1. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV1 HKCEE Macroeconomics vChapter 8 vExchange Rates and the Balance of Payments

2. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV2 Demand for Foreign Currencies wpayment for foreign imports We supply domestic currencies in the foreign exchange market in exchange for foreign currencies We demand for foreign currencies for: D foreign Currencies  S domestic currencies wmaking foreign investments

3. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV3 Supply of Foreign Currencies wpayment for domestic exports Foreign countries supply foreign currencies in the foreign exchange market in exchange for domestic currencies D domestic Currencies  S foreign currencies wmaking domestic investments Foreign countries demand for domestic currencies for: Task 1: Textbook/P.214/Q.10.1

4. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV4 Exchange Rates Example: wUS$1 = HK$7.8  HK$1 = US$0.129 An exchange rate is the price of a currency in terms of another currency. WThe exchange rate of US dollars in terms of HK dollars is 7.8 WThe exchange rate of HK dollars in terms of US dollars is 0.129

5. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV5 Floating Exchange Rate System Under the floating/flexible exchange rate system, the exchange rate of a currency is determined by its demand and supply.

6. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV6 Floating Exchange Rate System Example: US$1 = HK$8 Exchange rate of US$ (in terms of HK$) Quantity of US$ 0 DS 8 Q

7. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV7 Floating Exchange Rate System Example: US$1 = HK$8  US$1 = HK$9 wAppreciation of a currency occurs if: Appreciation of a currency occurs if its exchange rate rises Wits demand rises Wits supply falls Wits demand rises and supply falls

8. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV8 Floating Exchange Rate System Example: US$1 = HK$8  US$1 = HK$7 wDepreciation of a currency occurs if: Depreciation of a currency occurs if its exchange rate falls. Wits demand falls Wits supply rises Wits demand falls and supply rises

9. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV9 Floating Exchange Rate System Example: wBefore appreciation of US$: Appreciation of a foreign currency implies depreciation of local currency. WUS$1 = HK$8  HK$1 = US$0.129 wAppreciation of US$ (against HK$): WUS$1 = HK$8  US$1 = HK$9 WHence, HK$1 = US$0.129  HK$1 = US$0.111

10. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV10 Floating Exchange Rate System Example: wBefore depreciation of US$: Depreciation of a foreign currency implies appreciation of local currency. WUS$1 = HK$8  HK$1 = US$0.129 wDepreciation of US$ (against HK$): WUS$1 = HK$8  US$1 = HK$7 WHence, HK$1 = US$0.129  HK$1 = US$0.143

11. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV11 Fixed Exchange Rate System Under a fixed exchange rate system, the exchange rate of a currency is fixed by the government or monetary authority. The fixed rate should be kept at a level different from the market rate.

12. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV12 Fixed Exchange Rate System w Example: US$1 = HK$8  US$1 = HK$9 Revaluation of a currency occurs if the fixed rate is raised. w Example: US$1 = HK$8  US$1 = HK$7 Devaluation of a currency occurs if the fixed rate is decreased. Task 2: Textbook/P.217/Q.10.3

13. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV13 Linked Exchange Rate System v to govern the issuing of banknotes v to help stabilize the exchange rate of HK$ in terms of US$ Functions:

14. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV14 Linked Exchange Rate System v linked rate: US$1 = HK7.8 v applies to the exchange of US$ for HK$ between note-issuing banks & Exchange Fund, other banks & note-issuing banks Operations: v buying and selling of the Certificates of Indebtedness (CI) with US$ v difference between the linked and market rates will be cleared by engaging arbitrage

15. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV15 Linked Exchange Rate System v if market rate: US$1 = HK$7 v arbitrage occurs: If linked rate > market rate… W buying US$ at market rate (HK$7) W selling US$ at linked rate (HK$7.8) W buying US$ in the foreign exchange market W  a larger demand for US$ W  appreciation of US$ (say US$1 = HK$7.5)   appreciation stops if ↑ market rate = linked rate

16. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV16 Linked Exchange Rate System v if market rate: US$1 = HK$9 v arbitrage occurs: If linked rate < market rate… W buying US$ at linked rate (HK$7.8) W selling US$ at market rate (HK$9) W selling US$ in the foreign exchange market W  a larger supply for US$ W  depreciation of US$ (say US$1 = HK$8)   depreciation stops if ↓ market rate = linked rate

17. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV17 Effects of Changes in Exchange Rate v Example: If foreign currency appreciates/revalues Price of USA imports = US$1000 Before US$ appreciates: US$1 = HK$8 W  price of USA imports in terms of HK$ = HK$(8 × 1000) = HK$8000 After US$ appreciates: US$1 = HK$9 W  price of USA imports in terms of HK$ = HK$(9 × 1000) = HK$9000  ＋ HK$1000

18. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV18 Effects of Changes in Exchange Rate v Price of foreign imports in terms of local currency will rise If foreign currency appreciates/revalues   ↓ demand for foreign imports (by local consumers)

19. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV19 Effects of Changes in Exchange Rate v Example: If foreign currency appreciates/revalues Price of HK exports = HK$7800 Before US$ appreciates: US$0.125 = HK$1 W  price of HK exports in terms of US$ = US$(0.125 × 7800) = US$975 After US$ appreciates: US$0.111 = HK$1 W  price of HK exports in terms of US$ = US$(0.111 × 7800) = US$865.8  － US$109.2

20. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV20 Effects of Changes in Exchange Rate v Price of domestic exports in terms of foreign currency will fall If foreign currency appreciates/revalues   ↑ demand for domestic exports (by foreign countries)

21. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV21 Effects of Changes in Exchange Rate v Example: If foreign currency depreciates/devalues Price of USA imports = US$1000 Before US$ appreciates: US$1 = HK$8 W  price of USA imports in terms of HK$ = HK$(8 × 1000) = HK$8000 After US$ depreciates: US$1 = HK$7 W  price of USA imports in terms of HK$ = HK$(7 × 1000) = HK$7000  － HK$1000

22. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV22 Effects of Changes in Exchange Rate v Price of foreign imports in terms of local currency will fall If foreign currency depreciates/devalues   ↑ demand for foreign imports (by local consumers)

23. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV23 Effects of Changes in Exchange Rate v Example: If foreign currency depreciates/devalues Price of HK exports = HK$7800 Before US$ appreciates: US$0.125 = HK$1 W  price of HK exports in terms of US$ = US$(0.125 × 7800) = US$975 After US$ depreciates: US$0.143 = HK$1 W  price of HK exports in terms of US$ = US$(0.143 × 7800) = US$1115.4  ＋ US$140.4

24. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV24 Effects of Changes in Exchange Rate v Price of domestic exports in terms of foreign currency will rise If foreign currency depreciates/devalues   ↓ demand for domestic exports (by foreign countries) Task 3: Textbook/P.219/MCQ 1 /P.220/MCQ 2

25. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV25 Balance of Payments (BOP) v a set of statistical statements The Balance Of Payments Account v that systematically summarizes the economic transactions of an economy with the rest of the world, v in a specified period of time, usu. a year or quarter

26. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV26 Balance of Payments (BOP)  payments to other countries → debit side In the BOP Account… v two major accounts:  receipts by the country → credit side W the current account W the capital and financial account

27. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV27 The Current Account 1. Visible Trade, i.e. imports & exports of physical goods W the balance of trade (or trade balance) = value of exports of goods － value of imports of goods = value of (domestic exports ＋ re-exports) － value of imports vIt measures flow of real resources

28. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV28 The Current Account 2. Invisible Trade, i.e. imports & exports of services W the balance of invisible trade = value of exports of services － value of imports of services Task 4: Textbook/P.221/MCQ 3

29. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV29 The Current Account 3. Income WFactor incomes WNet factor income from abroad = factor incomes earned by residents from outside the economy － factor incomes earned by non-residents within the economy WMajor items: Wdirect investment income Wportfolio investment income Wother investment income Wcompensation of employees

30. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV30 The Current Account 4. Current Transfers Wunilateral flow of real and financial resources WIncluding gifts, grants, remittance & aids WIf linked to acquiring or disposing fixed assets, cash transfer is regarded as current transfer. Task 5: Textbook/P.223/MCQ 4 /P.224/MCQ 5 /P.225/Q.10.5

31. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV31 The Capital & Financial Account v Components: W capital transfers W non-produced & non-financial assets W Investments W reserve assets v Remark: Detailed classifications of the capital and financial account is NOT required in the HKCEE syllabus.)

32. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV32 v the Capital Account W It measures external transactions in capital transfers and non-produced/non-financed assets (such as patents & copyrights). W Capital inflows lead to credit while outflows lead to a debit. The Capital & Financial Account W A capital transfer is a transfer of ownership of a fixed asset or forgiveness of a liability.

33. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV33 v the Financial Account W It shows how an economy’s external transactions are financed.  It aims at acquiring lasting interest & influence in managing an overseas enterprise The Capital & Financial Account 1. Direct Investment:  Example: external investment in (overseas) real estate

34. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV34 v the Financial Account 2. Portfolio Investment:  It refers to investment in non-resident equities (i.e. stocks & shares), debt securities (e.g. bonds) and financial derivatives (e.g. options & warrants)  It involves NO lasting interest or influence in managing an overseas enterprise The Capital & Financial Account

35. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV35 v the Financial Account 3. Other Investment:  It refers to other financial claims (NOT classified as direct investment, portfolio investment or reserve assets) on and liabilities to non-residents.  Examples: short-term & long-term non-marketable loans & deposits. The Capital & Financial Account

36. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV36 v the Financial Account 4. Reserve Assets:  It consists of external assets (e.g. gold and foreign currencies) for (1) directly financing payment imbalances (i.e. BOP deficit/surplus) and (2) for indirectly regulating the magnitude of such imbalances by intervening the exchange rate of an economy in the foreign exchange markets. The Capital & Financial Account  It is readily available to and controlled by monetary authorities of an economy Task 6: Textbook/P.228/Q.10.6

37. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV37 vby excluding the changes in reserve assets, we may have BOP imbalances. The BOP Deficit or Surplus BOPFinancial Status Balanced BOPTotal receipts = Total payments BOP DeficitTotal receipts < Total payments BOP SurplusTotal receipts > Total payments Task 7: Textbook/P.229/MCQ 7

38. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV38 v Changes in Reserve Assets W With BOP deficit:  BOP deficit → outflow of gold/foreign currencies → credit the account → the BOP account gets balanced BOP Imbalances & Reserve Assets  BOP surplus → inflow of gold/foreign currencies → debit the account → the BOP account gets balanced W With BOP surplus:

39. By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV39 vAn economy may have balance of payment (BOP) deficit, surplus or balance, depending total receipts and total payments. BOP and BOP Account vHowever, according to accounting conventions (double-entry), the sum of all credit items is always equal to the sum of all debit items, the balance of payment (BOP) account is always in balance. Closer Look 10.5: Textbook/P.229-230