Exchange Rate Systems

1. This chapter deals with exchange rate systems. We first consider the concept of exchange rate, and then discuss the operations and adjustment mechanisms under the floating exchange rate system and the fixed exchange rate system. We also provide a brief history of the international monetary and exchange rate systems, which can help us to examine the advantages and disadvantages of the two exchange rate systems. Exchange Rate Systems Exchange Rate Systems Advanced Level Macroeconomics Advanced Level Microeconomics Dr. Lam Pun Lee Dr. Lam Pun Lee

2. US$1 ¥100 P.124 -- 12.2 Exchange Rate • is the amount of domestic currency exchanged for one unit of foreign currency • is the price of foreign currency in terms of domestic currency

3. In Japan, ¥100 = US$1  ¥140 = US$1  the exchange value of US$ ;  the value of foreign currency (US$) in terms of domestic currency (¥);  the value of domestic currency (¥) in terms of foreign currency (US$) ;

4. Export goods & services P.126 Receive foreign investments & loans = BoP credit Price of US$1 in terms of ¥ S 100 Import goods & services P.125 D Make foreign investments & loans = BoP debit Quantity of US$

5. Price of US$1 in terms of ¥ D Quantity of US$ The demand curve is downward sloping. The exchange rate of the US$ (in terms of ¥)   the domestic prices (in ¥) of imported goods from the USA will  (given Pf in US$ as constant)  the quantity demanded of imports   Japan’s quantity demanded (Qd of M X Pf) of US$ 

6. The supply curve is upward sloping. Price of US$1 in terms of ¥ The exchange rate of the US$ (in terms of ¥)  S  the foreign prices in US$ of Japan’s exported goods will  (given Pd in ¥ as constant)  the quantity demanded of Japan’s exports   US’s quantity supplied (TR in US$) of US$ only if foreign demand for local Japan exports is price elastic Quantity of US$

7. Price of ¥1 in terms of US$ Price of US$1 in terms of ¥ S S 0.01 100 D D Quantity of ¥ Quantity of US$ Textbook P.128 – C.1. a demand for a foreign currency  a supply of domestic currency a supply of foreign currency  a demand for domestic currency

8. Current Foreign Exchange Rate Arrangements Figure 33-7

9. 10.4.1.3 Floating Exchange Rate System

10.  Demand for & supply of foreign exchange  International balance of payments Export & import Capital movement  Exchange rate

11. Price of US$1 in terms of ¥ S D1 Quantity of US$ D2 P.130 Depreciation Depreciation of local currency ¥ is when the external value of a currency falls in the foreign exchange market. Example: In Japan, demand for imports from the USA   Demand curve for US$ will shift to the right  exchange rate of US$  depreciation of ¥

12. Price of US$1 in terms of ¥ S D1 Quantity of US$ D2 P.130 Appreciation Appreciation of local currency ¥ is when the external value of a currency rises in the foreign exchange market. Example: Demand for imports from the USA   Demand curve for US$ will shift to the left  exchange rate of US$  appreciation of ¥

13. 10.4.1.4 Factors Affecting the Exchange Rate

14. 1. Relative change in national income When the national income of Japan  the demand for imported goods & services   the demand for US$   the exchange value of US$  & Japanese ¥ depreciates

15. 2. Relative change in price Higher inflation in Japan  the price of exported goods relative to the USA   exports to the USA   the supply of US$   the price of imported goods relative to the USA   imports from the USA   the demand for US$   the exchange value of US$  & Japanese ¥ depreciates

16. 3. Relative change in interest rate Real interest rate of Japan  capital inflow to Japan   the supply of US$   capital outflow from Japan  the demand for US$   the exchange value of US$ & Japanese ¥ appreciates

17. The Exchange Rate Interest Rate Parity • Money is worth what it can earn. • Interest rate parity means equal interest rates.

18. The Exchange Rate Interest Rate Parity If the interest rate on the dollar is higher in the United States than another, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal.

19. 10.4.1.5 Purchasing Power Parity (PPP)

20. The Exchange Rate Purchasing Power Parity • Money is worth what it will buy. • Purchasing power parity means equal value of money.

21. The PPP theory states that all countries’ pricesare equal when measured in terms of the same currency. Example: US$1 = ¥100 Price of a big Mac in the USA = US$2 Price of a big Mac in Japan = ¥ 200 Price of a big Mac in Japan = US$2

22. Price of a good in Country A Price of a good in Country B > Price of a good in Country A Price of a good in Country B = Arbitrage Buy low and sell high

23. The PPP theory also states that the exchange rate between any countries’ currencies adjust to reflect differences in the price levels (or inflation rate) in the two countries. Example: If the inflation rate in Japan is 5% higher than that in the USA, the Japanese yen will depreciates against US$ by 5%.

24. The Exchange Rate Purchasing Power Parity • If prices increase in Canada and other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise. • Supply of (fall) and demand for (rise) dollars change • The exchange rate changes (rise), US$ appreciate

25. 10.4.1.6 Fixed exchange Rate System

26. The fixed exchange rate system is the system whereby the exchange rate is set by a government or by agreement among countries (Lam 1996: 297). In a country adopting a fixed exchange rate system, the monetary authority of the country buys and sells foreign currencies to maintain the value of its domestic currency in the foreign exchange market.

