International Finance Term Paper

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Kashmir Education Foundation, Rawalpindi *

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Economics

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Nov 24, 2024

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Running head: International Finance Term Paper 1 International Trade Finance Term Paper Impact of Exchange Rate on Macroeconomic variables Student Name – Student ID –

International Finance Term Paper 2 Table of Contents Introduction ...................................................................................................................................... 3 Fixed exchange rate ......................................................................................................................... 4 Floating exchange rate ..................................................................................................................... 4 Significance of exchange rate system .............................................................................................. 5 Impact of exchange rate on macroeconomic variables .................................................................... 6 Impact on GDP ............................................................................................................................. 6 Impact on Inflation ....................................................................................................................... 7 Impact on unemployment ............................................................................................................. 7 International Trade Finance ............................................................................................................. 8 Risks and Challenges of Trade Finance ........................................................................................... 8 How Trade Financing Reduces Risk ................................................................................................ 9 Other Benefits to Trade Finance .................................................................................................... 10 Floating exchange rate in Canada and present economic situation ............................................... 10 Conclusion ..................................................................................................................................... 12 References ...................................................................................................................................... 13

International Finance Term Paper 3 Introduction In this finance term paper, the facts and details about the selected topic will be discussed. The topic selected for this finance term paper is the impact of the exchange rate on macroeconomic variables. The impact of the exchange rate on macroeconomic variables will be discussed in the context of Canada or the Canadian economy. An exchange rate is described as the price of one country’s currency in terms of another country’s currency. On the other hand, the exchange rate means how a consumer can buy units of another country’s currency with the help of their home currency. The exchange rate policies plays important role in international trade and dealing with the global economy. There are two types of exchange rates such as fixed and flexible exchange rates. Both the fixed and flexible exchange rate has become an interesting topic around the world. Several financial researchers and economists are finding new facts and logic about the same. As of the present, many countries are opening doors to several big MNCs and joining hands with each other via international trade agreements; it shows that the global economy is opening to everyone. Big investors or the business organizations that are expanding their business scales in other countries look over the exchange rate before taking any decision. The exchange rate impacts macroeconomic variables like inflation and GDP. The main aim of this international finance term paper is to find out the impact of the exchange rate on macroeconomic variables such as unemployment, inflation, and economic growth. Exchange Rate Exchange Rate Fixed Exchange Rate Fixed Exchange Rate Flexible Exchange Rate Flexible Exchange Rate

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International Finance Term Paper 4 Fixed exchange rate The fixed exchange rate is one type of exchange rate regime. The fixed rate is the rate that a country uses to tie the value of its currency to the most commonly or widely used currency. For example, the US dollar is the most used country all over the world or in international trade transactions. Today, most countries peg their home currencies to the US dollar to check the value of their currency. In other words, in the fixed exchange rate system, the currency of one country is fixed against another country’s currency. The currencies can be fixed to either gold or the US dollar. This system is used by the monetary authorities or central banks of any country and they peg their home currencies against this to buy or sell the domestic currencies. There can be fluctuations in the fixed exchange rate. In order to maintain the fixed exchange rate, the monetary authorities or central bank of any country can intervene and make changes in the interest rate. As the fixed exchange rate has the potential to impact the macroeconomic variables of the economy so intervention is important. There are several countries such as UAE, Qatar, Hong Kong, Cuba, and Oman that follows the fixed exchange rate system and they have pegged their currencies to the US dollar. Floating exchange rate A floating exchange rate is another type of exchange rate system. The floating exchange rate refers to the rate of the currency which is determined by the demand and supply factors relative to the other currencies. The floating exchange rate fluctuates due to fluctuations in the international finance market. The floating exchange rate works in the open market system and is influenced by the forces of demand and supply. The collapse of the Bretton woods agreement is the reason the floating exchange system came into existence. Before it, the countries used to follow the exchange rate system but after some time, the countries stopped pegging their currencies to the US dollar and started floating instead. Canada also follows the floating exchange rate system. To keep the inflation low and economic growth stable, Canada for many decades has been following the floating exchange rate system and it has let her currency float in the market-determined forces. There are four benefits of the floating exchange system which include independence in monetary policy, clear and effective policy, economic and financial development, and flexibility in adjustment to the external shocks made by the global economies [ CITATION Law19 \l 16393 ]. Over the last few decades, the

