2. Exchange Rate Systems This chapter deals with exchange rate systems. We first consider the concept of exchange rate, and then discuss the operations and adjustment mechanisms under the floating exchange rate system and the fixed exchange rate system. We also provide a brief history of the international monetary and exchange rate systems, which can help us to examine the advantages and disadvantages of the two exchange rate systems. Dr. Lam Pun Lee Advanced Level Microeconomics Advanced Level Macroeconomics

3. 2 P.124 -- 12.2 Exchange Rate is the amount of domestic currency exchanged for one unit of foreign currency is the price of foreign currency in terms of domestic currency US$1 ¥100

4. 3 Figure 1Demand and Supply curves of foreign currency D S 7.8 0 Quantity of US$ Price of US$1 in terms of HK$

5. 4 Figure 2Demand and Supply curves of domestic currency D S 0.128 0 Quantity of HK$ Price of HK$1 in terms of US$

6. 5 P.124 B Price in foreign currency  Price in domestic currency ? Domestic price = Foreign price * exchange rate Pd = Pf * e Example ¥100 = US$1 Pf = US$2 Pd = ?

7. 6 In Japan, ¥100 = US$1  ¥140 = US$1  the exchange value of US$  ;  the value of foreign currency (US$) in terms of domestic currency (¥)  ;  the value of domestic currency (¥) in terms of foreign currency (US$)  ;

8. 7 Price of US$1 in terms of ¥ Quantity of US$ 100 D S Export goods & services P.126 Receive foreign investments & loans = BoP credit Import goods & services P.125 Make foreign investments & loans = BoP debit

9. 8 The demand curve is downward sloping. Quantity of US$ D Price of US$1 in terms of ¥ The exchange rate of the US$ (in terms of ¥)   the domestic prices (in ¥) of imported goods from the USA will  (given Pf in US$ as constant)  the quantity demanded of imports   Japan’s quantity demanded (Qd of M X Pf) of US$ 

10. 9 The supply curve is upward sloping. Quantity of US$ S Price of US$1 in terms of ¥ The exchange rate of the US$ (in terms of ¥)   the foreign prices in US$ of Japan’s exported goods will  (given Pd in ¥ as constant)  the quantity demanded of Japan’s exports   US’s quantity supplied (TR in US$) of US$  only if foreign demand for local Japan exports is price elastic

11. 10 Price of US$1 in terms of ¥ Quantity of US$ 100 D S Price of ¥1 in terms of US$ Quantity of ¥ 0.01 D S a demand for a foreign currency  a supply of domestic currency a supply of foreign currency  a demand for domestic currency Textbook P.128 – C.1.

12. 11 Exchange Rate Systems = P.129 Fixed exchange rate system

13. 12 Current Foreign Exchange Rate Arrangements Figure 33-7

14. 13

15. 14 Exchange rate Demand for & supply of foreign exchange International balance of payments Export & importCapital movement

16. 15  Exchange rate  Demand for & supply of foreign exchange  International balance of payments  Export & import  Capital movement

17. 16 BoP under different ERSs Wong (2000: 129)

18. 17 P.130 Depreciation Depreciation of local currency ¥ is when the external value of a currency falls in the foreign exchange market. Example: In Japan, demand for imports from the USA   Demand curve for US$ will shift to the right  exchange rate of US$   depreciation of ¥ Price of US$1 in terms of ¥ Quantity of US$ D1 S D2

19. 18 P.130 Appreciation Appreciation of local currency ¥ is when the external value of a currency rises in the foreign exchange market. Example: Demand for imports from the USA   Demand curve for US$ will shift to the left  exchange rate of US$   appreciation of ¥ Price of US$1 in terms of ¥ Quantity of US$ D1 S D2

20. 19 The Exchange Rate

21. 20

22. 21 1. Relative change in national income  the demand for imported goods & services   the demand for US$   the exchange value of US$  & Japanese ¥ depreciates When the national income of Japan 

23. 22 2. Relative change in price  the price of exported goods relative to the USA   exports to the USA   the supply of US$   the exchange value of US$  & Japanese ¥ depreciates Higher inflation in Japan  the price of imported goods relative to the USA   imports from the USA   the demand for US$ 

24. 23

25. 24

26. 25

27. 26 3. Relative change in interest rate  capital inflow to Japan   the supply of US$   the exchange value of US$ & Japanese ¥ appreciates Real interest rate of Japan   capital outflow from Japan   the demand for US$ 

28. 27 The Exchange Rate Interest Rate Parity –Money is worth what it can earn. –Interest rate parity means equal interest rates.

