.
As you can see, the link between risk and return is reciprocal. The question for investors and their advisers is: How can you get higher returns with less risk?
Key Takeaways
1. There is a direct relationship between risk and return because investors will demand more compensation for sharing more investment risk.
2. Actual return includes any gain or loss of asset value plus any income produced by the asset during a period.
3. Actual return can be calculated using the beginning and ending asset values for the period and any investment income earned during the period.
4. Expected return is the average return the asset has generated based on historical data of actual returns.
5. Investment risk is the possibility that an investment’s actual return will not be its expected return.
6. The standard deviation is a statistical measure used to calculate how often and how far the average actual return differs from the expected return.
7. Investment risk is exposure to:
• economic risk,
• industry risk,
• company- or firm-specific risk,
• asset class risk, or
• market risk.
Exercises
1. Selecting a security to invest in, such as a stock or fund, requires analyzing its returns. You can view the annual returns as well as average returns over a five-, ten-, fifteen-, or twenty-year period. Charts of returns can show the amount of volatility in the short term and over the longer term. What do you need to know to calculate the annual rate of return for an investment?
2. The standard deviation on the rate of return on an investment is a measure of its volatility or risk. What would a standard deviation of zero mean? What would a standard deviation of 10 per cent mean?
3. What kinds of risk are included in investment risk? Go online to survey current or recent financial news. Find and present a specific example of the impact of each type of investment risk. In each case, how did the type of risk affect investment performance?
12.4 DIVERSIFICATION: RETURN WITH LESS RISK
Learning Objectives
1. Explain the use of diversification in a portfolio strategy.
2. List the steps in creating a portfolio strategy, explaining the importance of each step.
3. Compare and contrast active and passive portfolio strategies.
Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk, and to lessen risk, you must expect less return. But another way to lessen risk is to diversify: to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.
Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify:
• between cyclical and countercyclical investments, reducing economic risk;
• among different sectors of the economy, reducing industry risks;
• among different kinds of investments, reducing asset class risk; and
• among different kinds of firms, reducing company risks.
To diversify well, you have to look at your collection of investments as a whole—that is, as a portfolio rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.
Steps to Diversification
In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.
Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is a short-term (less than ninety-day) government treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the Canadian government to become insolvent—go bankrupt—and have to default on its debt within such a short time.
The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return.
The second diversification decision is asset allocation: deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. Chart 12.4.1 shows an asset allocation for an investor’s portfolio.
Chart 12.4.1 Proposed Asset Allocation
Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks.
One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.
Security selection is the third step in diversification: choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.
Investment Strategies
Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. Chart 12.4.2 demonstrates the three levels of diversification.
Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a benchmark for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities.
There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments—that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called passive management. It also has the advantage of saving transaction costs (broker’s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.
In contrast, making security selection decisions to maximize returns and minimize risks is called active management. Investors who favour active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected.
Also, asset allocation can be actively managed through the strategy of market timing—shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds.
It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index (Malkiel, 2007).
Key Takeaways
1. Diversification can decrease portfolio risk by allowing you to choose investments with different risk characteristics and exposures.
2. A portfolio strategy involves:
• capital allocation decisions,
• asset allocation decisions, and
• security selection decisions.
3. Active management is a portfolio strategy including security selection decisions and market timing.
4. Passive management is a portfolio strategy omitting security selection decisions and relying on index funds to represent asset classes, while maintaining a long-term asset allocation.
Exercises
1. What is the meaning of the following expressions: “Don’t count your chickens before they hatch,” and “Don’t put all your eggs in one basket”? How do they relate to the challenge of reducing exposure to investment risks and building a high-performance investment portfolio?
2. Do you favour an active or a passive investment management strategy? Why? Identify all the pros and cons of these investment strategies and debate them with classmates. What factors favour an active approach? What factors favour a passive approach? Which strategy might prove more beneficial for first-time investors?
REFERENCES
Malkiel, B. G. (2007). A Random Walk Down Wall Street, 10th ed. New York: W. W. Norton & Company. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/04%3A_Planning_for_the_Future/4.01%3A_Investing.txt |
INTRODUCTION
By 1976, computers had been around for decades, but they were typically the size of a large room and just as expensive. To use one, you had to learn a programming language. On April 1, 1976, Steve Jobs, Steve Wozniak, and Ron Wayne started a company to make personal computers. On January 3, 1977, Jobs and Wozniak incorporated without Wayne, buying his 10 per cent share of the company for \$800 (Linzmayer, 1999).
On December 12, 1980, Apple Computer, Inc. went public; its stock sold for \$22 per share (FundingUniverse, 2009). Had you bought Apple’s stock when the company went public and held it until today, you would have earned an annual return of about 14.5 per cent.
Typically, an inventor has a great idea, then teams up with—or becomes—an entrepreneur. The entrepreneur’s job is to build a company that can make the invention a reality. The company needs to find the resources to make the product and sell it widely enough to pay for those resources and to create a profit, making the whole effort worthwhile. No matter how great the idea is, if it can’t be done profitably, it can’t be done. The personal computer had to be produced and sold to be widely used and useful.
As an investor, you buy stocks hoping to share in corporate profits, benefiting directly from the inventive vitality of the economy and participating in economic growth. Understanding what stocks are, where they come from, what they do, and how they have value will help you decide how to include stocks in your investment portfolio and how to use them to reach your investment goals.
REFERENCES
FundingUniverse. (2009). “Company Histories: Apple Computer, Inc.” Retrieved from: http://www.fundinguniverse.com/compa...-Computer-Inc- Company-History.html.
Linzmayer, R. (1999). Apple Confidential: The Real Story of Apple Computer, Inc. San Francisco: No Starch Press.
13.1 STOCKS AND STOCK MARKETS
Learning Objectives
1. Explain the role of stock issuance and ownership in economic growth.
2. Contrast and compare the roles of the primary and secondary stock markets.
3. Identify the steps of stock issuance.
4. Contrast and compare the important characteristics of common and preferred stock.
Resources have costs, so a company needs money, or capital, which is also a resource. To get that start-up capital, the company could borrow or it could offer a share of ownership, or equity, to those who chip in capital.
If the costs of debt (interest payments) are affordable, the company may choose to borrow, which limits the company’s commitment to its capital contributor. When the loan matures and is paid off, the relationship is over.
If the costs of debt are too high, however, or the company is unable to borrow, it seeks equity investors willing to contribute capital in exchange for an unspecified share of the company’s profits at some time in the future. In exchange for taking the risk of no exact return on their investment, equity investors get a say in how the company is run.
Stock represents those shares in the company’s future and the right to a say in how the company is run. The original owners—the inventor(s) and entrepreneur(s)—choose equity investors who share their ideals and vision for the company. Usually, the first equity investors are friends, family, or colleagues; this allows the original owners freedom of management. At that point, the corporation is privately held, and the company’s stock may be traded privately between owners. There may be restrictions on selling the stock, as is often the case for a family business, so that control stays within the family.
If successful, however, eventually the company needs more capital to grow and remain competitive. If debt is not desirable, then the company issues more equity, or stock, to raise capital. The company may seek out an angel investor, venture capital firm, or private equity firm. Such investors finance companies in the early stages in exchange for a large ownership and management stake in the company. Their strategy is to buy a significant stake when the company is still “private” and then realize a large gain, typically when the company goes public. The company may also seek a buyer, perhaps a competitive or complementary business.
Alternatively, the company may choose to go public, selling shares of ownership to investors in the public markets. Theoretically, this means sharing control with random strangers because anyone can purchase shares traded in the stock market. It may even mean losing control of the company. Founders can be fired, as Steve Jobs was from Apple in 1985 (although he returned as CEO in 1996).
Going public requires a profound shift in corporate structure and management. Once a company is publicly traded, it falls under the regulatory scrutiny of federal and provincial governments, and must regularly file financial reports and analysis. It must broaden participation on the board of directors and allow more oversight of management. Companies go public to raise large amounts of capital to expand products, operations, markets, or to improve or create competitive advantages. To raise public equity capital, companies need to sell stock, and to sell stock they need a market. That’s where the stock markets come in.
Primary and Secondary Markets
The private corporation’s board of directors—shareholders elected by the shareholders—must authorize the number of shares that can be issued. Since issuing shares means opening the company up to more owners, or sharing it among more people, only the existing owners have the authority to do so.
Those authorized shares are then issued through an initial public offering (IPO). At that point the company goes public. The IPO is a primary market transaction, which occurs when the stock is initially sold and the proceeds go to the company issuing the stock. After that, the company is publicly traded; its stock is outstanding, or publicly available. Then, whenever the stock changes hands, it is a secondary market transaction. The owner of the stock may sell shares and realize the proceeds. When most people think of “the stock market,” they are thinking of the secondary markets.
The existence of secondary markets makes the stock a liquid or tradable asset, which reduces its risk for both the issuing company and the investor buying it. The investor is giving up capital in exchange for a share of the company’s profit, with the risk that there will be no profit or not enough to compensate for the opportunity cost of sacrificing the capital. The secondary markets reduce that risk to the shareholder because the stock can be resold, allowing the shareholder to recover at least some of the invested capital and to make new choices with it.
Meanwhile, the company issuing the stock must pay the investor for assuming some of its risk. The less that risk is, because of the liquidity provided by the secondary markets, the less the company has to pay. The secondary markets decrease the company’s cost of equity capital.
A company hires an investment bank to manage its initial public offering of stock. For efficiency, the bank usually sells the IPO stock to institutional investors. Usually, the original owners of the corporation keep large amounts of stock as well.
What does this mean for individual investors? Some investors believe that after an initial public offering of stock, the share price will rise because the investment bank will have initially underpriced the stock in order to sell it. This is not always the case, however. Share price is typically more volatile after an initial public offering than it is after the shares have been outstanding for a while. The longer the company has been public, the more information is known about the company, and the more predictable its earnings, and thus its share price, are (Lowery, Officer, and Schwert, 2009).
When a company goes public, it may issue a relatively small number of shares. Its market capitalization—the total dollar value of its outstanding shares—may therefore be small. The number of individual shareholders, mostly institutional investors and the original owners, also may be small. As a result, the shares may be “thinly traded”—that is, traded infrequently or in small amounts.
Thinly traded shares may add to the volatility of the share price. One large shareholder deciding to sell could cause a decrease in the stock price, for example, whereas for a company with many shares and shareholders, the actions of any one shareholder would not be significant. As always, diversification—in this case, of shareholders—decreases risk. Thinly traded shares are less liquid and more risky than shares that trade more frequently.
Common, Preferred, and Foreign Stocks
A company may issue common stock or preferred stock. Common stock is more prevalent. All companies issue common stock, whereas not all issue preferred stock. The differences between common and preferred have to do with the investor’s voting rights, risk, and dividends.
Common stock allows each shareholder voting rights—one vote for each share owned. The more shares you own, the more you can influence the company’s management. Shareholders vote for the company’s directors, who provide policy guidance for and hire the management team that directly operates the corporation. After several corporate scandals in the early twenty-first century, some shareholders have assumed a more active voting role.
Common stockholders assume the most risk of any corporate investor. If the company encounters financial distress, its first responsibility is to satisfy creditors, then the preferred shareholders, and then the common shareholders. Thus, common stocks provide only residual claims on the value of the company. In the event of bankruptcy, in other words, common shareholders get only the residue—whatever is left after all other claimants have been compensated.
Common shareholders share the company’s profit after interest has been paid to creditors and a specified share of the profit has been paid to preferred shareholders. Common shareholders may receive all or part of the profit in cash—the dividend. The company is under no obligation to pay common stock dividends, however. The management may decide that the profit is better used to expand the company, to invest in new products or technologies, or to grow by acquiring a competitor. As a result, the company may pay a cash dividend only in certain years or not at all.
Shareholders investing in preferred stock, on the other hand, give up voting rights but get less risk and more dividends. Preferred stock typically does not convey voting rights to the shareholder. As noted above, preferred shareholders have a superior claim on the company’s assets in the event of bankruptcy. They get their original investment back before common shareholders, but after creditors.
Preferred dividends are more of an obligation than common dividends. Most preferred shares are issued with a fixed dividend as cumulative preferred shares. This means that if the company does not create enough profit to pay its preferred dividends, those dividends ultimately must be paid before any common stock dividend.
For the individual investor, preferred stock may have two additional advantages over common stock:
1. Less volatile prices
2. More reliable dividends
As the company goes through its ups and downs, the preferred stock price will fluctuate less than the common stock price. If the company does poorly, preferred stockholders are more likely to be able to recoup more of their original investment than common shareholders because of their superior claim. If the company does well, however, preferred stockholders are less likely to share more in its success because their dividend is fixed. Preferred shareholders are thus exposed to less risk, protected by their superior claim and fixed dividend. The preferred stock price reflects less of the company’s volatility.
Because the preferred dividend is more of an obligation than the common dividend, it provides more predictable dividend income for shareholders. This makes the preferred stock less risky and attractive to an investor looking for less volatility and more regular dividend income.
The following table summarizes the differences between common stock and preferred stock.
Table 13.1.1 Stock Comparisons
Common versus Preferred Stock Common Stock Preferred Stock
Voting Rights Yes Usually not
Downside Risk More Less
Upside Risk More Less or None
Reliability of Investment Income Less More
Price Volatility More Less
As an investment choice, preferred stock is more comparable to bonds than to common stock. Bonds also offer less volatility and more reliable income than common stock (see Chapter 14 “Owning Bonds and Investing Mutual Funds”). If there is a difference in the tax rate between dividend income (from preferred stock) and interest income (from bonds), you may find a tax advantage to investing in preferred stock instead of bonds.
Corporations often issue and trade their stocks on exchanges or in markets outside their home country, especially if the foreign market has more liquidity and will attract more buyers. For example, many foreign corporations issue and trade stock on the Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), or on the National Association of Securities Dealers Automated Quotations (NASDAQ).
Key Takeaways
1. Companies go public to raise capital to finance growth by selling equity shares in the public markets.
2. A primary market transaction happens between the original issuer and buyer.
3. Secondary market transactions are between all subsequent sellers and buyers.
4. The secondary market lowers risk and transaction costs by increasing liquidity.
5. Shares are authorized and issued and then become outstanding or publicly available.
6. Equity securities may be common or preferred stock, differing by:
• the assignment of voting rights,
• dividend obligations,
• claims in case of bankruptcy, and
• risk.
7. Common stocks have less predictable income, whereas most preferred stocks have fixed-rate cumulative dividends.
Exercises
1. What is a venture capitalist? Watch the video “Guy Kawasaki on Venture Capital – Part 1” (7:45). What top three pieces of advice does he give to new ventures seeking equity investment?
2. According to WebFinance’s Investorwords.com, what is an angel investor?
REFERENCES
Lowery, M. B., M. S. Officer, and G. W. Schwert. (2009). “The Variability of IPO Initial Returns.” Journal of Finance. Retrieved from: http://schwert.ssb.rochester.edu/ipovolatility.htm.
13.2 STOCK VALUE
Learning Objectives
1. Explain the basis of stock value.
2. Identify the factors that affect earnings expectations.
3. Analyze how market capitalization affects stock value.
4. Discuss how market popularity or perception of value affects stock value.
5. Explain how stocks can be characterized by their expected performance relative to the market.
The value of a stock is in its ability to create a return, to create income or a gain in value for the investor. With common stock, the income is in the form of a dividend, which the company is not obligated to pay. The potential gain is determined by estimations of the future value of the stock.
If you knew that the future value would likely be more than the current market price—over your transaction costs, tax consequences, and opportunity cost—then you would buy the stock.
If you thought the future value would be less, you would short the stock (borrow shares and sell them with the intent of buying it back when the price of the stock falls), or you would just look for another investment.
