Exchange Rate System

1
Exchange Rate System

• Flexible Exchange Rate System
• Fixed Exchange Rate System
• Linked Exchange Rate System

2
Flexible Exchange Rate System

• Demand for domestic countrys (HK) currency
• Demand for X
• Capital Inflow

3

• Supply of domestic countrys (HK) currency
• Demand for M
• Capital outflow

4
amount of domestic currency 1 unit of foreign
currency
exchange rate
e.g. HK5 Au1
S
D
Q
amount of foreign currency
5
Appreciation
a unit of domestic currency can buy more units of
foreign currencies
Depreciation
a unit of domestic currency can buy less units of
foreign currencies
6
Change in Demand

• demand for X
• capital inflow
• people expect domestic currency appreciate
• demand for domestic currency
• appreciation of domestic currency

7
Appreciation of Domestic Currency
exchange rate
S
S
HK5 Au1
HK4.5 Au1
D
Q
amount of foreign currency
8
Change in Supply

• demand for imports
• capital outflow
• people expect domestic currency depreciate
• supply of domestic currency
• depreciation of domestic currency

9
Depreciation of Domestic Currency
exchange rate
S
HK5.2 Au1
HK5 Au1
D
D
Q
amount of foreign currency
10
Domestic Price Level

• domestic price level
• X
• (demand for domestic currency)
• M
• (supply of domestic currency)
• depreciation of domestic currency

11
Interest Rate

• domestic interest rate
• capital inflow
• (demand for domestic currency)
• appreciation of domestic currency

12
Appreciation of Domestic Currency
exchange rate
S
S
HK5 Au1
HK4.5 Au1
D
Q
amount of foreign currency
13
Domestic Income Level

• assume exports are autonomous
• income level
• demand for M
• (supply of domestic currency )
• depreciation of domestic currency

14
Depreciation of Domestic Currency
exchange rate
S
HK8.2 US1
HK7.8 US1
D
Q
amount of foreign currency
15
Depreciation of Domestic Currency
exchange rate
S
HK5.2 Au1
HK5 Au1
D
D
Q
amount of foreign currency
16
Marshall-Lerner Condition

• Depreciation will improve the balance of payments
  position of a country, provided that the sum of
  elasticities of foreign demand for domestic
  exports ( Ex) domestic demand for imports ( Em
  )is greater than one.

17

• Depreciation

HK5
exchange rate HK5/Au1
Au1
HK5 (unchanged)
exchange rate HK5.2/Au1
Au0.96
18

• Depreciation (effect on exports)
• export prices in foreign currency
• (Au1 Au0.96)
• (export prices in domestic currency unchanged)
• (HK5 HK5)
• Qd of X
• export value ( P x Q) in domestic currency
• (HK5 x 1000 HK5x 1200)

19

• Depreciation (effect on imports)

HK5
exchange rate HK5/Au1
Au1
HK5.2
exchange rate HK5.2/Au1
Au1
20

• Depreciation
• import prices in domestic currency
• (HK5 HK5.2)
• (import prices in foreign currency unchanged)
• (Au1 Au1)
• Qd of M
• value of imports ( P x Q) in domestic currency ?

21
If demand for imports is

• elastic
• inelastic
• unitarily elastic

• value of imports in domestic currency
• unchanged

22

• If demand for exports is elastic ( Ex gt 1)
• export value ( P x Q) in domestic currency
• If demand for imports is elastic ( Em gt 1)
• import value in domestic currency

23

• Therefore, if demand for exports and demand for
  imports are elastic, depreciation of domestic
  currency will lead to improvement of balance of
  payments situation.
• If Ex Em gt 1
• depreciation will lead to improvement of BOP

24
Fixed Exchange Rate System
25
Devaluation
the official exchange rate is altered so that a
unit of the domestic currency can buy fewer units
of foreign currencies
Revaluation
the official exchange rate is altered so that a
unit of the domestic currency can buy more units
of foreign currencies
26
Effects of Devaluation

• The gap between official exchange rate and
  equilibrium exchange rate will be reduced.
•  
• Exports become more competitive in the
  international market.
•  
• Imports become more expensive.

27
HK Au
exchange rate
S
fixed rate1
HK5 Au1
D
Q
amount of foreign currency
28
HK US
exchange rate
Devaluation of domestic currency
S
HK5.2 US1
fixed rate2
fixed rate1
HK5 Au1
D
Q
amount of foreign currency
29
Effects of Revaluation

• The gap between official exchange rate and
  equilibrium exchange rate will be reduced.
•  
• Exports become less competitive in the
  international market.
•  
• Imports become cheaper.

