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NSS Exploring Economics 6

Chapter 13

International finance exchange rate and balance of payments

Questions
p.180
Think it over
1.
China enjoys a huge trade surplus in international trade, especially in its trade with the United
States. Does this imply that China gains more than the United States from international trade?
2.
To reduce its trade deficit with China, the US government frequently urges the Chinese
government to raise the value of renminbi. What is the relationship between the exchange rate
and the trade balance?
3.
How does a rising yuan affect the Chinese economy?
p.182
Test yourself
13.1
Refer to Table 13.1. What are the prices of buying one Hong Kong dollar in terms of the
following currencies from Hang Seng Bank at the specified moment?
a. US Dollar
b. Renminbi
c. Japanese Yen
Currency

Code

Bank Buy

Bank Sell

US Dollar

USD

7.7860

7.7990

Renminbi

CNY

1.1488

1.1529

Japanese Yen
(per 1,000)

JPY

88.9000

89.1300

Table 13.1
Exchange rates of some foreign currencies against the Hong Kong dollar at Hang Seng Bank
(as at 7 Jul 2010 10:40)

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p.184
Test yourself
13.2
Study table 13.2 and fill in the blanks with the following words:
appreciation

depreciation

revaluation

devaluation

The exchange rate of Currency A


01-01-2011 1 unit of Currency A = 100 units of domestic currency
01-02-2011 1 unit of Currency A = 150 units of domestic currency
Table 13.2 The change in the exchange rate of Currency A in Country X
a.

b.

Suppose Country X adopts a flexible exchange rate system. The change in the exchange
rate in Country X implies a/an
of Currency A and a/an
of domestic
currency.
Suppose Country X adopts a fixed exchange rate system. The change in the exchange
rate in Country X implies a/an
of Currency A and a/an
of domestic
currency.

p.186
Test yourself
13.3
Suppose the exchange rate of the USD against the HKD is USD 1 to HKD 7.8,
a. what is the price of a DVD selling at USD 15 in HK dollars?
b. what is the price of a T-shirt selling at HKD 100 in US dollars?
p.188
Test yourself
13.4
When the exchange rate of a foreign currency falls, how do the import values in foreign
currency and domestic currency change? Use a table to summarise your answer as above.
p.191
Test yourself
13.5
When the exchange rate of a foreign currency falls, how do the export values in domestic
currency and foreign currency change? Use a table to summarise your answer as above.

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p.197
Fig. 13.17
Are they recorded as credits or debits in the goods account?
p.198
Test yourself
13.6
How is income in the current account related to GDP and GNP?
p.200
Test yourself
13.7
Identify if the following transactions should be recorded as credits or debits. Also identify to
which sub-accounts they belong.
Transactions

Credit

Debit Goods

Services

Income

Current
transfers

a. A branch of a Hong Kong


company operating in Canada
distributes a profit of HK$1
million to its head office in
Hong Kong.
b. A Hong Kong retailer imports
HK$1.5 million worth of
computers from the United
States.
c. Cathay Pacific transports
goods for a Japanese company
for HK$2 million.
d. A rich man donates HK$5
million to a university in the
mainland of China.

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NSS Exploring Economics 6


Questions and Answers to Exercises (Chapter 13)

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p.205
Test yourself
13.8
Discuss the relation between the market BoP and the accounting BoP by filling in the blanks.
Hints are given for the first one.
Market
BoP
In surplus

Change in reserve assets

Accounting
BoP

To settle the market imbalance, the central bank


buys / sells / does not buy or sell foreign currencies
from / to the market. As a result, reserve assets
increase / decrease / remain unchanged.

In surplus /
In deficit /
Balanced

Balanced

In deficit

Table 13.7
Relation between market BoP, change in reserve assets and accounting BoP
p.206
Test yourself
13.9
Below is a hypothetical balance of payments. Fill in the following blanks to find the market
BoP and the accounting BoP.
Balance (in $ million)
Current Account 1. Goods
-500
2. Services
600
3. Income
400
4. Current transfers
-150
Current Account Balance
Capital and Financial Account
1. Balance excluding reserve assets
2. Change in reserve assets
Capital and Financial Account Balance