29. 28 The Exchange Rate Interest Rate Parity If the interest rate on the dollar is higher in the United States than another, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal.

30. 29

31. 30 The Exchange Rate Purchasing Power Parity –Money is worth what it will buy. –Purchasing power parity means equal value of money.

32. 31 Example: US$1 = ¥100 Price of a big Mac in the USA = US$2 The PPP theory states that all countries’ prices are equal when measured in terms of the same currency. Price of a big Mac in Japan = ¥ 200 Price of a big Mac in Japan = US$2

33. 32 Arbitrage Price of a good in Country A > Price of a good in Country B Buy low and sell high Price of a good in Country A = Price of a good in Country B

34. 33 Example: If the inflation rate in Japan is 5% higher than that in the USA, the Japanese yen will depreciates against US$ by 5%. The PPP theory also states that the exchange rate between any countries’ currencies adjust to reflect differences in the price levels (or inflation rate) in the two countries.

35. 34

36. 35 The Exchange Rate Purchasing Power Parity –If prices increase in Canada and other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise. –Supply of (fall) and demand for (rise) dollars change –The exchange rate changes (rise), US$ appreciate

37. 36

38. 37 The fixed exchange rate system is the system whereby the exchange rate is set by a government or by agreement among countries (Lam 1996: 297). In a country adopting a fixed exchange rate system, the monetary authority of the country buys and sells foreign currencies to maintain the value of its domestic currency in the foreign exchange market.

39. 38 Price of US$1 in terms of ¥ Quantity of US$ 100 D1 S1 D2 S2

40. 39 P.130 Devaluation Devaluation is when the value of a currency relative to one or more other currencies is lowered by the monetary authority. Example: If the Japanese government changes the fixed exchange rate from P1 to P2  the exchange value of foreign currencies (US$)   devaluation of ¥ D2 Price of US$1 in terms of ¥ Quantity of US$ D1 S P1 P2

41. 40 P.130 Revaluation Revaluation is when the value of a currency relative to one or more other currencies is raised by the monetary authority. Example: If the Japanese government changes the fixed exchange rate from P1 to P2  the exchange value of foreign currency (US$)   a revaluation of ¥ D2 Price of US$1 in terms of ¥ Quantity of US$ D1 S P1 P2

42. 41

43. Figure 5Floating exchange rate and balance of payments 0 US$ P(HK$) S D1D1 D2D2 0 US$ P(HK$) S D1D1 D2D2 (a) (b) BOP deficit BOP surplus Dr. Lam Pun Lee Advanced Level Microeconomics Advanced Level Macroeconomics

44. 43 Under a floating exchange rate system, the market mechanism would operate to restore equilibrium simultaneously in the BOP and the exchange rate. Whenever a country experiences a BOP deficit, the country’s currency will depreciate to restore equilibrium in the BOP. Whenever a country experiences a BOP surplus, the country’s currency will appreciate to restore equilibrium in the BOP.

