Economics Chapter 7 Exchange rate. Currencies Do you know these currencies?

Economics

Chapter 7

Exchange rate

Currencies Do you know these 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 (assume USD and HKD)

2. 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

The USD appreciates relative to the EUR

HKD JPY

The HKD appreciates relative to the JPY

Date US$1 equals

1 April 2011 € 0.7

1 May 2011 € 0.8

Date HK$1 equals

1 April 2011 ¥10.40

1 May 2011 ¥11.00

Depreciation USD Euro

The EUR depreciates relative to the USD

HKD JPY

The JPY depreciates relative to the HKD

Date €1 equals

1 April 2011 US$ = US$1.43

1 May 2011 US$ = US$1.25

Date JP¥1 equals

1 April 2011 HK$ = HK$0.096

1 May 2011 HK$ = HK$0.091

Floating exchange rate

Depreciation: exchange rate

Appreciation: 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

HKD and USD

Exchange rate: US$1:HK$7.75–7.85

Controlled by the HKSAR Gov’t (HKMA)

Brief history of linked exchange rates system in HK:

History of Hong Kong's Exchange Rate SystemPeriod Exchange rate regime Features

1863–1935 Silver Standard Silver dollars as legal tenderDecember 1935–June 1972

Sterling exchange •Standard exchange rate:£1:HK$16 (December 1935–November 1967)•£1:HK$14.55 (November 1967–June 1972)

July 1972–November 1974

Fixed exchange rate against the US dollar

•Exchange rate:US$1:HK$5.650 (June 1972–February 1973)•US$1:HK$5.085 (February 1973–November 1974)

November 1974–October 1983

Free floating •Exchange rates on selected days:US$1:HK$4.965 (25 November 1974)•US$1:HK$9.600 (24 September 1983)

1983–Present Linked exchange rate system

•US$1:HK$7.80 (1983–1998)(for issue and redemption of Certificates of Indebtedness)•US$1:HK$7.75 (1998–2005)(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$7.75–7.85 (May 2005 onwards)HKMA set up upper and lower guaranteed limit since 18 May 2005

Source: http://en.wikipedia.org/wiki/Hong_Kong_dollar

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

Exchange rate of local currency against foreign

currency

Increase Appreciation Revaluation

Decrease Depreciation Devaluation

Example countries USA China


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

HKMA to buy Certificate of Indebtedness [CIs] (負責證明書 ) As a support for banknotes issued In this case, the bank pays US$1 million to HKMA

* In reverse, banks return HKD & CIs to the HKMA and get back the USD.

Certificatesof

Indebtedness

US$ 1: HK$7.8

HKMA

Linked exchange rate system in HKExchange rates change with the USD Under the linked exchange rate system, the exchange rates of the HKD

against other foreign currencies change with the USD.

Against other currencies if USD appreciation HKD appreciation (against other currencies) if USD depreciation HKD depreciation (against other currencies)

DateUS$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 appreciatesagainst EUR

Fixed EUR depreciates against HKD, (i.e. HKD appreciates against EUR)

HK people suffer from RMB appreciationExchange 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 fromthe mainland

Before that, HK people went shopping in the mainland

Nowadays, mainland visitor come to HKfor 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 economy’s 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. Current account ( 經常帳 )B. Capital and financial account (資本及金融帳 )

International purchases or sales of

assetsCapital transfers

All external transactions not

included in capital & financial account

Capital and financial account

Current account

BOP account


A. Current account:1. Goods (visible trade) Net receipt brought by merchandise trade (商品貿易 ) Receipt: Exports of goods, e.g. garments, jewellery… Payment: Imports of goods, e.g. rice, cars…

Types of BOT:

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

Trade deficit (貿易赤字 ) Exports < Imports BOT < 0

Balance BOT (貿易平衡 ) Exports = Imports BOT = 0

Trade surplus (貿易盈餘 ) 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:3. Factor income Net income from abraod All forms of investment income

Dividends Interest from deposit

4. Current transfers Unilateral (單向 ) transfer of goods and capital No economic value being received in return For example: donations, remittances 匯款

Net income from abroad = Factor income from abroad – Factor income paid abroad


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:

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

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


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 gov’t buys or sells assets, e.g. gold)

A. Current account balance:Total balance of the 4 components: Visible trade Invisible trade Factor income Current transfer

B. Capital and financial account:

Capital transfer

External transactions in non-produced, non-financial assets

External investment

------------------------------------------------------------------------------------

Changes in reserve assets (the gov’t buys or sells assets, e.g. gold)

BO

P

Bal

ance

of

BO

P

Balance of payment (BOP) accountB. Capital and financial account:

* Think about money inflow (to HK) or outflow (to other countries)

(Textbook p.13)

Transaction Capital flowBalance 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.


