5b Chapter 7 - Exchange Rate

Economics
Chapter 7
Exchange rate
Currencies
Do
you know these currencies?
Currencies
Currencies
Currencies
Currencies
Currencies
Currencies
Major currencies
USA: US Dollar [Code: USD; Sign: $]
British: Pound sterling [Code: GBP; Sign: ]
Europe: Euro [Code: EUR; Sign:]
China: Renminbi [Code: RMB; Sign: ]
Hong Kong Dollar [Code: HKD; Sign: $]
Japanese yen [Code: JPY; Sign: ]
Currencies
Why do we need foreign currencies?
Purchasing materials in foreign countries
Travelling
Investment
Remittances to relatives or friends
Etc.
Exchange rate
Exchange rate
the price at which two currencies are exchanged
the price of a foreign currency in terms of

the local currency, or vice versa
convertibility rate
Exchange rate
Expression (assume USD and HKD)
1.
The exchange rate of USD
.US$
1 can be converted into HK$ 7.8
.HKD/USD
= 7.8 / 1 = 7.8
Exchange rate
Expression
2.
(assume USD and HKD)
The exchange rate of HKD
.HK$
1 can be converted into US$
.USD/HKD
Floating exchange rate
Exchange rate is
Free-floating
Depends on market demand and supply
Appreciation
A rise in exchange rate
Depreciation
A fall in exchange rate
Appreciation
USD Euro
Date
1 April 2011
1 May 2011
US$1 equals
0.7
0.8
The USD appreciates relative to the EUR
HKD JPY
Date
1 April 2011
1 May 2011
HK$1 equals
10.40
11.00
The HKD appreciates relative to the JPY
Depreciation
USD Euro
Date
1
1 April
April 2011
2011
US$ = US$1.43
1 May 2011
US$ = US$1.25
The EUR depreciates relative to the USD
HKD JPY
1 equals
Date
1
1 April
April 2011
2011
JP1 equals
HK$ = HK$0.096
1 May 2011
HK$ = HK$0.091
The JPY depreciates relative to the HKD
Floating exchange rate

Appreciation: exchange rate
Depreciation: exchange rate
There is only one exchange rate between two currencies.

Appreciation of one currency = Depreciation of the other
Linked exchange rate system in HK

Since 1983
HKD linked with USD at a fixed exchange rate
Aim: To maintain stability of the exchange rate between H

KD and USD
Exchange rate: US$1:HK$7.757.85
Controlled by the HKSAR Govt (HKMA)
Brief history of linked exchange rates syste

m in HK:
History of Hong Kong's Exchange Rate System
Period
Exchange rate regime
18631935
Silver Standard
December 1935
Sterling exchange
June 1972
July 1972
November 1974
Fixed exchange rate

against the US dollar
November 1974
October 1983
Free floating
1983Present
Linked exchange rate

system
Features
Silver dollars as legal tender
Standard exchange rate:1:HK$16 (December 1935
November 1967)
1:HK$14.55 (November 1967June 1972)
Exchange rate:US$1:HK$5.650 (June 1972February 1973)
US$1:HK$5.085 (February 1973November 1974)
Exchange rates on selected days:US$1:HK$4.965 (25
November 1974)
US$1:HK$9.600 (24 September 1983)
US$1:HK$7.80 (19831998)
(for issue and redemption of Certificates of Indebtedness)
US$1:HK$7.75 (19982005)
(The HKMA undertakes to convert the HK dollars in licensed
banks clearing accounts maintained with the HKMA into US
dollars at the fixed exchange rate of HK$7.75 to US$1. The
rate has been moving to 7.80 by 1 pip each calendar day
starting from 1 April 1999 ending 12 August 2000.)
US$1:HK$7.757.85 (May 2005 onwards)
HKMA set up upper and lower guaranteed limit since 18 May
2005
Source: http://en.wikipedia.org/wiki/Hong_Kong_dollar

Revaluation
Originally, HKMA fixed the rate at US$1:HK$7.8
If HKMA set the rate at US$1:HK$6

(meaning that less HK dollar can be bought by US$1)
(value of HK dollar increases)
the rate of HKD against USD rises
The government re-pegs exchange rate at a higher level

