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Outline: A. Balance of Payment B. Determinants of Import and Export C. Demand and Supply of Foreign Exchange D. Equilibrium Exchange Rate
Foreign exchanges refer to currencies of foreign countries Example: HKD is domestic currency; USD is foreign currency. 1. Demand for foreign currency is equivalent to Supply of domestic currency (e.g., selling HKD for USD). 2. Supply of foreign currency is equivalent to Demand of domestic currency (e.g., selling USD for HKD)
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1. Transactions that create earnings (supply) of foreign exchanges carry a positive sign. 2. Transactions that use up (demand) foreign exchanges carry a negative sign.
Current account Exports of goods and services. Imports of goods and services. Balance of trade Income (received/paid) on investments (e.g. dividends). Transfer of funds (from/to) abroad (e.g., remittance). Current account balance Capital/Financial account (capital outflow/inflow) (Increase/Decrease) in domestic ownership of foreign assets. (Increase/Decrease) in foreign ownership of domestic assets. Errors & omissions (e.g., unreported transactions) . Capital account balance Official settlement account Changes in official reserves (sell(+)/buy(-) foreign currency (+/-)$XX
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(+)$XX (-) $XX (+/-)$XX (+/-) $XX (+/-) $XX (+/-) $XX
Example: A Hong Kong textile company sells USD 1m of products to the US, then deposits the USD 1m revenue in a New York bank In HKs BOP: Current A/C: export of goods and services +HKD 7.8m. Capital A/C: increase in domestic ownership of foreign assets -HKD 7.8m.
Question: If the HK company keeps the USD 1m in cash, does it change the way in which the above transaction is recorded in HKs BOP?
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Example: if HK has a trade deficit (e.g., imports exceeds exports by HKD 3m) : Spending of foreign exchange is larger than earning of foreign exchange. The trade deficit has to be financed by the capital account surplus, e.g., selling government bonds to foreigners (increase in foreign ownership of domestic assets by HKD 3m). Or, financed by the official reserves (the HK government sells USD for HKD 3m).
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Remark: Export and Import are parts of national incomes =>The economic performance of countries/economies are interrelated through changes in exports and imports Example: If the US has poor economic performance, National income of the US will decrease. Demand for import from overseas will decrease. Demand for HKs exports will decrease.
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If the exchange rate of USD falls (in terms of HKD) HK consumers buy more US goods, and thus buy more USD (sell more HKD). Quantity demanded for USD increases. Demand curve for USD is downward sloping.
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Example 1.1:
US$1 = HK$8 US$1 = HK$6 Price of US made sports shoes in US$ Price of US made sports shoes in HK$ Quantity demanded of US sports shoes Quantity demanded of US$ US$50 HK$400 20 US$1,000 US$50 HK$300 28 US$1,400
Review question: How is HKs trade balance affected by the appreciation of HKD?
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Q of USD
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Example 1.2:
US$1 = HK$8 US$1 = HK$6 Price of US made sports shoes in US$ Price of US made sports shoes in HK$ Quantity demanded of US sports shoes Quantity demanded of US$ US$50 HK$400 20 US$1,000 US$50 HK$300
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US$1,100
Review question: How is HKs trade balance affected by the appreciation of HKD?
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Factors that will shift the demand curve for foreign currency
1. Relative price level between the domestic country and foreign country If US product prices rise, the demand curve for USD shifts to the left .
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Example 1.3:
Price of US made sports shoes in US$ Exchange rate Price of US made sports shoes in HK$ Quantity demanded of US sports shoes Quantity demanded of US$ US$50 US$60
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Q of USD
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2. Interest rate If US interest rate rises Investors buy more USD (sell more HKD) since investment in US (e.g. bonds) becomes more attractive. The demand curve for USD shifts to the right.
3. Domestic income If HK national incomes rise HK consumers buy more foreign goods.
4. Expectation Expectation about future changes in relative price, interest rate and income. If investors expect a future appreciation of HKD (against USD): The current demand curve for USD shifts to the left.
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If the exchange rate of USD falls (in terms of HKD) US consumers buy less HK goods, and thus buy less HKD (sell less USD). Quantity supplied of USD decreases. The supply curve for USD is upward sloping.
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Example 2.1:
Exchange rate Price of HK made clothing in HK$ Price of HK made clothing in US$ Quantity demanded of HK made clothing Quantity supplied of US$ US$1 = HK$8 US$1 = HK$6 HK$120 US$15 30 US$450 HK$120 US$20 20 US$400
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Q of USD
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Factors that will shift the supply curve for foreign currency
1. Relative price level between the domestic country and foreign country If HK product prices rise, the supply curve for USD shifts to the left .
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Example 2.2:
Price of HK made clothing in HK$ Exchange rate Price of HK made clothing in US$ Quantity demanded of HK made clothing Quantity supplied of US$ HK$120 HK$160
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Q of USD
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2. Interest rate If HK interest rate rises. Investors sell more USD (buy more HKD) since investment in HK becomes more attractive. The supply curve of USD shifts to the right.
4. Expectation
Expectation about future changes in relative price, interest rate and income. If investors expect a future appreciation of HKD: The current supply curve of USD shifts to the right
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Summary
Price effect (shifts both demand and supply curves): If domestic (HK) product prices rise
(IM rises) Demand for foreign currency (USD) increases. (EX falls) Supply of foreign currency (USD) decreases.
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Summary
Interest rate effect (shifts both demand and supply curves): If domestic (HK) interest rate rises (Capital outflow falls) Demand for foreign currency (USD) decreases. (Capital inflow rises) Supply of foreign currency (USD) increases.
If foreign interest rate rises (Capital outflow rises) Demand for foreign currency (USD) increases. (Capital inflow falls) Supply of foreign currency (USD) decreases.
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Summary
Income effect (shifts either demand or supply curve): If domestic (HK) incomes rise
(IM rises) Demand for foreign currency (USD) increases.
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HKD7.75
D2 D1
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7.85
Upper bound
} Trading band
7.75 Lower bound