By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV1 HKCEE Macroeconomics vChapter 8 vExchange Rates...

By Mr. LAU san-fat CH8-Exchange Rates & the BOP-SV 1

HKCEE Macroeconomics

Chapter 8

Exchange Rates and the

Balance of Payments


Demand for Foreign Currencies

payment for foreign imports

•We supply domestic currencies in the foreign exchange market in exchange for foreign currencies

•We demand for foreign currencies for:

•D foreign Currencies S domestic currencies

making foreign investments


Supply of Foreign Currencies

payment for domestic exports

• Foreign countries supply foreign currencies in the foreign exchange market in exchange for domestic currencies

• D domestic Currencies S foreign currencies

making domestic investments

• Foreign countries demand for domestic currencies for:

Task 1: Textbook/P.214/Q.10.1


Exchange Rates

• Example: US$1 = HK$7.8 HK$1 = US$0.129

• An exchange rate is the price of a currency in terms of another currency.

The exchange rate of US dollars in terms of HK dollars is 7.8

The exchange rate of HK dollars in terms of US dollars is 0.129


Floating Exchange Rate System

• Under the floating/flexible exchange rate system, the exchange rate of a currency is determined by its demand and supply.



• Example: US$1 = HK$8Exchange rate of US$

(in terms of HK$)

Quantity of US$0

D S

8

Q



• Example: US$1 = HK$8 US$1 = HK$9

Appreciation of a currency occurs if:

• Appreciation of a currency occurs if its exchange rate rises

its demand rises its supply falls its demand rises and supply falls



• Example: US$1 = HK$8 US$1 = HK$7

Depreciation of a currency occurs if:

• Depreciation of a currency occurs if its exchange rate falls.

its demand falls its supply rises

its demand falls and supply rises



• Example:

Before appreciation of US$:

• Appreciation of a foreign currency implies depreciation of local currency.

US$1 = HK$8 HK$1 = US$0.129

Appreciation of US$ (against HK$):

US$1 = HK$8 US$1 = HK$9

Hence, HK$1 = US$0.129 HK$1 = US$0.111



• Example:

Before depreciation of US$:

• Depreciation of a foreign currency implies appreciation of local currency.

US$1 = HK$8 HK$1 = US$0.129

Depreciation of US$ (against HK$):

US$1 = HK$8 US$1 = HK$7

Hence, HK$1 = US$0.129 HK$1 = US$0.143


Fixed Exchange Rate System

• Under a fixed exchange rate system, the exchange rate of a currency is fixed by the government or monetary authority.

• The fixed rate should be kept at a level different from the market rate.


Fixed Exchange Rate System

Example: US$1 = HK$8 US$1 = HK$9

• Revaluation of a currency occurs if the fixed rate is raised.

Example: US$1 = HK$8 US$1 = HK$7

• Devaluation of a currency occurs if the fixed rate is decreased.



Linked Exchange Rate System

to govern the issuing of banknotes

to help stabilize the exchange rate of HK$ in terms of US$

• Functions:



linked rate: US$1 = HK7.8

applies to the exchange of US$ for HK$ between note-issuing banks & Exchange Fund, other banks & note-issuing banks

• Operations:

buying and selling of the Certificates of Indebtedness (CI) with US$ difference between the linked and market rates will be cleared by engaging arbitrage



if market rate: US$1 = HK$7

arbitrage occurs:

• If linked rate > market rate…

buying US$ at market rate (HK$7) selling US$ at linked rate (HK$7.8) buying US$ in the foreign exchange market a larger demand for US$ appreciation of US$ (say US$1 = HK$7.5) appreciation stops if ↑market rate = linked rate



if market rate: US$1 = HK$9

arbitrage occurs:

• If linked rate < market rate…

buying US$ at linked rate (HK$7.8) selling US$ at market rate (HK$9) selling US$ in the foreign exchange market a larger supply for US$

depreciation of US$ (say US$1 = HK$8) depreciation stops if ↓market rate = linked rate


Effects of Changes in Exchange Rate

Example:

• If foreign currency appreciates/revalues

Price of USA imports = US$1000

Before US$ appreciates: US$1 = HK$8 price of USA imports in terms of HK$ = HK$(8 × 1000) = HK$8000

After US$ appreciates: US$1 = HK$9 price of USA imports in terms of HK$ = HK$(9 × 1000) = HK$9000 ＋ HK$1000



Price of foreign imports in terms of local currency will rise


↓demand for foreign imports (by local consumers)



Example:


Price of HK exports = HK$7800

Before US$ appreciates: US$0.125 = HK$1 price of HK exports in terms of US$ = US$(0.125 × 7800) = US$975

After US$ appreciates: US$0.111 = HK$1 price of HK exports in terms of US$ = US$(0.111 × 7800) = US$865.8 －US$109.2



Price of domestic exports in terms of foreign currency will fall


↑demand for domestic exports (by foreign countries)