27. Price of US$1 in terms of ¥ S2 S1 100 D1 D2 Quantity of US$

28. Price of US$1 in terms of ¥ S P2 P1 D1 Quantity of US$ D2 P.130 Devaluation Devaluation is when the value of a currency relative to one or more other currencies is lowered by the monetary authority. Example: If the Japanese government changes the fixed exchange rate from P1 to P2  the exchange value of foreign currencies (US$)   devaluation of ¥

29. Price of US$1 in terms of ¥ S P1 P2 D1 Quantity of US$ D2 P.130 Revaluation Revaluation is when the value of a currency relative to one or more other currencies is raised by the monetary authority. Example: If the Japanese government changes the fixed exchange rate from P1 to P2  the exchange value of foreign currency (US$)   a revaluation of ¥

30. 10.4.2.1 BoP Adjustment under a Floating Exchange Rate System

31. BOP deficit BOP surplus Figure 5 Floating exchange rate and balance of payments Advanced Level Macroeconomics Advanced Level Microeconomics Dr. Lam Pun Lee Dr. Lam Pun Lee P(HK$) P(HK$) S S D1 D2 D2 D1 0 0 US$ US$ (b) (a)

32. Under a floating exchange rate system, the market mechanism would operate to restore equilibrium simultaneously in the BOP and the exchange rate. Whenever a country experiences a BOP deficit, the country’s currency will depreciate to restore equilibrium in the BOP. Whenever a country experiences a BOP surplus, the country’s currency will appreciate to restore equilibrium in the BOP.

33. 1. A balance of payments deficit Whenever a country experiences a BOP deficit, the country’s currency will depreciate to restore equilibrium in the BOP. Example: BOP deficit  excess demand for foreign currency  exchange value of foreign currency  & depreciation of domestic currency  prices of exported goods in foreign currency  & prices of imported goods in domestic currency   Export  & Import   BOP deficit   ...  equilibrium/balanced market BoP

34. 2. A balance of payments surplus Whenever a country experiences a BOP surplus, the country’s currency will appreciate to restore equilibrium in the BOP. Example: BOP surplus  excess supply of foreign currency  exchange value of foreign currency  & appreciation of domestic currency  prices of exported goods in foreign currency  & prices of imported goods in domestic currency   Export  & Import   BOP surplus   ...  equilibrium in BoP/balanced market BoP

35. 10.4.2.2 Marshall-Lerner Condition

36. Depreciation  export prices in foreign currency  (export prices in domestic currency unchanged)  quantity demanded for exports  • export value (TR) in domestic currency  • As TR = Constant P X Bigger Q Depreciation  import prices in domestic currency  (import prices in foreign currency unchanged)  quantity demanded for imports   Elastic demand for imports  import value (TR) in domestic currency 

37. The Marshall-Lerner condition says that depreciation (or in fixed ERS, devaluation) will improve the balance of payments position of a country provided that the sum of elasticities of foreign demand for domestic exports and domestic demand for imports is greater than unity (1).

38. 10.4.2.3 BoP Adjustment under a Fixed Exchange Rate System

39. Under a fixed exchange rate system, the country’s currency is backed up with foreign currencies.

40. 1. A balance of payments deficit When there is a BOP deficit (e.g. X < M), the foreign reserves of that country will fall. This also implies a fall in the country’s money supply. Price (fall) and real interest rate (rise) adjustment can restore the BoP to equilibrium/balanced market BoP.

41. 1. A balance of payments deficit  Foreign exchange reserves  Price adjustment  Money supply   Domestic price level   Relative price of exports   Exports   Relative price of imports   Imports   BOP deficit  until balanced market BoP

42. 1. A balance of payments deficit  Foreign exchange reserves  Interest rate adjustment  Money supply   Interest rate   Capital inflows  & Capital outflows   BOP deficit  until balanced market BoP

43. 2. A balance of payments surplus When there is a BOP surplus, the foreign reserves of that country will rise. This also implies a rise in the country’s money supply. Price (rise) and real interest rate (fall) adjustment can restore the BoP to equilibrium/balanced market BoP.

44. 2. A balance of payments surplus  Foreign exchange reserves  Price adjustment  Money supply   Domestic price level   Relative price of exports   Exports   Relative price of imports   Imports   BoP surplus  until balanced market BoP

45. 1. A balance of payments surplus  Foreign exchange reserves  Interest rate adjustment  Money supply   Interest rate   Capital inflows  & Capital outflows   BoP surplus  until balanced market BoP Defects & desirability => Notes P.22 –10.4.2.3.2

46. 10.4.3 Other Measures of Correcting Payments Imbalances

47. Although there is an automatic adjustment mechanism under a fixed exchange rate system, the system may work very s…l….o…..w.…..l…….y. Therefore, some governments would like to employ other measures to help correct the BoP Imbalances more quickly.

48. Limitation: It may invite retaliation  X   Receipts  Balance of payments may even be worsen off. 1. Trade restriction ( e.g. Tariff, quota, etc.) Deficit: M   Payments   Deficit 

49. Surplus: Expansionary fiscal policy  Aggregate demand   National income   Imports   Payments   Surplus   …  equilibrium in BOP 3. Fiscal policy Deficit: Contractionary fiscal policy  G  or T   AD   National income   Imports   Payments   Deficit   …  equilibrium in BOP

50. Surplus: Expansionary monetary policy  Money supply   Interest rate   Capital inflow  & Capital outflow   Surplus   …  equilibrium in BOP 3. Monetary policy Deficit: Contractionary monetary policy  Money supply   Interest rate   Capital inflow  & Capital outflow   Deficit   …  equilibrium in BOP