Chapter 18

Exchange Rate Determination I:

Prices and the Real Exchange Rate

Exchange Rate Crises & Hong Kong

HK Dollars, as currency, is printed by money center banks Standard Chartered, HSBC, and, now, Bank of China.

During the 1970’s, the banks faced little limitation on money creation. In July of 1982, the HK dollar was depreciating at a rate of 7.7% per year.

In 1983, Britain and the People’s Republic were engaged in talks about the terms on which Hong Kong would be returned to China. Responding to news from these talks, currency traders unloaded there HK dollar positions.

As a response, the Hong Kong dollar depreciated rapidly. By September 1983, the HK dollar was depreciating at a rate of 65% per year.

Policy Response: Currency Board

The government announced that Hong Kong would switch to a currency board system.

A currency board is an arrangement whereby a country can only issue domestic currency if it backed up by central bank holdings of a specific foreign currency.

To give permission to a money center bank to print 7.8 HK dollars, the government would have to acquire US$1.

This has been the monetary policy of Hong Kong ever since.

Objectives

Students should be able to define the real and nominal exchange rate.

Students should be able to define purchasing power parity and differentiate relative and absolute PPP. Explain why inflation in Hong Kong differs from the US.

Students should be able to demonstrate that the capital account is the negative of the current account.

Students should understand the effect of some events on the real exchange rates.

Bilateral Exchange Rate

Bilateral Exchange Rate is the exchange rate of one countries’ currency vs. another’s.

Exchange rates can be written in two ways which are inverses of each other.

Definition 1 The price of foreign currency in terms of domestic currency (the # of domestic currency units needed to purchase 1 unit of foreign currency)

HK$7.8 per 1 US$

Definition 2 The price of domestic currency in terms of foreign currency (the # of foreign currency units needed to purchase 1 unit of domestic currency.

US$.128 per 1 HK$

Terminology Typically, a bilateral

exchange rate is reported as the # of units of the currency with the lower value per unit of the currency of the higher value.

Examples HK$7.8 per 1 US$ ¥120.14 per 1 US$ US1.53 per 1 ₤

An appreciation of a currency is an increase in the value of a currency.

A depreciation is a decrease in value.

A depreciation would increase the exchange rate by Definition 1.

Ex. A movement of HK$7.8 to HK$10 per US is a depreciation.

A depreciation would decrease the exchange rate by Definition 2.

Ex. A movement of US$.127 to US$.1 would be a depreciation of HK dollar.

Exchange Rates

HK has a fixed bilateral exchange rate with the US. HK Exchange Fund (the currency board operated by HKMA) will buy or sell HK$ at a fixed exchange rate. No one will ever buy for more or sell for less.

Effective Exchange Rate is a weighted average of a country’s bilateral exchange rates [weights are by share of trade].

HK effective exchange rate fluctuates since US dollar fluctuates relative to important HK trading partners such as Japan, Germany, etc.

HK Effective Exchange Rate

108

110

112

114

116

118

120

122

1998 1999 2000 2001 2002

Effective Exchange Rate HK

Ind

ex

(10

0 in

19

90

)

Real Exchange Rate Real exchange rates are the price of domestic goods relative to

the price of foreign goods. In other words, real exchange rates are the # of foreign goods that must be given up to obtain 1 domestic good.

A foreigner compares the price of their foreign goods with the price of our domestic goods. To buy 1 foreign good, he must pay PF foreign currency units

where PF ≡ Foreign price level. To buy 1 domestic good, he must pay P domestic currency

units, but he must pay Nominal Exchange Rate × P. (using Definition 2).

Define

Real exchange rate can be calculated on a bilateral basis or an index basis.

F

PE Nominal Exchange Rate×

P

HK: US Real Exchange Rate

.06

.08

.10

.12

.14

.16

.18

.20

.22

1980 1985 1990 1995 2000

Real Exchange Rate US$ per HK$

Law of One Price (LoOP)

Arbitrage should insure that identical goods should sell for the same price in different markets.

For easily transportable, standardized goods sold in highly competitive markets (such as gold), LoOP holds.

Why doesn’t LoOP hold for most goods?

1. Transport Costs – Large costs of moving goods may keep arbitrage from working.

2. Non-traded Goods – Some goods, such as real estate, have near infinite transport prices.

3. Pricing-to-Market – Firms with market power may find it optimizing to charge different prices in different markets.

4. Tariffs & Taxes – Imported goods may face additional taxes

Purchasing Power Parity (PPP)

PPP theory says LoOP applies to all markets. Define relative prices of foreign goods

Absolute PPP says that the real exchange rate is always E = 1 or the Def. 2 of the Nominal exchange rate = XP

Relative PPP says that the growth rate of the real exchange rate is zero

FPXP P

EXCHANGE RATE Fg

Does PPP Hold?

