Transcript Exchange Rate Determination I: Prices and the Real Exchange Rate

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
122
Index (100 in 1990)
120
118
116
114
112
110
108
1998
1999
2000
2001
Effective Exchange Rate HK
2002
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).
P
 Define
E  Nominal Exchange Rate×
PF
 Real exchange rate can be calculated on a bilateral basis or an
index basis.
HK: US Real Exchange Rate
.22
.20
.18
.16
.14
.12
.10
.08
.06
1980
1985
1990
Real Exchange Rate
1995
2000
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.

1.
2.
3.
4.
Why doesn’t LoOP hold for
most goods?
Transport Costs – Large costs
of moving goods may keep
arbitrage from working.
Non-traded Goods – Some
goods, such as real estate,
have near infinite transport
prices.
Pricing-to-Market – Firms with
market power may find it
optimizing to charge different
prices in different markets.
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
F
P
XP 
P
 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
g
EXCHANGE RATE
  F 
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
Average Annual
Inflation Differential
with the US
8.00
I t al y
6.00
NZ
4.00
UK
2.00
0.00
-4.00
-2.00
Canada
Denmar k
Swi t z. 0.00 Ger many 2.00
-2.00
Fr ance
4.00
6.00
NL
Japan
-4.00
-6.00
A v e r a g e A n n u a l D e p r e c i a t i o n ( %) A g a i n s t t h e U S $
8.00
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
Year 2000
Indonesia
Hong Kong
China
Japan
Macau
Singapore
Philippines
Indonesia
Exchange
Rate
XP
0.128
0.150
0.121
0.522
0.009
0.006
0.125
0.203
0.580
0.724
0.023
0.091
0.022
0.130
Real
Exchange
Rate
0.858
0.231
1.448
0.613
0.801
0.249
0.171
Philippines
Singapore
Macau
Japan
China
Hong Kong
0
0.2
0.4
0.6
0.8
1
Real Exchange Rate w/ USA
1.2
1.4
1.6
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 ExportsServices 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
Financial
+ Financial
Account →
Account
=
+ Change in
Reserve Assets
(Debt Forgiveness, Patents)
Direct Investment
(FDI of Foreign Companies – FDI by
Domestic Companies)
+ 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)
-Accumulation of Foreign Exchange
Reserves
Hong Kong Current Account &
Capital Account 2001
Net
Goods
Services
Income
Current Transfers
Current Account
Capital Account
Direct Investment
Portfolio Investment
Financial Derivatives
Other Investment
Change in Reserves
Capital &Financial
Account
Credit
-64970
133468
41175
-13878
95795
 Hong Kong had a
Debit
1488982
323087
384595
4719
2201383
1553952
189619
343420
18597
2105588
96 million dollar
current account
surplus in 2001.
 Hong Kong had a
-9155
97 million dollar
Into HK
Abroad
96948
185424
88476
capital & financial
Foreign Holdings Holdings of
of Hong Kong
Foreign Assets
account deficit.
Assets
-322045
-9054
312992  The difference is
39640
-100507
-140147
133783
-327414
-461197
reserve assets.
-36530
-97359
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 + EXIM
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.

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.
2.


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.
Equilibrium Real Exchange Rates
E
S-I
E*
NX
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
S-I’
E
S-I
E**
NX