45. 44

46. 45

47. 46 1. A balance of payments deficit Example: BOP deficit  excess demand for foreign currency  exchange value of foreign currency  & depreciation of domestic currency  prices of exported goods in foreign currency  & prices of imported goods in domestic currency   Export  & Import  ...  equilibrium/balanced market BoP Whenever a country experiences a BOP deficit, the country’s currency will depreciate to restore equilibrium in the BOP.  BOP deficit 

48. 47 2. A balance of payments surplus Example: BOP surplus  excess supply of foreign currency  exchange value of foreign currency  & appreciation of domestic currency  prices of exported goods in foreign currency  & prices of imported goods in domestic currency   Export  & Import  ...  equilibrium in BoP/balanced market BoP Whenever a country experiences a BOP surplus, the country’s currency will appreciate to restore equilibrium in the BOP.  BOP surplus 

49. 48

50. 49  export prices in foreign currency  (export prices in domestic currency unchanged)  quantity demanded for exports  Depreciation   export value (TR) in domestic currency    As TR = Constant P X Bigger Q  import prices in domestic currency  (import prices in foreign currency unchanged)  quantity demanded for imports  Depreciation Elastic demand for imports  import value (TR) in domestic currency  

51. 50 The Marshall-Lerner condition says that depreciation (or in fixed ERS, devaluation) will improve the balance of payments position of a country provided that the sum of elasticities of foreign demand for domestic exports and domestic demand for imports is greater than unity (1).

52. 51

53. 52 Under a fixed exchange rate system, the country’s currency is backed up with foreign currencies.

54. 53 When there is a BOP deficit (e.g. X < M), the foreign reserves of that country will fall. This also implies a fall in the country’s money supply. Price (fall) and real interest rate (rise) adjustment can restore the BoP to equilibrium/balanced market BoP. 1. A balance of payments deficit

55. 54  Foreign exchange reserves   Domestic price level  Price adjustment  Relative price of exports   Exports   Money supply   Relative price of imports   Imports   BOP deficit  until balanced market BoP 1. A balance of payments deficit

56. 55  Foreign exchange reserves   Interest rate  Interest rate adjustment  Money supply   Capital inflows  & Capital outflows   BOP deficit  until balanced market BoP 1. A balance of payments deficit

57. 56 When there is a BOP surplus, the foreign reserves of that country will rise. This also implies a rise in the country’s money supply. Price (rise) and real interest rate (fall) adjustment can restore the BoP to equilibrium/balanced market BoP. 2. A balance of payments surplus

58. 57  Foreign exchange reserves   Domestic price level  Price adjustment  Relative price of exports   Exports   Money supply   Relative price of imports   Imports   BoP surplus  until balanced market BoP 2. A balance of payments surplus

59. 58  Foreign exchange reserves   Interest rate  Interest rate adjustment  Money supply   Capital inflows  & Capital outflows   BoP surplus  until balanced market BoP 1. A balance of payments surplus Defects & desirability => Notes P.22 –10.4.2.3.2

60. 59

61. 60 Although there is an automatic adjustment mechanism under a fixed exchange rate system, the system may work very s…l….o…..w.…..l…….y. Therefore, some governments would like to employ other measures to help correct the BoP Imbalances more quickly.

62. 61 1. Trade restriction ( e.g. Tariff, quota, etc.) M   Payments   Deficit  Deficit: It may invite retaliation  X   Receipts  Balance of payments may even be worsen off. Limitation:

63. 62 3. Fiscal policy Contractionary fiscal policy  G  or T   AD   National income   Imports   Payments   Deficit   …  equilibrium in BOP Deficit: Expansionary fiscal policy  Aggregate demand   National income   Imports   Payments   Surplus   …  equilibrium in BOP Surplus:

64. 63 3. Monetary policy Contractionary monetary policy  Money supply   Interest rate   Capital inflow  & Capital outflow   Deficit   …  equilibrium in BOP Deficit: Expansionary monetary policy  Money supply   Interest rate   Surplus   …  equilibrium in BOP Surplus:  Capital inflow  & Capital outflow 

65. 64 4. Devaluation and revaluation Need devaluation  M  & X   Deficit  if (i) the Marshall-Lerner condition is fulfilled (ii) the country has idle production capacity Deficit: Need revaluation  M  & X   Surplus  if the Marshall-Lerner condition is fulfilled Surplus:

66. 65 Effects on the neighborhood countries of the devaluation Goods of these countries is much cheaper relative to Hong Kong’s Effect on tourist and import-export Effect on investment and hence economic growth

