Transcript Multi-fiber agreement

Who determines the value of Renminbi?
The Chinese government, the US government, or the market?
Ka-fu Wong
University of Hong Kong
ECON1001: Introduction to Economics, 2006 Fall
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How is the price of an ordinary good (say, a bottle of wine)
determined?
Price
Supply
Market
Demand
Quantity
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How is the price of a currency (say, Reminbi) determined?
US$/yuan
Supply
Add supply
Market
Price regulation
(ceiling or floor)
Demand
Quantity regulation
Yuan
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Devaluation, Revaluation of Reminbi
US$/yuan
Supply
Devaluation
Reminbi becomes cheaper
Revaluation
Reminbi becomes more expensive
Demand
Yuan
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Depreciation, Appreciation of Japanese Yen
US$/yen
Supply
Depreciation
Yen becomes cheaper
New supply
Appreciation
Yen becomes more expensive
Demand
yen
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How is the price of a currency (say, Reminbi) determined?
 Arbitrage:
 Purchasing Power Parity
 Uncovered interest parity
 Covered interest parity
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Four Student Canteens at HKU
Main Library Annex
Chong Yuet Ming
Amenties Centre
Haking Wong Bldg
SWIRE Hall
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Prices of Big Mac
CYM MacDonald
Case 1
7.80
SWIRE MacDonald
15.60
What would you do?
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What would you do?
Choose the cheaper MacDonald for lunch.
Buy Big Mac from CYM and sell at SWIRE.
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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.
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What would you do in the absence of
transaction costs?
CYM MacDonald
SWIRE MacDonald
Case 2
PCYM
>
PSWIRE
Case 3
PCYM
<
PSWIRE
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Arbitrage activities continue until prices
equalize.
Punch line:
Arbitrage is a strong driving force to
equalize prices.
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Prices of Big Mac (assume 1USD = 7.8 HKD)
HK MacDonald
US MacDonald
Case 4
HKD 7.80
USD 1
Case 5
HKD 15.60
USD 1
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Prices of Big Mac (assume 1USD = e HKD)
HK MacDonald
US MacDonald
Case 7
PHK
>
e  PUS
Case 8
PHK
<
e  PUS
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Arbitrage activities continue until prices equalize
That is,
PHK = e  PUS and
e = PHK / PUS
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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
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Purchasing Power Parity
PHK = e  PUS
Three variables in the relation:
e
PHK
PUS
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 .
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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.
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Arbitrage opportunities across space
A
P1
X
P2
B
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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.
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Arbitrage across time
Today
Stock
prices
142
Tomorrow
<
150
If cost of interest is zero,
one would like to buy stock today, hold it for a day
and sell it tomorrow. Profit= 8.
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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.
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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)
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Big Mac Index, The Economist, May 25th 2006
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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
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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
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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
$/Yuan
S
D
Yuan
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Why would the US want to see a revaluation of Reminbi?
US$/yuan
Supply
Demand
Yuan
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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
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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







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What is your prediction of the Reminbi exchange rate in a few
years time? Give your reasons.
 7.8 yuan = 1 USD? About 4 %?
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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 Quantitative
Estimation,” 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
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End
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