30
HK US
exchange rate
Revaluation of domestic currency
S
fixed rate1
HK5 Au1
D
Q
amount of foreign currency
31
HK US
exchange rate
Revaluation of domestic currency
S
fixed rate1
HK5 Au1
fixed rate2
HK4.5 Au1
D
Q
amount of foreign currency
32
Balance of Payments Deficit
33
Balance of Payments Deficit
HK US
exchange rate
S
fixed rate
HK5 Au1
D
Q
amount of foreign currency
34
Balance of Payments Deficit
HK US
exchange rate
S
S
fixed rate
HK5 Au1
D
Bop deficit
Q
amount of foreign currency
35
HK Au
exchange rate
S
fixed rate
HK5 Au1
D
Q
Bop deficit
amount of foreign currency
36
government increase the supply of foreign currency
HK US
exchange rate
S
S
fixed rate
HK5 Au1
D
Q
Bop deficit
amount of foreign currency
37
Balance of Payments Surplus
38
HK Au
exchange rate
S
fixed rate
HK5 Au1
D
D
Q
Bop surplus
amount of foreign currency
39
HK Au
exchange rate
S
fixed rate
HK7.8 US1
D
Q
Bop surplus
amount of foreign currency
40
HK Au
exchange rate
government increase the demand for foreign
currency
S
fixed rate
HK5 Au1
D
D
Q
Bop surplus
amount of foreign currency
41
HK US
exchange rate
Dirty Floating
S
upper limit
HK7.8 US1
lower limit
D
Q
amount of foreign currency
42
Foreign Exchange Control

• prohibit or restrict the purchase of foreign
  exchange
• black market will emerge

43
Self-adjustment Mechanism under Fixed Exchange
Rate System

• BOP deficit to support the exchange
  rate, govt S of foreign
  currency ( D for domestic
  currency)
• Ms
  P
• X , M
• BOP deficit
• (if
  Marshall-Lerner Condition is
• satisfied???
• interest rate
• capital inflow

44
Monetary Interdependence under Fixed Exchange
Rate System

• Ms in foreign country
• P in foreign currency
• trade surplus (X , M )
• to maintain the fixed exchange rate,
  government demand for foreign currency
• (supply of domestic currency )
• Ms P

45
Monetary Interdependence under Fixed Exchange
Rate System

• r in foreign country
• capital inflow in domestic country
• to maintain the fixed exchange rate,
  government demand for foreign currency
• (supply of domestic currency )
• Ms r

46
Monetary Interdependence under Fixed Exchange
Rate System

• Foreign country
• Ms
• inflation
• r

• Domestic country
• Ms
• inflation
• r

47
Comparison between Flexible and Fixed Exchange
Rate Systems

• Flexible exchange rate
• exchange rate is determined by demand for and
  supply of foreign currency

• Fixed exchange rate
• the government fixes the foreign exchange rate
  by buying and selling of foreign exchange

48

• Flexible exchange rate
• depreciation or appreciation of a currency is
  determined by the market forces
• speculation in foreign exchange market is common

• Fixed exchange rate
• devaluation or revaluation of a currency is
  determined by the government
• speculation occurs when there is rumour about the
  change in government policy

49

• Flexible exchange rate
• self-adjusting mechanism operates to eliminate
  external disequilibrium by change in foreign
  exchange rate

• Fixed exchange rate
• self-adjusting mechanism operates through the
  change in money supply, domestic interest rate
  and domestic price

50
Advantages of Flexible Exchange Rate System

• a currency will not be over-valued or
  under-valued
• Balance of payments deficit or surplus will be
  corrected automatically through market forces
• lead to an efficient allocation of resources
• no policy conflict
• enables a country to pursue an independent
  economic policy

51
Advantages of Flexible Exchange Rate System

• minimize outside influences on the domestic
  economy as there is no imported inflation or
  deflation
• there is no need for central banks to keep
  official reserves in order to intervene in the
  foreign exchange market

52
Disadvantages of Flexible Exchange Rate System

• Flexible Exchange Rate
• increase business uncertainties and reduce volume
  of trade
• Such uncertainties can be reduced or eliminated
  by forward market

• Fixed Exchange Rate
• there are also uncertainties under the fixed
  exchange rate system
• speculative transactions are self-fulfilling

53
Disadvantages of Flexible Exchange Rate System

• Flexible Exchange Rate
• increase currency speculation and it is therefore
  destabilizing
• speculation can be stabilizing

• Fixed Exchange Rate
• one-way option speculation

54
Flexible Exchange Rate System

• Flexible Exchange Rate
• The external sector is always in equilibrium
• no policy problem

• Fixed Exchange Rate
• Inflation in a country will lead to balance of
  payment deficits and the government is likely to
  initiate contractionary policies to combat
  inflation.
• deflationary biased

55
Policy Conflict

• inflation in domestic country
• BOP deficit
• supply of foreign currency
• government initiates contrationary policies to
  combat inflation

56
Policy Conflict

• if BOP deficit unemployment
• What should the government do?
• contrationary policy (e.g. G ), or
• expansionary policy (e.g. G )

57
Advantages of Fixed Exchange Rate

• Certainty

58
The Hong Kong Linked Exchange Rate System (Oct.
1983 Sept. 1998 present)

• This system was adopted at a time following rapid
  depreciation of the Hong Kong dollar. It was
  used by the Hong Kong government to stabilize the
  value of the Hong Kong dollar.