67. 66

68. 67 Floating Exchange RateFixed Exchange Rate A floating exchange rate system frees the govern- ment from taking care of the BOPs condition and allows it to use its resources exclusively to maintain internal balance. Maintaining internal & external balances The government must hold adequate reserves to maintain the fixed rate & must take measures to correct external imba- lances if the automatic adjustment mechanism works too slowly. Sometimes, there may be conflicts in maintaining internal and external balances

69. 68 The case for and against floating exchange rates For Monetary policy autonomy Exchange rates as automatic stabilizers Against Discipline problem Destabilizing speculation and money market disturbances Injury to international trade and investment

70. 69 For floating : monetary policy autonomy Under fixed exchange rate system, countries other than the reserve center cannot have monetary policy: –Have to adjust money supply (and hence the interest rate) to maintain the exchange rate at a fixed level  if they have no restriction on capital flow. Hence no control on inflation. –Have to impose restriction on international payments if we want some autonomy in monetary policy  distorting international trade

71. 70 Against fixed : Tradeoff between fixed exchange rate regime and monetary policy autonomy Under fixed exchange rate regime, a country cannot use monetary policy to affect output Monetary policy, if any, serves to fix the exchange rate In other words, for fixed exchange rate regime, we sacrifice monetary policy as a tool to affect the economy Currency board system is one form of fixed exchange rate regime.

72. 71 For floating : Exchange rates as automatic stabilizers A temporary fall in export demand => fall in domestic currency demand => domestic currency depreciates => cheaper export => more Qd for export

73. 72 Against floating : Discipline Government might embark on over-expansionary fiscal or monetary policy, falling into the inflation bias trap  because no need to worry about losses of foreign reserves.

74. 73 Against floating : Destabilizing speculation and money market disturbances Anything that fluctuates, including floating exchange rate, can be speculated. Speculation may lead to –instability in foreign exchange markets and hence –negative effect on countries’ internal and external balances. Disturbances (temporary) to the home money market could be more disruptive under floating than under a fixed rate.

75. 74 Against floating : Injury to international trade and investment Fluctuating exchange rates implies more uncertain returns on investment and prices of goods traded internationally. Theoretically, exchange rate risk may be avoided through a transactions in the forward exchange market. –May be costly to use.

76. 75

77. 76 The Gold Standard Experimentation in exchange rate systems The Bretton Woods Systems The mixed system 19301940 1970 Time

78. 77

79. 78 External Balance occurs when a country’s BOP position is in balance. Internal balance occurs when a country can attain low unemployment and low inflation.

80. 79 It can happen that a country pursues fiscal and monetary policies to achieve internal balance, but that these may have the opposite effect with respect to external balance. Whether there is a conflict between the objectives of internal and external balance depends on both the initial payments position and the domestic situation.

81. 80 inflation unemployment B.O.P Surplus B.O.P. Deficit C D B A

82. 81 1. Payments deficit with deflationary gap (A)  close the deflationary gap Expansionary policy  further increase in the payments deficit  conflict

83. 82 2. Payments deficit with inflationary gap (B)  close the inflationary gap Contractionary policy  reduce the payments deficit  no problem

84. 83 3. Payments surplus with deflationary gap (C)  close the deflationary gap Expansionary policy  reduce the payments surplus  no problem

85. 84 4. Payments surplus with inflationary gap (D)  close the inflationary gap Contractionary policy  further increase the payments surplus  conflicit

86. 85

87. 86 PeriodExchange Rate RegimeFeatures 1863-1935Silver StandardSilver dollars as legal tender 12/1935 -6/1972 Sterling Exchange Standard Exchange rate £1: HK$16 (12/38-11/67) £1: HK$14.55 (11/67-6/72) 7/1972 -11/1974 Fixed Exchange Rate Against US$ Exchange rate US$1: HK$5.630 (6/72-2/73) US$1: HK$5.085 (2/73-11/74) 11/1974 -10/1983 Free Floating Exchange rate US$1: HK$4.965 (25/11/1974) US$1: HK$4.6 (6/3/1978) US$1: HK$9.6 (24/9/1983) 10/1983 - now Linked Exchange Rate System US$1: HK$7.8 (for issues and redemption of Certificates of Indebtedness)