Every investor wants to know what a stock will be worth, which is why so many stock analysts spend so much time estimating future value. Equity analysis is the process of gathering as much information as possible and making the most educated guesses.
Corporations exist to make profit for the owners. The better a corporation is at doing that, the more valuable it is, and the more valuable are its shares. A company also needs to increase earnings, or grow, because the global economy is competitive. A corporation’s future value depends on its ability to create and grow earnings.
That ability depends on many factors. Some factors are company-specific, some are specific to the industry or sector, and some are macroeconomic forces. Chapter 12 “Investing” discusses these factors in terms of the risk that a stock creates for the investor. The risk is that the company will not be able to earn the expected profit.
A company’s size is an indicator of its earnings and growth potential. Size may correlate with age. A large company typically is more mature than a smaller one, for example. A larger company may have achieved economies of scale or may have gotten large by eliminating competitors or dominating its market. Size in itself is not an indicator of success, but similarly sized companies tend to have similar earnings growth (Fama and French, 1992).
Companies are usually referred to by the size of their market capitalization, or market cap. Common market cap categories are based on the following sizes: micro, small, mid (medium), and large, or:
• micro cap, with a market capitalization between \$50 million and \$300 million;
• small cap, with a market capitalization between \$300 million and \$2 billion;
• mid cap, with a market capitalization between \$2 billion and \$10 billion; and
• large cap, with a market capitalization of more than \$10 billion.
The market capitalization of a company—along with industry and economic indicators—is a valuable indicator of earnings potential.
In the stock market, the forces of supply and demand determine stock prices. The more demand or popularity there is for a company’s stock, the higher its price will go (unless the company issues more shares). A stock is popular, and thus in greater demand, if it is thought to be more valuable—that is, if it has more earnings and growth potential.
Sometimes a company is under- or overpriced relative to the going price for similar companies. If the market recognizes this “error,” the stock price should rise or fall as it “corrects” itself.
A growth stock is a stock that promises a higher rate of return because the market has underestimated its growth potential. It is a stock that has been underpriced for some reason. For example, investors may be wary of the outlook for its industry. Because it is underpriced, a value stock is expected to provide a higher-than-average return.
Stocks may be characterized by the role that they play in a diversified portfolio—and some by their colorful names—as shown in Table 13.2.1.
Table 13.2.1 Definitions of Stocks and their Roles in a Portfolio
Stock Definition Role
Growth stock Underestimated potential for growth. Expect a higher rate of return.
Value stock Undervalued by the market; underpriced. Expect a higher-than-average return.
Defensive stock Less volatility than the overall market and less sensitive to market changes. Expect the value to fall less than the market’s during a market decline.
Cyclical stock More volatility than the overall market and more sensitive to market changes. When the market rises, expect the price to rise at a higher rate. When the market falls, expect the price to fall at a higher rate.
Speculative stock Overvalued by the market; overpriced. Expect the price to continue rising for a time before it falls.
Blue chip stock Stock of a stable, well-established, large cap company. Expect stable returns.
Widow-and-orphan stock A blue chip defensive stock. Expect a steady dividend.
Wallflower stock Overlooked and therefore underpriced. Expect the value to rise when the stock is “discovered.”
Penny stock Low-priced stock of a small or micro-cap company. Expect the value to rise if and when the company succeeds.
Each of these terms names a stock’s relationship to the market and to investors. For example, an investor who wants to invest in stocks but wants to minimize economic risk would include defensive stocks along with some blue chips. Implicit is its potential for price growth, risk, or role in a diversified portfolio.
Key Takeaways
1. A stock’s value is based on the corporation’s ability to create and grow profits.
2. Earnings expectations are based on industry- and company-specific factors.
3. The size of the market capitalization affects stock value.
4. A stock’s market popularity or perception of value affects its value.
5. Stocks can be characterized by their expected behaviour relative to the market as:
• growth stocks,
• value stocks,
• cyclical stocks,
• defensive stocks, or
• other named types (e.g., blue chip stocks, penny stocks).
REFERENCES
Fama, E. F., and K. R. French. (1992). “The Cross-section of Expected Stock Returns.” Journal of Finance 47: 427–486.
13.3 COMMON MEASURES OF VALUE
Learning Objectives
1. Identify common return ratios and evaluate their usefulness.
2. Explain how to interpret dividend yield.
3. Explain the significance of growth ratios.
4. Explain the significance of market value ratios.
A corporation creates a return for investors by creating earnings. Those earnings may be paid out in cash as a dividend or retained as capital by the company. A company’s ability to create earnings is watched closely by investors because the company’s earnings are the investor’s return.
A company’s earnings potential can be tracked and measured, and several measurements are expressed as ratios. Mathematically, as discussed in Chapter 3 “Financial Statements,” a ratio is simply a fraction. In investment analysis, a ratio provides a clear means of comparing values. Three kinds of ratios important to investors are return ratios, growth ratios, and market value ratios.
The ratios described here are commonly presented in news outlets and websites where stocks are discussed (e.g., the Toronto Stock Exchange and the NASDAQ Stock Market), so chances are you won’t have to calculate them yourself. Nevertheless, it is important to understand what they mean and how to use them in your investment thinking.
Return Ratios
One of the most useful ratios in looking at stocks is the earnings per share (EPS): the dollar value of the earnings per each share of common stock. It calculates the company’s earnings, or the portion of a company’s profit allocated to each outstanding share of common stock. The calculation lets you see how much you benefit from holding each share. Here is the formula for calculating EPS:
EPS = (net income − preferred stock dividends)
average number of common shares outstanding
The company’s earnings are reported on its income statement as net income, so a shareholder could easily track earnings growth. However, the EPS allows you to make a direct comparison to other stocks by putting the earnings on a per-share basis, creating a common denominator. Earnings per share should be compared over time and also compared to the EPS of other companies.
When a stock pays a dividend, that dividend is income for the shareholder. Investors concerned with the cash flows provided by an equity investment look at dividends per share (DPS) as a measure of the company’s ability and willingness to pay a dividend.
DPS = common stock dividends
average number of common
shares outstanding
Another measure of the stock’s usefulness in providing dividends is the dividend yield, which calculates the dividend as a percentage of the stock price. It is a measure of the dividend’s role as a return on investment: for every dollar invested in the stock, how much is returned as a dividend, or actual cash payback? An investor concerned about cash flow returns can compare companies’ dividend yields.
dividend yield = dividend per share (in dollars)
price per share (in dollars)
Earnings are either paid out as dividends or are retained by the company as capital. That capital is used by the company to finance operations, capital investments such as new assets for expansion and growth, or repayment of debt.
The dividend is the return on investment that comes as cash while you own the stock. Some investors see the dividend as a more valuable form of return than the earnings that are retained as capital by the company. It is more liquid, since it comes in cash and comes sooner than the gain that may be realized when the stock is sold (more valuable because time affects value). It is the “bird in the hand,” perhaps less risky than waiting for the eventual gain from the company’s retained earnings.
Some investors see a high dividend as a sign of the company’s strength, indicative of its ability to raise ample capital through earnings. Dividends are a sign that the company can earn more capital than it needs to finance operations, make capital investments, or repay debt. Thus, dividends are capital that can be spared from use by the company and given back to investors.
Other investors see a high dividend as a sign of weakness, indicative of a company that cannot grow because it is not putting enough capital into expansion and growth or into satisfying creditors. This may be because it is a mature company operating in saturated markets, a company stifled by competition, or a company without the creative resources to explore new ventures.
As an investor, you need to look at dividends in the context of the company and your own income needs.
Growth Ratios
The more earnings are paid out to shareholders as dividends, the less earnings are retained by the company as capital.
earnings = dividends + capital retained
Since retained capital finances growth, the more earnings are used to pay dividends, the less earnings are used to create growth. Two ratios that measure a company’s choice in handling its earnings are the dividend payout rate and the retention rate. The dividend payout rate compares dividends to earnings, while the retention rate compares the amount of capital retained to earnings.
The dividend payout rate equals the dividend as a percentage of earnings.
dividend payout rate = dividends / earnings
The retention rate equals the retained capital as a percentage of earnings.
retention rate = capital retained / earnings
Because earnings = dividends + capital retained, then 100 per cent of earnings = dividend payout + retention rate.
If a company’s dividend payout rate is 40 per cent, then its retention rate is 60 per cent; if it pays out 40 per cent of its earnings in dividends, then it retains 60 per cent of them.
Since Microsoft has earnings of \$15.3 billion and dividends of \$4.68 billion, it must retain \$10.62 billion of its earnings. So, for Microsoft,
dividend payout rate = 4.68 billion/15.3 billion = 30.59%
retention rate = 10.62 billion/15.3 billion = 69.41%
There is no benchmark dividend payout or retention ratio for every company; they vary depending on the age and size of the company, industry, and economic climate. These numbers are useful, however, to get a sense of the company’s strategy and to compare it to competitors.
A company’s value lies in its ability to grow and to increase earnings. The rate at which it can retain capital—that is, earn it and not pay it out as dividends—is a factor in determining how fast it can grow. This rate is measured by the internal growth rate and the sustainable growth rate. The internal growth rate answers the question, “How fast could the company grow (increase earnings) without any new capital, without borrowing or issuing more stock?” Given how good the company is at taking capital and turning it into assets and using those assets to create earnings, the internal growth rate looks at how fast the company can grow without any new borrowing or new shares issued.
The sustainable growth rate answers the question, “How fast could the company grow without changing the balance between using debt and using equity for capital?” Given how good the company is at taking capital and turning it into assets and using those assets to create earnings, the sustainable growth rate looks at how fast the company can grow if it uses some new borrowing, but keeps the balance between debt and equity capital stable.
Both growth rates use the retention rate as a factor in allowing growth. The fastest rate of growth could be achieved by having a 100 per cent retention rate—that is, by paying no dividends and retaining all earnings as capital.
An investor who is not using stocks as a source of income, but rather for their potential gain, may look for higher growth rates (evidenced by a higher retention rate and a lower dividend payout rate). An investor looking for income from stocks would instead be attracted to companies offering a higher dividend payout rate and a lower retention rate (despite lower growth rates).
Market Value Ratios
While return and growth ratios are measures of a company’s fundamental value, and therefore the value of its stocks, the actual stock price is affected by the market. Investors’ demand can result in the under- or overpricing of a stock, depending on its attractiveness in relation to other investment choices or opportunity cost.
A stock’s market value can be compared with that of other stocks. The most common measure for doing so is the price-to-earnings ratio (P/E). The price-to-earnings ratio is calculated by dividing the price per share (in dollars) by the earnings per share (in dollars). The result shows the investment needed for every dollar of return that the stock creates.
P/E = price per share / earnings per share
For Microsoft, for example, the price per share is around \$24 and the EPS is \$1.70, so the P/E = 24.00/1.70 = \$14.12. This means that the price per share is around fourteen times bigger than the earnings per share.
The larger the P/E ratio, the more expensive the stock is and the more you have to invest to get one dollar’s worth of earnings in return. To get \$1 of Microsoft’s earnings, you have to invest around \$14. By comparing the P/E ratio of different companies, you can see how expensive they are relative to each other.
A low P/E ratio could be a sign of weakness. Perhaps the company has problems that make it riskier going forward, even if it has earnings now, so the future expectations and thus the price of the stock is now low. Or it could be a sign of a buying opportunity for a stock that is currently underpriced.
A high P/E ratio could be a sign of a company with great prospects for growth and so a higher price than would be indicted by its earnings alone. On the other hand, a high P/E could indicate a stock that is overpriced and has nowhere to go but down. In that case, a high P/E ratio would be a signal to sell your stock.
How do you know if the P/E ratio is “high” or “low”? You can compare it to other companies in the same industry or to the average P/E ratio for a stock index of similar-type companies based on company size, age, debt levels, and so on. As with any of the ratios discussed here, this one is useful in comparison.
Another indicator of market value is the price-to-book ratio (P/B). Price-to-book ratio compares the price per share to the book value of each share. The book value is the value of the company that is reported “on the books”—the company’s balance sheet—using the intrinsic or original values of assets, liabilities, and equity. The balance sheet does not show the market value of the company’s assets, for example, or what they could be sold for today; it shows what they were worth when the company acquired them. The book value of a company should be less than its market value, which should have appreciated over time. The company should be worth more as times goes on.
P/B = price per share
book value of
equity per share
Since the price per share is the market value of equity per share, the P/B ratio compares the current market value of the company’s equity to its book value. If that ratio is greater than one, then the company’s equity is worth more than its original value, and the company has been increasing its value. If that ratio is less than one, then the company’s current value is less than its original value, so the value has been decreasing. A P/B of one would indicate that a company has just been breaking even in terms of value over the years.
The higher the P/B ratio, the better the company has done in increasing its value over time. You can calculate the ratio for different companies and compare them by their ability to increase value.
Table 13.3.1 provides a summary of the return, growth, and market value ratios.
Table 13.3.1 Ratios and Their Uses
Ratio What It Measures
Earnings per Share (EPS) Earning (in dollars) for every outstanding share of stock
Dividends per Share (DPS) Dividend (in dollars) for every outstanding share of stock
Dividends Yield Dividend (in dollars) returned for every dollar invested in the stock
Dividends Payout Percentage of earnings retained as capital
Internal Growth Rate The fastest rate of growth without using more debt or issuing more equity
Sustainable Growth Rate The fastest rate of growth using more debt but without changing the balance of debt and equity
Price-to-Earnings Ratio (P/E) The market value of each dollar’s worth of earnings
Price-to-Book Ratio (P/B) The market value of the company’s equity compared to its book value
Ratios can be used to compare a company with its past performance, with its competitors, or with competitive investments. They can be used to project a stock’s future value based on the company’s ability to earn, grow, and be a popular investment. A company has to have fundamental value to be an investment choice, but it also has to have market value to have its fundamental value appreciated in the market and to have its price reflect its fundamental value.
Key Takeaways
1. Earnings per share (EPS) and dividends per share (DPS) indicate stock returns on investment.
2. Dividend yield measures a shareholder’s cash return relative to investment.
3. Growth ratios such as the internal and sustainable growth rates indicate the company’s ability to grow given earnings and dividend expectations.
4. Market value ratios, most commonly price-to-earnings and price-to-book, indicate a stock’s market popularity and its effects on its price.
13.4 EQUITY STRATEGIES
Learning Objectives
1. Identify and explain the rationales behind common long-term strategies.
2. Identify and explain the rationales behind common short-term strategies.
The best stock strategy is to know what you are looking for (i.e., what kind of stock will fulfill the role you want it to play in your portfolio) and to do the analyses you need to find it. That is easier said than done, however, and it requires that you have the knowledge, skill, and data for stock analysis. Commonly used general stock strategies may be long term (returns achieved in more than one year) or short term (returns achieved in less than one year), but the strategies you choose should fit your investing horizon, risk tolerance, and needs. An important part of that strategy, as with financial planning in general, is to check your stock investments and re-evaluate your holdings regularly. How regularly depends on the long- or short-term horizon of your investing strategies.
Long-Term Strategies
Long-term strategies favour choosing a long-term approach to avoid the volatility and risk of market timing. For individual investors, a buy-and-hold strategy can be effective over the long run. The strategy is just what it sounds like: you choose the stocks for your equity investments, and you hold them for the long term. The idea is that if you choose wisely and your stocks are well diversified, over time you will do at least as well as the stock market itself. Though it suffers through economic cycles, the economy’s long-term trend is growth.
