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Topic 4 The Balance of Payments and Exchange Rates

Outline: A. Balance of Payment B. Determinants of Import and Export C. Demand and Supply of Foreign Exchange D. Equilibrium Exchange Rate

Section A: Balance of Payments (BOP)

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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Section A: Balance of Payments (BOP)


BOP records a countrys transactions in goods, services
and assets with the rest of the world. BOP is also a record of a countrys sources (supply) and uses (demand) of foreign exchanges. Usually recorded in local currency (at equivalent amount of foreign currency).

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

(-/+)$XX (+/-)$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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Remark: The balances of these three accounts must be


summed to zero.

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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Notice that both the current account and capital account


concern with transactions of the private sector Official settlement account concerns with transactions of the government sector Normally the BOP Balance is defined as the balance of the private sector: BOP Balance = Balance in the Current Account + Balance in the Capital Account

Section B: The determinants of imports and exports


Major determinants of the demand for Imports (IM):
Domestic incomes rise (+ effect on IM) Domestic prices rise relative to foreign prices (+ effect on IM) Exchange rate of domestic currency rises (+ effect on IM)

Major determinants of the demand for Exports (EX):


Foreign incomes rise (+ effect on EX) Domestic prices rise relative to foreign prices (- effect on EX) Exchange rate of domestic currency rises (- effect on EX)

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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Section C: Demand and Supple of Foreign Exchange


Definition of Exchange Rate: Price of foreign currency in terms of domestic currency Examples: USD1 = HKD7.75 HKD/USD = 7.75 USD/HKD = 0.129

Without government intervention, exchange rate is determined by Demand and Supply.


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The demand for foreign currency

Consider the exchange rate between USD and HKD:

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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Draw the Demand Curve for USD (Example 1.1)


HKD/USD

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

US$1 = HK$8 US$1 = HK$8 HK$400 20 US$1,000 HK$480 15 US$900

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Draw the Demand Curve for USD (Example 1.3)


HKD per USD

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.

The demand curve for USD shifts to the right.


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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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The supply for foreign currency

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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Draw the Supply Curve of USD (Example 2.1)


HKD/USD

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

US$1 = HK$8 US$1 = HK$8 US$15 20 US$300 US$20 12 US$240

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Draw the Supply Curve of USD (Example 2.2)


HKD per USD

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.

3. Foreign income If US national incomes rise. US consumers buy more HK goods.

The supply curve of foreign currency shifts to the right.


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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.

If foreign (US) product prices rise


(IM falls) Demand for foreign currency (USD) decreases. (EX rises) Supply of foreign currency (USD) increases.

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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.

If foreign (US) incomes rise


(EX rises) Supply of foreign currency (USD) increases.

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Section D: Equilibrium Exchange Rate


Without government intervention, the equilibrium exchange rate is determined by demand and supply. HKD per USD S1 S2

HKD7.75

D2 D1
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Quantity of USD available in the currency market

Managed exchange rate (e.g., Hong Kongs linked


exchange rate system) Exchange rate is subject to demand and supply forces within the trading band. If the fluctuations are too large, central bank will intervene the market. If foreign currency appreciates too much (above the upper bound), central bank will sell foreign currency to dampen the appreciation. If foreign currency depreciates too much (below the lower bound), central bank will buy foreign currency to dampen the depreciation.
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Managed exchange rate


HKD per USD S

7.85

Upper bound

} Trading band
7.75 Lower bound

D Quantity of USD available in the currency market


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