A Hong Kong resident buys a property in the mainland.


A Hong Kong company sells the patent of a product to a Japanese company.


A mainland resident sells his property in Hong Kong.


A US company sets up a branch office in Hong Kong


Balance of payment (BOP) accountBOP

= 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)

- 1,0001,000

800200

BOP = (A) + (B1) - 200

Balance of payment (BOP) accountBalance 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

100,000

- 135,00035,000

-50,00080,00040,00030,000

Balance of BOP = [ (A) + (B) + (C) ] 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 BOP1. BOP deficit

HK buys thing from the USA Payment to USA

HK has nothing to sell to the USA No receipts from USA

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 receiptsin its external transactions excluding reserve asset transactions.

HK USA

$1000

$0

The meaning of BOP2. BOP surplus

HK sells thing to the USA Receipts from USA

HK buys nothing from the USA No payments to USA

HK has received payment. reserves assets

BOP surplus will be found if the receipts of an economy are larger than its paymentsin its external transactions excluding reserve asset transactions.

HK USA

$0

$1000

The meaning of BOP3. Balanced BOP

HK sells thing to the USA Receipts from USA

HK buys thing from the USA Payments to USA

HK has received and made payments. reserves assets remains unchanged

Balanced BOP will be found if the receipts of an economy equal to its paymentsin its external transactions excluding reserve asset transactions.

HK USA

$1000

$1000

The meaning of BOP

Summary

BOPReserve assets

ActualShown in

balance sheet of BOP

BOP deficit -[ receipts < payments ]

+ ve

Balanced BOP 0[ receipts = payments ]

Unchanged 0

BOP surplus +[ receipts > payments ]

- ve


Example: Below is the balance of payment account of a country

Answer the questions based on the information above.

a. Suppose the domestic exports of goods are $650 million and imports of goods are $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 of payments. (4%)

Balance (HK$

million)

Current account Goods Services Factor income Current transfersCapital and financial account Balance of capital and financial account excluding reserve asset transactions Reserve assets (net change)

580-430120-40

-250X



a. Suppose the domestic exports of goods are $650 million and imports of goods are $200 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)


580-430120-40

-250X



b. Find the current account balance. (2%)

Answer:

Current account balance = ($580 - $430 + $120 - $40 ) million = $230 million

Balance (HK$

million)


580-430120-40

-250X



c. Find the value of X. What is the change in the reserve assets? Find the balance of payments. 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

Balance (HK$

million)


580-430120-40

-250X

National income identity and the BOP

Current account balance (CA) or (NX) X = Total exports of goods and services M = Total imports of goods and services Assume:

No factor income flow No current transfer

NX = Net exports

Capital and financial account balance (KA)

NX X - M


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

Current account balance Capital and financial account balance

Type NX KA Type

Surplus +ve -ve Deficit

Balanced 0 0 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 C = Private consumption expenditure SP = Private saving T = Tax revenue

Y C + SP + T …… (2)


Put (2) into (1)

C + I + G + NX = C + SP + T

I + G + NX = SP + T

NX = SP + ( T – G ) – I ……(3)

or NX = ( SP – I ) – ( G – T )

Y C + SP + T …… (2)

Y C + I + G + NX …… (1)


Equation (3) :

( T – G ) = Gov’t tax revenue – Gov’t expenditure

i.e. The gov’t budget surplus

If surplus budget, i.e. T > G, then gov’t reserves increases

i.e. public saving ( SG) increases

Equation (4) :

NX SP + T – G – I

NX SP + SG – I


Equation (4) :

SP = Private saving SG = Government saving

In total:

SN = SP + SG = National saving

Equation (5):Meaning that:

Current account balance is domestic (national) saving minus domestic investment.