International Finance Term Paper 5 Canadian dollar has fluctuated effectively against the US dollar. Following is the chart showing fluctuations in the Canadian dollar against the US dollar over the last few decades – Source: [ CITATION Sta22 \l 16393 ] Significance of exchange rate system The exchange rate system plays important role in analyzing and measuring the condition or status of the domestic economy. An exchange rate system helps the monetary authority of any country to stabilize the economic conditions as well as avoid any conflict with the domestic objectives due to the fluctuations in the international finance market or foreign trade [ CITATION Emm21 \l 16393 ]. In order to grow internationally as well as look after the national economy, adopting the exchange rate system is as important as adopting the monetary policy [ CITATION IMF00 \l 16393 ]. The exchange rate system helps in controlling the macroeconomic variables that affect the national economy. In order to maintain the independence

International Finance Term Paper 6 in monetary policy, enjoy sustainable economic growth, and remain competitive in the international market, it is important to adopt an exchange rate system that is suitable for the countries respectively. Impact of exchange rate on macroeconomic variables The exchange rate system provides information about the prices of currencies in terms of foreign currencies. But in addition, it also provides information about its effects on the macroeconomic variables of national economies such as GDP growth, inflation, interest rates, and unemployment rates [ CITATION Rav15 \l 16393 ]. Short-term fluctuations related to the exchange rate as well as its’ impact on the macroeconomic variables can be seen and survived easily. But in the long run, its’ impact on macroeconomic variables can impact the export-import, trade, banking, and other sectors of domestic economies. So, systematic interventions are important to reduce the impact of the exchange rate. To have a significant growth in the international market, it is important to have a stable trade policy and the impact of the exchange rate system can be seen in stable trade policies [ CITATION Men22 \l 16393 ]. The research on the exchange rate system has shown that there is a significant relationship between the exchange rate and macroeconomic variables like inflation and GDP. Impact on GDP There is a significant relationship between the exchange rate system and gross domestic product (GDP). The GDP is one of the important macroeconomic variables when it is to determine the exchange rate and fluctuations in the exchange rate can impact the GDP. So, both have a positive relationship with each other. The choice of the exchange rate can impact the economic growth or gross domestic product [ CITATION Muh10 \l 16393 ]. Several kinds of research to date have shown that the countries that follow a fixed exchange rate system may not have a fast growth rate in GDP, but they have probably higher investments. However, in the case of the floating exchange rate system, the countries were seen as having the fastest economic growth or improvement in GDP. The balance of payment is the main indicator of the exchange rate and which further determines its’ impact on economic growth. The balance of payment determines the FDI coming into the country or the net revenue balance generated as well as the foreign

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International Finance Term Paper 7 deficit [ CITATION Rav15 \l 16393 ]. And these factors affect the exchange rate which further affects the gross domestic product growth of the country. Impact on Inflation Inflation is another important macroeconomic variable that determines the economic status of any country. The exchange rate system does have a significant impact on the inflation rate in any country. In the case of a fixed exchange rate, where one currency is pegged against another currency, the fixed exchange rate system lowers the inflation rate and helps in providing a stable & discipline policy regime. Today, in emerging economies, there is a vital relationship between exchange rates and inflation. With the increase in the exchange rate, the prices of goods and services become cheaper for the international consumer which further results in an increase in exports and total demand & prices. The increase in the exchange rate raises the inflation rate in the country. The fixed exchange rate system may act as a constraint and prevent the fast-rising of the domestic money supply. But still, it can also lead to more inflation when the pegged currency is indulging in expansionary monetary policy. Impact on unemployment Unemployment is another macroeconomic variable. There are several theories when it comes to describing the relationship between the exchange rate and the unemployment rate. The real exchange rate has an impact on the unemployment rate. It provides that the fluctuations in the real exchange rate can impact the volatility of the domestic currency which further impacts the product as well as the unemployment rate. And it provides that there are negative effects of the exchange rate on unemployment [ CITATION Zah16 \l 16393 ]. When the currency appreciates due to the fluctuations in the exchange rate, the imports become cheaper which affects the domestic businessmen, and manufacturers and cause unemployment among them. In the case of a fixed exchange rate system, there are fewer cases of it affecting the unemployment rate. However, in the floating exchange rate system, the currency is not pegged and is determined by the demand and supply forces in the global economy. And if any country’s currency appreciates, people living there will start to import more, and this affects the demand and supply forces in the international market and influences other currencies or their exchange rates and can lead to significant impact on unemployment.

