exchange rate system flexible exchange rate system fixed exchange rate system linked exchange rate...
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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