Chapter 18 Exchange Rate Determination I: Prices and the Real Exchange Rate

Exchange Rate Crises & Hong Kong HK Dollars, as currency, is printed by money center banks Standard Chartered, HSBC, and, now, Bank of China. During the 1970’s, the banks faced little limitation on money creation. In July of 1982, the HK dollar was depreciating at a rate of 7.7% per year. In 1983, Britain and the People’s Republic were engaged in talks about the terms on which Hong Kong would be returned to China. Responding to news from these talks, currency traders unloaded there HK dollar positions. As a response, the Hong Kong dollar depreciated rapidly. By September 1983, the HK dollar was depreciating at a rate of 65% per year.

Policy Response: Currency Board The government announced that Hong Kong would switch to a currency board system. A currency board is an arrangement whereby a country can only issue domestic currency if it backed up by central bank holdings of a specific foreign currency. To give permission to a money center bank to print 7.8 HK dollars, the government would have to acquire US$1. This has been the monetary policy of Hong Kong ever since.

Objectives Students should be able to define the real and nominal exchange rate. Students should be able to define purchasing power parity and differentiate relative and absolute PPP. Explain why inflation in Hong Kong differs from the US. Students should be able to demonstrate that the capital account is the negative of the current account. Students should understand the effect of some events on the real exchange rates.

Bilateral Exchange Rate Bilateral Exchange Rate is the exchange rate of one countries’ currency vs. another’s. Exchange rates can be written in two ways which are inverses of each other. Definition 1 The price of foreign currency in terms of domestic currency (the # of domestic currency units needed to purchase 1 unit of foreign currency) HK$7.8 per 1 US$ Definition 2 The price of domestic currency in terms of foreign currency (the # of foreign currency units needed to purchase 1 unit of domestic currency. US$.128 per 1 HK$

Terminology Typically, a bilateral exchange rate is reported as the # of units of the currency with the lower value per unit of the currency of the higher value. Examples HK$7.8 per 1 US$ ¥ per 1 US$ US1.53 per 1 ₤ An appreciation of a currency is an increase in the value of a currency. A depreciation is a decrease in value. A depreciation would increase the exchange rate by Definition 1. Ex. A movement of HK$7.8 to HK$10 per US is a depreciation. A depreciation would decrease the exchange rate by Definition 2. Ex. A movement of US$.127 to US$.1 would be a depreciation of HK dollar.

Exchange Rates HK has a fixed bilateral exchange rate with the US. HK Exchange Fund (the currency board operated by HKMA) will buy or sell HK$ at a fixed exchange rate. No one will ever buy for more or sell for less. Effective Exchange Rate is a weighted average of a country’s bilateral exchange rates [weights are by share of trade]. HK effective exchange rate fluctuates since US dollar fluctuates relative to important HK trading partners such as Japan, Germany, etc.

HK Effective Exchange Rate

Real Exchange Rate Real exchange rates are the price of domestic goods relative to the price of foreign goods. In other words, real exchange rates are the # of foreign goods that must be given up to obtain 1 domestic good. A foreigner compares the price of their foreign goods with the price of our domestic goods. To buy 1 foreign good, he must pay P F foreign currency units where P F ≡ Foreign price level. To buy 1 domestic good, he must pay P domestic currency units, but he must pay Nominal Exchange Rate × P. (using Definition 2). Define Real exchange rate can be calculated on a bilateral basis or an index basis.

HK: US Real Exchange Rate

Law of One Price (LoOP) Arbitrage should insure that identical goods should sell for the same price in different markets. For easily transportable, standardized goods sold in highly competitive markets (such as gold), LoOP holds. Why doesn’t LoOP hold for most goods? 1. Transport Costs – Large costs of moving goods may keep arbitrage from working. 2. Non-traded Goods – Some goods, such as real estate, have near infinite transport prices. 3. Pricing-to-Market – Firms with market power may find it optimizing to charge different prices in different markets. 4. Tariffs & Taxes – Imported goods may face additional taxes

Purchasing Power Parity (PPP) PPP theory says LoOP applies to all markets. Define relative prices of foreign goods Absolute PPP says that the real exchange rate is always E = 1 or the Def. 2 of the Nominal exchange rate = XP Relative PPP says that the growth rate of the real exchange rate is zero

Does PPP Hold? Does Absolute or Relative PPP hold? In short run, NO. Exchange rates are much more volatile than inflation rates. In long run for countries with similar levels of development, PPP holds. Example. Twenty year averages for OECD countries. Rapidly developing countries typically see long-term real exchange rate appreciations Hong Kong has had much faster inflation than the US over the life of the exchange rate peg.

Long Run

Rich Countries are more expensive than poor countries. Many types of services have unchanging technology (like haircuts) or inherently limited supply (like real estate). Most technology advances occur in traded goods sector. As a country grows wealthier and more technologically advanced, the countries residents will pay more for real estate or services. If traded goods have roughly equal prices across countries, but a countries non-traded goods start to become more expensive as it develops, the overall relative price of its goods will increase.

XP vs. Exchange Rate

Current Account The current account is, conceptually, the amount of income earned overseas less the amount of income earned by foreigners from the domestic economies. Current Account =Balance on Goods(Goods Exports-Goods Imports) + Balance on Services(Services Exports- Services Imports) + Net Investment Income (Investment Income Earned Overseas – Investment Income Paid to Foreigners) +Net Transfers(Donations from Overseas)

Capital & Financial Account The capital account (more accurately the capital & financial account) records capital inflows into the country. The account includes the financial account, the capital account, and change in reserve assets. Capital & Capital Account (Debt Forgiveness, Patents) Financial+ Financial Account → Direct Investment(FDI of Foreign Companies – FDI by Domestic Companies) Account = + Portfolio Investment (Domestic Securities Purchases by Foreigners – Foreign Securities Purchases by Domestic Residents) + Other Investments(Deposits in Domestic Banks by Foreigners – Deposits in Foreign Banks by Domestic Residents) + Change in Reserve Assets -Accumulation of Foreign Exchange Reserves

Hong Kong Current Account & Capital Account 2001 Hong Kong had a 96 million dollar current account surplus in Hong Kong had a 97 million dollar capital & financial account deficit. The difference is reserve assets.

Net Savings = Net Exports Capital Account = I – S Current Account = EX – IM S = GDP – C – G GDP = C + I + G + EX – IM → GDP – C – G = I + EX- IMS = I + EX – IM → S – I = EX - IM Net Capital Outflows = Goods Outflows When an economy provides more goods to the world economy than it receives in return it will have extra foreign funds. These will be used to acquire foreign assets.

Real Exchange Rate and Net Exports An increase in the real exchange rate has counter-veiling effects on net exports. 1. The value/price of a given amount of export goods will rise relative to a given amount of import goods when domestic goods increase in relative price. An economy exports 100 apples at price of $1 each and imports 100 oranges at price of $1. Net exports are zero. If price of apples goes to $2, then net exports will increase to When relative price of domestic goods increases, the domestic economy will export fewer goods and import more goods. In very short run, the first effect will dominate. In medium to long run, the second effect tends to dominate.

Equilibrium Real Exchange Rates NX S-I E E*E*

Real Exchange Rate Determination The real exchange rate, in the medium run, is determined by the position of savings and investment. Shortfalls in domestic savings result in high real exchange rates and low net exports EventS - I / NXE Government Deficits ←↑ Productivity Boom ←↑

Domestic Funds Shortfall NX S-I E S-I’ E**