Example:

• If foreign currency depreciates/devalues

Price of USA imports = US$1000

Before US$ appreciates: US$1 = HK$8 price of USA imports in terms of HK$ = HK$(8 × 1000) = HK$8000

After US$ depreciates: US$1 = HK$7 price of USA imports in terms of HK$ = HK$(7 × 1000) = HK$7000 － HK$1000



Price of foreign imports in terms of local currency will fall


↑demand for foreign imports (by local consumers)



Example:


Price of HK exports = HK$7800

Before US$ appreciates: US$0.125 = HK$1 price of HK exports in terms of US$ = US$(0.125 × 7800) = US$975

After US$ depreciates: US$0.143 = HK$1 price of HK exports in terms of US$ = US$(0.143 × 7800) = US$1115.4 ＋US$140.4



Price of domestic exports in terms of foreign currency will rise


↓demand for domestic exports (by foreign countries)

Task 3: Textbook/P.219/MCQ 1 /P.220/MCQ 2


Balance of Payments (BOP)

a set of statistical statements

• The Balance Of Payments Account

that systematically summarizes the economic transactions of an economy with the rest of the world,

in a specified period of time, usu. a year or quarter


Balance of Payments (BOP)

payments to other countries → debit side

•In the BOP Account…

two major accounts:

receipts by the country → credit side

the current account

the capital and financial account


The Current Account

1. Visible Trade, i.e. imports & exports of physical goods

the balance of trade (or trade balance) = value of exports of goods － value of imports of goods = value of (domestic exports ＋ re-exports) － value of imports

It measures flow of real resources


The Current Account

2. Invisible Trade, i.e. imports & exports of services

the balance of invisible trade = value of exports of services － value of imports of services

Task 4: Textbook/P.221/MCQ 3


The Current Account

3. IncomeFactor incomesNet factor income from abroad = factor incomes earned by residents from outside the economy － factor incomes earned by non-residents within the economy

Major items:direct investment incomeportfolio investment incomeother investment incomecompensation of employees


The Current Account

4. Current Transfersunilateral flow of real and financial resourcesIncluding gifts, grants, remittance & aidsIf linked to acquiring or disposing fixed assets, cash transfer is regarded as current transfer.

Task 5: Textbook/P.223/MCQ 4 /P.224/MCQ 5 /P.225/Q.10.5


The Capital & Financial Account

Components: capital transfers

non-produced & non-financial assets

Investments

reserve assets

Remark: Detailed classifications of the capital and financial account is NOT required in the HKCEE syllabus.)


the Capital Account It measures external transactions in capital transfers and non-produced/non-financed assets (such as patents & copyrights).

Capital inflows lead to credit while outflows lead to a debit.


A capital transfer is a transfer of ownership of a fixed asset or forgiveness of a liability.


the Financial Account It shows how an economy’s external transactions are financed.

It aims at acquiring lasting interest & influence in managing an overseas enterprise


1. Direct Investment:

Example: external investment in (overseas) real estate


the Financial Account

2. Portfolio Investment: It refers to investment in non-resident equities (i.e. stocks & shares), debt securities (e.g. bonds) and financial derivatives (e.g. options & warrants)

It involves NO lasting interest or influence in managing an overseas enterprise



the Financial Account

3. Other Investment: It refers to other financial claims (NOT classified as direct investment, portfolio investment or reserve assets) on and liabilities to non-residents.

Examples: short-term & long-term non-marketable loans & deposits.



the Financial Account4. Reserve Assets:

It consists of external assets (e.g. gold and foreign currencies) for (1) directly financing payment imbalances (i.e. BOP deficit/surplus) and (2) for indirectly regulating the magnitude of such imbalances by intervening the exchange rate of an economy in the foreign exchange markets.


It is readily available to and controlled by monetary authorities of an economy



by excluding the changes in reserve assets, we may have BOP imbalances.

The BOP Deficit or Surplus

BOP Financial Status

Balanced BOP Total receipts = Total payments

BOP Deficit Total receipts < Total payments

BOP Surplus Total receipts > Total payments

Task 7: Textbook/P.229/MCQ 7


Changes in Reserve Assets With BOP deficit:

BOP deficit → outflow of gold/foreign currencies → credit the account → the BOP account gets balanced

BOP Imbalances & Reserve Assets

BOP surplus → inflow of gold/foreign currencies → debit the account → the BOP account gets balanced

With BOP surplus:


An economy may have balance of payment (BOP) deficit, surplus or balance, depending total receipts and total payments.

BOP and BOP Account

However, according to accounting conventions (double-entry), the sum of all credit items is always equal to the sum of all debit items, the balance of payment (BOP) account is always in balance.

Closer Look 10.5: Textbook/P.229-230

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By Mr. LAU san-fatCH8-Exchange Rates & the BOP-SV1 HKCEE Macroeconomics vChapter 8 vExchange Rates...

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