By minimizing the number of transactions, you can minimize transaction costs. Since you are holding your stocks, you are not realizing gains and are not paying gains tax. Thus, even if your gross returns are not spectacular, you are minimizing your costs and maximizing net returns. This strategy is optimal for investors with a long horizon, low risk tolerance, and little need for liquidity in the short term.
Another long-term strategy is dollar-cost averaging. The idea of dollar-cost averaging is that you invest in a stock gradually by buying the same dollar amount of the same stock at regular intervals. This is a way of negating the effects of market timing. By buying at regular intervals, you will buy at times when the price is low and when it is high, but over time your price will average out. Dollar-cost averaging is a way of avoiding a stock’s price volatility because the net effect is that you buy the stock at its average price.
An investor uses dollar-cost averaging when regular payroll deductions are made to fund defined contribution retirement plans. The same amount is contributed to the plan in regular intervals and is typically used to purchase the same set of specified assets.
A buy-and-hold or dollar-cost averaging strategy only makes sense over time because both assume a long time horizon in order to “average out” volatility, making them better than other investment choices. If you have a long-term horizon—as with a retirement plan, for example—those strategies can be quite effective. However, market or economic cycles can be long too, so you need to think about whether your “long-term” horizon is likely to outlast or be surpassed by the market’s cycle, especially as you near your investment goals.
Direct investment and dividend reinvestment are ways of buying shares directly from a company without going through a broker. This allows you to avoid brokerage commissions. Direct investment means purchasing shares from the company, while dividend reinvestment means having your dividends automatically invested in more shares (rather than being sent to you as cash). Dividend reinvestment is also a way of building up your equity in the stock by reinvesting cash that you might otherwise spend.
The advantage of direct investment and dividend reinvestment is primarily the savings on brokers’ commissions. You can also buy fractional shares—that is, less than a whole share—and there is no minimum amount to invest, as there can be with brokerage transactions. The disadvantage is that by having funds automatically reinvested, you are not actively deciding how they should be invested and thus may be missing better opportunities.
Indexing is a passive long-term investment strategy to invest in index funds as a diversified asset rather than select stocks. Instead of choosing individual large cap companies, for example, you could invest in the S&P 500’s index fund, which would provide more diversification for only one transaction cost than you could get picking individual securities. The disadvantage to indexing is that you do not enjoy the potential of individual stocks producing above-average returns.
Table 13.4.1 summarizes long-term stock strategies.
Table 13.4.1 Long-Term Stock Strategies
Strategy
Avoids
Market
Timing
Avoids
Stock
Selection
Lowers
Transaction
Costs
Schedules
Investment
(Savings)
Buy and Hold
Dollar-Cost Averaging
Direct Investment
Dividend Reinvestment
Indexing
Short-Term Strategies
Short-term stock strategies rely on market timing to earn above-average returns. Some advisers believe that the stock market fluctuates between favouring value stocks and favouring growth stocks. That is, the market will go through cycles when value stocks that are temporarily underpriced outperform stocks of companies poised for higher growth, and vice versa. If true, you would want to weight your portfolio with growth stocks when they are favoured and with value stocks when they are favoured.
This value-growth weighting strategy relies on market timing, which is difficult for the individual investor to harness. It also relies on correctly identifying growth and value stocks and market trends in their favour, complicating the process of market timing even further.
Day trading is a very short-term strategy of taking and closing a position in a day or two. Literally, it means buying in the morning and selling in the afternoon. Day trading became popular in the 1990s when stock prices were riding the tide of the tech stock bubble. At that time, it was possible to hold a stock for just a few hours and earn a gain. Technology, especially the Internet, also made real-time quotes and other market data available to individual investors at a reasonable cost. At the same time, Internet and discount brokers drove down the costs of trading.
Day trading declined, but did not die, after the tech bubble burst. It turns out that in a bubble, any strategy can make money, but when market volatility is more closely related to earnings potential and fundamental value, there is no alternative to doing your homework, knowing as much as possible about your investments, and making appropriate strategic choices.
Key Takeaways
1. Common long-term strategies try to maximize returns by
• minimizing transaction costs, or
• minimizing the effects of market timing.
2. Long-term stock strategies include buy and hold, dollar-cost averaging, direct investment, dividend reinvestment, and indexing.
3. Common short-term strategies try to maximize return by taking advantage of market timing.
Exercises
1. Review your investing horizon, risk tolerance, and needs. In your personal finance journal, record your ideas about the effects of your horizon, risk profile, and personal circumstances on your decisions about investing in stocks. Rank the long- and short-term investment strategies in order of their appropriateness for you. Explain why your top-ranked strategies seem best for you at this time.
2. Survey (but do not join) websites for day traders online. Then read the article “Day trading strategies for beginners” from Investopedia.com. What information in this article might discourage you from getting involved in day trading? | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/04%3A_Planning_for_the_Future/4.02%3A_Owning_Stocks.txt |
INTRODUCTION
One definition of a bond is an affinity between people. In science, that affinity is physically held together by an attraction of atoms. In finance, a bond is a debt agreement holding lender and borrower together in a shared financial fate.
Investors buy bonds to participate in economic growth as lenders rather than as shareholders, with less risk and a firmer claim on assets. Bonds are issued by different kinds of organizations—by governments as well as by corporations—giving investors different kinds of partners in growth.
Since bonds are a different form of capital than stocks, and since bond investments are made by different kinds of borrowers, bonds offer diversification from the stocks in your portfolio. Your use of bonds may change over time, as your risk tolerance or liquidity needs change.
Mutual funds are not another kind of asset, but another way of investing in any kind of asset. The fund is a pool capable of much greater diversification than an individual’s investment portfolio, given transaction costs. A mutual fund can also provide security selection, expertise, liquidity, and convenience. Some funds are even designed to perform the asset allocation task for the investor. Mutual funds are fast becoming the dominant investment vehicle for individual investors, changing the role of the broker and financial adviser.
Mutual funds may be purchased by parents and/or grandparents to help provide for their future. Elder Margaret Reynolds said that one reason she and her husband “buy mutual funds and trust funds [is] because I don’t know what it’s going to be like in 20 years for my grandchildren, so those are the things that we do now” (Elder Reynolds, Video 7). Elder Reynolds and her husband look after their grandchildren to make sure that they are cared for in the future. This is good financial planning.
14.1 BONDS AND BOND MARKETS
Learning Objectives
1. Identify bond features that can determine risk and return.
2. Identify various Canadian federal, provincial, and municipal bonds.
3. Compare and contrast features of the corporate bond markets, the markets for corporate stock, and the markets for government bonds.
4. Explain the role of rating agencies and the process of bond rating.
Bonds are a relatively old form of financing. Formalized debt arrangements long preceded corporate structure and the idea of equity (stock) as we know it. Venice issued the first known government bonds of the modern era in 1157 (Barmash, 2003), while private bonds are cited in British records going back to the thirteenth century (Adams, 1921).
Bonds
In addition to financing government projects, bonds are used by corporations to capitalize growth. Bonds are also a legal arrangement, and as such are subject to various conditions, obligations, and consequences. As a result of their legal and financial roles, bonds carry a quaint and particular vocabulary. Bonds come in all shapes and sizes to suit the needs of the borrowers and the demands of lenders. Table 14.1.1 lists the descriptive terms for basic bond features.
Table 14.1.1 Basic Bond Features
Bond Term Meaning
Issuer Borrower
Investor Lender or Creditor
Principal, Face Value, Par Value Amount Borrowed
Coupon Rate Interest Rate
Coupon Interest Payment
Maturity Due Date
Term Time until Maturity
Yield to Maturity Annualized Return on Bond Investment
Market Value Current Price
The coupon is usually paid to the investor twice yearly. It is calculated as a percentage of the face value—amount borrowed—so that the annual coupon = coupon rate × face value. By convention, each individual bond has a face value of \$1,000. A corporation issuing a bond to raise \$100 million would have to issue 100,000 individual bonds (100,000,000 divided by 1,000). If those bonds pay a 4 per cent coupon, a bondholder who owns one of those bonds would receive a coupon of \$40 per year (1,000 × 4%), or \$20 every six months.
The coupon rate of interest on the bond may be fixed or floating and may change. A floating rate is usually based on another interest benchmark, such as the prime rate, a widely recognized benchmark of prevailing interest rates.
A zero-coupon bond has a coupon rate of zero: it pays no interest and repays only the principal at maturity. A “zero” may be attractive to investors, however, because it can be purchased for much less than its face value. A registered coupon bond is registered for principal only and not for interest. A registered bond is issued by the issuing company and is registered in the owner’s name. A bearer bond does not register the bond in the investor’s name (Kapoor et al., 2015). There are deferred coupon bonds (also called split-coupon bonds and issued below par), which pay no interest for a specified period, followed by higher-than-normal interest payments until maturity. There are also step-up bonds that have coupons that increase over time.
The face value—the principal amount borrowed—is paid back at maturity. If the bond is callable, it may be redeemed after a specified date, but before maturity. A borrower typically “calls” its bonds after prevailing interest rates have fallen, making lower-cost debt available. Borrowers can borrow new, cheaper debt and pay off the older, more expensive debt. As an investor (lender), you would be paid back early, which sounds great, but because interest rates have fallen, you would have trouble finding another bond investment that would pay as high a rate of return.
A convertible bond is a corporate bond that may be converted into common equity at maturity or after some specified time. If a bond were converted into stock, the bondholder would become a shareholder, assuming more of the company’s risk.
The bond may be secured by collateral, such as property or equipment, sometimes called a mortgage bond. If unsecured, or secured only by the “full faith and credit” of the borrower (the borrower’s unconditional commitment to pay principal and interest on the debt), the bond is a debenture. In other words, a debenture “is a bond that is backed only by the reputation of the issuing corporation” (Kapoor et al., 2015, p. 366). Most bonds are issued as debentures. The First Nations Finance Authority “is a not-for-profit finance authority formed in 1995 to provide member First Nations with the opportunity to use debentures to access long-term affordable financing. Its primary purpose is to raise long-term private capital at preferred rates for public works, such as roads, water and sewer, and buildings” (Cooper, 2016, p. 171). These debentures are secured through property-taxes or long-term revenue sources (Cooper, 2016).
A bond specifies if the borrower has more than one bond issue outstanding or more than one set of lenders to repay, which establishes the bond’s seniority in relation to previously issued debt. This “pecking order” determines which lenders will be paid back first in case of default on the debt or bankruptcy. Thus, when the borrower does not meet its coupon obligations, investors holding senior debt as opposed to subordinated debt have less risk of default. In case of bankruptcy, senior debt will be paid first and subordinate debt second.
Bonds may also come with covenants or conditions on the borrower. Covenants are usually attached to corporate bonds and require the company to maintain certain performance goals during the term of the loan. Those goals are designed to lower default risk for the lender. Examples of typical covenants are:
• dividend limits,
• debt limits,
• limits on sales of assets, and
• maintenance of certain liquidity ratios or minimum cash balances.
Corporations issue corporate bonds, usually with maturities of ten, twenty, or thirty years. Corporate bonds tend to be the most “customized,” with features such as callability, conversion, and covenants.
The Canadian government issues two types of bonds: marketable bonds and T-Bills.
Canada Treasury bills, also known as T-Bills, are investments fully guaranteed by the Government of Canada, which means the principal and rate of interest are guaranteed. T-Bills are considered the safest Canadian investment you can hold with a term of one year or less. They are offered for terms of one month to one year. Interest is paid at maturity. T-Bills can be purchased from most financial institutions and can be sold at market value at any time. The minimum investment for a T-Bill having a term of three months to one year is \$5,000. The minimum investment for a T-Bill having a term of one or two months is \$25,000 (Canadian Bank Rates, 2013).
Marketable bonds not only have a specific maturity date and interest rate, but they are also transferable and can thus be traded in the bond market. All Canadian-dollar marketable bonds are non-callable, which means they cannot be called in by the government to be redeemed before maturity. Marketable bonds also pay a fixed rate of interest semi-annually (Kapoor et al., 2015).
Real Return Bonds are Canadian government bonds that pay a fixed rate of interest semi-annually that is adjusted by inflation. This ensures your purchasing power remains constant regardless of the future inflation rate.
The sale of Canada Savings Bonds ended November 1, 2017. It was the third type of bond issued by the Canadian government.
Provincial and municipal governments issue bonds in order to raise funds for program spending and to fund deficits. Provincial bonds or debentures are primarily used by provincial governments and are secured by the province through its ability to levy taxes. A general obligation bond is a bond backed by a municipal government. Canadian municipalities often issue two forms of general obligation debt: the serial bond, in which the principal and interest mature on different dates or are paid in installments; and the bullet bond, in which the entire principal is repaid on the bond’s maturity date while regular interest payments are made on the investors’ shares during the term of the fund (Hanniman, 2015). Municipal bullet bonds are often offset by sinking funds “to which annual or semi-annual deposits are made for the purpose of redeeming a bond issue” (Kapoor et al., 2015, p. 368). A revenue bond is repaid out of the revenue generated by the project that the debt is financing. For example, toll revenue may secure a debt that finances a highway. Revenue bonds are not common in Canada and are currently only used in Toronto (Hanniman, 2015).
Foreign corporations and governments also issue bonds. You should keep in mind, however, that foreign government defaults are not uncommon. Mexico in 1994, Russia in 1998, and Argentina in 2001 are all recent examples. Foreign corporate or sovereign debt also exposes the bondholder to currency risk, as coupons and principal will be paid in the foreign currency.
Bond Markets
The volume of capital traded in the bond markets is far greater than what is traded in the stock markets. All sorts of borrowers issue bonds: corporations; national, provincial, and municipal governments. Even small towns issue bonds to finance capital expenditures such as schools, fire stations, and roads. Each kind of bond has its own market.
Private placement refers to bonds that are issued in a private sale rather than through the public markets. The investors in privately placed bonds are institutional investors such as insurance companies, endowments, and pension funds.
Corporate bonds are traded in over-the-counter transactions through brokers and dealers. Because the details of each bond issue may vary—maturity, coupon rate, callability, convertibility, covenants, and so on—it is hard to directly compare bond values the way stock values are compared. As a result, the corporate bond markets are less transparent to the individual investor.
To provide guidance, rating agencies provide bond ratings; that is, they “grade” individual bond issues based on the likelihood of default and thus the risk to the investor. Rating agencies are comprised of independent agents that base their ratings on the financial stability of the company, its business strategy, competitive environment, and its outlook for the industry and the economy—any factors that may affect the company’s ability to meet coupon obligations and pay back debt at maturity.
Ratings agencies such as DBRS, Fitch Ratings, A. M. Best, Moody’s, and Standard & Poor’s are hired by large borrowers to analyze the company and rate its debt. Moody’s also rates government debt. Ratings agencies use an alphabetical system to grade bonds (shown in Table 14.1.2) based on the highest-to-lowest rankings of two well-known agencies.
Table 14.1.2 Bond Ratings
Standard & Poor’s Moody’s Grade Meaning
AAA Aaa Investment Risk is almost zero
AA Aa Investment Low risk
A A Investment Risk if economy declines
BBB Baa Investment Some risk; more if economy declines
BB Ba Speculative Risky
B B Speculative Risky; expected to get worse
CCC Caa Speculative Probable bankruptcy
C Ca Speculative Probable bankruptcy
C C Speculative In bankruptcy or default
D Speculative In bankruptcy or default
A plus sign (+) following a rating indicates that it is likely to be upgraded, while a minus sign (−) following a rating indicates that it is likely to be downgraded.
Bonds rated BBB or Baa and above are considered investment grade bonds: relatively low risk and “safe” for both individual and institutional investors. Bonds rated below BBB or Baa are speculative in that they carry some default risk. These are called speculative grade bonds, junk bonds, or high-yield bonds. Because they are riskier, speculative grade bonds need to offer investors a higher return or yield in order to be “priced to sell.”
