HKCEE Macroeconomics
Chapter 8
Exchange Rates and the
Balance of Payments
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
1
Demand for Foreign Currencies
•We demand for foreign currencies for:
 payment for foreign imports
 making foreign investments
•We supply domestic currencies in the foreign
exchange market in exchange for foreign
currencies
•D foreign Currencies  S domestic currencies
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
2
Supply of Foreign Currencies
• Foreign countries demand for domestic
currencies for:
 payment for domestic exports
 making domestic investments
• Foreign countries supply foreign currencies
in the foreign exchange market in
exchange for domestic currencies
• D domestic Currencies  S foreign currencies
Task 1: Textbook/P.214/Q.10.1
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
3
Exchange Rates
• An exchange rate is the price of a
currency in terms of another currency.
• Example:
 US$1 = HK$7.8  HK$1 = US$0.129
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
4
Floating Exchange Rate System
• Under the floating/flexible exchange rate
system, the exchange rate of a currency is
determined by its demand and supply.
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
5
Floating Exchange Rate System
• Example: US$1 = HK$8
Exchange rate of US$
(in terms of HK$)
D
S
8
Quantity of US$
0
By Mr. LAU san-fat
Q
CH8-Exchange Rates & the BOP-SV
6
Floating Exchange Rate System
• Appreciation of a currency occurs if its
exchange rate rises
• Example: US$1 = HK$8  US$1 = HK$9
 Appreciation of a currency occurs if:
 its demand rises
 its supply falls
 its demand rises and supply falls
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
7
Floating Exchange Rate System
• Depreciation of a currency occurs if its
exchange rate falls.
• Example: US$1 = HK$8  US$1 = HK$7
 Depreciation of a currency occurs if:
 its demand falls
 its supply rises
 its demand falls and supply rises
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
8
Floating Exchange Rate System
• Appreciation of a foreign currency implies
depreciation of local currency.
• Example:
 Before appreciation of US$:
 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$0.111
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
9
Floating Exchange Rate System
• Depreciation of a foreign currency implies
appreciation of local currency.
• Example:
 Before depreciation of US$:
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
10
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.
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
11
Fixed Exchange Rate System
• Revaluation of a currency occurs if the
fixed rate is raised.
 Example: US$1 = HK$8  US$1 = HK$9
• Devaluation of a currency occurs if the
fixed rate is decreased.
 Example: US$1 = HK$8  US$1 = HK$7
Task 2: Textbook/P.217/Q.10.3
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
12
Linked Exchange Rate System
• Functions:
 to govern the issuing of banknotes
 to help stabilize the exchange rate of HK$
in terms of US$
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
13
Linked Exchange Rate System
• Operations:
 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
 buying and selling of the Certificates of
Indebtedness (CI) with US$
 difference between the linked and market rates
will be cleared by engaging arbitrage
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
14
Linked Exchange Rate System
• If linked rate > market rate…
 if market rate: US$1 = HK$7
 arbitrage occurs:
 buying US$ 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
15
Linked Exchange Rate System
• If linked rate < market rate…
 if market rate: US$1 = HK$9
 arbitrage occurs:
 buying US$ 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
16
Effects of Changes in Exchange Rate
• If foreign currency appreciates/revalues
 Example:
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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
17
Effects of Changes in Exchange Rate
• If foreign currency appreciates/revalues
 Price of foreign imports in terms of local
currency will rise
  ↓demand for foreign imports (by local
consumers)
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
18
Effects of Changes in Exchange Rate
• If foreign currency appreciates/revalues
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
19
Effects of Changes in Exchange Rate
• If foreign currency appreciates/revalues
 Price of domestic exports in terms of foreign
currency will fall
  ↑demand for domestic exports (by foreign
countries)
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
20
Effects of Changes in Exchange Rate
• If foreign currency depreciates/devalues
 Example:
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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
21
Effects of Changes in Exchange Rate
• If foreign currency depreciates/devalues
 Price of foreign imports in terms of local
currency will fall
  ↑demand for foreign imports (by local
consumers)
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
22
Effects of Changes in Exchange Rate
• If foreign currency depreciates/devalues
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
23
Effects of Changes in Exchange Rate
• If foreign currency depreciates/devalues
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
24
Balance of Payments (BOP)
• The Balance Of Payments Account
 a set of statistical statements
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
25
Balance of Payments (BOP)
•In the BOP Account…
 payments to other countries → debit side
 receipts by the country → credit side
 two major accounts:
 the current account
 the capital and financial account
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
26
The Current Account
It measures flow of real resources
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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
27
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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
28
The Current Account
3. Income
Factor incomes
Net 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 income
portfolio investment income
other investment income
compensation of employees
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
29
The Current Account
4. Current Transfers
unilateral flow of real and financial resources
Including gifts, grants, remittance & aids
If 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
30
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.)
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
31
The Capital & Financial Account
 the Capital Account
 It measures external transactions in capital
transfers and non-produced/non-financed
assets (such as patents & copyrights).
 A capital transfer is a transfer of ownership of
a fixed asset or forgiveness of a liability.
 Capital inflows lead to credit while outflows
lead to a debit.
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
32
The Capital & Financial Account
 the Financial Account
 It shows how an economy’s external
transactions are financed.
1. Direct Investment:
 It aims at acquiring lasting interest & influence in
managing an overseas enterprise
 Example: external investment in (overseas)
real estate
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
33
The Capital & Financial Account
 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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
34
The Capital & Financial Account
 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.
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
35
The Capital & Financial Account
 the Financial Account
4. 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
Task 6: Textbook/P.228/Q.10.6
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
36
The BOP Deficit or Surplus
by excluding the changes in reserve
assets, we may have BOP imbalances.
BOP
Financial Status
Balanced BOP
Total receipts = Total payments
BOP Deficit
Total receipts < Total payments
BOP
Surplus
Total receipts >7Total payments
Task 7:
Textbook/P.229/MCQ
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
37
BOP Imbalances & Reserve Assets
 Changes in Reserve Assets
 With BOP deficit:
 BOP deficit → outflow of gold/foreign currencies
→ credit the account → the BOP account gets
balanced
 With BOP surplus:
 BOP surplus → inflow of gold/foreign currencies
→ debit the account → the BOP account gets
balanced
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
38
BOP and BOP Account
An economy may have balance of payment
(BOP) deficit, surplus or balance, depending
total receipts and total payments.
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
By Mr. LAU san-fat
CH8-Exchange Rates & the BOP-SV
39