Devaluation
Originally, HKMA fixed the rate at US$1:HK$7.8
If HKMA set the rate at US$1:HK$9

(meaning that more HK dollar can be bought by US$1)
(value of HK dollar decreases)
the rate of HKD against USD falls
The government re-pegs exchange rate at a lower level
Difference:
Exchange rate system
Floating
Fixed
Exchange rate is determined by
Market
Government
Increase
Appreciation
Revaluation
Decrease
Depreciation
Devaluation
USA
China
Exchange rate of
local currency
against foreign
currency
Example countries

Strong reserves support
A currency board system
HK monetary base is support by USD
Maintain the exchange rate when issuing banknotes

Operation
The bank is going to issue $7,800,000 banknotes
It needs to pay USD of equivalent value (US$ 1 : HK$7.8) to HKM
A to buy Certificate of Indebtedness [CIs] ( )
As a support for banknotes issued
In this case, the bank pays US$1 million to HKMA
US$ 1: HK$7.8
Certificates
of
Indebtedness
HKMA
* In reverse, banks return HKD & CIs to the HKMA and get back the USD.

Exchange rates change with the USD
Under the linked exchange rate system, the exchange rates of the HKD agains
t other foreign currencies change with the USD.
Date
US$1 equals
(EUR/USD)
US$1 equals
(Linked exchange
rate system,
HKD/USD)
Euro 1 equals
(HKD/EUR)
1 April 2011
0.7
HK$ 7.8
HK$HK$11.14
1 May 2011
0.8
HK$ 7.8
HK$HK$9.75
USD appreciates
against EUR
Fixed
EUR depreciates against HKD,

(i.e. HKD appreciates against EUR)
Against other currencies
if USD appreciation HKD appreciation (against other currencies)

if USD depreciation HKD depreciation (against other currencies)
HK people suffer from RMB appreciation

Exchange rates change with the USD
RMB appreciates against USD
since 1994
Since 2006, exchange rose quickly
USD depreciation is faster
HKD is linked to USD,
so HKD follows USD and
depreciates against RMB sharply
Meaning that HK people needs to
pay more HKD to buy products from
the mainland
Before that, HK people went shopping
in the mainland
Nowadays, mainland visitor come to HK
for shopping
RMB annual average middle exchange

rate from USD and HKD
(1 foreign currency unit to RMB)
year
US dollar
HK dollar
1996
8.3142
1.07510
1997
8.2898
1.07090
1998
8.2791
1.06880
1999
8.2783
1.06660
2000
8.2784
1.06180
2001
8.2770
1.06080
2002
8.2770
1.06070
2003
8.2770
1.06240
2004
8.2768
1.06230
2005
8.1917
1.05300
2006
7.9718
1.02620
2007
7.6040
0.97459
2008
6.9451
0.8919
2009
6.8310
0.8812
Source: http://en.wikipedia.org/wiki/List_of_Renminbi_exchange_rates
Balance of payment (BOP) account

Definition
The record of an economys receipts and payments arising from

external transactions
BOP account of HK
For a specific time period

Economic transactions between HK residents and non-residents

Components of the BOP account:
A.
B.
Current account ( )
Capital and financial account ( )
BOP account
Current account
All external
transactions not
included in capital &
financial account
Capital and
financial account
International
purchases or sales of
assets
Capital transfers

A. Current account:
1.
.
.
.
Goods (visible trade)

Net receipt brought by merchandise trade ( )
Receipt: Exports of goods, e.g. garments, jewellery
Payment: Imports of goods, e.g. rice, cars
Balance of visible trade = Total exports of goods Total imports of goods
Types of BOT:
Trade deficit ( )
Exports < Imports
BOT < 0
Balance BOT ( )
Exports = Imports
BOT = 0
Trade surplus ( )
Exports > Imports
BOT > 0

A. Current account:
2.
Services (invisible trade)
Net receipt brought by services
Receipt: Exports of services, e.g. local airline
Payment: Imports of services, e.g. World Cup broadcasting
Balance of invisible trade = Total exports of services Total imports of services

A. Current account:
Factor income
Net income from abraod
All forms of investment income
3.
.
.
Dividends
Interest from deposit
Net income from abroad

