Exchange Rate Determination I:
Prices and the Real Exchange Rate

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HK Dollars, as currency, is printed by money center banks Standard Chartered, HSBC, and, now, Bank of
China.
During the 1970’s, the banks faced little limitation on money creation. In July of 1982, the HK dollar was depreciating at a rate of 7.7% per year.
In 1983, Britain and the People’s Republic were engaged in talks about the terms on which Hong
Kong would be returned to China. Responding to news from these talks, currency traders unloaded there HK dollar positions.
As a response, the Hong Kong dollar depreciated rapidly. By September 1983, the HK dollar was depreciating at a rate of 65% per year.

 The government announced that Hong Kong would switch to a currency board system.
 A currency board is an arrangement whereby a country can only issue domestic currency if it backed up by central bank holdings of a specific foreign currency.
 To give permission to a money center bank to print
7.8 HK dollars, the government would have to acquire US$1.
 This has been the monetary policy of Hong Kong ever since.

 Students should be able to define the real and nominal exchange rate.
 Students should be able to define purchasing power parity and differentiate relative and absolute PPP.
 Explain why inflation in Hong Kong differs from the US.
 Students should be able to demonstrate that the capital account is the negative of the current account.
 Students should understand the effect of some events on the real exchange rates.

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
Bilateral Exchange
Rate is the exchange rate of one countries’ currency vs. another’s.
Exchange rates can be written in two ways which are inverses of each other.
 Definition 1 The price of foreign currency in terms of domestic currency (the
# of domestic currency units needed to purchase
1 unit of foreign currency)

HK$7.8 per 1 US$
 Definition 2 The price of domestic currency in terms of foreign currency
(the # of foreign currency units needed to purchase
1 unit of domestic currency.

US$.128 per 1 HK$

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Typically, a bilateral exchange rate is reported as the # of units of the currency with the lower value per unit of the currency of the higher value.
Examples
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HK$7.8 per 1 US$
¥120.14 per 1 US$
US1.53 per 1 ₤
An appreciation of a currency is an increase in the value of a currency.
A depreciation is a decrease in value.
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A depreciation would increase the exchange rate by Definition 1.
Ex. A movement of HK$7.8 to HK$10 per US is a depreciation.
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A depreciation would decrease the exchange rate by Definition 2.
Ex. A movement of US$.127 to US$.1 would be a depreciation of HK dollar.

 HK has a fixed bilateral exchange rate with the US.
HK Exchange Fund (the currency board operated by
HKMA) will buy or sell HK$ at a fixed exchange rate.
No one will ever buy for more or sell for less.
 Effective Exchange Rate is a weighted average of a country’s bilateral exchange rates [weights are by share of trade].
 HK effective exchange rate fluctuates since US dollar fluctuates relative to important HK trading partners such as Japan, Germany, etc.

122
120
118
116
114
112
110
108
1998 1999 2000 2001
Effective Exchange Rate HK
2002

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Real exchange rates are the price of domestic goods relative to the price of foreign goods. In other words, real exchange rates are the # of foreign goods that must be given up to obtain 1 domestic good.
A foreigner compares the price of their foreign goods with the price of our domestic goods.
 To buy 1 foreign good, he must pay P F where P F ≡ Foreign price level. foreign currency units
 To buy 1 domestic good, he must pay P domestic currency units, but he must pay Nominal Exchange Rate × P. (using
Definition 2).
Define
P
E

Nominal Exchange Rate×
F P
Real exchange rate can be calculated on a bilateral basis or an index basis.

.22
.20
.18
.16
.14
.12
.10
.08
.06
1980 1985 1990
Real Exchange Rate
1995 2000
US$ per HK$

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Arbitrage should insure that identical goods should sell for the same price in different markets.
For easily transportable, standardized goods sold in highly competitive markets
(such as gold), LoOP holds.
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1.
2.
3.
4.
Why doesn’t LoOP hold for most goods?
Transport Costs – Large costs of moving goods may keep arbitrage from working.
Non-traded Goods – Some goods, such as real estate, have near infinite transport prices.
Pricing-to-Market – Firms with market power may find it optimizing to charge different prices in different markets.
Tariffs & Taxes – Imported goods may face additional taxes

 PPP theory says LoOP applies to all markets.
 Define relative prices of foreign goods
XP
 P
F
P
 Absolute PPP says that the real exchange rate is always E = 1 or the Def. 2 of the
Nominal exchange rate = XP
 Relative PPP says that the growth rate of the real exchange rate is zero g
EXCHANGE RATE  
F  

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Does Absolute or Relative PPP hold?
In short run, NO. Exchange rates are much more volatile than inflation rates.
 In long run for countries with similar levels of development, PPP holds.
 Example. Twenty year averages for OECD countries.
 Rapidly developing countries typically see long-term real exchange rate appreciations
 Hong Kong has had much faster inflation than the US over the life of the exchange rate peg.