59
The difference between fixed exchange rate and
linked exchange rate

• the authorities are not obliged to intervene, as
  there is an arbitrage and competition mechanism
  to ensure the convergence of the market rate with
  the official rate.

60
US1
Exchange Fund
note issuing banks
Certificate of Indebtedness (CIs)
HK7.8
US
linked exchange rate HK7.8
US1

other licensed banks and public
61
US1
Exchange Fund
note issuing banks
Certificate of Indebtedness (CIs)
HK7.8
US1
HK7.8
linked exchange rate HK7.8
US1

other licensed banks and public
62
The Process of Arbitrage
US1
Exchange Fund
note issuing banks
CIs (HK7.8)
HK7.7
US1
linked exchange rate HK7.8
US1

open market rate HK7.7
US1
other licensed banks and public

63
The Process of Arbitrage
US1
Exchange Fund
note issuing banks
CIs (HK7.8)
HK7.9
US1
linked exchange rate HK7.8
US1

open market rate HK7.9
US1
other licensed banks and public

64
Effects of the Arbitrage

• If there are no transaction costs, arbitrage in
  either direction will continue until the free
  market exchange rate equals the linked rate.
• If there are transaction costs, the free- market
  exchange rate will fluctuate within a narrow
  range around the linked exchange rate.

65
Remarks

• The note-issuing banks can only issue currency
  notes by paying US dollars to the Exchange Fund
  in advance.
• currency in Hong Kong cannot be increased if Hong
  Kong is unable to earn US dollars, or other
  foreign currencies easily convertible into US
  dollars

66
inflation in HK X , M BOP
deficit note-issuing banks demand for
HK Ms
67
US interest rate Hong Kong capital outflow
Hong Kong has to increase interest rate
68

• AL 89/9
•  
• Under the fixed exchange rate system, a country
  can correct its balance of payments deficit by
  either devaluing its currency or implementing a
  contractionary domestic policy.
• a. Explain with appropriate diagrams how the two
  policies can reduce a balance of payments
  deficit.
• b. 'These two policies have different impacts on
  the economy and, as a result, should be used
  under different conditions.' Explain.

69
AL 89/9
Expenditure
CIGX-M
M
trade deficit
X
450
Y
70
Contractionay policy reduces trade deficit by
reducing the income level.
Expenditure
CIGX-M
CIGX-M
M
trade deficit
X
450
Y
71
effects of devaluation
Expenditure
CIGX-M
CIGX-M
M
trade deficit
M
X
X
450
Y
72

• AL 90/7
•  
• Under Hong Kong's present linked exchange rate
  system, what will happen to the exchange rate
  between the Japanese yen and the Hong Kong
  dollar, if assuming other things being equal,
• a. the US dollar depreciates by 10 percent
  against the Japanese yen?
• b. Hong Kong has a large surplus against Japan in
  its balance of payments?
• c. the inflation rate rises in the U.S.A.?
• Use simple diagrams to illustrate your answer.

73
Al 90/7 (a)
HK/Yen
D
S
D
E
E
quantity of Yen
74
Al 90/7 (b)
HK/Yen
S
D
S
E
E
quantity of Yen
75
AL 90/7 (c)
HK/Yen
S (HK exports )
D (HK imports )
S
D
E
E
quantity of Yen
76

• AL 94/6
•  
• Use demand and supply analysis, with the
  vertical axis as the exchange rate (price of
  foreign currency) to explain how an increase in
  imports would affect
•  
• the exchange rate under a floating exchange rate
  system.
• b. the official and the black market exchange
  rates in a fixed exchange rate system (assume
  that the black market exchange rate is initially
  higher than the official rate).

77
Price of foreign currency
S
e1
(black market rate)
A
ec
(official rate)
D
Mc
Quantity of foreign currency
78
Price of foreign currency
S
e2
(black market rate)
e1
(black market rate)
A
ec
(official rate)
D
D
Mc
Quantity of foreign currency
79

• 96/8
•  Under a fixed exchange rate system Country A
  over-values its currency, which leads to an
  external deficit.
•  
• a. Illustrate the situation using a well-labelled
  diagram.
• b. What should be the government of Country A do
  in the foreign exchange market to maintain the
  exchange rate at the fixed rate? How will this
  affect the money supply of Country A?
• c. Explain whether Country A can eliminate its
  external deficit by promoting export

80
Price of foreign currency
S
S
e
(official rate)
D
Quantity of foreign currency
BOP deficit
81
Price of foreign currency
S
e2
B
e1
A
D
D
Quantity of foreign currency