= Factor income from abroad Factor income paid abroad
4.
.
.
.
Current transfers
Unilateral ( ) transfer of goods and capital
No economic value being received in return
For example: donations, remittances

A. Current account balance:
Total balance of the 4 components:
Visible trade
Invisible trade
Factor income
Current transfer
Current account balance
= Balance of (Goods + Services + Factor income + Current
transfer)

Given the following table, calculate the current account balance of HK
: Components
Value ($ million)
Exports of goods
500
Imports of goods
200
Exports of services
350
Imports of services
100
Dividends from USA company
50
Compensation to employees in Europe
80
Donation to Japan
120

= ( $500 - $200 + $350 - $100 + $50 - $80 - $120 ) million
= $400 million

B. Capital and financial account:
It records investment and capital transfers between local residents and
non-residents and changes in reserve assets
Capital transfer
External transactions in non-produced, non-financial assets
External investment
-----------------------------------------------------------------------------------
Changes in reserve assets (the govt buys or sells assets, e.g. gold)
A. Current account balance:
Capital transfer
External transactions in non-produced, non-financial assets
External investment
-----------------------------------------------------------------------------------
Changes in reserve assets (the govt buys or sells assets, e.g. gold)
Balance of BOP
BOP
Total balance of the 4 components:

Visible trade
Invisible trade
Factor income
Current transfer

* Think about money inflow (to HK) or outflow (to other countries)
(Textbook p.13)
Transaction
Capital flow
Balance of capital and

financial account
A US resident buys shares in a listed company

in Hong Kong.
Inflow / Outflow
Increase / Decrease
A Hong Kong resident transfers his deposits

from a local bank too an overseas bank.
Inflow / Outflow
Increase / Decrease
A Hong Kong resident buys a property in the

mainland.
Inflow / Outflow
Increase / Decrease
A Hong Kong company sells the patent of a

product to a Japanese company.
Inflow / Outflow
Increase / Decrease
A mainland resident sells his property in Hong

Kong.
Inflow / Outflow
Increase / Decrease
A US company sets up a branch office in Hong

Kong
Inflow / Outflow
Increase / Decrease
BOP
= Balance of Current Acc. +

Balance of Capital and financial Acc. (excluding reserve asset transaction)
Balance ($)
(A) Current account
(B) Capital and financial account
(1) Balance of capital and financial account
excluding reserve asset transactions
(2) Reserve assets (net change)
BOP = (A) + (B1)
- 1,000
1,000
800
200
- 200
Balance of BOP
= Balance of Current Acc. + Balance of Capital and financial Acc.

=0
Balance (HK$ million)
(A) Current account [ (1) + (2) + (3) + (4) ]
(1) Goods
(2) Services
(3) Factor income
(4) Current transfer
(B) Capital and financial account
(C) Net errors and omissions
Balance of BOP = [ (A) + (B) + (C) ]
100,000
-50,000
80,000
40,000
30,000
- 135,000
35,000
Total = 0

According to the accounting rule:
Balance of BOP account must be zero.
i.e. Balance of BOP

= Current acc. balance + Capital and financial balance
=0
If balance of BOP 0, the difference will be counted as

Net errors and omissions.
The meaning of BOP

1.
BOP deficit
HK buys thing from the USA
Payment to USA
HK has nothing to sell to the USA
No receipts from USA
$1000
USA
HK
$0
HK has no additional money for receipt.

Need to pay from its reserves asset.
reserves assets
. BOP deficit
will be found if the payments

of an economy are larger than its receipts
in its external transactions excluding reserve asset transactions.
The meaning of BOP

2.
BOP surplus
HK sells thing to the USA
Receipts from USA
HK buys nothing from the USA
No payments to USA
$0
USA
HK
$1000
HK has received payment.

reserves assets
. BOP surplus
will be found if the receipts

of an economy are larger than its payments
The meaning of BOP

3.
Balanced BOP
HK sells thing to the USA
Receipts from USA
HK buys thing from the USA
Payments to USA
$1000
USA
HK
$1000
HK has received and made payments.