200

Market BoP
Accounting BoP

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pp.210-212
Exercises
Multiple Choice Questions
1.
Which of the following statements about exchange rates is correct?
A. The exchange rate of a foreign currency is the amount of domestic currency required to
be exchanged for one unit of the foreign currency.
B. The exchange rate of a foreign currency is the quantity of imports that can be exchanged
with one unit of exports.
C. The exchange rate of a currency is determined by the demand for and supply of the
currency.
D. The exchange rate of buying foreign currency from banks is usually lower than the
exchange rate of selling foreign currency to banks.
2.
When the exchange rate of a foreign currency increases,
A. the domestic currency appreciates under a flexible exchange rate system.
B. both the foreign currency and the domestic currency are revaluated under a flexible
exchange rate system.
C. the domestic currency is devaluated under a fixed exchange rate system.
D. the foreign currency depreciates under a fixed exchange rate system.
3*.
When the Hong Kong dollar appreciates against the Japanese yen,
A. the prices of imports from Japan in Hong Kong dollars will rise.
B. the prices of imports from Japan in Japanese yen will fall.
C. the prices of exports to Japan in Hong Kong dollars will rise.
D. the prices of exports to Japan in Japanese yen will rise.
4*.
When the British pound appreciates against the Hong Kong dollar,
A. the change in the expenditure on imports from the United Kingdom in Hong Kong
dollars will be uncertain.
B. the change in the expenditure on imports from the United Kingdom in pounds will be
uncertain.
C. revenue from exports to the United Kingdom in Hong Kong dollars will fall.
D. revenue from exports to the United Kingdom in pounds will rise.

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5.
Which of the following statements about the linked exchange rate system in Hong Kong is
INCORRECT?
A. Note-issuing banks can transact US dollars with the Exchange Fund at the linked rate.
B. Licensed banks can transact foreign currencies with the Exchange Fund at the linked
rate.
C. The market exchange rate of the Hong Kong dollar relative to the US dollar is not fixed.
D. The market exchange rate of the Hong Kong dollar relative to renminbi is flexible.
6**.
Year

Exchange rates

2005
2010

USD 1 = AUD 1.20


USD 1 = AUD 1.30

The above change in the exchange rate of the US dollar against the Australian dollar would
lead to
A. fewer Australian tourists visiting Hong Kong.
B. a larger volume of Hong Kong goods exported to Australia.
C. a smaller volume of Australian goods exported to Hong Kong.
D. a trade deficit in Hong Kong against Australia.
7.
Which of the following will have favourable effects on the current account of Hong Kongs
balance of payments?
A. A student buys a computer imported from Taiwan.
B. A Hong Kong resident receives interest from his or her US deposits.
C. An investor from the mainland of China buy Hong Kong stocks.
D. A Hong Kong resident buys a house in Canada.

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8*.
From the following information, find the value of domestic exports of goods:
Re-exports of goods
$280
Net income from abroad -$10
Net current transfers
$100
Exports of services
$300
Imports of services
$250
Imports of goods
$420
Current account balance $600
A.
B.
C.
D.

$1,210
$1,160
$780
$600

10.
Which of the following statements about the balance of payments account is correct?
A. The accounting balance of payments is always balanced.
B. A balance of payments surplus will lead to a decrease in the reserve assets of the central
bank.
C. Under a balance of payments deficit, the central bank will buy foreign currency in the
market to settle the imbalance.
D. Excluding the changes in reserve assets, the market balance of payments is always
balanced.

Short Questions
1.
a. Define exchange rate.
(2 marks)
b. Explain how an appreciation of domestic currency affects the domestic prices and
foreign prices of a countrys exports and imports, respectively.
(6 marks)
2.
What are the effects of Hong Kongs linked exchange rate system on
a. the market exchange rate of the US dollar relative to the Hong Kong dollar;
(2 marks)
b. the market exchange rates of foreign currencies other than the US dollar relative to the
Hong Kong dollar?
(2 marks)

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3.
Despite the fact that the market balance of payments may not be balanced, the accounting
balance of payments is always balanced. Explain if you agree with this statement. (6 marks)
4**.
Are the following items a stock or a flow? Explain.
a. Exchange rate
b. Current account balance
c. Foreign exchange reserve

(2 marks)
(2 marks)
(2 marks)