- 4.00
8.00
6.00
I t al y
NZ
- 2.00
J apan
4.00
UK
2.00
Canada
0.00
Denmar k
Swi t z .
- 2.00
0.00
Ger many 2.00
NL
Fr anc e
4.00
- 4.00
6.00
- 6.00
A v e r a g e A n n u a l D e p r e c i a t i o n ( % ) A g a i n s t t h e U S $
8.00

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Many types of services have unchanging technology
(like haircuts) or inherently limited supply (like real estate).
Most technology advances occur in traded goods sector.
As a country grows wealthier and more technologically advanced, the countries residents will pay more for real estate or services.
If traded goods have roughly equal prices across countries, but a countries non-traded goods start to become more expensive as it develops, the overall relative price of its goods will increase.

Year 2000
Hong Kong
China
Japan
Macau
Singapore
Philippines
Indonesia
Exchange
Rate
0.128
0.121
0.009
0.125
0.580
0.023
0.022
XP
0.150
0.522
0.006
0.203
0.724
0.091
0.130
Real
Exchange
Rate
0.858
0.231
1.448
0.613
0.801
0.249
0.171
Indonesia
Philippines
Singapore
Macau
Japan
China
Hong Kong
0 0.2
0.4
0.6
0.8
1
Real Exchange Rate w/ USA
1.2
1.4
1.6

 The current account is, conceptually, the amount of income earned overseas less the amount of income earned by foreigners from the domestic economies.
Current Account = Balance on Goods (Goods Exports-Goods
Imports)
+ Balance on Services (Services Exports-
Services Imports)
+ Net Investment
Income
(Investment Income
Earned Overseas –
Investment Income
Paid to Foreigners)
+Net Transfers (Donations from
Overseas)

 The capital account (more accurately the capital & financial account) records capital inflows into the country. The account includes the financial account, the capital account, and change in reserve assets.
Capital
&
Capital
Account
(Debt Forgiveness, Patents)
Financial + Financial
Account →
Direct Investment (FDI of Foreign Companies – FDI by
Domestic Companies)
Account
=
+ Portfolio
Investment
+ Change in
Reserve Assets
+ Other Investments
(Domestic Securities Purchases by
Foreigners – Foreign Securities
Purchases by Domestic Residents)
(Deposits in Domestic Banks by
Foreigners – Deposits in Foreign
Banks by Domestic Residents)
-Accumulation of Foreign Exchange
Reserves

Goods
Services
Income
Current Transfers
Current Account
Capital Account
Direct Investment
Portfolio Investment
Financial Derivatives
Other Investment
Change in Reserves
Capital &Financial
Account
Net
-64970
133468
41175
-13878
95795
Credit
1488982
323087
384595
4719
2201383
Debit
1553952
189619
343420
18597
2105588
 Hong Kong had a
96 million dollar current account surplus in 2001.

-9155
96948
Into HK Abroad
185424
Foreign Holdings Holdings of
88476
Foreign Assets
-322045 of Hong Kong
Assets
-9054
39640
133783
-100507
-327414
312992
-140147
-461197
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-36530
-97359
Hong Kong had a
97 million dollar capital & financial account deficit.
The difference is reserve assets.

 Capital Account = I – S
 Current Account = EX – IM
 S = GDP – C – G
 GDP = C + I + G + EX – IM → GDP – C – G = I + EX-
IM S = I + EX – IM → S – I = EX - IM
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Net Capital Outflows = Goods Outflows
When an economy provides more goods to the world economy than it receives in return it will have extra foreign funds. These will be used to acquire foreign assets.

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1.
An increase in the real exchange rate has counter-veiling effects on net exports.
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The value/price of a given amount of export goods will rise relative to a given amount of import goods when domestic goods increase in relative price.
An economy exports 100 apples at price of $1 each and imports 100 oranges at price of $1. Net exports are zero. If price of apples goes to $2, then net exports will increase to
100.
2.
When relative price of domestic goods increases, the domestic economy will export fewer goods and import more goods.
In very short run, the first effect will dominate.
In medium to long run, the second effect tends to dominate.

S-I
E
E *
NX

 The real exchange rate, in the medium run, is determined by the position of savings and investment.
 Shortfalls in domestic savings result in high real exchange rates and low net exports
Event
Government
Deficits
Productivity
Boom
S - I / NX
←
←
E
↑
↑

E**
E
SI’
S-I
NX