reserves assets remains unchanged
. Balanced
BOP will be found if the receipts

of an economy equal to its payments
The meaning of BOP

Summary
Reserve assets
BOP
BOP deficit
Balanced BOP
BOP surplus
[ receipts < payments ]
0
[ receipts = payments ]
+
[ receipts > payments ]
Actual
Shown in
balance sheet of BOP
+ ve
Unchanged
- ve
Example: Below is the balance of payment account of a country

Balance
(HK$
million)
Current account
Goods
Services
Factor income
Current transfers
Capital and financial account
Balance of capital and financial account excluding reserve asset transactions
Reserve assets (net change)
580
-430
120
-40
-250
X
Answer the questions based on the information above.

a.
Suppose the domestic exports of goods are $650 million and imports of goods ar
e $200 million. Find the value of re-exports. (2%)
b.
Find the current account balance. (2%)
c.
Find the value of X. What is the change in the reserve assets? Find the balance o
f payments. (4%)

Balance
(HK$
million)
Current account
Goods
Services
Factor income
Current transfers
580
-430
120
-40
-250
X
a. Suppose the domestic exports of goods are $650 million and imports of goods are $2
00 million. Find
the value of re-exports. (2%)
Answer:
Balance of goods trade = Exports of goods + Re-exports of goods Total imports of goods
$580 million = $650 million + Re-exports - $200 million
The value of re-export = ( $580 + $200 - $650 ) million = $130 million

Balance
(HK$
million)
Current account
Goods
Services
Factor income
Current transfers
b. Find the current account balance. (2%)

Answer:
Current account balance = ($580 - $430 + $120 - $40 ) million = $230 million
580
-430
120
-40
-250
X

Balance
(HK$
million)
Current account
Goods
Services
Factor income
Current transfers
580
-430
120
-40
-250
X
c. Find the value of X. What is the change in the reserve assets? Find the balance of pa
yments.
Answer: Balance of BOP = Bal. of current acc. + Bal. of capital and financial acc. = $0
i.e.
$230 million - $250 million +X = 0

X = $20 million
Since reserve assets decrease by $20 million, we can see BOP deficit.
BOP = $230 million - $250 million = - $20 million
National income identity and the BOP

Current
X = Total exports of goods and services

M = Total imports of goods and services
Assume:
account balance (CA) or (NX)
No factor income flow

No current transfer
NX = Net exports
Capital
NX X - M
and financial account balance (KA)

According
to the accounting rule,
Current account balance (NX) and

Capital and financial account balance (KA)
will offset each other.
i.e. NX + KA = 0
NX - KA
NX = - KA
Capital and financial account balance
Type
NX
KA
Type
Surplus
+ve
-ve
Deficit
Balanced
Balanced
Deficit
-ve
+ve
Surplus

National income identity
National income (from expenditure approach)
Y = National income
C = Private consumption expenditure
I = Investment expenditure
G = Government consumption expenditure
NX = Net exports
Y C + I + G + NX
(1)

National income identity
Another expression
Y = National income
SP = Private saving
T = Tax revenue
Y C + SP + T
(2)

Put (2) into (1)
Y C + I + G + NX
(1)
Y C + SP + T
(2)
C + I + G + NX = C + SP + T
I + G + NX = SP + T
NX = SP + ( T G ) I (3)
or NX = ( SP I ) ( G T )

Equation (3) :
NX SP + T G I
( T G ) = Govt tax revenue Govt expenditure

i.e. The govt budget surplus
If surplus budget, i.e. T > G, then govt reserves increases
i.e. public saving ( SG) increases
Equation (4) :
NX SP + SG I

Equation (4) :
NX SP + SG I
SP = Private saving
SG = Government saving
In total:
SN = SP + SG = National saving
Equation (5):
NX SN I
Meaning that:
Current account balance is domestic (national) saving minus do
mestic investment.
Economic implications of NX = SN - I
Given NX = SN I and NX = - KA
Current account
(NX)
Surplus
( NX > 0 )
Balanced
( NX = 0 )
Deficit
( NX < 0 )
Capital and
financial
account
( KA = - NX )
Capital flow
Domestic saving vs.