88. 87 Figure 3The linked exchange rate system Market exchange rate determined by market forces Note-issuing banksExchange Fund Other licensed banksNon-bank public HK$ notes traded at US$1 = HK$7.80 HK$ Certificates of Indebtedness issued or redeemed at US$1 = HK$7.80

89. 88

90. 10.4.6 Adjustment mechanisms and official settlement 10.4.6.1 Currency Notes Arbitrage Linked Rate HK$:US$ = 7.8:1.0 Free Market Rate HK$:US$ = 8.0:1.0

91.   BoP deficit => free market rate is weaker than the linked rate   Bank X sells US$1,000 for HK$ in the market Local Bank HK$8000 HK$7800 (in currency notes)   Bank X then recoups from the Currency Board US$1,000 (paying HK$7,800 in currency notes) Profit of HK$200 for Bank X Market exchange rate back to linked rate foreign reserve assets of the Currency Board

92. 91

93. 92

94. 93

95. Effectiveness of currency notes arbitrage will depend on: (i)commitment of the Currency Board on the Convertibility Undertaking (ii)whether banks charge a high fee for handling large amounts of currency notes (iii)whether transaction costs in moving large amounts of currency notes is high (iv) attitude of arbitrageurs towards the 2-day time lag (v) transferability between aggregate balance of banking sector and currency notes (vi)whether convertibility undertaking covers aggregate balance at the pegged rate

96. Interest Rate Adjustment to ensure exchange rate stability Financial Inflow (whether initiated by commercial banks or by their customers) Financial Inflow External Value of HK$ Currency Board Foreign Reserve Assets Commercial Banks Foreign Reserves Aggregate Balance of Commercial Banks Interbank Interest Rates Interest Rate Differencial (Vis-a-vis rest of the World) Interest Rate Arbitrage Opportunities Financial Outflow Offsetting (+ve) (-ve) (+ve) (-ve) (+ve)

97. 96 A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. Under the linked exchange rate system of Hong Kong, which of the following statements is true? 2 1 3 4

98. 97 Under the linked exchange rate system of Hong Kong, which of the following statements is true? 1 Only banknotes and coins are required to be fully backed up by the US dollar. Deposits are not included. A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. 2 1 3 4

99. 98 Under the linked exchange rate system of Hong Kong, which of the following statements is true? Only the official rate is fixed. The market rate fluctuates. 2 A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. 2 1 3 4

100. 99 Under the linked exchange rate system of Hong Kong, which of the following statements is true? The depreciation of the USD against other currencies implies more expensive imports to Hong Kong, as the external value of the HK dollar against other currencies must follow that of the USD. 3 A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. 2 1 3 4

101. 100 Under the linked exchange rate system of Hong Kong, which of the following statements is true? The balance of visible trade is not directly determined by the exchange rate between two currencies. 4 A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. 2 1 3 4

102. 101 Under the linked exchange rate system of Hong Kong, which of the following statements is true? C A.The money supply M1 of Hong Kong has to be fully backed up by the US dollar. B.The market exchange rate of the HK dollar relative to the US dollar is fixed. C.Hong Kong will decrease its imports when the US dollar depreciates against other currencies. D.Hong Kong will always have a visible trade deficit. 2 1 3 4

103. 102

104. 103 Effective exchange rate (Trade weighted) indices for HK dollars (Nov 1983 = 100) Source: Hong Kong Monthly Digest of Statistics.

105. 104 Effective Exchange Rate Indices REER back to pre-crisis level Not a strong impediment to competitiveness Exchange Rates 199719981999 Dec

106. Figure 5Monthly average trade-weighted EERI for the Hong Kong dollar Source: Hong Kong Monthly Digest of Statistics Dr. Lam Pun Lee Advanced Level Microeconomics Advanced Level Macroeconomics