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Ka-fu Wong University of Hong Kong

Ka-fu Wong University of Hong Kong. Who determines the value of Renminbi? The Chinese government , the US government , or the market ?. ECON1001: Introduction to Economics, 2006 Fall. How is the price of an ordinary good (say, a bottle of wine) determined?. Price. Supply. Market. Demand.

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Ka-fu Wong University of Hong Kong

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  1. Ka-fu WongUniversity of Hong Kong Who determines the value of Renminbi? The Chinese government, the US government, or the market? ECON1001: Introduction to Economics, 2006 Fall

  2. How is the price of an ordinary good (say, a bottle of wine) determined? Price Supply Market Demand Quantity

  3. How is the price of a currency (say, Reminbi) determined? US$/yuan Supply Add supply Market Price regulation (ceiling or floor) Demand Yuan Quantity regulation

  4. Devaluation, Revaluation of Reminbi US$/yuan Supply Devaluation Reminbi becomes cheaper Revaluation Reminbi becomes more expensive Demand Yuan

  5. Depreciation, Appreciation of Japanese Yen US$/yen Supply New supply Depreciation Yen becomes cheaper Appreciation Yen becomes more expensive Demand yen

  6. How is the price of a currency (say, Reminbi) determined? • Arbitrage: • Purchasing Power Parity • Uncovered interest parity • Covered interest parity

  7. Four Student Canteens at HKU Main Library Annex Chong Yuet Ming Amenties Centre Haking Wong Bldg SWIRE Hall

  8. Prices of Big Mac CYM MacDonald SWIRE MacDonald Case 1 7.80 15.60 What would you do?

  9. What would you do? Choose the cheaper MacDonald for lunch. Buy Big Mac from CYM and sell at SWIRE.

  10. Effect of our action Choose the cheaper MacDonald (CMY) for lunch. Buy Big Mac from CMY and sell at SWIRE. At SWIRE More supply of Big Mac, less demand for Big Mac Price of Big Mac falls. At CMY Greater demand for Big Mac, less supply for Big Mac Price of Big Mac increases.

  11. What would you do in the absence of transaction costs? CYM MacDonald SWIRE MacDonald Case 2 PCYM > PSWIRE PSWIRE < Case 3 PCYM

  12. Arbitrage activities continue until prices equalize. Punch line: Arbitrage is a strong driving force to equalize prices.

  13. Prices of Big Mac (assume 1USD = 7.8 HKD) HK MacDonald US MacDonald HKD 7.80 USD 1 Case 4 Case 5 HKD 15.60 USD 1

  14. Prices of Big Mac (assume 1USD = e HKD) HK MacDonald US MacDonald Case 7 PHK > e  PUS Case 8 < PHK e  PUS

  15. Arbitrage activities continue until prices equalize That is, PHK = e  PUS and e = PHK / PUS

  16. Purchasing Power Parity Prices of the same good at different locations, when expressed in the same currency, have to equalize. That is, PHK = e  PUS Exchange rate implied by PPP e = PHK / PUS

  17. Purchasing Power Parity PHK = e  PUS Three variables in the relation: e PUS PHK Knowing any two of them, we can compute the third. If e is fixed, PUS has to adjust when there is a change in PHK . If PUS is fixed, e has to adjust when there is a change in PHK .

  18. Other arbitrage opportunities across space • International phone call: • HK direct to Beijing (Price= P1) • HK to Canton province, from where the call is redirected to Beijing (Price= P2) • Arbitrage opportunities exists when P1 P2, or P1-P2  0. • Arbitrage activities (though illegal) will drive P1-P2 towards zero.

  19. Arbitrage opportunities across space A P1 X P2 B

  20. Other arbitrage opportunities across space • Buying or selling Japanese Yen • HKD direct to JPY (Price= P1) • HKD to Swedish Krona and Swedish Krona to Yen (Price= P2) • Arbitrage opportunities exists when P1 P2, or P1-P2  0. • Arbitrage activities will drive P1-P2 towards zero.

  21. Arbitrage across time Today Tomorrow Stock prices < 150 142 If cost of interest is zero, one would like to buy stock today, hold it for a day and sell it tomorrow. Profit= 8.

  22. Arbitrage across time in real life In real life, interest rate is nonzero and we do not know tomorrow’s stock price for sure. Thus, economic theory has to adjust for these factors but still uses this idea of arbitrage.

  23. What does PPP tell us about exchange rates? • “Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.” (http://www.economist.com/markets/bigmac/about.cfm, subscription required)

  24. Big Mac Index, The Economist, May 25th 2006

  25. Why is Big Mac Index so far off from the actual exchange rates? Adjustment of prices slow in general (price rigidity) Transportation takes time (some goods are perishable) Other factors (and also noise) that determines the exchange rate. Noise  need to use econometrics (economic statistics) to test the theory

  26. There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s exchange rate? US$/yuan Supply Demand Yuan

  27. There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s exchange rate? At least three markets in each country: goods, labor. and money. China domestic US domestic Yuan $ S S D D Foreign exchange market $/Yuan S D Yuan

  28. Why would the US want to see a revaluation of Reminbi? US$/yuan Supply Demand Yuan

  29. What would be the consequence of a 20% revaluation of Reminbi on (1) China, (2) Hong Kong, (3) US and western countries, (4) Japan and the newly industrialized countries, (5) Developing countries US$/yuan Supply 20% revaluation Demand Yuan

  30. Consider all options for China to reform its regime. Why did China choose the basket peg over its alternatives? • Exchange Arrangements with No Separate Legal Tender • Currency Board Arrangements • Other Conventional Fixed Peg Arrangements • Pegged Exchange Rates within Horizontal Bands • Crawling Pegs • Exchange Rates within Crawling Bands • Managed Floating with No Predetermined Path for the Exchange Rate • Independently Floating

  31. What is your prediction of the Reminbi exchange rate in a few years time? Give your reasons. • 7.8 yuan = 1 USD? About 4 %?

  32. References: • Taylor, Alan M. and Mark P. Taylor (2004): “The Purchasing Power Parity Debate,” NBER Working Paper No. 10607. • Chang, Gene (2006) “How Much is Chinese Currency Undervalued? A QuantitativeEstimation,” Mimeo, Shanghai University of Finance and Economics. • McKinnon, Ronald (2006): “China’s Exchange Rate Appreciation in the Light of the Earlier Japanese Experience,” Mimeo, Stanford University

  33. End

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