Domestic investment
KA < 0
Capital and financial acc.

offsets current acc. surplus
Net capital flow < 0
Net capital outflow
SN > I
Saving > Investment
Outward investment
KA = 0

is balanced
Net capital flow = 0
No capital
inflow or outflow
SN = I
Saving = Investment
Domestic saving
equals domestic
investment
KA > 0

offsets current acc. deficit
Net capital flow > 0
Net capital inflow
SN < I
Saving < Investment
Inward investment
Question
Which of the following statements about national saving is COR
RECT?
A. National saving must be equal to domestic investment in a cl
osed economy.
B. Private saving must be equal to public saving.
C. National saving must not be equal to domestic investment in
an open economy.
D. None of the above.
Answer
A
In a closed economy, Y = C + I + G, so I = Y C G. A
s S = Y C G, S = I.
Option C is incorrect. In an open economy, S I = NX.
If NX = 0, national saving is equal to domestic investme
nt.
Question
If government consumption expenditure exceeds tax revenue,
(1) national saving is negative.
(2) public saving is negative.
(3) there is a budget deficit.
A.
B.
C.
D.
(1) and (2) only

(1) and (3) only
(2) and (3) only
(1), (2) and (3)
Answer
C
(2) is correct. Public saving = Tax revenue Government consum
ption expenditure
If government consumption expenditure is larger than tax revenu
e, public saving will be negative.
(3) is correct. When government consumption expenditure is larg
er than tax revenue, the government revenue cannot cover all her
expenses. There is a budget deficit.
(1) is incorrect. National saving = Private saving + Public saving
We can only tell that public saving is negative. Whether national
saving is negative or not depends on the value of private saving.
Question
In an open economy, if domestic investment exceeds national sav
ing, there will be a _____________ and the net capital outflow is
_____________.
A.
B.
C.
D.
trade surplus positive

trade surplus negative
trade deficit positive
trade deficit negative
Answer
D
As S I = NX, when I > S, NX < 0. Therefore, there will be a tra
de deficit. As part of domestic investment is financed by borrowi
ng from abroad, there is a net capital inflow (i.e. the net capital o
utflow is negative).
Question
In an open economy, if national saving is larger than domestic inv
estment, the value of exports will be _____________ than the val
ue of imports. The capital and financial account balance will be _
____________.
A. greater positive
B. greater negative
C. smaller positive
D. smaller negative
Answer
B
As S I = NX, when S > I, NX > 0. Therefore, the value of expor
ts will be greater than the value of imports. As the surplus in savi
ng is used to finance foreign investment, there will be a net capita
l outflow. The capital and financial account will be negative.
Question
Given
SP = Y T C where SP = Private saving
SG = T G
SG = Public saving
SN = SP + SG
Y = National income
T = Tax revenue
SN = National saving
(a) Prove that SN = Y C G (i.e., prove that the national savin
g is equal to the national income minus private consumption exp
enditure and government consumption expenditure). (3 marks)
(b) Prove that in a closed economy, SN = I (i.e., prove that when
there is
no external trade, domestic saving is always equal to
domestic investment). (4 marks)
Answer
a)
b)
S N S P + SG
YTC+TG
YCG
In a closed economy, Y C + I + G
YCGI
SN I
Question
Given
NX = SN I (1)
SN = SP + SG (2)
SG = T G (3)
Put (2) and (3) into (1):
NX = (T G) + (SP I) Equation A
(a) With reference to Equation A, state one possible
allocatio
n of private saving.(1 mark)
(b) With reference to Equation A, state the condition under whic
h a country with a budget deficit will also have a current acco
unt deficit (i.e., twin deficits). (4 marks)
Answer
a. From Equation A, we have: SP = I + (G T) + NX
I = Domestic investment
NX = Outward investment
G T = Purchase of new government debts
b. From (a), we have: SP = I + (G T) + NX