Although the term “junk bonds” sounds derogatory, not all speculative grade bonds are “worthless” or are issued by “bad” companies. Bonds may receive a speculative rating if their issuers are young companies, in a highly competitive market, or capital intensive, requiring lots of operating capital. Any of those features would make it harder for a company to meet its bond obligations, thus earning its bonds a speculative rating. In the 1980s, for example, companies such as CNN and MCI Communications issued high-yield bonds, which became lucrative investments as the companies grew into successful corporations.
Default risk is the risk that a company won’t have enough cash to meet its interest payments and principal payment at maturity. That risk depends, in turn, on the company’s ability to generate cash, profit, and grow to remain competitive. Bond-rating agencies analyze an issuer’s default risk by studying its economic, industry, and firm-specific environments in order to estimate its current and future ability to satisfy its debts. The default risk analysis is similar to equity analysis, but bondholders are more concerned with cash flows—cash to pay back the bondholders—and profits, rather than profits alone.
Bond ratings can determine the coupon rate the issuer must offer investors to compensate them for default risk: the higher the risk, the higher the coupon must be. Ratings agencies have been criticized recently for not being objective enough in their ratings of the corporations that hire them. Nevertheless, over the years, bond ratings have proven to be a reliable guide for bond investors.
Key Takeaways
1. Bond features that can determine risk and return include:
• coupon and coupon structure,
• maturity, callablility, and convertibility,
• security or debenture,
• seniority or subordination, and
• covenants.
2. Provincial and municipal governments issue
• revenue bonds secured by project revenues, or
• general obligation bonds secured by the government issuer.
3. Corporate bonds may be issued through the public bond markets or through private placement.
4. The secondary bond market offers little transparency because of the differences among bonds and the lower volume of trades.
5. To help provide transparency, rating agencies analyze default risk and rate specific bonds.
REFERENCES
Adams, G. B. (1921). The Constitutional History of England. London: H. Holt.
Barmash, I. (2003). The Self-Made Man. Washington, DC: Beard Books.
Canadian Bank Rates. (2013). “Government of Canada Treasury Bill.” Retrieved from http://canadianbankrates.ca/treasurybillrates.php.
Cooper, T. (2016). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp.161–176. Sydney, NS: Cape Breton University Press.
Hanniman, K. (2015). “A Good Crisis: Canadian Municipal Credit Conditions After the Lehman Brothers Bankruptcy.” Institute on Municipal Finance & Governance, no. 22. Retrieved from: https://munkschool.utoronto.ca/imfg/...ne_sept_17.pdf.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
14.2 BOND VALUE
Learning Objectives
1. Explain how bond returns are measured.
2. Define and describe the relationships between interest rates, bond yields, and bond prices.
3. Define and describe the risks that bond investors are exposed to.
4. Explain the implications of the three types of yield curves.
5. Assess the role of the yield curve in bond investing.
Bond rating does not replace bond analysis, which focuses on bond value. Like any investment, a bond is worth the value of its expected return. That value depends on the amount expected and the certainty of that expectation. To understand bond values, then, is to understand the value of its return and the costs of its risks.
Bonds return two cash flows to their investors: 1) the coupon, or the interest paid at regular intervals, usually twice yearly or yearly, and 2) the repayment of the principal at maturity. The amounts are spelled out in the bond itself. The coupon rate is specified (for a fixed-rate bond) and the face value is the principal to be returned at the stated maturity.
Unlike a stock, for which the cash flows—both the amount and the timing—are “to be determined,” in a bond everything about the cash flows is established at the outset. Any bond feature that makes those cash flows less certain increases the risk to the investor and thus the investor’s return. If the bond has a floating-rate coupon, for example, then there is uncertainty about the amount of the coupon payments. If the bond is callable, there is uncertainty about the number of coupon payments.
Whatever the particular features of a bond, as debt instruments, bonds expose investors to specific risks. What are those risks, and what is their role in defining expectations of returns?
Bond Returns
Unlike a stock, a bond’s future cash returns are known with certainty. You know what the coupon will be (for a fixed-rate bond) and you know that at maturity the bond will return its face value. For example, if a bond pays a 4 per cent coupon and matures in 2028, you know that every year you will receive \$20 twice per year (20 = 4% × 1,000 × ½) until 2028, when you will also receive the \$1,000 face value at maturity. You know what you will get and when you will get it. However, you can’t be sure what that will be worth to you when you do. You don’t know what your opportunity cost will be at the time.
Investment returns are quoted as an annual percentage of the amount invested, the rate of return. For a bond, that rate is the yield. Yield is expressed in two ways: the current yield and the yield to maturity. The current yield is a measure of your bond’s rate of return in the short term, if you buy the bond today and keep it for one year. You can calculate the current yield by looking at the coupon for the year as a percentage of your investment or the current price, which is the market price of the bond.
current yield = annual coupon (interest received, or cash flows) / market value =
(coupon rate × face value) / market value
So, if you bought a 4 per cent coupon bond, which is selling for \$960 today (its market value), and kept it for one year, the current yield would be 40 (annual coupon) / 960 (market value) = 4.1667%. The idea of the current yield is to give you a quick look at your immediate returns (your return for the next year).
In contrast, the yield to maturity (YTM) is a measure of your return if you bought the bond and held it until maturity, waiting to claim the face value. That calculation is a bit more complicated, because it involves the relationship between time and value (as we saw in Chapter 4 “Evaluating Choices: Time, Risk, and Value”), since the yield is over the long term until the bond matures. You will find bond yield-to-maturity calculators online, and many financial calculators have the formulas preprogrammed.
To continue the example, if you buy a bond for \$960 today (2018), you will get \$20 every six months until 2028, when you will also get \$1,000. Because you are buying the bond for less than its face value, your return will include all the coupon payments (\$400 over ten years) plus a gain of \$40 (1,000 − 960 = 40). Over the time until maturity, the bond returns coupons plus a gain. Its yield to maturity is close to 4.5 per cent.
Bond prices—their market values—have an inverse relationship to the yield to maturity. As the price goes down, the yield goes up, and as the price goes up, the yield goes down.
The yield to maturity is directly related to interest rates in general, so as interest rates increase, bond yields increase and bond prices fall. As interest rates fall, bond yields fall and bond prices increase. Chart 14.2.1 shows these relationships.
You can use the yield to maturity to compare bonds to see how good they are at creating returns. This yield holds if you hold the bond until maturity, but you may sell the bond at any time. When you sell the bond before maturity, you may have a gain or a loss, since the market value of the bond may have increased or decreased since you bought it. That gain or loss would be part of your return along with the coupons you have received over the holding period, or the period of time that you held the bond.
Your holding period yield is the annualized rate of return that you receive depending on how long you have held the bond, its gain or loss in market value, and the coupons you received in that period. For example, if you bought the bond for \$960 and sold it again for \$980 after two years, your return in dollars would be the coupons of \$80 (\$40 per year × 2 years) plus your gain of \$20 (\$980 − \$960), relative to your original investment of \$960. Your holding period yield would be close to 5.2 per cent.
Bond Risks
The basic risk of bond investing is that the returns—the coupon and the principal repayment (face value)—will not be repaid, or that when they are repaid, they won’t be worth as much as you thought they would be. The risk that the company will be unable to make its payments is default risk—the risk that it will default on the bond. You can estimate default risk by looking at the bond rating as well as the economic and sector- and firm-specific factors that define the company’s soundness.
Part of a bond’s value is that you can expect regular coupon payments in cash, which you could spend or reinvest. There is a risk, however, that when you go to reinvest the coupon, you will not find another investment opportunity that will pay as high a return because interest rates and yields have fallen. This is called reinvestment risk. Your coupons are the amount you thought they would be, but they are not worth as much as you expected because you cannot earn as much from them.
If interest rates and bond yields have dropped, your fixed-rate bond, which is paying a coupon that is now higher than other bonds, has become more valuable. Its market price has risen. But the only way to realize the gain from the higher price is to sell the bond, and then you won’t have any place to invest the proceeds in other bonds to earn as much return.
Reinvestment risk is one facet of interest rate risk, which arises from the fundamental relationship between bond values and interest rates. Interest rate risk is the risk that a change in prevailing interest rates will change bond value—that interest rates will rise and the market value of the bond will fall. (If interest rates fell, the bond value would increase, which the investor would not see as a risk.)
Another threat to the value of your coupons and principal repayment is inflation. Inflation risk is the risk that your coupons and principal repayment will not be worth as much as you thought, because inflation has decreased the purchasing power or the value of the dollars you receive.
A bond’s features can make it more or less vulnerable to these risks. In general, the longer the term to maturity, the riskier the bond. The longer the term is, the greater the probability that the bond will be affected by a change in interest rates, a period of inflation, or a damaging business cycle.
In general, the lower the coupon rate and the smaller the coupon, the more sensitive the bond will be to a change in interest rates. The lower the coupon rate and the smaller the coupon, the more of the bond’s return comes from the repayment of principal, which only happens at maturity. More of your return is deferred until maturity, which also makes it more sensitive to interest rate risk. A bond with a larger coupon provides more liquidity, over the term of the bond, and less exposure to risk. Chart 14.2.2 shows the relationship between bond characteristics and risks.
Chart 14.2.2 Bond Characteristics and Risks
A zero-coupon bond offers the lowest coupon rate possible: zero. Investors avoid reinvestment risk since the only return—and reinvestment opportunity—comes when the principal is returned at maturity. However, a “zero” is exposed to the maximum interest rate risk, because interest rates will always be higher than its coupon rate of zero. The attraction of a zero is that it can be bought for a very low price.
As a bond investor, you can make better decisions if you understand how the characteristics of bonds affect their risks and yields as you use those yields to compare and choose bonds.
Yield Curve
Interest rates affect bond risks and bond returns. If you plan to hold a bond until maturity, interest rates also affect reinvestment risk. If you plan to sell the bond before maturity, you face interest rate risk or the risk of a loss of market value. When you invest in bonds, then, you want to be able to forecast future interest rates.
Investors can get a sense of how interest rates are expected to change in the future by studying the yield curve, a graph that compares the terms of the yields for bonds of different maturities.
The yield curve illustrates the term structure of interest rates, or the relationship of interest rates to time. Usually, the yield curve is upward sloping—that is, long-term rates are higher than short-term rates. Long-term rates indicate expected future rates. If the economy is expanding, future interest rates are expected to be higher than current interest rates, because capital is expected to be more productive in the future. Future interest rates will also be higher if there is inflation because lenders will want more interest to make up for the fact that the currency has lost some of its purchasing power.
A flat yield curve indicates that future interest rates are expected to be about the same as current interest rates or that capital will be about as productive in the economy as it is now. A downward-sloping yield curve shows that future interest rates are expected to be lower than current rates. This is often interpreted as a signal of a recession, because capital would be less productive in the future if the economy were less productive then.
The yield curve is not perfectly smooth; it changes every day as bonds trade and new prices and new yields are established in the bond markets. It is a widely used indicator of interest rate trends, however. It can be useful to know the broad trends in interest rates that the market sees.
For your bond investments, an upward-sloping yield curve indicates that interest rates will go up, which means that bond yields will go up but bond prices will go down. If you are planning to sell your bond in that period of rising interest rates, you may be selling at a loss.
Because of their known coupon and face value, many investors use bonds to invest funds for a specific purpose. For example, suppose you have a child who is eight years old and you want her to be able to go to university in ten years. You might invest in bonds that have ten years until maturity. However, if you invest in bonds that have twenty years until maturity, they will have a higher yield (all else being equal), so you could invest less now.
You could buy the twenty-year bonds but plan to sell them before maturity for a price determined by what interest rates are in ten years (when you sell them). If the yield curve indicates that interest rates will rise over the next ten years, then you could expect your bond price to fall, and you would have a loss when you sell the bond, which would take away from your returns.
In general, rising interest rates mean losses for bondholders who sell before maturity, and falling interest rates mean gains for bondholders who sell before maturity. Unless you are planning to hold bonds until maturity, the yield curve can give you a sense of whether you are more likely to have a gain or loss.
Key Takeaways
1. All bonds expose investors to:
• default risk (the risk that coupon and principal payments won’t be made),
• reinvestment risk (the risk that coupon payments will be reinvested at lower rates),
• interest rate risk (the risk that changing interest rates will affect bond values), and
• inflation risk (the risk that inflation will devalue bond coupons and principal repayment).
2. Bond returns can be measured by yields.
• The current yield measures short-term return on investment.
• The yield to maturity measures return on investment until maturity.
• The holding period yield measures return on investment over the term that the bond is held.
3. There is a direct relationship between interest rates and bond yields.
4. There is an inverse relationship between bond yields and bond prices (market values).
5. There is an inverse relationship between bond prices (market values) and interest rates.
6. The yield curve illustrates the term structure of interest rates, showing yields of bonds with differing maturities and the same default risk. The purpose of a yield curve is to show expectations of future interest rates.
7. The yield curve may be:
• upward sloping, indicating higher future interest rates;
• flat, indicating similar future interest rates; or
• downward sloping, indicating lower future interest rates.
Exercises
1. How do you buy bonds? Read Investopedia’s primer “Bond Basics: How to Trade Bonds.”
2. Read Investopedia’s explanation of how to read a bond table, “Bond Basics: How To Read A Bond Table.” In the example of a bond table, suppose you invested \$5,000 in Avco’s bond issue. What coupon rate were you getting? When was the maturity date, and how much did you get then? What was the current value of the bond at that time? What does it mean for a bond to be trading above par? What was the bond’s annual return during the time you held it? If you held the bond for ten years, what cash flows did you receive? Would you have reinvested in the bond when it matured, or would you have sold it and why? Study the other corporate bonds listed in the Investopedia example of a bond table.
3. To find out more about how to use bond tables when making investment decisions, read the article “Reading Bond Prices in the Newspaper” by the Securities Industry and Financial Markets Association. Where will you find bond tables? What will you compare in bond tables? At the top of this Securities Industry and Financial Markets Association page, click on one of the bond markets “at-a-glance” under “Bond Markets & Prices.” Then enter the name of an issuer on the form and choose the data you want to see. For example, enter your province’s name and ask to see all the bonds by yield or by maturity date or by some other search factor. What do these data tell you? For each search factor, how would the information assist you in making decisions about including bonds in your investment portfolio?
4. Experiment with Investopedia’s Yield to Maturity calculator. Why should you know the yield to maturity (indicated as “YTM” on the calculator) before investing in bonds?
14.3 BOND STRATEGIES
Learning Objectives
1. Discuss diversification as a strategic use of bonds.
2. Summarize strategies to achieve bond diversification.
3. Define and compare matching strategies.
4. Explain life cycle investing and bond strategy.
Bonds provide more secure income for an investment portfolio, while stocks provide more growth potential. When you include bonds in your portfolio, you do so to have more income and less risk than you would have with just stocks. Bonds also diversify the portfolio. Because debt is so fundamentally different from equity, debt markets and equity markets respond differently to changing economic conditions.
Diversification Strategies
If your main strategic goal of including bonds is diversification, you can choose an active or passive bond selection strategy. As with equities, an active strategy requires individual bond selection, while a passive strategy involves the use of indexing, or investing through a broadly diversified bond index fund or mutual fund in which bonds have already been selected.
The advantage of the passive strategy is its greater diversification and relatively low cost. The advantage of an active strategy is the chance to create gains by finding and taking advantage of market mispricings. An active strategy is difficult for individual investors in bonds, however, because the bond market is less transparent and less liquid (this applies mostly to corporate bonds, not government bonds) than the stock market.
