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 (assume USD and HKD)
2.
The exchange rate of HKD

1
HK$ 1 can be converted into US$
7.8

1
USD/HKD =
7.8
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
HK$1 equals
¥10.40
1 May 2011
¥11.00
The HKD appreciates relative to the JPY
Depreciation

USD Euro


€1 equals
Date
1 April 2011
US$
1 May 2011
US$
1
=
0.7
1
=
0.8
US$1.43
US$1.25
The EUR depreciates relative to the USD
HKD JPY
Date
1 April 2011
1 May 2011

JP¥1 equals
1
HK$
= HK$0.096
10.40
1
HK$ = HK$0.091
11
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
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 System
•
Period
Exchange rate regime
1863–1935
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
1983–Present
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 1967–June 1972)
•Exchange rate:US$1:HK$5.650 (June 1972–February 1973)
•US$1:HK$5.085 (February 1973–November 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 (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
Linked exchange rate system in HK
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
Linked exchange rate system in HK
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
Linked exchange rate system in HK
Strong reserves support

A currency board system

HK monetary base is support by USD

Maintain the exchange rate when issuing banknotes
Linked exchange rate system in HK
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$1 million to HKMA
US$ 1: HK$7.8
Certificates
of
Indebtedness
HKMA
* In reverse, banks return HKD & CIs to the HKMA and get back the USD.
Linked exchange rate system in HK
Exchange 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.

Date
US$1 equals
(EUR/USD)
US$1 equals
(Linked exchange
rate system,
HKD/USD)
1 April 2011
€ 0.7
HK$ 7.8
HK$ 0.7 = HK$11.14
1 May 2011
€ 0.8
HK$ 7.8
HK$
USD appreciates
against EUR
Fixed
Euro 1 equals
(HKD/EUR)
7.8
7.8
0.8
= HK$9.75
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 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
Balance of payment (BOP) account
Components of the BOP account:
A.
B.
Current account (經常帳)
Capital and financial account (資本及金融帳)
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
Balance of payment (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…
Balance of visible trade = Total exports of goods – Total imports of goods
Types of BOT:
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
Balance of payment (BOP) account
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
Balance of payment (BOP) account
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 (單向) transfer of goods and capital
No economic value being received in return
For example: donations, remittances 匯款
Balance of payment (BOP) account
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)
Balance of payment (BOP) account
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
Current account balance
= ( $500 - $200 + $350 - $100 + $50 - $80 - $120 ) million
= $400 million
Balance of payment (BOP) account
B. Capital and financial account:
It records investment and capital transfers between local residents and
non-residents and changes in reserve assets

Capital transfer

External transactions in non-produced, non-financial assets

External investment
-----------------------------------------------------------------------------------
Changes in reserve assets (the gov’t buys or sells assets, e.g. gold)
B. Capital and financial account:

Capital transfer

External transactions in non-produced, non-financial assets

External investment
-----------------------------------------------------------------------------------
Changes in reserve assets (the gov’t buys or sells assets, e.g. gold)
Balance of BOP
Total balance of the 4 components:

Visible trade

Invisible trade

Factor income

Current transfer
BOP
A. Current account balance:
Balance of payment (BOP) account
B. Capital and financial account:
* Think about money inflow (to HK) or outflow (to other countries)
(Textbook p.13)
Transaction
Capital flow
Balance of capital and
financial account
A US resident buys shares in a listed company
in Hong Kong.
Inflow / Outflow
Increase / Decrease
A Hong Kong resident transfers his deposits
from a local bank too an overseas bank.
Inflow / Outflow
Increase / Decrease
A Hong Kong resident buys a property in the
mainland.
Inflow / Outflow
Increase / Decrease
A Hong Kong company sells the patent of a
product to a Japanese company.
Inflow / Outflow
Increase / Decrease
A mainland resident sells his property in Hong
Kong.
Inflow / Outflow
Increase / Decrease
A US company sets up a branch office in Hong
Kong
Inflow / Outflow
Increase / Decrease
Balance of payment (BOP) account
BOP
= Balance of Current Acc. +
Balance of Capital and financial Acc. (excluding reserve asset transaction)
Balance ($)
(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 payment (BOP) account
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
Balance of payment (BOP) account
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
in its external transactions excluding reserve asset transactions.
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
$1000



HK has received and made payments.
 reserves assets remains unchanged
Balanced BOP will be found if the receipts
of an economy equal to its payments
in its external transactions excluding reserve asset transactions.
The meaning of BOP
Summary
Reserve assets
BOP
BOP deficit
Balanced BOP
BOP surplus
[ receipts < payments ]
0
[ receipts = payments ]
+
[ receipts > payments ]
Actual
Shown in
balance sheet of BOP

+ ve
Unchanged
0

- ve
Balance of payment (BOP) account
Example: Below is the balance of payment account of a country
Balance
(HK$
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
are $200 million. Find the value of re-exports. (2%)
b.
Find the current account balance. (2%)
c.
Find the value of X. What is the change in the reserve assets? Find the balance
of payments. (4%)
Balance of payment (BOP) account
Example: Below is the balance of payment account of a country
Balance
(HK$
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
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 = $130 million
Balance of payment (BOP) account
Example: Below is the balance of payment account of a country
Balance
(HK$
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)
b. Find the current account balance. (2%)
Answer:
Current account balance = ($580 - $430 + $120 - $40 ) million = $230 million
580
-430
120
-40
-250
X
Balance of payment (BOP) account
Example: Below is the balance of payment account of a country
Balance
(HK$
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
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
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
NX  X - M
Capital and financial account balance (KA)
National income identity and the BOP

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 and the BOP
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 and the BOP
National income identity
 Another expression




Y = National income
C = Private consumption expenditure
SP = Private saving
T = Tax revenue
Y  C + SP + T
…… (2)
National income identity and the BOP
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 )
National income identity and the BOP
Equation (3) :
NX  SP + T – G – I
( 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 + SG – I
National income identity and the BOP
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
domestic 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
• Capital and financial acc.
is balanced
• Net capital flow = 0
• No capital
inflow or outflow
• SN = I
• Saving = Investment
• Domestic saving
equals domestic
investment
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.
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
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.
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
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.
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
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)
b)
SN  SP + S G
Y–T–C+T–G
Y–C–G
In a closed economy, Y  C + I + G
Y–C–GI
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)
(b)
With reference to Equation A, state one possible
allocation of private saving.(1 mark)
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.
Question
Given
Local 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.
Question
Below is the data of a country.
$ billion
Exports
Imports
GDP
Consumption expenditure
Government consumption expenditure
Investment expenditure
Tax revenue
(a)
(b)
(c)
50
60
470
80
90
X
30
Calculate the public saving. (2 marks)
Calculate X. (2 marks)
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 + (470–30–80) billion = $300 billion (2)
Question
The table shows the current account of the balance of payments
account of country A.
$ million
Domestic exports
120
Re–exports
130
Exports of services
150
Imports of goods
200
Imports of services
160
(a)
(b)
(c)
Find the net exports of Country A. (1 mark)
With the result in (a), prove that the country’s saving was not
sufficient to finance its domestic investment. (3 marks)
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)
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)