NX = (SP - I ) - (G T)
If the budget deficit (G T) of a country is larger than
the difference between private saving and domestic i
nvestment (SP I), there will be twin deficits.
Question
Given
Local resident expenditure is the total expenditure of local house
holds, firms and the government.
Local resident expenditure = C + I + G
where C = Private consumption expenditure
I = Gross investment expenditure
(a) Prove that if the income of an economy is higher than its resi
dent expenditure, it will have a current account surplus; when
the income of an economy is lower than its resident expenditu
re, it will have a current account deficit. (3 marks)
(b) With reference to the answer in (a), if the income of an econo
my is higher than its resident expenditure, how will the capita
l and financial account be affected? (2 marks)
Answer
(a)Given Y C + I + G + NX
NX Y (C + I + G)
If Y > (C + I + G), NX > 0;
If Y < (C + I + G), NX < 0.
(b)From (a),
If Y > (C + I + G), NX > 0;
Since NX = - KA
KA < 0
That is, there is a net capital outflow.
Question
Below is the data of a country.
$ billion
Exports
Imports
GDP
Consumption expenditure
Government consumption expenditure
Investment expenditure
Tax revenue
50
60
470
80
90
X
30
(a) Calculate the public saving. (2 marks)

(b) Calculate X. (2 marks)
(c) Calculate the national saving. (2 marks)
Answer
(a)
Public saving = Tax revenue Government consumption expenditure
= $(30 90) billion = $60 billion (2)
(b) GDP = C I G NX
$470 billion = 80 X 90 (50 60) billion
X = 310 (2)
(c)
National saving = Public saving Private saving
National saving = $60 billion + (GDP tax consumption)
National saving = $60 billion + (4703080) billion = $300 billion (2)
Question
The table shows the current account of the balance of payments accou
nt of country A.
$ million
Domestic exports
120
Reexports
130
Exports of services
150
Imports of goods
200
Imports of services
160
(a) Find the net exports of Country A. (1 mark)
(b) With the result in (a), prove that the countrys saving was not
su
fficient to finance its domestic investment. (3 marks)
(c) Let net exports be the current account balance. Find the implied ca
pital and financial account balance. Was there a net capital inflow or o
utflow? (3 marks)
Answer
(a) Net exports = 120 + 130 + 150 200 160 = $40 million (1)
(b) C + S + T = Y = C + I + G + NX (1)
NX = SN I (1)
Since NX < 0, SN < I (1)
(c) Current account balance + capital and financial account balance = 0 (1)
A deficit in net exports (or current account balance) implies
a positive balance in the capital and financial account. (1)
This means the country had a net capital inflow. (1)

5b Chapter 7 - Exchange Rate

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5b Chapter 7 - Exchange Rate

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Economics

you know these currencies?

Purchasing materials in foreign countries

Remittances to relatives or friends

the price at which two currencies are exchanged

the price of a foreign currency in terms of

The exchange rate of USD

1 can be converted into HK$ 7.8

(assume USD and HKD)

The exchange rate of HKD

1 can be converted into US$

Floating exchange rate

Depends on market demand and supply

A rise in exchange rate

A fall in exchange rate

The USD appreciates relative to the EUR

The HKD appreciates relative to the JPY

The EUR depreciates relative to the USD

The JPY depreciates relative to the HKD

Floating exchange rate

There is only one exchange rate between two currencies.

Linked exchange rate system in HK

HKD linked with USD at a fixed exchange rate

Aim: To maintain stability of the exchange rate between H

Exchange rate: US$1:HK$7.757.85

Controlled by the HKSAR Govt (HKMA)

Brief history of linked exchange rates syste

Fixed exchange rate

Linked exchange rate

Linked exchange rate system in HK

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$6

the rate of HKD against USD rises

The government re-pegs exchange rate at a higher level

Linked exchange rate system in HK

Originally, HKMA fixed the rate at US$1:HK$7.8

If HKMA set the rate at US$1:HK$9

the rate of HKD against USD falls

The government re-pegs exchange rate at a lower level

Exchange rate is determined by

Linked exchange rate system in HK

A currency board system

HK monetary base is support by USD

Maintain the exchange rate when issuing banknotes

Linked exchange rate system in HK

Linked exchange rate system in HK

EUR depreciates against HKD,

Against other currencies

if USD appreciation HKD appreciation (against other currencies)

HK people suffer from RMB appreciation

RMB annual average middle exchange

Balance of payment (BOP) account

The record of an economys receipts and payments arising from

For a specific time period

Balance of payment (BOP) account

Balance of payment (BOP) account

Goods (visible trade)

Balance of visible trade = Total exports of goods Total imports of goods

Exports < Imports

Exports > Imports

Balance of payment (BOP) account

Services (invisible trade)