Does Absolute or Relative PPP hold? In short run, NO. Exchange rates are much more

volatile than inflation rates. In long run for countries with similar levels of

development, PPP holds. Example. Twenty year averages for OECD countries.

Rapidly developing countries typically see long-term real exchange rate appreciations Hong Kong has had much faster inflation than the US

over the life of the exchange rate peg.

Long Run

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

-4.00 -2.00 0.00 2.00 4.00 6.00 8.00

Aver age Annual Depr eciation (%) Against the US $

Ave

rag

e A

nn

ual

In

flat

ion

Dif

fere

nti

al

wit

h t

he

US

J apan

NZ

Italy

Switz. Germany

NL

Denmark

UK

FranceCanada

Rich Countries are more expensive than poor countries. Many types of services have unchanging technology

(like haircuts) or inherently limited supply (like real estate).

Most technology advances occur in traded goods sector.

As a country grows wealthier and more technologically advanced, the countries residents will pay more for real estate or services.

If traded goods have roughly equal prices across countries, but a countries non-traded goods start to become more expensive as it develops, the overall relative price of its goods will increase.

XP vs. Exchange Rate

RealExchange ExchangeRate XP Rate

Hong Kong 0.128 0.150 0.858China 0.121 0.522 0.231Japan 0.009 0.006 1.448Macau 0.125 0.203 0.613Singapore 0.580 0.724 0.801Philippines 0.023 0.091 0.249Indonesia 0.022 0.130 0.171

Year 2000

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Hong Kong

China

Japan

Macau

Singapore

Philippines

Indonesia

Real Exchange Rate w/ USA

Current Account

The current account is, conceptually, the amount of income earned overseas less the amount of income earned by foreigners from the domestic economies.

Current Account = Balance on Goods (Goods Exports-Goods Imports)

+ Balance on Services (Services Exports-Services Imports)

+ Net Investment Income

(Investment Income Earned Overseas – Investment Income Paid to Foreigners)

+Net Transfers (Donations from Overseas)

Capital & Financial Account

The capital account (more accurately the capital & financial account) records capital inflows into the country. The account includes the financial account, the capital account, and change in reserve assets.

Capital &

Capital

Account

(Debt Forgiveness, Patents)

Financial + Financial Account →

Direct Investment (FDI of Foreign Companies – FDI by Domestic Companies)

Account=

+ Portfolio

Investment

(Domestic Securities Purchases by Foreigners – Foreign Securities Purchases by Domestic Residents)

+ Other Investments (Deposits in Domestic Banks by Foreigners – Deposits in Foreign Banks by Domestic Residents)

+ Change in Reserve Assets

-Accumulation of Foreign Exchange Reserves

Hong Kong Current Account & Capital Account 2001

Capital Account -9155Into HK Abroad

Direct Investment 96948 185424 88476Foreign Holdings Holdings ofof Hong Kong Foreign AssetsAssets

Portfolio Investment -322045 -9054 312992Financial Derivatives 39640 -100507 -140147Other Investment 133783 -327414 -461197Change in Reserves -36530Capital &Financial -97359Account

Hong Kong had a 96 million dollar current account surplus in 2001.

Hong Kong had a 97 million dollar capital & financial account deficit.

The difference is reserve assets.

Net Credit DebitGoods -64970 1488982 1553952Services 133468 323087 189619Income 41175 384595 343420Current Transfers -13878 4719 18597Current Account 95795 2201383 2105588

Net Savings = Net Exports

Capital Account = I – S Current Account = EX – IM S = GDP – C – G GDP = C + I + G + EX – IM → GDP – C – G = I + EX-

IM S = I + EX – IM → S – I = EX - IM

Net Capital Outflows = Goods Outflows When an economy provides more goods to the world

economy than it receives in return it will have extra foreign funds. These will be used to acquire foreign assets.

Real Exchange Rate and Net Exports

An increase in the real exchange rate has counter-veiling effects on net exports.

1. The value/price of a given amount of export goods will rise relative to a given amount of import goods when domestic goods increase in relative price. An economy exports 100 apples at price of $1 each and

imports 100 oranges at price of $1. Net exports are zero. If price of apples goes to $2, then net exports will increase to 100.

2. When relative price of domestic goods increases, the domestic economy will export fewer goods and import more goods.

In very short run, the first effect will dominate. In medium to long run, the second effect tends to dominate.

Equilibrium Real Exchange Rates

NX

S-IE

E*

Real Exchange Rate Determination

The real exchange rate, in the medium run, is determined by the position of savings and investment.

Shortfalls in domestic savings result in high real exchange rates and low net exports

Event S - I / NX E

Government Deficits

← ↑

Productivity

Boom

← ↑

Domestic Funds Shortfall

NX

S-IES-I’

E**