NX SP + SG – I

NX SN – I

Economic implications of NX = SN - I

Given NX = SN – I and NX = - KA

Current account(NX)

Capital and financial account

( KA = - NX )

Capital flowDomestic saving vs. Domestic investment

Surplus( NX > 0 )

KA < 0

• Capital and financial acc. offsets current acc. surplus

• Net capital flow < 0• Net capital outflow

• SN > I• Saving > Investment• Outward investment

Balanced( NX = 0 )

KA = 0

• Capital and financial acc. is balanced

• Net capital flow = 0• No capital

inflow or outflow

• SN = I• Saving = Investment• Domestic saving

equals domestic investment

Deficit( NX < 0 )

KA > 0

• Capital and financial acc. 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 CORRECT?

A. National saving must be equal to domestic investment in a closed 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. As 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 investment.

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. (1) and (2) only

B. (1) and (3) only

C. (2) and (3) only

D. (1), (2) and (3)

Answer

C

(2) is correct. Public saving = Tax revenue – Government consumption expenditure

If government consumption expenditure is larger than tax revenue, public saving will be negative.

(3) is correct. When government consumption expenditure is larger 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 saving, there will be a _____________ and the net capital outflow is _____________.

A. trade surplus … positive

B. trade surplus … negative

C. trade deficit … positive

D. trade deficit … negative

Answer

D

As S – I = NX, when I > S, NX < 0. Therefore, there will be a trade deficit. As part of domestic investment is financed by borrowing from abroad, there is a net capital inflow (i.e. the net capital outflow is negative).

Question

In an open economy, if national saving is larger than domestic investment, the value of exports will be _____________ than the value 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 exports will be greater than the value of imports. As the surplus in saving is used to finance foreign investment, there will be a net capital outflow. The capital and financial account will be negative.

QuestionGiven

SP = Y – T – C where SP = Private saving

SG = T – G SG = Public saving

SN = SP + SG Y = National income

T = Tax revenue

C = Private consumption expenditure

G = Government consumption expenditure

SN = National saving

(a) Prove that SN = Y – C – G (i.e., prove that the national saving is equal to the national income minus private consumption expenditure 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) SN SP + SG

Y – T – C + T – G

Y – C – G

b) In a closed economy, Y C + I + G

Y – C – G ISN I

QuestionGivenNX = 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 allocation of private saving.(1 mark)

(b) With reference to Equation A, state the condition under which a country with a budget deficit will also have a current account 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 investment (SP – I), there will be twin deficits.

QuestionGivenLocal resident expenditure is the total expenditure of local households, firms and the government.

Local resident expenditure = C + I + G where C = Private consumption expenditure

I = Gross investment expenditure

G = Government consumption expenditure

(a) Prove that if the income of an economy is higher than its resident expenditure, it will have a current account surplus; when the income of an economy is lower than its resident expenditure, it will have a current account deficit. (3 marks)

(b) With reference to the answer in (a), if the income of an economy is higher than its resident expenditure, how will the capital 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.

QuestionBelow is the data of a country.

(a) Calculate the public saving. (2 marks)

(b) Calculate X. (2 marks)

(c) Calculate the national saving. (2 marks)

$ billion

ExportsImportsGDPConsumption expenditureGovernment consumption expenditureInvestment expenditureTax revenue

5060

4708090X

30

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 + (470–30–80) billion = $300 billion (2)

QuestionThe table shows the current account of the balance of payments account of country A.

(a) Find the net exports of Country A. (1 mark)

(b) With the result in (a), prove that the country’s saving was not sufficient to finance its domestic investment. (3 marks)

(c) Let net exports be the current account balance. Find the implied capital and financial account balance. Was there a net capital inflow or outflow? (3 marks)

$ millionDomestic exports 120Re–exports 130Exports of services 150Imports of goods 200Imports of services 160

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 他和 current account balance) implies

a positive balance in the capital and financial account. (1)

This means the country had a net capital inflow. (1)

Economics Chapter 7 Exchange rate. Currencies Do you know these currencies?

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Transcript of Economics Chapter 7 Exchange rate. Currencies Do you know these currencies?