If your main strategic goal of including bonds is to lower the risk of your portfolio, you should keep in mind that bond risk varies.
Another way to look at the effect of default risk on bond prices is to look at spreads. A spread is the difference between one rate and another. With bonds, the spread generally refers to the difference between one yield to maturity and another. Spreads are measured and quoted in basis points. A basis point is one one-hundredth of a per cent, or 0.0001 or 0.01 per cent.
The most commonly quoted spread is the difference between the yield to maturity for a Treasury bond and a corporate bond with the same term to maturity. Treasury bonds are considered to have no default risk because it is unlikely that the Canadian government will default. Treasuries are exposed to reinvestment, interest rate, and inflation risks, however.
Corporate bonds are exposed to all four types of risk. So, the difference between a twenty-year corporate bond and a twenty-year Treasury bond is the difference between a bond with and without default risk. The difference between their yields—the spread—is the additional yield for the investor for taking on default risk. The riskier the corporate bond, the greater the spread.
Spreads generally fluctuate with market trends and with confidence in the economy or expectations of economic cycles. When spreads narrow, the yields on corporate bonds are closer to the yields on Treasury bonds, indicating that there is less concern with default risk. When spreads widen, corporate bondholders worry more about default risk.
As the spread widens, corporate yields rise and/or Treasury yields fall. This means that corporate bond prices (market values) are falling and/or Treasury bond values are rising. This is sometimes referred to as the “flight to quality.” In uncertain times, investors would rather invest in Treasuries than corporate bonds, because of the increased default risk of corporate bonds. As a result, Treasury prices rise (and yields fall) and corporate prices fall (and yields rise).
Longer-term bonds are more exposed to reinvestment, interest rate, and inflation risk than shorter-term bonds. If you are using bonds to achieve diversification, you want to be sure to be diversified among bond maturities. For example, you would want to have some short-term (less than one year until maturity), intermediate-term (two to ten years until maturity), and long-term (more than ten years until maturity) bonds, in addition to diversifying on the basis of industries and company and perhaps even countries.
Matching Strategies
Matching strategies are used to create a bond portfolio that will finance specific funding needs, such as education, a down payment on a second home, or retirement. If the timing and cash flow amounts of these needs can be predicted, then a matching strategy can be used to support them. This strategy involves matching a “liability” (to yourself, because you “owe” yourself the chance to reach that goal) with an “asset” (a bond investment). The two most commonly used matching strategies are immunization and cash flow matching.
Immunization is designing a bond portfolio that will achieve a certain rate of return over a specific period of time, based on the idea of balancing interest rate risk and reinvestment risk.
Recall that as interest rates rise, bond values decrease, but reinvested income from bond coupons earns more. As interest rates fall, bond values increase, but reinvested income from bond coupons decreases. Immunization is the idea of choosing a portfolio of bonds such that the exposure to interest rate risk is exactly offset by the exposure to reinvestment risk for a certain period of time, thus guaranteeing a minimum return over that period (Maginn, Tuttle, Pinto, and McLeavey, 2007).
In other words, the interest rate risk and the reinvestment risk cancel each other out, and the investor is left with a guaranteed return. You would use this kind of strategy when you had a liquidity need with a deadline—for example, to fund a child’s higher education.
Cash flow matching, also called a dedication strategy, is an alternative to immunization. It involves choosing bonds that match your anticipated cash flow needs by having maturities that coincide with the timing of those needs. For example, if you will need \$50,000 for travel in twenty years, you could buy bonds with a face value of \$50,000 and a maturity of twenty years. If you hold the bonds to maturity, their face value provides the amount of cash flow you need, and you don’t have to worry about interest rate or reinvestment risk. You can plan on having \$50,000 in twenty years, barring any default.
If you had the \$50,000 now, you could just stuff it under your mattress or save it in a savings account. But buying a bond has two advantages: 1) you may be able to buy the bond for less than \$50,000 now, requiring less upfront investment; and 2) over the next twenty years, the bond will also pay coupons at a higher rate than you could earn with a savings account or under your mattress.
If you will need different cash flows at different times, you can use cash flow matching for each one. When cash flow matching is used to create a steady stream of regular cash flows, it is called bond laddering. You invest in bonds of different maturities, such that you would have one bond maturing and providing cash flow in each period (like the GIC laddering discussed in Chapter 7 “Financial Management”).
Strategies such as immunization and cash flow matching are designed to manage interest rate and reinvestment risk to minimize their effects on your portfolio’s goals. Since you are pursuing an active strategy by selecting individual bonds, you must also consider transaction costs and the tax consequences of your gain (or loss) at maturity and their effects on your target cash flows.
Life Cycle Investing
Bonds are most commonly used to reduce portfolio risk. Typically, as your risk tolerance decreases with age, you will include more bonds in your portfolio, shifting its weight from stocks, which have more growth potential, to bonds, which have more income and less risk. This change in the weighting of portfolio assets usually begins as you get closer to retirement.
For years, the conventional wisdom was that you should have the same percentage of your portfolio invested in bonds as your age, so that you have 30 per cent of your portfolio in bonds when you are thirty, 50 per cent when you are fifty, and so on. That wisdom is now being questioned, however, because while bonds are lower risk, they also have lower growth potential. Today, since more people can expect to live much longer past retirement age, they run a real risk of outliving their funds if they invest as conservatively as the conventional wisdom suggests.
It is still true nevertheless that for most people, risk tolerance changes with age, and your investment in bonds should reflect that change.
Key Takeaways
1. One strategic use of bonds in a portfolio is to increase diversification.
2. Diversification can be achieved by: an active strategy, using individual bond selection; or a passive strategy, using indexing.
3. Spreads indicate the “price” or the yield on default risk.
4. Matching strategies to minimize interest rate and reinvestment risks can include: immunization, cash flow matching, and bond laddering.
5. Life cycle investing considers the relationship of age and risk tolerance to the strategic use of bonds in a portfolio.
Exercises
In your personal finance journal, record your bond strategy. What will be your purpose in including bonds in your portfolio? What types of bonds will you include and why? Will you take an active or passive approach and why? How will spreads inform your investment decisions? Which bond strategies described in this section will you plan to use and why? How will your bond strategies reflect your needs to diversify, reduce risk, and maximize liquidity at the right times? How will your bond strategies reflect your age and risk tolerance?
REFERENCES
Maginn, J. L., D. Tuttle, J. Pinto., and D. McLeavey. (2007). Managing Investment Portfolios: A Dynamic Process, 3rd ed. Charlottesville, VA: CFA Institute.
14.4 MUTUAL FUNDS
Learning Objectives
1. Identify the general purposes of using mutual funds in individual investment portfolios.
2. Analyze the advantages of an index fund or a fund of funds.
3. List and define the structures of mutual funds.
4. Describe the strategic goals of lifestyle funds, leveraged funds, and inverse funds.
5. Identify the costs and differences in costs of mutual fund investing.
6. Calculate returns from mutual fund investing.
7. Summarize the information found in a mutual fund prospectus.
As defined in the Chapter 12 “Investing,” a mutual fund is a portfolio of securities consisting of one type of security or a combination of several different types. A fund serves as a convenient way for an investor to have a diversified portfolio of investments in just about any investable asset. The oldest mutual fund is believed to have been founded by Adriaan van Ketwich in 1774. Ketwich invited investors to contribute to a trust fund to spread the risk of investing in foreign bonds. The idea moved from the Netherlands to Scotland to the United States, where the Boston Personal Property Trust established the first mutual fund in 1893 (Investment Funds Institute of Canada, 2017).
Mutual funds play a significant role in individual investment decisions. A mutual fund provides an investor with cheaper and simpler diversification and security selection, requiring only one transaction to own a diversified portfolio (the mutual fund). By buying shares in the fund rather than individual securities, you achieve extensive diversification for a much lower transaction cost than by investing in individual securities and making individual transactions. You also receive the benefit of professional security selection, which theoretically minimizes the opportunity costs of lesser choices. So, by using a mutual fund, you get more and better security selection and diversification.
A mutual fund also provides stock and bond issuers with a mass market. Rather than selling shares to investors individually (and incurring the costs of doing so), issuers can more easily find a market for their shares in mutual funds.
Structures and Types of Mutual Funds
Like stocks and bonds, mutual funds may be actively or passively managed. As you read in Chapter 13 “Owning Stocks” and Chapter 14 “Owning Bonds and Investing in Mutual Funds,” actively managed funds provide investors with professional management and the expected research, analysis, and watchfulness that goes with it. Passively managed index funds, on the other hand, are designed to mirror the performance of a specific index constructed to be representative of an asset class.
Mutual funds are structured in three ways:
1. Closed-end funds
2. Open-end funds
3. Exchange-traded funds
Closed-end funds are funds for which a limited number of shares are issued. Once all shares have been issued, the fund is “closed” so a new investor can only buy shares from an existing investor. Since the shares are traded on an exchange, the limited supply of shares and the demand for them in that market directly determines the value of the shares for a closed-end fund.
Most mutual funds are open-end funds in which investors buy shares directly from the fund and redeem or sell shares back to the fund. The price of a share is its net asset value (NAV), or the market value of each share as determined by the fund’s assets and liabilities and the number of shares that exist. Here is the basic formula for calculating NAV:
NAV = (market value of fund securities − fund liabilities)
number of shares outstanding
Demand for shares is reflected in the number of shares outstanding, because the fund can create new shares for new investors. NAV calculations are usually done once per day at the close of trading, when mutual fund transactions are recorded.
The NAV is the price that the fund will pay you when you redeem your shares, so it is a gauge of the shares’ value. It will increase if the market value of the securities in the fund increases faster than the number of new shares.
Exchange-traded funds (ETFs) are structured like closed-end funds, but are traded like stocks. Shares are traded and priced continuously throughout the day’s trading session, rather than once per day at the end of trading. ETFs trade more like individual securities; that is, if you are trying to time a market, they are a nimbler asset to trade than open- or closed-end funds.
Originally designed as index funds, exchange-traded funds now target just about every asset, sector, and economic region imaginable.
Table 14.4.1 compares the features of closed-end funds, open-end funds, and ETFs.
Table 14.4.1 Fund Features
Closed-End Open-End ETF
Number of Shares Limited Unlimited Limited
Trades End of the trading day Fund sponsor Continuously
Traded with Other shareholders (after the fund closes) End of the trading day Other shareholders
Shares of closed-end funds and exchange-traded funds are bought and sold on exchanges, much like shares of stock. You would go through a broker to make those transactions. Shares of open-end funds may be bought and sold directly from the fund sponsor, a mutual fund company, or investment manager. You can make those transactions at any of the company’s offices, by telephone, or online. About 40 per cent of all mutual fund transactions are done directly (without a broker) through a retirement plan contribution or a mutual fund company (The Investment Company Institute, 2009).
Some other types of mutual funds are shown in Table 14.4.2. Some research companies, such as Morningstar, track as many as forty-eight different categories of mutual funds.
Table 14.4.2 Other Types of Mutual Funds
Mutual Funds Definition
Funds of funds Mutual funds that own shares in other mutual funds rather than in specific securities. If you decide to use mutual funds rather than select securities, a fund of funds will provide expertise in choosing funds. Funds of stocks and bonds that manage portfolio risk based on age or the time horizon for liquidity needs.
Lifestyle funds Lifestyle funds perform both security selection and asset allocation for investors, determined by the target date. For example, if you were now thirty years old, you might choose a lifestyle fund with a target date of thirty-five years from now for your retirement savings. As the fund approaches its target date, its allocation of investments in stocks and bonds will shift to carry less risk as the target nears. Lifestyle funds are used primarily in saving for retirement; many are created as funds of funds.
Leveraged funds Funds that invest both investors’ money and money that the fund borrows to augment the investable assets and thus potential returns. Because they use borrowing, leveraged funds are riskier than funds that do not use leverage.
Inverse funds Funds that aim to increase in value when the market declines, to be countercyclical to index funds, which aim to increase in value when the market rises. Inverse funds, also called “bear funds,” are set up to perform contrary to the index. Since most economies become more productive over time, however, you can expect indexes to rise over time, so an inverse fund would make sense only as a very short-term investment.
Mutual Fund Fees and Returns
All funds must disclose their fees to potential investors: sales fees, management fees, and expenses. A load fund charges a sales commission on each share purchase. That sales charge (also called a front-end load) is a percentage of the purchase price. A no-load fund, in contrast, does not charge a sales commission, because shares may be purchased directly from the fund or through a discount broker. The front-end load can be as much as 8.5 per cent, so if you plan to invest often or in large amounts, that can be a substantial charge. For example, a \$5,000 investment may cost you \$425, reducing the amount you have to invest and earn a return.
A fund may charge a back-end load, actually a deferred sales charge, paid when you sell your shares instead of when you buy them. The charge may be phased out if you own the shares for a specified length of time, however, usually five to seven years.
A fund may charge a management fee on an annual basis. The management fee is stated as a fixed percentage of the fund’s asset value per share. Management fees can range from 0.1 per cent to 2.0 per cent annually. Typically, a more actively managed fund can be expected to charge a higher management fee, while a passively managed fund such as an index fund should charge a minimal management fee.
A fund may charge an annual distribution fee, also calculated as not more than 1.0 per cent per year of the fund’s asset value. Some mutual funds charge other extra fees as well, passing on fund expenses to shareholders. You should consider fee structure and rate when choosing mutual funds, and this can be done through calculations of the expense ratio.
Taken together, the annual management, distribution, and expense fees are measured by the management expense ratio (MER)—the total annual fees expressed as a percentage of your total investment. MER costs “are deducted before the fund’s performance returns are calculated” (Kapoor et al., 2015, p. 356). Therefore, if your return is 15 per cent and your MER is 2 per cent, you will receive a return of 13 per cent. That may not sound like much, but it means that if the fund earns a 5 per cent return, your net return may be less than 3 per cent (and after taxes, it’s even less). When choosing a fund, you should be aware of all charges—especially annual or ongoing charges—that can affect your investment return.
Owning shares of a mutual fund means owning shares in a pool of assets. The returns of the fund are the returns of those assets: interest, dividends, or gains (losses). Income may come from interest distribution if the fund invests in bonds or interest-producing assets or as dividend distribution if the fund invests in stocks.
Mutual funds buy and sell or “turn over” the fund assets. Even passively managed funds need to rebalance to keep pace with their benchmarks as market values change. The turnover ratio is the percentage of fund assets that have been turned over or replaced in the past year, a measure of the fund’s trading activity.
Turnover can create capital gains or losses. Periodically, usually once per year, the fund’s net capital gains (or losses) are distributed on a per share basis as a capital gains distribution. You would expect turnover to produce more gains than losses. The more turnover, or the higher the turnover ratio, the greater the capital gains distributions you may expect.
Unless you have invested in a tax-exempt savings plan such as an RRSP, interest and dividend distributions are taxable as personal income, as are capital gains, including capital gains distributions. A higher turnover ratio may mean a higher tax expense for capital gains distributions. Most open-end mutual funds allow you the option of having your income and gains distributions automatically reinvested rather than paid out, which means that you may be paying taxes on earnings without ever “seeing” the money.
Mutual Fund Information and Strategies
All mutual fund companies must offer a prospectus, a published statement detailing the fund’s assets, liabilities, management personnel, and performance record. You should always take the time to read it and to take a closer look at the fund’s investments to make sure that the fund will be compatible and appropriate to your investment goals.
For example, suppose you have an investment in a TSX Index fund and now are looking for a global stock fund to complement and diversify your holdings in domestic (Canadian) equities. You go to the website of a large mutual fund company offering hundreds of funds. You find a stock fund called “Global Stock Fund”: it sounds like it’s just what you are looking for. Looking closer, however, you can see that this fund is invested in the stocks of companies in Germany, Japan, and the United Kingdom. While they are not Canadian stocks, those economies are similar to the US economy—perhaps too similar to provide the diversity you are looking for.
