Exchange Rate System

Flexible Exchange Rate System Fixed Exchange Rate System Linked Exchange Rate System

Flexible Exchange Rate System

Demand for domestic countrys (HK) currency
Demand for X Capital Inflow

 Supply of domestic countrys (HK) currency Demand for M Capital outflow

exchange rate amount of domestic currency 1 unit of foreign currency

S

e.g. HK$5
Au$1

D Q

amount of foreign currency

Appreciation
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

exchange rate

Appreciation of Domestic Currency

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

exchange rate

Depreciation of Domestic Currency

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

exchange rate

Appreciation of Domestic Currency

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

exchange rate

Depreciation of Domestic Currency

S

HK$8.2 US$1 HK$7.8 US$1

D Q

amount of foreign currency

exchange rate

Depreciation of Domestic Currency

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 Au$1 exchange rate

= HK$5/Au$1

HK$5 (unchanged) Au$0.96

exchange rate = HK$5.2/Au$1

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 Au$1 exchange rate

= HK$5/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

value of imports in domestic currency elastic
inelastic unitarily elastic 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
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.

exchange rate

HK$
Au$

HK$5 Au$1

fixed rate1

D Q

amount of foreign currency

exchange rate

HK$
US$

Devaluation of domestic currency

S

HK$5.2 US$1 HK$5 Au$1

fixed rate2 fixed rate1

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.

exchange rate

HK$
US$

Revaluation of domestic currency

S

HK$5 Au$1

fixed rate1

D
Q

amount of foreign currency

exchange rate

HK$
US$

Revaluation of domestic currency

S

HK$5 Au$1 HK$4.5 Au$1

fixed rate1 fixed rate2

D
Q

amount of foreign currency

Balance of Payments Deficit

exchange rate

HK$
US$

Balance of Payments Deficit

HK$5 Au$1

fixed rate

D
Q

amount of foreign currency

exchange rate

HK$
US$

Balance of Payments Deficit

S S

HK$5 Au$1

fixed rate

D
Bop deficit Q

amount of foreign currency

exchange rate

HK$
Au$

HK$5 Au$1

fixed rate

D
Bop deficit Q

amount of foreign currency

exchange rate

HK$
US$

government increase the supply of foreign currency

S S

HK$5 Au$1

fixed rate

D
Bop deficit Q

amount of foreign currency

Balance of Payments Surplus

exchange rate

HK$
Au$

HK$5 Au$1

fixed rate

D
Bop surplus

D
Q

amount of foreign currency

exchange rate

HK$
Au$

HK$7.8 US$1

fixed rate

D
Bop surplus Q

amount of foreign currency

exchange rate

HK$
Au$

government increase the demand for foreign currency S

HK$5 Au$1

fixed rate

D
Bop surplus

D
Q

amount of foreign currency

exchange rate

HK$
US$

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

Domestic country
Ms inflation

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 undervalued 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

Flexible Exchange Rate 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 selffulfilling

Disadvantages of Flexible Exchange Rate System

Flexible Exchange Rate
increase currency speculation and it is therefore destabilizing speculation can be stabilizing

Fixed Exchange Rate

one-way option speculation

Flexible Exchange Rate System

Flexible Exchange Rate 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. 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 note issuing banks HK$7.8 US$ linked exchange rate = HK$7.8 US$1 other licensed banks and public Exchange Fund

Certificate of Indebtedness (CIs)

US$1 note issuing banks Exchange Fund

HK$7.8 US$1

Certificate of Indebtedness (CIs)

HK$7.8 linked exchange rate = HK$7.8 US$1

other licensed banks and public

The Process of Arbitrage US$1 note issuing banks Exchange Fund

CIs
HK$7.7 US$1 (HK$7.8) linked exchange rate = HK$7.8 US$1

open market rate

other licensed banks and public = HK$7.7 US$1

The Process of Arbitrage US$1 note issuing banks Exchange Fund

CIs
HK$7.9 US$1 (HK$7.8) linked exchange rate = HK$7.8 US$1

open market rate

other licensed banks and public = HK$7.9 US$1

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 freemarket 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

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

effects of devaluation
Expenditure C+I+G+X-M C+I+G+X-M

trade deficit

X X

450

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 E

quantity of Yen

Al 90/7 (b)
HK$/Yen

S D

E E

quantity of Yen

AL 90/7 (c)
HK$/Yen

D (HK imports

S (HK exports S

E E

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 a. 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)

ec
(official rate)

D Mc

Quantity of foreign currency

Price of foreign currency

S e2
(black market rate)

e1
(black market rate)

ec
(official rate)

D
D Mc

Quantity of foreign currency

96/8 Under a fixed exchange rate system Country A overvalues 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 BOP deficit Quantity of foreign currency

Price of foreign currency

S

e2

e1

D
D

Quantity of foreign currency