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 X Capital Inflow

Supply of domestic country’s (HK) currency Demand for M Capital outflow

amount of domestic currency 1 unit of foreign currency exchange rate e.g. HK$5 Au$1 S D Q amount of foreign currency

Appreciation Depreciation 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

Appreciation of Domestic Currency exchange rate S S’ HK$5 Au$1 HK$4.5 Au$1 D Q amount of foreign currency

Change in Supply demand for imports capital outflow people expect domestic currency depreciate supply of domestic currency depreciation of domestic currency

Depreciation of Domestic Currency exchange rate S HK$5.2 Au$1 HK$5 Au$1 D’ D Q amount of foreign 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

Appreciation of Domestic Currency exchange rate S S’ HK$5 Au$1 HK$4.5 Au$1 D Q amount of foreign currency

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

Depreciation of Domestic Currency exchange rate S HK$8.2 US$1 HK$7.8 US$1 D Q amount of foreign currency

Depreciation of Domestic Currency exchange rate S HK$5.2 Au$1 HK$5 Au$1 D’ D Q amount of foreign 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 exchange rate = HK$5/Au$1 Au$1 HK$5 (unchanged)

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 exchange rate = HK$5/Au$1 Au$1 HK$5.2 exchange rate = HK$5.2/Au$1 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 Revaluation 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.

amount of foreign currency HK$ Au$ exchange rate S fixed rate1 HK$5 Au$1 D Q amount of foreign currency

Devaluation of domestic currency HK$ US$ exchange rate Devaluation of domestic currency S HK$5.2 US$1 fixed rate2 fixed rate1 HK$5 Au$1 D Q amount of foreign currency

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.

Revaluation of domestic currency HK$ US$ exchange rate Revaluation of domestic currency S fixed rate1 HK$5 Au$1 D Q amount of foreign currency

Revaluation of domestic currency HK$ US$ exchange rate Revaluation of domestic currency S fixed rate1 HK$5 Au$1 fixed rate2 HK$4.5 Au$1 D Q amount of foreign currency

Balance of Payments Deficit

Balance of Payments Deficit HK$ US$ exchange rate S fixed rate HK$5 Au$1 D Q amount of foreign currency

Balance of Payments Deficit HK$ US$ exchange rate S’ S fixed rate HK$5 Au$1 D Bop deficit Q amount of foreign currency

amount of foreign currency HK$ Au$ exchange rate S’ fixed rate HK$5 Au$1 D Bop deficit Q amount of foreign currency

government increase the supply of foreign currency HK$ US$ exchange rate S’ S” fixed rate HK$5 Au$1 D Bop deficit Q amount of foreign currency

Balance of Payments Surplus

amount of foreign currency HK$ Au$ exchange rate S fixed rate HK$5 Au$1 D D’ Bop surplus Q amount of foreign currency

amount of foreign currency HK$ Au$ exchange rate S fixed rate HK$7.8 US$1 D’ Bop surplus Q amount of foreign currency

government increase the demand for foreign currency HK$ Au$ exchange rate government increase the demand for foreign currency S fixed rate HK$5 Au$1 D” D’ Bop surplus Q amount of foreign currency

amount of foreign currency HK$ US$ exchange rate Dirty Floating S upper limit HK$7.8 US$1 lower limit D Q amount of foreign currency

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 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

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 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 increase currency speculation and it is therefore destabilizing speculation can be stabilizing Fixed Exchange Rate one-way option speculation

Flexible Exchange Rate System 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 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.

US$1 Exchange Fund note issuing banks Certificate of Indebtedness (CIs) HK$7.8 US$ linked exchange rate HK$7.8 US$1 = other licensed banks and public

US$1 Exchange Fund note issuing banks Certificate of Indebtedness (CIs) HK$7.8 US$1 HK$7.8 linked exchange rate HK$7.8 US$1 = other licensed banks and public

The Process of Arbitrage US$1 Exchange Fund note issuing banks CIs (HK$7.8) HK$7.7 US$1 linked exchange rate HK$7.8 US$1 = open market rate HK$7.7 US$1 other licensed banks and public =

The Process of Arbitrage US$1 Exchange Fund note issuing banks CIs (HK$7.8) HK$7.9 US$1 linked exchange rate HK$7.8 US$1 = open market rate HK$7.9 US$1 other licensed banks and public =

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 C+I+G+X-M M trade deficit X 450 Y

Contractionay policy reduces trade deficit by reducing the income level. Expenditure C+I+G+X-M C+I+G’+X-M M trade deficit X 450 Y

effects of devaluation Expenditure C+I+G+X’-M’ C+I+G+X-M M trade deficit M’ X’ X 450 Y

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 D’ S D E’ E quantity of Yen

Al 90/7 (b) HK$/Yen S D S’ E E’ quantity of Yen

AL 90/7 (c) S’ (HK exports ) D’ (HK imports ) S D E’ E HK$/Yen quantity of Yen

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).

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

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

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 S S’ e* (official rate) D Quantity of foreign currency BOP deficit

Price of foreign currency S e2 B e1 A D’ D Quantity of foreign currency