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 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

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

18. Depreciation (effect on exports)
export prices in foreign currency
(Au$1 Au$0.96)
(export prices in domestic currency unchanged)
(HK$ HK$5)
Qd of X
export value ( P x Q) in domestic currency
(HK$5 x HK$5x 1200)

19. 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

20. Depreciation
import prices in domestic currency
(HK$ HK$5.2)
(import prices in foreign currency unchanged)
(Au$ Au$1)
Qd of M
value of imports ( P x Q) in domestic currency ?

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

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 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

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

28. 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

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. 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

31. 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

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

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

40. 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

41. 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

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

47. 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

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

51. 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

52. 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

53. 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

54. 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”

55. Policy Conflict inflation in domestic country BOP deficit
supply of foreign currency
government initiates contrationary policies to combat inflation

56. Policy Conflict if BOP deficit + unemployment
What should the government do?
contrationary policy (e.g. G ), or
expansionary policy (e.g. G )

57. Advantages of Fixed Exchange Rate
Certainty

58. The Hong Kong Linked Exchange Rate System (Oct. 1983 – Sept
The Hong Kong Linked Exchange Rate System (Oct – Sept – 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.

59. 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.

60. 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

61. 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

62. 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 =

63. 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 =

64. 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.

65. 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

66. inflation in HK X , M BOP deficit note-issuing banks’ demand for HK$Ms

67. US interest rate Hong Kong capital outflow
Hong Kong has to increase interest rate

68. 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.

69. AL 89/9
Expenditure
C+I+G+X-M M
trade deficit X
450 Y

70. 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

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

72. 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.

73. Al 90/7 (a)
HK$/Yen D’ S D E’ E
quantity of Yen

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

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

76. 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).

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

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

79. 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

80. Price of foreign currencyS S’ e*
(official rate) D
Quantity of foreign currency
BOP deficit

81. Price of foreign currencyS e2 B e1 A D’ D
Quantity of foreign currency