1 Ka-fu Wong University of Hong Kong Who determines the value of Renminbi? The Chinese government, the US government, or the market? ECON1001: Introduction to Economics, 2006 Fall

2 How is the price of an ordinary good (say, a bottle of wine) determined? Supply Demand Price Quantity Market

3 How is the price of a currency (say, Reminbi) determined? Supply Demand US$/yuan Yuan Market Price regulation (ceiling or floor) Quantity regulation Add supply

4 Devaluation, Revaluation of Reminbi Supply Demand US$/yuan Yuan Devaluation Reminbi becomes cheaper Revaluation Reminbi becomes more expensive

5 Depreciation, Appreciation of Japanese Yen Supply Demand US$/yen yen New supply Depreciation Yen becomes cheaper Appreciation Yen becomes more expensive

6 How is the price of a currency (say, Reminbi) determined? Arbitrage: Purchasing Power Parity Uncovered interest parity Covered interest parity

7 Chong Yuet Ming Amenties Centre SWIRE Hall Haking Wong Bldg Main Library Annex Four Student Canteens at HKU

8 CYM MacDonaldSWIRE MacDonald Prices of Big Mac Case 1 What would you do?

9 What would you do? Choose the cheaper MacDonald for lunch. Buy Big Mac from CYM and sell at SWIRE.

10 Effect of our action More supply of Big Mac, less demand for Big Mac At SWIRE Price of Big Mac falls. Greater demand for Big Mac, less supply for Big Mac At CMY Price of Big Mac increases. Choose the cheaper MacDonald (CMY) for lunch. Buy Big Mac from CMY and sell at SWIRE.

11 CYM MacDonaldSWIRE MacDonald What would you do in the absence of transaction costs? P CYM P SWIRE Case 2 P CYM P SWIRE Case 3 > <

12 Punch line: Arbitrage activities continue until prices equalize. Arbitrage is a strong driving force to equalize prices.

13 HK MacDonaldUS MacDonald Prices of Big Mac (assume 1USD = 7.8 HKD) HKD 7.80USD 1 Case 4 HKD 15.60USD 1 Case 5

14 HK MacDonaldUS MacDonald Prices of Big Mac (assume 1USD = e HKD) P HK e  P US Case 7 P HK e  P US Case 8 > <

15 Arbitrage activities continue until prices equalize That is, P HK = e  P US and e = P HK / P US

16 Prices of the same good at different locations, when expressed in the same currency, have to equalize. That is, Purchasing Power Parity Exchange rate implied by PPP e = P HK / P US P HK = e  P US

17 If e is fixed, P US has to adjust when there is a change in P HK. Purchasing Power Parity Three variables in the relation: Knowing any two of them, we can compute the third. P HK = e  P US e P HK P US If P US is fixed, e has to adjust when there is a change in P HK.

18 Other arbitrage opportunities across space International phone call: HK direct to Beijing (Price= P1) HK to Canton province, from where the call is redirected to Beijing (Price= P2) Arbitrage opportunities exists when P1  P2, or P1-P2  0. Arbitrage activities (though illegal) will drive P1-P2 towards zero.

19 Arbitrage opportunities across space A B X P2P2 P1P1

20 Other arbitrage opportunities across space Buying or selling Japanese Yen HKD direct to JPY (Price= P1) HKD to Swedish Krona and Swedish Krona to Yen (Price= P2) Arbitrage opportunities exists when P1  P2, or P1-P2  0. Arbitrage activities will drive P1-P2 towards zero.

21 Arbitrage across time TodayTomorrow Stock prices If cost of interest is zero, < one would like to buy stock today, hold it for a day and sell it tomorrow. Profit= 8.

22 Arbitrage across time in real life In real life, interest rate is nonzero and we do not know tomorrow’s stock price for sure. Thus, economic theory has to adjust for these factors but still uses this idea of arbitrage.

23 What does PPP tell us about exchange rates? “Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.” ( subscription required)

24 Big Mac Index, The Economist, May 25th 2006

25 Why is Big Mac Index so far off from the actual exchange rates? Adjustment of prices slow in general (price rigidity) Noise  need to use econometrics (economic statistics) to test the theory Other factors (and also noise) that determines the exchange rate. Transportation takes time (some goods are perishable)

26 There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s exchange rate? Supply Demand US$/yuan Yuan

27 There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s exchange rate? S D S D S D US domestic China domestic Foreign exchange market Yuan $/Yuan Yuan $ At least three markets in each country: goods, labor. and money.

28 Why would the US want to see a revaluation of Reminbi? Supply Demand US$/yuan Yuan

29 What would be the consequence of a 20% revaluation of Reminbi on (1) China, (2) Hong Kong, (3) US and western countries, (4) Japan and the newly industrialized countries, (5) Developing countries Supply Demand US$/yuan Yuan 20% revaluation

30 Consider all options for China to reform its regime. Why did China choose the basket peg over its alternatives? Exchange Arrangements with No Separate Legal Tender Currency Board Arrangements Other Conventional Fixed Peg Arrangements Pegged Exchange Rates within Horizontal Bands Crawling Pegs Exchange Rates within Crawling Bands Managed Floating with No Predetermined Path for the Exchange Rate Independently Floating

31 What is your prediction of the Reminbi exchange rate in a few years time? Give your reasons. 7.8 yuan = 1 USD? About 4 %?

32 References:  Taylor, Alan M. and Mark P. Taylor (2004): “The Purchasing Power Parity Debate,” NBER Working Paper No  Chang, Gene (2006) “How Much is Chinese Currency Undervalued? A Quantitative Estimation,” Mimeo, Shanghai University of Finance and Economics.  McKinnon, Ronald (2006): “China’s Exchange Rate Appreciation in the Light of the Earlier Japanese Experience,” Mimeo, Stanford University

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