Or suppose you are looking for a bond fund to create income and security. You find a fund called the “Investment Grade Fixed Income Fund.” On closer inspection, however, you find that the fund does not invest only in investment grade bonds but that the average rating of its bonds is investment grade. This means that the fund invests in many investment grade bonds, but also in some speculative grade bonds, to achieve higher income. While this fund may suit your need for income, it may not be appropriate for your risk tolerance.
Mutual fund companies make this information readily available online and in prospectuses. You should always make the extra effort to be sure you know what’s in your fund. In addition, mutual funds are widely followed by many performance analysts. Ratings agencies such as Morningstar and investment publications such as Barron’s and Forbes track, analyze, and report the performance of mutual funds. That information is available online or in print and provides comparisons of mutual funds that you may find helpful in choosing your fund. For more information on Canadian mutual funds, please see the FUNDATA website.
In print and online newspapers, mutual fund performance is reported daily in the form of tables that compare the average returns of funds from week to week. Reported average returns are based on the net asset value per share (NAVPS). Investors can use this information to choose or compare funds and track the performance of funds they own.
In conclusion, since a mutual fund may be made up of any kind or many kinds of securities (e.g., stocks, bonds, real estate, and commodities), it is not really another kind of investment. Rather, it is a way to invest without specifically selecting securities, a way of achieving a desired asset allocation without choosing individual assets.
The advantages of investing in a mutual fund are the diversification available with minimal transaction costs and the professional management or security selection that you buy when you buy into the fund.
Compared to actively managed funds, passively managed or index funds offer similar diversification, but with lower management fees and expense ratios because you aren’t paying for market timing or security selection skills. The turnover ratio shows how passive or active the fund management is.
Performance history has shown that actively managed funds, on average, do not necessarily outperform passively managed funds (Malkiel, 2007).
Since they usually have higher fees, any advantage created by active management is usually cancelled out by their higher costs. Still, there are investors who believe that some mutual funds and mutual fund managers can, on average, outperform the markets or the indexes that provide the benchmarks for passively managed funds.
Key Takeaways
1. Mutual funds provide investors with:
• diversification,
• security selection, and
• asset allocation.
2. Funds may be actively or passively managed.
3. Index funds mirror an index of securities, providing diversification without security selection.
4. Funds of funds provide the investor with pre-selected funds.
5. Mutual funds may be structured as:
• closed-end funds,
• open-end funds, or
• exchange-traded funds.
6. Some funds are structured to achieve specific investment goals:
• lifestyle funds with target dates to minimize liquidity risk through asset allocation,
• leveraged funds to increase return through using debt, and
• inverse funds to increase return through active management with the expectation of a down market.
7. Mutual fund costs may include:
• a sales charge when shares are purchased, or front-end load,
• a sales charge when shares are sold, or back-end load,
• a management fee while shares are owned, or
• a distribution fee while shares are owned.
8. The management expense ratio is the total mutual fund cost expressed as a percentage of the funds invested.
9. Fees vary by:
• fund sponsor,
• fund strategy (active or passive), and
• fund sales (direct or through a broker).
10. Returns from a mutual fund include returns on the securities it owns, including:
• interest distributions,
• dividend distributions, and
• capital gains distributions.
11. A fund prospectus details the fund’s investment holdings, historic returns, and costs. Mutual fund ratings in the financial media are another source of information.
Exercises
1. Read Investopedia’s article “Mutual Funds: The Costs.” What is your management expense ratio (MER)? Do mutual funds with higher expenses generally earn higher returns?
2. Review Investopedia’s article on “Mutual Funds: How To Read A Mutual Fund Table.” What do the columns mean? What is being compared? What can you learn from mutual fund tables that may help you choose funds or track the performance of funds you own? Share your ideas with classmates.
3. In your personal finance journal, record your study of a fund you choose to track. Read the prospectus, check its ratings, and compare its week-to-week performance with that of similar funds in the mutual funds table in the financial section of a newspaper. Record your observations, questions, and commentary as you go about deciding hypothetically whether or not to invest in that fund.
REFERENCES
Investment Funds Institute of Canada. (2017). “The History of Mutual Funds.” Retrieved from: https://www.ific.ca/en/articles/who-...-mutual-funds/.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Malkiel, B. G. (2007). A Random Walk Down Wall Street. New York: W. W. Norton & Company.
The Investment Company Institute. (2009). Investment Company Fact Book, 49th ed. Retrieved from: http://www.ici.org/pdf/2009_factbook.pdf. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/04%3A_Planning_for_the_Future/4.03%3A_Owning_Bonds_and_Investing_in_Mutual_Funds.txt |
INTRODUCTION
Some people know what they want to do at an early age. For most people, however, the path is just not that clear. Career planning and development can be a process of trial and error as you learn your abilities and preferences by trying them out. Sometimes a job is not what you thought it would be, and sometimes you are not who you thought you would be. The better your decision-making process, the more objective and methodical it is, the less trial and error you will have to endure.
Your financial sustainability depends on having income to support your spending, saving, and investing. A primary component of your income—especially earlier in your adult life—is income from your wages or salary—that is, from working, or selling your labour. Your ability to maximize the price that your labour can bring depends on the labour market you choose and your ability to sell yourself. Those abilities will be called on throughout your working life. You will make job and career choices for many different reasons. This chapter looks only at the financial context of those choices.
15.1 CHOOSING A JOB
Learning Objectives
1. Describe the macroeconomic factors that affect job markets.
2. Describe the microeconomic factors that influence job and career decisions.
3. Relate life stages to both microeconomic factors and income needs.
4. Describe how relationships between life stages, income needs, and microeconomic factors may affect job and career choices.
A person starting out in the world of work today can expect to change careers—not just jobs—an average of seven times before retiring (Baum and Ma, 2007).
Those career changes may reflect the process of gaining knowledge and skills as you work or changes in industry and economic conditions over several decades of your working life. Knowing this, you cannot base career decisions solely on the circumstances of the moment. However, you also cannot ignore the economics of the job market.
You may have a career in mind but have no idea how to get started, or you may have a job in mind but have no idea where it may lead. If you have a career in mind, you should research its career path, or sequence of steps that will enable you to advance. Some careers have a well-established career path; for example, careers in law, medicine, teaching, or civil engineering. In other occupations and professions, career paths may not be well defined.
Before you can even focus on a career or a job, however, you need to identify the factors that will affect your decision-making process.
Macro Factors of the Job Market
The job market is the market where buyers (employers) and sellers (employees) of labour trade, but it usually refers to the possibilities for employment and its rewards. These will differ by field of employment, types of jobs, and geographic region. The opportunities offered in a job market depend on the supply and demand for jobs, which in turn depend on the need for labour in the broader economy and in a specific industry or geographic area.
The economic cycle can affect the aggregate job market or employment rate. If the economy is in a recession, the economy is producing less, and there is less need for labour, so fewer jobs are available. If the economy is expanding, production and its need for labour are growing.
Typically, a recession or expansion affects different industries in different ways. Some industries are cyclical and some are countercyclical. For example, in a recession, consumer spending is often down, so retail shops and consumer goods manufacturers—in cyclical industries—may be cutting jobs. Meanwhile, more people are continuing their education to improve their skills and the chances of getting a job, which is harder to do in a recession, so jobs in higher education—a countercyclical industry—may be increasing.
Global events such as an outbreak of war, the nationalization of a scarce natural resource, the price of a critical commodity such as crude oil, the collapse of a vital industry, and so on, may also cause changes in the global economy that affect job markets.
Another macroeconomic factor is change in technology, which can open up new fields of employment and make others obsolete. With the advent of digital cameras, for example, even single-use conventional cameras are no longer being manufactured in great quantity, and film developers are not needed as much as they once were. However, there are more jobs for developers of electronic cameras and digital applications for creating images and using digital images in communications channels, such as mobile phones.
A demographic shift can also change entire industries and job opportunities. A historical example, repeated in many developing countries, is the mass migration of rural families to urban centres and factory towns during an industrial revolution. Changes in the composition of a society, such as the average age of the population, also affect job supply and demand. Baby booms create demand for more educators and pediatricians, for example, while aging populations create more demand for goods and services relating to elder care.
Social and cultural factors affect consumer behaviour, and consumer preferences can change a job market. Demand for certain kinds of products and services, for example—organic foods, hybrid cars, clean energy, and “green” buildings—can increase job opportunities in businesses that address those preferences. Changes in demand for a product or service will change the need for labour to produce it.
If you are entrepreneurial and intend to be self-employed, your job opportunities may be affected by the ease with which you can start and maintain a business. Ease of entry, in turn, may be affected by macro factors such as the laws and regulations in the province where you intend to do business and the existing competition in the market you are entering.
The labour market is competitive, not just at an individual level but on a global, industrywide scale. As transportation and especially communication technology has improved, many steps in a manufacturing or even a service process may be outsourced to foreign labour. That competition affects the Canadian job market as jobs are moved overseas, but it also opens new markets in developing economies. You may be interested in an overseas job, as Canadian companies open offices in Asia, South America, Africa, or elsewhere. Globalization affects job markets everywhere.
Micro Factors of Your Job Market
Whether you are employed or self-employed, whether you look forward to going to work every day or dread it, employment determines how you spend most of your waking hours during most of your days. Employment determines your income and thus your lifestyle, your physical well-being, and to a large extent your emotional satisfaction. Everyone has a different idea about what a “good job” is. That idea may change over a lifetime as circumstances change, but some specific micro factors will weigh on your decisions, including your:
• abilities,
• skills,
• knowledge, and
• lifestyle choices.
Abilities are innate talents or aptitudes—what you are capable of or good at. Circumstances may inhibit your abilities or may even cause disabilities. However, you can often develop your abilities—and compensate for disabilities—through training or practice. Sometimes you don’t even know what abilities you have until some experience brings them out.
When Lori says she is “good with people” or when Skyler says that he is a “natural athlete,” they are referring to abilities that will make them better at some jobs than others. Abilities can be developed and may require upkeep; athletic ability, for example, requires regular fitness workouts to really be maintained. You also may find that you lack some abilities, or think you do because you’ve never tried using them.
Usually, by the time you graduate from high school, you are aware of some of your abilities, although you may not be aware of how they may help or hinder you in different jobs. Also, your idea of your abilities relative to others may be skewed by your context. For example, you may be the best writer in your high school, but not compared to a larger pool of more competitive students. Your high school or university career office may be able to help you identify your abilities and skills and apply that knowledge to your career decisions.
Your job choices are not predetermined by your abilities or apparent lack thereof. An ability can be developed or used in a way you have not yet imagined. A lack of ability can sometimes be overcome by using other talents to compensate. Thus, ability is a factor in your job decisions, but certainly not the only one. Your knowledge and skills are equally—if not more—important.
Skills and knowledge are learned attributes. A skill is a process that you learn to apply, such as programming a computer, welding a pipe, or making a customer feel comfortable making a purchase. Knowledge refers to your education and experience and your understanding of the contexts in which your skills may be applied.
Education is one way to develop skills and knowledge. In secondary education, a vocational program prepares you to enter the job market directly after high school and focuses on technical skills such as baking, bookkeeping, automotive repair, or building trades. A university preparatory program focuses on developing general skills that you will need to further your formal education, such as reading, writing, research, and quantitative reasoning.
Past high school or a year or two of college, it is natural to question the value of more education. Tuition is real money and must be earned or borrowed, both of which have costs. There is also the opportunity cost of the wages you could be earning instead. As mentioned in the introduction, financial education will help to build financial literacy and self-sufficiency among youth so that they can make the right financial choices when it comes to their education, make the most of their earnings, and avoid the heavy debt and financial challenges that many Canadians are currently experiencing.
“Education is so important,” explains Elder Kewistep. “With a degree it opens the door. If you go further, the door will open even more” (Elder Kewistep, Video 3).
However, education adds to your earning power significantly by raising the price of your labour. The more education you have, the more knowledge and skills you have. The smaller the supply of labour with your particular knowledge and skills, the higher the price your labour can command. This relationship is the rationale for becoming specialized within a career. However, both specialization and versatility may have value in certain job markets, raising the price of your labour.
More education also confers more job mobility—the ability to change jobs when opportunities arise, because your knowledge and skills make you more useful, and thus valuable, in more ways. Your value as a worker or employee enables you to command higher pay for your labour.
Not only are you likely to earn more if you are better educated, but you are also more likely to have a job with a pension plan, health insurance, and paid vacations—benefits that add to your total compensation (Baum and Ma, 2007).
Your choices will depend on the characteristics and demands of a job and how they fit your unique constellation of knowledge, skills, personality, characteristics, and aptitudes. For example, your knowledge of finance, visual pursuit skills, ability to manage stress and tolerate risk, aptitude for numerical reasoning, enjoyment of competition, and preference to work independently may suit you for employment as a stockbroker or futures trader. Your manual speed and accuracy, verbal comprehension skills, enjoyment of detail work, strong sense of responsibility, desire to work regular hours in a small group setting, and preference for public service may suit you for training as a court stenographer. Your word fluency, social skills, communication skills, organizational skills, preference to work with people, and desire to lead others may suit you for jobs in education or sales. And so on.
Lifestyle choices affect the amount of income you will need to achieve and maintain your lifestyle and the amount of time you will spend earning income. Lifestyle choices thus affect your career path and job choices in key ways. Typically, when you are beginning a career and have few, if any, dependents, you are more willing to sacrifice time and even pay for a job that will enhance your skills and help you to progress along your career path. As a journalist, for example, you may volunteer for an overseas post; or as a nurse you may volunteer for extra rotations. As a computer programmer, you may assist in the development of open source software.
As you advance in your career, and perhaps become more settled in your life—for example, by starting a family—you are less willing to sacrifice your personal life to your career, and may seek out a job that allows you to earn the income that supports your dependents while not taking away too much of your time.
Your income needs typically increase as you have dependents and are trying to save and accumulate wealth, and then decrease when your dependents are on their own and you have accumulated some wealth. Your sources of income shift as well, from relying on income from labour earlier in your life to relying on income from investments later.
When your family has grown and you once again have fewer dependents, you may really enjoy fulfilling your ambitions, as you have decades of skills and knowledge to apply and the time to apply them. Increasingly, as more people retain their health into older age, they are working in retirement—earning a wage to improve their quality of life or eliminate debt, turning a hobby into a business, or trying something they have always wanted to do. Your life cycle of career development may follow the pattern shown in Table 15.1.1.
Table 15.1.1 Life Cycle Career Development
Life Stage Career Concerns
Exploration and establishment Develop your skills, acquire knowledge, explore jobs, start earning income, gain experience
Growth Advance your career, leverage knowledge and skills, increase earnings
Accomplishment Achieve your goals, maximize earnings, build on success and reputation
Late career Redirect knowledge and skills, contribute, mentor successors
Regardless of age, your lifestyle choices will affect your job opportunities and career choices. For example, you may choose to live in a specific geographic region based on its
• rural or urban location,
• proximity to your family or friends,
• differences or similarities to where you grew up,
• cultural or recreational offerings,
• political characteristics,
• climate, and
• cost of living.
Sometimes you may choose to sacrifice your lifestyle preferences for your ambitions, and sometimes you may sacrifice your ambitions for your preferences. It’s really a matter of figuring out what matters at the time, while keeping in mind the effect of this decision on the next one.
Key Takeaways
1. Macroeconomic factors affect job markets, including:
• economic cycles,
• new technology or obsolescence,
• demographic changes,
• changes in the global economy,
• changes in consumer preferences, and
• changes in laws and regulations.
