Exchange Rate System

1. Exchange Rate System Flexible Exchange Rate System Fixed Exchange Rate System Linked Exchange Rate System

2. Flexible Exchange Rate System • Demand for domestic country’s (HK) currency • Demand for X • Capital Inflow

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

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

5. 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

6. Change in Demand • demand for X • capital inflow • people expect domestic currency appreciate demand for domestic currency appreciation of domestic currency

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

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

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

10. Domestic Price Level • domestic price level • X (demand for domestic currency) • M (supply of domestic currency) • depreciation of domestic currency

11. Interest Rate • domestic interest rate • capital inflow (demand for domestic currency) • appreciation of domestic currency

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

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

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

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

16. 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.

17. HK$5 exchange rate = HK$5/Au$1 Depreciation Au$1 HK$5 (unchanged) exchange rate = HK$5.2/Au$1 Au$0.96

18. 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)

19. HK$5 exchange rate = HK$5/Au$1 Depreciation (effect on imports) Au$1 HK$5.2 exchange rate = HK$5.2/Au$1 Au$1

20. 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 ?

21. elastic inelastic unitarily elastic value of imports in domestic currency unchanged If demand for imports is

22. 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

23. 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

24. Fixed Exchange Rate System

25. 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

26. 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.

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

28. 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

29. 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.

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

31. 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

32. Balance of Payments Deficit

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

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

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

36. 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

37. Balance of Payments Surplus

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

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

40. 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

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

42. Foreign Exchange Control • prohibit or restrict the purchase of foreign exchange • black market will emerge

43. 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

44. 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

45. 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

46. Foreign country Ms inflation r Domestic country Ms inflation r Monetary Interdependence under Fixed Exchange Rate System

47. 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 Comparison between Flexible and Fixed Exchange Rate Systems

48. 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

49. 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

50. 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