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Exchange Rate System

Flexible Exchange Rate System

Fixed Exchange Rate System

Linked Exchange Rate System

Flexible Exchange Rate System

• Demand for domestic country’s (HK) currency

Demand for XCapital Inflow

• Supply of domestic country’s (HK) currency

Demand for MCapital outflow

D

S

exchange rate

Q

amount of domestic currency

1 unit of foreign currencye.g. HK$5

Au$1

amount of foreign currency

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

Change in Demand

• demand for X

• capital inflow

• people expect domestic currency appreciate

demand for domestic currency

appreciation of domestic currency

D

S

exchange rate

Q

HK$5

Au$1

amount of foreign currency

S’

HK$4.5

Au$1

Appreciation of Domestic Currency

Change in Supply

• demand for imports

• capital outflow

• people expect domestic currency depreciate

supply of domestic currency

depreciation of domestic currency

D

S

exchange rate

Q

amount of foreign currency

D’

HK$5

Au$1

HK$5.2

Au$1

Depreciation of Domestic Currency

Domestic Price Level

• domestic price level

• X

(demand for domestic currency)

• M

(supply of domestic currency)

• depreciation of domestic currency

Interest Rate

• domestic interest rate

• capital inflow

(demand for domestic currency)

• appreciation of domestic currency

D

S

exchange rate

Q

HK$5

Au$1

amount of foreign currency

S’

HK$4.5

Au$1

Appreciation of Domestic Currency

Domestic Income Level

• assume exports are autonomous

• income level

• demand for M

(supply of domestic currency )

• depreciation of domestic currency

D

S

exchange rate

Q

amount of foreign currency

HK$7.8

US$1

HK$8.2

US$1

Depreciation of Domestic Currency

D

S

exchange rate

Q

amount of foreign currency

D’

HK$5

Au$1

HK$5.2

Au$1

Depreciation of Domestic Currency

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.

Depreciation

HK$5

Au$1

Au$0.96

HK$5 (unchanged)

exchange rate

= HK$5/Au$1

exchange rate

= HK$5.2/Au$1

Depreciation (effect on exports)

export prices in foreign currency (Au$1 Au$0.96)

(export prices in domestic currency unchanged)(HK$5 HK$5)

Qd of X

export value ( P x Q) in domestic currency(HK$5 x 1000 HK$5x 1200)

Depreciation (effect on imports)

HK$5

Au$1

Au$1

HK$5.2

exchange rate

= HK$5/Au$1

exchange rate

= HK$5.2/Au$1

Depreciation

import prices in domestic currency

(HK$5 HK$5.2)

(import prices in foreign currency unchanged)

(Au$1 Au$1)

Qd of M

value of imports ( P x Q) in domestic currency ?

If demand for imports is

• elastic

• inelastic

• unitarily elastic

value of imports in domestic currency

unchanged

If demand for exports is elastic ( Ex > 1)

export value ( P x Q) in domestic currency

If demand for imports is elastic ( Em > 1)

import value in domestic currency

• 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 > 1

depreciation will lead to improvement of BOP

Fixed Exchange Rate System

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

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.

D

S

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

Au$

fixed rate1

D

S

exchange rate

Q

HK$5.2

US$1

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate1

Devaluation of domestic currency

fixed rate2

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.

D

S

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate1

Revaluation of domestic currency

D

S

exchange rate

Q

HK$4.5

Au$1

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate1

Revaluation of domestic currency

fixed rate2

Balance of Payments Deficit

D

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate

Balance of Payments Deficit

S

D

S’

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate

Balance of Payments Deficit

S

Bop deficit

D

S’

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

Au$

fixed rate

Bop deficit

D

S’

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

US$

fixed rate

government increase the supply of foreign currency

S”

Bop deficit

Balance of Payments Surplus

D

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

Au$

fixed rate

S

Bop surplus

D’

exchange rate

Q

amount of foreign currency

HK$7.8

US$1

HK$

Au$

fixed rate

S

Bop surplus

D’

D”

exchange rate

Q

amount of foreign currency

HK$5

Au$1

HK$

Au$

fixed rate

S

Bop surplus

D’

government increase the demand for foreign currency

exchange rate

Q

amount of foreign currency

HK$7.8

US$1

HK$

US$

S

D

upper limit

lower limit

Dirty Floating

Foreign Exchange Control

• prohibit or restrict the purchase of foreign exchange

• black market will emerge

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

Monetary Interdependence under Fixed Exchange Rate System

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

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

Monetary Interdependence under Fixed Exchange Rate System

Foreign country

Ms

inflation

r

Domestic country

Ms

inflation

r

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

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

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

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

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

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

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

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”

Policy Conflict

• inflation in domestic country

• BOP deficit

• supply of foreign currency

• government initiates contrationary policies to combat inflation

Policy Conflict

• if BOP deficit + unemployment

• What should the government do?

• contrationary policy (e.g. G ), or

• expansionary policy (e.g. G )

Advantages of Fixed Exchange Rate

• Certainty

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.

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.

note issuing banks Exchange Fund

US$1

Certificate of Indebtedness (CIs)HK$7.8

linked exchange rate

HK$7.8 US$1

=

other licensed banks and

public

US$

note issuing banks Exchange Fund

US$1

Certificate of Indebtedness (CIs)HK$7.8

linked exchange rate

HK$7.8 US$1

=

other licensed banks and

public

US$1 HK$7.8

note issuing banks Exchange Fund

US$1

HK$7.7

linked exchange rate

HK$7.8 US$1

=

other licensed banks and

public

The Process of Arbitrage

open market rate

HK$7.7 US$1

=

US$1

CIs

(HK$7.8)

note issuing banks Exchange Fund

US$1

HK$7.9

linked exchange rate

HK$7.8 US$1

=

other licensed banks and

public

The Process of Arbitrage

open market rate

HK$7.9 US$1

=

US$1

CIs

(HK$7.8)

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.

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

inflation in HK

X , M

BOP deficit

note-issuing banks’ demand for HK$

Ms

US interest rate

Hong Kong capital outflow

Hong Kong has to increase interest rate

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.

AL 89/9

Expenditure

Y

X

M

C+I+G+X-M

450

trade deficit

Contractionay policy reduces trade deficit by reducing the income level.

Expenditure

Y

X

M

C+I+G+X-M

450

trade deficit

C+I+G’+X-M

effects of devaluation

Expenditure

Y

X

M

C+I+G+X-M

450

trade deficitM’

X’

C+I+G+X’-M’

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.

Al 90/7 (a)

HK$/Yen

quantity of Yen

D

D’ S

E

E’

Al 90/7 (b)

HK$/Yen

quantity of Yen

DS’

E

E’

S

AL 90/7 (c)

HK$/Yen

quantity of Yen

D

D’ (HK imports )

S

E’

E

S’ (HK exports )

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

 a. 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).

Price of foreign currency

Quantity of foreign currency

ec

e1

Mc

D

S

A

(black market rate)

(official rate)

Price of foreign currency

Quantity of foreign currency

ec

e1

e2

Mc

D

D’

S

A

(black market rate)

(official rate)

(black market rate)

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

Price of foreign currency

Quantity of foreign currency

e*

D

S’S

(official rate)

BOP deficit

Price of foreign currency

Quantity of foreign currency

e1

e2

D

D’

S

A

B