2. Job markets are globally competitive.
3. Microeconomic factors influence job and career decisions, including:
• abilities or aptitudes,
• skills and knowledge, and
• lifestyle choices.
4. Microeconomic factors and income needs change over a lifetime and typically correlate with age and stage of life.
5. Job and career choices should realistically reflect income needs.
Exercises
1. Record in your personal finance journal your work history and current thoughts about your future work life. What jobs have you held? In each job, what experience, knowledge, or skills did you acquire or develop? What are your future job preferences, and why do you prefer them? Do you have a planned career path? What potential advantages and opportunities do your preferences or plans offer? What potential disadvantages and costs may your preferences or plans entail?
2. Go online to find out the differences in definition between an occupation and a vocation, profession, trade, career, and career path. Which combination of concepts best describes the approach you plan to take to satisfy your needs for income from future employment?
3. In your personal finance journal, list your most important job skills, aptitudes, and preferences on which you plan to expand or build a career. Then list the specific job skills you feel you need to develop further through additional education or experience. How and where will you get those skills and at what cost? Next, describe the lifestyle you hope to support through income from future employment. What aspects of that lifestyle would be easiest for you to modify or sacrifice for your career or income goals?
REFERENCES
Baum, S., and J. Ma. (2007). Education Pays: The Benefits of Higher Education for Individuals and Society. Princeton, NJ: The College Board.
15.2 FINDING A JOB
Learning Objectives
1. List and describe venues for finding job opportunities.
2. Explain the value of networking.
3. Trace the steps in pursuing a job opportunity, specifically your cover letter, resumé, and interview.
4. Identify the critical kinds of information that should be provided in a job offer.
A job search is a part of everyone’s life, sooner or later. It may be repeated numerous times throughout your career. You may initiate a job search in hopes of improving your position and career or changing careers, or you may be forced into the job market after losing your job. Whatever the circumstances, when you look for a job you are seeking a buyer for your labour. The process of having to “sell” yourself (your time, energy, knowledge, and skills) is always revealing and valuable.
Finding a Job Market
Before you can look for a job, you need to have an idea of what job market you are in. The same macro factors that you consider in your choice of career may make your job search easier or harder. Ultimately, they may influence your methods of searching or even your job choice itself. For example, as unemployment has increased in the wake of the most recent financial crisis, the labour market has become much more competitive. In turn, job seekers have become much more creative about advertising their skills—from broader networking to papering a neighborhood with brochures on windshields—and more accepting of job conditions, including lower compensation.
Knowing the job classification and industry name will focus your search process and make it more efficient. Once you understand your job market, look at the macro and micro factors that affect it along with your personal choices. For example, knowing that you are interested in working in business, transportation, or the leisure and hospitality industry, you are ready to research these fields more and plan your job search accordingly.
You are looking for a buyer of your labour, so you need to find the markets where buyers shop. One of the first things to do is find out where jobs in your field are advertised. Jobs may be advertised in:
• networking websites such as LinkedIn,
• trade magazines,
• professional organizations or their journals,
• career fairs,
• employment agencies,
• employment websites,
• government websites,
• company websites, and
• your university’s career development office.
Consider Sandy, for example, who is graduating with a bachelor’s degree in administration and a certificate in hospitality, tourism, and gaming entertainment management from First Nations University of Canada. Her dream job is to work for a resort location. There are several websites and journals that provide useful information about the industry. They also list upcoming trade conferences that may be a good opportunity for Sandy to meet some people in the industry.
Browsing online, Sandy learns about a big job fair coming to her region, sponsored by a chamber of commerce and an economic development agency. This is her chance to meet recruiters in her industry and find out about actual opportunities. Each prospective employer will have a table, and Sandy will go from table to table, getting information, dropping off her resumé, and possibly setting up interviews.
She also plans to register with an employment agency that specializes in hotel management for smaller hotels and inns. The agency will screen her application and try to match her with appropriate jobs in its listings. For a specified time, it will keep her resumé on file for future opportunities.
Sandy’s strategy includes posting her resumé on employment websites, such as Monster.ca, and Careerbuilder.ca. Browsing jobs online, Sandy discovers that there is a strong seasonal demand for hospitality workers at First Nations resorts and casinos in different locations throughout Canada, and this gives her an idea. If the right choice doesn’t come up right away, maybe a summer job working for one of these resorts and casinos would be a good way to develop her knowledge and skills further while looking for her dream job in management.
Sandy needs to research destinations as well as businesses, and she wants to talk with people directly. She knows that cold calls—calling potential employers on the phone as a complete unknown—is the hardest way to sell herself. In any industry, cold calling has a much lower success rate than calling with a referral or some connection—otherwise known as networking.
Networking is one of the most effective ways of finding a job. It can take many forms, but the idea is to use whatever professional, academic, or social connections you have to enlist as many volunteers as possible to help in your job search. LinkedIn is a business- and employment-oriented social networking service that is available online and via mobile apps. According to popular theory, your social networks can be seen as assets that potentially help you build opportunities and wealth. The number and positions of people you can network with and the economically viable connections you can have with them are a form of capital—that is, social capital. Another example of a networking group is the Aboriginal Government Employees’ Network (AGEN) in Regina, Saskatchewan. This organization partners with, promotes, and supports workplace environments that are committed to the recruitment, retention, and advancement of Indigenous employees throughout Saskatchewan’s government ministries, agencies, boards, commissions and Crown corporations. AGEN’s vision is to provide a network that supports current and future Indigenous employees through personal and professional development while promoting Indigenous cultural awareness.
Word of mouth is a powerful tool, and the more people know about your job search, the more likely it is that they or someone they know will learn of opportunities. Sandy’s strategy also includes joining online career networking sites, such as LinkedIn, and discussion lists for people in the hospitality industry. Sandy finds a helpful Yahoo! group called The Innkeeper Club and posts a query about what employers look for in a manager.
While Sandy was in university getting her degree and certificate in hospitality management, her best friend from high school was happily styling hair in a local salon. Sandy never thought to network through her friend, but it turns out that one of her friend’s clients has a sister who helps to manage a First Nations casino and resort in central Saskatchewan, and they are thinking about hiring someone to manage their hotel. Her friend passed along her name and resumé to her client’s sister and she has an interview in a week.
That’s how networking works—you just never know who may be helpful to you. The obvious people to start with are all the people that you know: former professors, former employers, friends, family, friends of family, friends of friends, family of friends, and so on. The more people you can talk with or send your resumé to (i.e., the more people you can impress), the greater the chances that someone will make an offer.
Another good networking strategy is to call or email people working in the industry, especially individuals who are currently in or just above the position you’d like to have, and ask to talk with them about their work. If you make it clear that you are not asking for or expecting a job offer from them, many people will be happy to take a half hour to discuss their jobs with you. They may have valuable tips or leads for you or be willing to pass along your name to someone else who does.
Selling Yourself: Your Cover Letter and Resumé
To get a job you will have to convince someone who does not know you that you are worth paying for. You have an opportunity to prove that in your cover letter and resumé and again in your interview.
The cover letter, whether mailed or emailed, is your introduction to your prospective employer. You have three paragraphs on one page to briefly introduce yourself and show how you can make a profitable contribution to the company. The objective of the cover letter is to get the reader to look at your resumé with a favourable impression of you created by the letter.
Your first paragraph should establish your purpose in making contact, the reason for the letter. You should make it clear what job you are applying for and why you are making this particular contact. If someone referred you, mention him or her by name. If you met the addressee previously, remind him or her where and when that was—for example, “It was great to chat with you at the Jobs Fair in Saskatoon last week.” The more specifically you can identify yourself and separate yourself from the pool of other job seekers, the better.
The second paragraph of your cover letter should summarize your background, education, and experience. All this information is on your resumé in more detail, so this is not the place to expound at length. You want to show briefly that you are qualified for the position and have the potential to make a contribution.
Your third paragraph is your opportunity to leave the door open for further communication. Make it clear where and how you can be reached and how much you appreciate the opportunity to be considered for the position.
The resumé—the summary list of your skills and knowledge—is what will really sell you to an employer, once you have made a good enough impression with the cover letter to get him or her to turn the page. A good resumé provides enough information to show that you are willing and able to contribute to your employer’s success—that it is worth it to hire you or at least to talk to you in an interview.
List the pertinent facts of where and how you can be reached: address, phone number, and email address. Your qualifications will be mainly education and experience. List any degrees, certificates, or training you have completed after high school. Be sure to include anything that distinguishes your academic career, such as honours, prizes, or scholarships.
List any employment experience, including summer jobs, even if they don’t seem pertinent to the position you are applying for. You may think that being a camp counsellor has nothing to do with being a radiology technician, but it shows that you have experience working with children and parents, have held a position where you are responsible for others, and that you are willing to work during your school breaks, thus showing ambition. If you are starting out and can’t be expected to have lots of employment experience, employers look for hints about your character—things like ambition, initiative, responsibility—that may indicate your success working for them.
Internships and co-op terms that you did in university or high school are also impressive, as they show your willingness to go beyond the standard curriculum and learn by working—something an employer will expect you to continue to do on the job too. While you are in school, you should recognize the value added by experiential learning and the positive impression that it will make. An internship or co-op term can also give you a head start in networking if your supervisor will be a good reference or source of contacts for you. The internship may even result in a job offer; you may not necessarily want to accept it, but at the very least, having an offer to fall back on takes some of the pressure off your search.
For each job, be clear about the position you held and the two most important duties or roles you performed. Don’t go into too much detail, however; the time to expand on your story is in the interview.
If you have done internships or volunteer work, or if you are a member of civic or volunteer organizations, be sure to list those as well. They are hints about you as a person and may help you to stand out in the pool of applicants.
A common mistake is to list too much extra information on your resumé and to focus too much on what you want—for example, by stating an objective such as “to obtain a great position in hotel management.” Your employer cares about what you can do for the company, not for yourself. The following are some tips for developing your resumé:
• Avoid adjectives or adverbs when describing your past performance. If you were an achiever in school, that will be reflected in your grades, degrees, honours, and awards. “Hype” can sound boastful; besides, you can discuss your performance in detail at the interview.
• Be honest and state your case without exaggeration. It is easier than ever for employers to check on your history, and they will. Falsification of information on your resumé may become grounds for dismissal if you are hired.
• Don’t include personal details unless they are strongly relevant to the job you are seeking. Employers typically do not want to know that you love dogs or were raised in Singapore.
• Be correct. Proofread your resumé and have someone else proof it as well. This is your opportunity to make a good impression. Any error indicates not just that you made an error, but that you are sloppy, lazy, or willing to let your work go public with errors.
• Keep it to one page, if possible. Employers are typically looking at many resumés to fill one position, so make it easy and quick for the reader to see how qualified you are.
A myriad of sample resumés and sample cover letters may be found online, but be wary of templates that may not fit you or your prospective job. Employers in your field may have particular expectations for what should be on your resumé or how it should be structured. Maybe you should list your skills or perhaps your education first. Perhaps it would be preferable to list your past employment experiences in reverse chronological order (with your most recent job first). Advice about how to write a resumé is plentiful, but there is no one right or best way. Choose an appropriate style and format for your job category that will present you in the best possible light as a prospective employee.
Many employers want you to fill out an application form independently of or instead of a resumé. They may also ask for references, especially from former employers who are willing to recommend you. Be aware that hirers and human resources department personnel routinely follow up on references and letters of recommendation. Read the article “How to Fill Out a Job Application” on thebalancecareers.com to find out more about filling out employment applications.
There are also many resources available in print and online to help you write a good resumé.
Selling Yourself: Your Interview
The interview—a face-to-face conversation with a prospective employer—is your chance to get an offer. You want to make a good personal impression: dress professionally but in clothes that fit well and comfortably; be polite and cordial but also careful not to assume too familiar a tone.
You may be asked a series of predetermined questions, or your interviewer may let the conversation develop in a more open-ended manner. The interviewer may let you establish its direction in order to learn more about how you think. But however the conversation is guided, you want to be able to showcase your suitability for the job and what you bring to it.
Table 15.2.1 identifies some questions employers commonly ask in job interviews.
Table 15.2.1 Questions Prospective Employers Commonly Ask
Tell us a little about yourself and what brings you here today.
Why did you leave your last job?
Why do you want this job? What do you know about us?
Why do you want to work for us?
How does your education/background/experience make you a good fit for this job?
Why do you think you’re the best person for the job?
What qualities and skills can you bring to the job?
Do you feel you have strong communication skills/technology skills/writing skills (etc., as relevant)?
What can you do for our company?
How will you be an asset to us?
How can you help us improve our efficiency/productivity/products/services/bottom line (etc., as relevant)?
What are your career goals?
Where do you see yourself in five years’ time?
Are you a team player?
Have you had much experience working as part of a team?
What was your contribution to the team?
What were the results of the team effort?
What are your strengths and weaknesses?
What successes and failure have you experienced in your career so far?
How would you handle a situation in which …?
What would you do if …?
Have you ever had a problem with …?
What is your ideal job?
What qualities do you look for ideally in a position/company/boss/coworker?
Be prepared for interviewers who prefer to focus on general behavioural questions rather than on job-specific questions. Behavioural interviews emphasize your past actions as indicators of how you might perform in the future. The so-called STAR Method is a good approach to answering behavioural questions, as it helps you to be systematic and specific in making your past work experiences relevant to your present job quest. The STAR Method is a process of conveying specific situations, actions, and outcomes in response to an interviewer’s question about something you did.
• Situation: Give specific details about the situation and its context.
• Task: Describe the task or goal that arose in response to the situation.
• Action: Describe what you did and who was involved.
• Result: Describe the (positive) outcome. (Reeves, 2009)
For example, a typical behavioural interview may include the following exchange:
Question: We are looking for someone who is willing to take initiative in keeping our office systems working efficiently and who can work without a lot of direct supervision. Does that describe you?
Answer: Absolutely. For example, in my last job I noticed that the office supply system was not working well. People were running out of what they needed before letting me know what to order (Situation). I thought there needed to be a better way to anticipate and fill those needs based on people’s actual patterns of use (Task). So, I conducted a poll on office supply use and used that information to develop a schedule for the automatic resupply of key items on a regular basis (Action). The system worked much more smoothly after that. I mentioned it in my next performance review, and my boss was so impressed that she put me in for a raise (Results).
There are some questions employers should not ask you, however. Unless the information is a legal requirement for the job you are interviewing for, antidiscrimination laws make it illegal for an employer to ask you your age; your height or weight; personal information such as your racial identity, sexual orientation, or health status; or questions about your marital status and family situation, such as the number of children you have, whether you are single, or if you are pregnant or planning to start a family.
It is also important for you to prepare a few questions that you can ask your interviewer. They could be about the company’s products or services, the company’s mission or goals, the work you would be doing, who you would be reporting to, where you would be located, and the opportunities for advancement. You want your questions to be specific enough to show that you have already done some research on the company, its products, and markets. This is a chance to demonstrate your knowledge of the job, company, or industry—in other words, that you have done your homework—as well as your interest and ambition.
Unless your interviewer mentions compensation, don’t bring it up. Once you have the job offer, then you can discuss compensation, but in the interview you want to focus on what you can do for the company, not what the company can do for you.
You can also use the interview to learn more about the company. Try to pick up clues about the company’s mission, corporate culture, and work environment. Are people wearing business attire or “business casual”? Are there cubicles and private offices or a more open workspace? Are people working in teams, or is it more of a conventional hierarchy? You want to be in a workplace where you can be comfortable and productive. Be open-minded—you may be able to work quite well in an environment you have never worked in before—but think about how you can do your best work in that environment.