International Finance Term Paper 8 International Trade Finance Companies engage in international trade and commerce by using financial instruments and products that facilitate them. Trade finance facilitates business transactions between importers and exporters. Banks and companies utilize various financial products to facilitate trade transactions under the umbrella term of trade finance. A trade transaction involves two parties: (1) the exporter, who needs to be paid for their products, and (2) the importer, who wants to ensure the goods are of the right quality and quantity. Finance of international trade is the financing of international trade flows. Risk mitigation is a tool for reducing the risks involved in international trade transactions. Risks and Challenges of Trade Finance Product risks: Product-related risks are those the seller automatically has to accept as an integral part of their commitment; an example would be a performance warranty, maintenance agreement, or service obligation. In order to ensure the quality of their products, the buyer needs to consider external factors such as negligence during production and extreme weather during the shipment. After contracts are signed, disputes may arise between the parties over these issues. Having a contract drafted correctly is crucial to ensuring that any changes that affect the Product will automatically result in compensation for the seller. Manufacturing risks – Especially vulnerable to manufacturing risks are custom-made products or those with unique specifications. If any adjustments are needed, the seller would usually be responsible for covering the costs. When risks related to product planning are addressed, a buyer is often required to enter into payment obligations earlier in the transaction. Buyers and sellers typically provide separate guarantees and payment terms during product development, production, and delivery. As well to the Product itself, the transport of goods presents additional risks. Cargo insurance reduces the risks associated with cargo and transport, as defined by standard international policy provisions (issued by the American Institute of Marine Underwriters or the Institute of London Underwriters). Sellers should be aware of how cargo insurance is handled by whose responsibility it is to arrange the insurance - the delivery terms sometimes determine this. In addition to cargo insurance, some delivery terms require the buyer to arrange insurance. In the

International Finance Term Paper 9 event of a change of the transport route or port of embarkation, for example, and the items arrive in damaged condition, the buyer may not be able to claim the insurance. Foreign exchange risk – In recent years, markets have been difficult, and foreign exchange levels have been uncertain more than ever. All of these factors mean that a company's currency risk management strategy needs to be strong. As the financial markets become increasingly regulated and scrutinized by governments, and as margins continue to tighten, even more pressure is being applied to reduce risk. Traditional currency risk management has often been a secondary concern. Risk management policies need to be implemented for the range of financial instruments available today. Market volatility and the need to operate in various currencies make policies flexible and important. Volatility in exchange rates affects all types of businesses, and this is important when there are changes in the value of assets, liabilities, and cash flows; it is certainly the case when the assets are denominated in a foreign currency. Contracts in which you have agreed to sell products internationally or in which exchange rate fluctuations are included can also be affected by volatility. It will have a negative impact on your profit margin. Before developing its strategy, a company should analyze what proportion of its business is based on imports or exports, the types of currencies used, when payments are to be made, and what type of currency is used for these transactions. How Trade Financing Reduces Risk By reconciling the divergent needs of exporters and importers, trade finance can reduce the risks associated with global trade. Importers always pay for exports upfront, reducing the risk of the importer accepting the shipment but refusing to pay for it. The exporter, however, may refuse to ship the goods if the importer pays upfront. The problem can be solved by having the importer's bank issue a letter of credit to the exporter's bank confirming the shipping occurred once the exporter presents documents proving it did. If the exporter has met the terms of the agreement and the issuing bank receives proof that the goods were shipped, the exporter will be paid. When a buyer obtains a letter of credit, his or her bank pays the seller on behalf of the buyer. The buyer's bank must confirm that the buyer is financially sound enough to meet the purchase agreement. The role of trade finance is to build trust between importers and exporters to facilitate trade. With trade finance, importers and exporters can take advantage of various financial options

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International Finance Term Paper 10 tailored to fit their needs. Multiple products can be combined or layered to facilitate a smooth transaction. Other Benefits to Trade Finance Also, trade finance helps companies boost their efficiency and revenues by reducing risks associated with non-payments or non-receipts. There are no circumstances in which trade finance does not improve cash flow and increase efficiency. It can also be extended as a credit line. Companies that factor in their accounts receivables can receive a cash payment using trade finance. Trade transactions can be facilitated using a letter of credit to reduce the risk of nonpayment and non-receipt of goods by exporters and importers. Due to this solution, the cash flow of the importer is improved since the importer is assured of payment from the buyer's bank. Furthermore, trade finance ensures fewer delays in payments and shipments, helping importers and exporters plan their cash flow more efficiently. To finance the company's growth, trade finance uses goods as collateral. A company's revenue and profits can be increased through trade finance. For instance, a U.S. company might be unable to produce the goods for an order with an overseas company. The exporter can, however, complete the order through export financing or assistance from private or governmental trade finance agencies. By providing creative financial solutions, trade finance enables the U.S. business to win new business. Financial Hardship Can Be Reduced Without trade financing, and a business may fall behind on payments and lose a key customer or supplier. In times of financial difficulty, companies can benefit from options like revolving credit and accounts receivable factoring. Floating exchange rate in Canada and present economic situation Canada has earned an effective growth rate due to the floating exchange rate system. Canada is among the top-tier global economies in the twenty-first century due to being an open economy and following a floating exchange rate system. It showcases an example of an effective floating exchange rate system along with systematic monetary policy can help in achieving a lower inflation rate and stable domestic production in the country [ CITATION Law10 \l 16393 ]. A few decades ago, Canada was among the major industrial countries that left the Bretton woods system and adopted the flexible or floating exchange rate system to perform well economically.

International Finance Term Paper 11 With the help of the floating exchange rate system, it has achieved a lower unemployment rate as well. Recently as the world is recovering from the covid-19 pandemic, Canada is also recovering from the severe economic impacts of covid-19 on its’ economy. In the fourth quarter of 2021, Canada has seen 1.6% growth in the real gross domestic product and it has improved better than in the quarter 3rd of 2021. As in amongst the recovery of the post-pandemic world, there is a 4% rise in the growth rate of Canada [ CITATION Ban21 \l 16393 ]. However, in the initial months of 2022, there is only a 0.8% rise in the growth rate of Canada which is the lowest performance. This is all due to a decline in the export volume and less governmental spending on the household. Canada’s rise in economic growth rate potential is all dependent upon the global economy as well as the US economy. Source: [ CITATION Tra22 \l 16393 ]

International Finance Term Paper 12 Source: [ CITATION Kel22 \l 16393 ] Conclusion In this international finance term paper, detailed information about Canada’s exchange rate system is discussed. Both the fixed and flexible exchange rate system has their merits and demerits. Several countries still follow the fixed exchange rate system. And the major global economic countries including Canada follow the floating exchange rate system. In this, the impact of the exchange rate system on macroeconomic variables like inflation, GDP, and unemployment rates are discussed. The exchange rate plays a significant part in the national economic aspects. The fluctuations in the exchange rate system impact the national economies and to maintain the exchange rate, continuous systematic interventions are needed almost all the time. As discussed in this paper, Canada has adopted the floating exchange rate system after leaving the Bretton woods system; it has been able to gain several benefits like independent monetary policy, low inflation, and unemployment, stable economic growth, etc. The present economic conditions of Canada are also discussed. To conclude, it is important to select the appropriate exchange rate system that suits the fiscal and monetary policy framework of the country.

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International Finance Term Paper 13 References Bakhshi, Z., & Ebrahimi, M. (2016). The effect of real exchange rate on unemployment. Marketing and Branding Research, 3 , 4-13. Bank For Canadian Entrepreneurs. (2021). 2021 economic outlook: Playing catch-up . Retrieved from BDC.com: https://www.bdc.ca/en/articles-tools/blog/2021-economic-outlook- canada Bizuneh, M. (2022). Are We Floating Yet? Duration of Fixed Exchange Rate Regimes. Eastern Economic Journal, 48 , 63-89. IMF. (2000). Exchange Rate Regimes in an Increasingly Integrated World Economy . Retrieved from IMF: https://www.imf.org/external/np/exr/ib/2000/062600.htm Karakostas, E. (2021). The Significance of the Exchange Rates: A Survey of the Literature. Modern Economy, 12 , 1628-1647. Khan, M. A. (2010). Impact of Per Capita Income on Exchange Rate with Regression Tool. SSRN , 1-11. Ramasamy, R., & Abar, S. K. (2015). Influence of Macroeconomic Variables on Exchange Rates . Journal of Economics, Business and Management, 3 (2), 276-281. Schembri, L. (2010). Canada’s Experience with a Flexible Exchange Rate in the 1950s: Valuable Lessons Learned. Bank of Canada Review , 3-15. Schembri, L. L., & Alberta, E. (2019). The merits of a floating exchange rate . Retrieved from Bank of Canada: https://www.bankofcanada.ca/2019/06/merits-of-a-floating-exchange- rate/ Statista. (2022). U.S. Dollar (USD) to Canadian dollar (CAD) exchange rate from January 2012 to February 24, 2022 . Retrieved from Statista.com: https://www.statista.com/statistics/960306/quarterly-exchange-rate-usd-to-cad/ Szabolcs, K. (2022). US Dollar to Canadian Dollar (USD/CAD) 5 years forex chart . Retrieved from Chartoasis.com: https://www.chartoasis.com/usd-cad-forex-chart-5-years-cop0/

International Finance Term Paper 14 Trading Economics. (2022). Canada GDP Growth Rate . Retrieved from Trading Economics.com: https://tradingeconomics.com/canada/gdp-growth

International Finance Term Paper

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