After your interview, send a thank-you note, and follow up with a phone call if you don’t hear back. You may ask your interviewer for feedback—so that you can learn for future interviews—but don’t be surprised (and be gracious) if you don’t get it. Always leave the door open. You never know.
Accepting an Offer
A job offer should include details about the work you will be performing, the compensation, and the opportunity to advance from there. If any of that information is missing, you should ask about it.
In many jobs—especially in entry-level positions—you may be asked to do many things, so the job description may be fairly vague. Your willingness to do whatever is asked of you (within the law and according to ethical standards) should be compensated by what you stand to gain from the job—in pay or in new knowledge and experience or in positioning yourself for your next job. Some jobs are better looked at as a kind of graduate education.
Your compensation includes not only your wages or salary, but also any benefits that the employer provides. As you read in previous chapters, benefits may include health and dental insurance, disability insurance, life insurance, and a retirement plan. Compensation also includes time off, sick days, and vacation days. You should understand the company’s policies and flexibility in applying them.
Know what your total compensation will be and whether it is reasonable for the job, industry, and current job market. Asking around may help, especially in online discussion groups with relative anonymity. People are often reluctant to disclose their compensation, and companies discourage sharing this information because it typically reveals discrepancies. For example, people hired in the past may be receiving less (or more) pay than people hired recently for the same position. In addition, the gender gap—in which men receive higher pay than women in the same position—is often a problem.
To gauge how reasonable a job offer is, you can look at the research on pay scales or find statistical averages by profession or region collected by various professional associations. Online resources include simple salary comparison calculators, such as the one at salary.com. You will also find data and related articles linking salaries to specific job titles, area codes, provinces, educational levels, and years of work experience on websites such as PayScale.
Realistically compare the job offer to your needs. Different geographic areas have different costs of living, for example, so the same salary may afford you a very different lifestyle in Regina than in Vancouver. Your employment compensation is most likely an important source—perhaps your only source—of income. That income finances your plan for spending, saving, and investing. A budget can help you to see if that income will be sufficient to meet your financial goals. If you already have financial responsibilities—student loans, car loans, or dependents, for example—you may find that you can’t afford the job.
You can negotiate your compensation offer; many employers expect you to try, but some will just stand by their offer—take it or leave it. Your ability to negotiate depends in part on the number of candidates for that particular job and how quickly the employer needs to fill it. You will find guidelines online for evaluating job offers and negotiating your compensation, as well as a simple “Job Offer Checklist,” on the CollegeGrad webpage Job Offer Negotiation.
In some cases, your employer may offer you a contract, a legal agreement that details your responsibilities and compensation and your employer’s responsibilities and expectations. As with any contract, you should thoroughly understand it before signing. If you will be employed as a member of a trade or labour union under a collective bargaining agreement, the terms of the contract may be applicable to all union members and therefore not negotiable by individual employees.
It is exciting to get a job offer, but don’t let the excitement overwhelm your good sense. Before you accept a job, you should be sure that you can live with it. You never really know what a job is like until you start, but it is better to go into it optimistically. When you are just starting a career or trying one out, it is most important to be able to learn and grow in your job, and you may have a period of “paying your dues.” But if you are really miserable in a job, you won’t be able to learn and grow, no matter how “golden” the opportunity is supposed to be.
Key Takeaways
1. Venues for finding jobs include:
• trade magazines,
• professional organizations or their journals,
• career fairs,
• employment agencies or “headhunters,”
• employment websites,
• company websites,
• government websites, and
• your university’s career development office.
2. Networking is a valuable way to expand your job search.
3. Selling your labour to a prospective employer usually involves sending a cover letter and resumé, filling out an application form, and/or having an interview.
• The cover letter should get a prospective employer to read your resumé.
• The resumé should get the employer to offer you an interview.
• The interview should get the employer to offer you the job.
4. A job offer includes information on the job, compensation (including benefits), and opportunities for advancement.
5. Accepting a job offer may involve:
• evaluating the offer in relation to your needs,
• examining a job contract, or
• negotiating the compensation.
Exercises
1. In what sector of the economy or in what industry will you seek a job or develop your career? Record or chart your thoughts in your personal finance journal. What are the reasons for your choices? What education, knowledge, skills, aptitudes, preferences, and experiences do you bring to them?
2. In your personal finance journal, list all the individuals and groups you can think of to tell about your job search or career development quest. Include their contact information. Write a message you could adapt, as needed, for each audience to send when you are ready. Then go online to research other individuals and groups you could include in your networking or could go to for more information about job opportunities.
3. Write or revise your resumé and draft a general cover letter you could adapt for different job openings. Network with classmates to get critiques and ideas for clarifying or improving these tools to attract a prospective employer. What other supporting documents could you include in your job application?
4. How will you prepare for a job interview? Read “In a Near-Death Event, a Corporate Right of Passage,” a New York Times interview with John Chambers the CEO of Cisco Systems, about corporate leadership and recruitment.
5. Anticipate the questions you may be asked in an interview. For example, what could you say in a behavioural interview? For edification and fun, collaborate with classmates to do mock job interviews. Videotape your interviews. As an employer, would you hire yourself? What interviewing preparations and skills do you think you need to work on?
REFERENCES
Reeves, E. G. (2009). Can I Wear My Nose Ring to the Interview? New York: Workman Publishing.
15.3 LEAVING A JOB
Learning Objectives
1. Describe the processes of voluntary job loss.
2. Describe the processes of involuntary job loss.
3. Identify the financial impacts of an involuntary job loss.
4. Identify major federal legislation that addresses employment issues and describe its importance in labour markets.
Statistically, it is almost impossible for you to expect to have one job or career for your entire working life. At least once, and possibly many times, you will change jobs or even careers, in which case you will have to leave your current or former job and find another. Handling that transition can be difficult, especially if the transition is not what you would have preferred. How you handle that transition may affect your success or satisfaction with your next position.
You may leave your job voluntarily or involuntarily. When you leave voluntarily, presumably you have had a chance to make a reasoned decision and have decided that the net benefits of moving on are more than the net benefits of staying.
Leaving Voluntarily
You may wish to leave a job and move to another in order to:
• move to a position with more responsibility, opportunity to advance, or compensation;
• be in a more compatible work environment or corporate culture;
• learn a new skill;
• become self-employed by beginning an entrepreneurial venture; or
• make a transition from a military to a civilian job.
In other cases, you may leave employment permanently or temporarily because you wish to:
• further your education;
• assume family care, for example of a child or parent;
• take time off for recreation; or
• retire.
Whatever your motivation for leaving your job, your decision should make sense; that is, it should be based on a reasoned analysis of how it will affect your life. If you have dependents, you will have to consider how your decision may affect their lives too.
Since your job is a source of income, leaving your job means a loss of that income. You need to consider how you can maintain or change your current use of income (i.e., your spending and saving levels) with that loss.
If you are changing jobs, your new job will replace that income with new income that is more than, equal to, or less than your old paycheque. If it is equal to or more than your former income, you may maintain or even expand your spending, saving, and investing activities. Extra income will provide you with more choices of how to consume or save. If it is less than your former income, you will have to decrease your spending or saving to fit your current needs. Your budget can help you foresee the effects of your new income on your spending and saving.
If you are leaving employment, then there will be no replacement income, so your spending and saving activities should reflect that loss, unless you have an alternative source of income to replace it. If you are going on to graduate school, perhaps you have a fellowship or scholarship. If you are assuming family care responsibilities, perhaps another family member has offered financial support. If you are retiring, you should have income from invested capital (e.g., your retirement savings) that can be used to replace your wages or salary.
If you are initiating the job change, be sure you try to cause the least disruption and cost to your employer. Let your employer know of your decision as soon as it is practical, and certainly before anyone else in the company knows. Two weeks’ notice is the convention, but the more notice you can give, the less inconvenience you will cause. Offer to help train your successor or be available to provide information or assist in the transition. The more cordially you leave your job, the better your relationship with your former employer will be, which may reflect well on you in future networking.
If you participated in a defined contribution retirement plan, you own those funds to the extent that you are vested in your employer’s contributions and have contributed your own funds. You can leave those funds as they are invested, or you can transfer them to your new job’s plan and invest them differently. There may be some time limits to doing so, and there may be tax considerations as well, so be sure you consult with your former employer and understand the tax rules before moving any funds.
The decision to leave a job and perhaps to leave employment means leaving non-income benefits that can create opportunity costs, including:
• intellectual or emotional gratifications of the work,
• enjoyment of your colleagues, and
• opportunities to learn.
If you have had a negative work experience, leaving may allow you to reduce boredom, eliminate job dissatisfaction, end conflict, avoid unwanted overtime, or reduce stress, but these are reasons for leaving a job that you probably should not share with a new or prospective employer.
As you can see, many micro and macro factors may enter into a decision to leave a job. You spend many of your waking hours working, and deciding to change jobs is about much more than just income. But it is still a decision about income, so you should carefully weigh the effects of that decision on your financial well-being.
Leaving Involuntarily
If you leave your job involuntarily, you will have to make adjustments for a loss of income that you were not planning to make. That may be difficult, but not necessarily as difficult as you think.
Involuntary job loss may be due to your employer’s decision, an accident or disability, or unexpected circumstances such as the acquisition, merger, downsizing, or closing of the company you work for. Your employer also may decide to lay you off or fire you. A layoff implies a temporary job loss due to a circumstance in which your employer needs or can afford less labour.
If the layoff is due to an economic recession when there is less demand for the product you create, then it may be affecting your entire industry. That would mean you would have a harder time finding a similar job. If layoffs are widespread enough, however, there may be federal, provincial, or local government programs aimed at helping the many people in your situation, such as a retraining program or temporary income assistance.
You may get laid off because your employer is no longer as competitive or profitable and so has to cut costs, or because the company has lost financing. If the layoffs are specific to your employer, you may be able to find a similar position with another company or you may be able to establish your own competitive business in the same industry.
When you are fired, the employer permanently terminates your employment based on your performance. Involuntary termination, or getting fired, will cause a sudden loss of income that usually requires sudden adjustments to spending and saving. You may have to use your accumulated savings to finance your expenditures until that income can be replaced by a new job.
An injury or illness—to you or a dependent—may create a temporary or permanent involuntary job loss. It usually also means a period of unemployment. Depending on the circumstances, your employer may be willing to help ease the transition, perhaps by offering you a more flexible schedule, adjusting your responsibilities, or providing specialized equipment to enable you to do a job.
By law, employers may not discriminate against people with disabilities so long as they are able to do a job. A job accommodation is any reasonable adjustment to a job or work environment that makes it possible for an individual with a disability to perform or continue to perform job duties.
If you become disabled and unable to work, you may be able to replace some or all of your wage income with insurance coverage, if you have disability insurance that covers the specific circumstances (as discussed in Chapter 10 “Personal Risk Management: Insurance”). If your disability is permanent, you may qualify for federal assistance through the Canada and Quebec Pension Plans. Workers’ compensation plans are also available in each province and territory; these plans provide medical, financial, and rehabilitative assistance to workers who have a disability due to a work-related accident or illness. Some employers also provide disability income protection for their employees through group insurance plans. Medical insurance policies include disability coverage; the extent of one’s coverage is dependent on the cost of one’s premium, the insurance company, and policy details. Provincial governments and territories also have social programs that provide some insurance against disability (Kapoor et al., 2015). If someone else is liable for your disability, in the case of an accident or through negligence, his or her insurance coverage may provide some benefit, or you may have a legal claim that could provide a financial settlement.
If your employer initiates your job change, be sure to discuss his or her obligations to you before you leave. Some employer responsibilities are prescribed by law. Other responsibilities are prescribed by union contract, if applicable, and some are conventions or courtesies that your employer may—or may not—choose to extend.
Severance is compensation and benefits offered by your employer when you are laid off. Under Canadian federal law, “an employee has the right to collect severance pay if they have completed at least 12 consecutive months of continuous employment before their layoff or dismissal resulted in a termination of employment. They are entitled to two days’ regular wages for each full year that they worked for the employer before their termination of employment. The minimum benefit is five days’ wages” (Employment and Social Development Canada, 2017). Your employer is also not required to “pay” for your remaining sick days or vacation days or to extend your benefits, including retirement contributions or life insurance, unless specified in a contract.
Employment Protection
Federal and provincial laws govern relationships between employers and employees. A large part of employment law addresses hiring and firing issues as well as working conditions. You should be familiar with the laws that apply where you work (as they differ by province and sometimes by county) so that you understand your responsibilities to your employer.
Workers can sue a company for wrongful discharge—that is, for being fired for any reason barred by an employment law. Employers often seek to protect themselves from suits by requiring terminated employees to sign a form releasing the company from liability.
Companies have ethical standards for dealing with the hiring and firing of employees, but they may also have informal practices for encouraging unwanted employees in good standing to leave. Employment laws cannot protect workers against some unethical practices, but they have clauses that prohibit retaliation against employees who invoke those laws or enlist government assistance to enforce them. The laws also protect whistleblowers who report employer infractions to government authorities.
The federal government provides employment insurance through the Employment Insurance program to employees who lose their jobs through no fault of their own (Government of Canada, 2016). You must meet eligibility requirements to qualify, and the benefits are limited, although they may be extended in certain circumstances.
Your job and eventually your career will play many roles in your life. It will determine how you spend your time, who you spend your time with, where you live, and how you live. It will probably be a primary determinant of income and therefore of how much you can spend, save, and invest. How you chose to spend, save, and invest is up to you, and your financial decisions can have far-reaching consequences. The more you know and the more you understand, the more you can make decisions that can allow you to realize your dreams.
Key Takeaways
1. You can expect to leave a job at least once in your career.
2. You can leave a job voluntarily or involuntarily.
3. You may leave voluntarily to change jobs or to leave employment, temporarily or permanently.
4. You may leave a job involuntarily through a layoff, disabling accident or injury, or firing.
5. Leaving a job involuntarily means a sudden loss of income.
6. Involuntary job loss may be compensated with severance and/or employment insurance.
7. Federal, provincial, and local laws address employment issues, including hiring, working conditions, compensation, and dismissal. These laws exist to protect workers.
Exercises
1. What do you look for in a job? Record in your personal finance journal the characteristics of a job that you value most when seeking a job and the characteristics that bother you the most or would cause you to consider leaving a job voluntarily. Take an online job satisfaction survey or collaborate with classmates to develop questions for a job satisfaction survey that you can administer to other students. What do you find are the top ten characteristics of a great job offering a lot of job satisfaction?
2. View the following list of reasons for leaving a job at https://www.thebalancecareers.com/reasons-for-leaving-a-job-2061664.
Have you ever cited one of those reasons as the reason you left your job? For each item on the list, brainstorm with classmates why it would or would not be useful to use such a reason in a job interview. What does the item say about you as a worker or as an employee?
3. Record in your personal finance journal the outcome of every job you have held. For each job, have a column for listing your reason(s) for taking it and another column listing your reason(s) for leaving it. Also, note what you liked most and least about each job. Do you notice any patterns emerging in the data about your job history? Is there anything about those patterns that you would like to change?
REFERENCES
Employment and Social Development Canada. (2017). Termination, Layoff or Dismissal. Retrieved from: https://www.canada.ca/en/employment-...rmination.html.
Government of Canada. (2016). “EI Regular Benefits—Overview.” Retrieved from: https://www.canada.ca/en/services/be...r-benefit.html.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson. | textbooks/biz/Finance/Financial_Empowerment%3A_Personal_Finance_for_Indigenous_and_Non-Indigenous_People_(Schneider)/04%3A_Planning_for_the_Future/4.04%3A_Career_Planning.txt |
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