Structured Questions
1.
Explain how each of the following events is recorded in the current account and how it
affects Hong Kongs market balance of payments (e.g. it is recorded as a credit/debit in a subaccount and it improves/worsens the market BoP).
a**. The Hong Kong Monetary Authority (HKMA) uses reserve assets to buy USD 2 billion
from the market.
(3 marks)
b. A Hong Kong manufacturer exports HKD 3 million worth of his latest bicycle model to
India.
(2 marks)
c. A French painter sends two of his paintings worth HKD 4 million to an art gallery in
Hong Kong as a gift.
(2 marks)
d. An Australian professor lectures at a university in Hong Kong for two weeks and earns
HKD 0.5 million as a result.
(2 marks)
2.
Year

Exchange rates

2005
2010

CAD 1 = HKD 7.45


CAD 1 = HKD 8

a.

Between 2005 and 2010, did the US dollar appreciate or depreciate against the Canadian
dollar?
(2 marks)
b*. Under what condition would the expenditure on goods imported from Canada to Hong
Kong in Hong Kong dollars decrease? Use a diagram to illustrate.
(7 marks)
c*. Under what condition would the expenditure on goods exported from Hong Kong to
Canada in Hong Kong dollars increase? Use a diagram to illustrate.
(7 marks)

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d**. If Hong Kong suffers a balance of payments deficit, will depreciation of the Hong Kong
dollar improve the balance of payments position? Explain.
(3 marks)
Answers
P.180
Think it over
1. China enjoys a huge trade surplus in international trade, especially in its trade with
United States. Does this imply that China gains more than the United States from
international trade?
As discussed in Chapter 11, the gain from exports is equal to the difference between the
total value of exports and the total domestic production cost of exports, while the gain
from imports is equal to the difference between the total domestic production cost of
imports (if produced domestically) and the total value of imports. The larger the
difference, the larger the gain.
The trade balance is the difference between the total value of exports and the total value
of imports. A positive trade balance is called a trade surplus, while a negative one is
called a trade deficit.
The huge trade surplus implies that Chinese exports are far larger than its imports.
However, this does not imply that China gains more than the US from trade.
2.

To reduce its trade deficit with China, the US government frequently urges the Chinese
government to raise the value of its currency. What is the relationship between the
exchange rate and the trade balance?
When the US dollar depreciates (or the Chinese yuan appreciates), the US trade balance
may not improve (or the Chinese trade balance may not worsen). (This is discussed in
Section 13.2 of this chapter.)

3.

How does a rising yuan affect the Chinese economy?


A rising yuan will raise the prices of Chinese exports (in foreign currency) and reduce
the volume of exports. Many firms in the export sector may suffer and, as a result, they
may dismiss many workers.
On the other hand, a rising yuan will lower the prices of Chinese imports (in terms of
yuan) and increase their quantities. The import-competing sectors face more fierce
competition and may dismiss many workers.
Moreover, unemployment will reduce government tax revenue but increase its transfer
payments. As a result, the fiscal balance may worsen.

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P.182
Test Yourself 13.1
To buy HKDs from a bank, we have to sell a foreign currency to it. Hence, the
relevant exchange rates are in the Bank Buy column of foreign currencies.
a.

USD 1 = HKD 7.7860


USD

1
7.7860
= HKD
7.7860
7.7860

HKD 1 = USD 0.1284


b.

CNY 1 = HKD 1.1488


CNY

1
1.1488
= HKD
1.1488
1.1488

HKD 1 = CNY 0.8705


c.

JPY 1,000 = HKD 88.9000


JPY

1,000
88.9000
= HKD
88.9000
88.9000

HKD 1 = JPY 11.2486


P.184
Test Yourself 13.2
a. Suppose Country X adopts a flexible exchange rate system. The change in the exchange
rate in Country X implies a/an appreciation of Currency A and a/an depreciation of
domestic currency.
b.

Suppose Country X adopts a fixed exchange rate system. The change in the exchange
rate in Country X implies a/an revaluation of Currency A and a/an devaluation of
domestic currency.

P.186
Test Yourself 13.3
a. The price of the DVD in HKDs = Pf e
= USD 15 HKD 7.8/USD = HKD 117
b.

The price of the T-shirt in USDs = Pd

1
e

= HKD 100 USD 1/HKD 7.8


= USD 12.82

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P.188
Test Yourself 13.4
In foreign currency

In domestic currency

Price of
imports

Remains unchanged
(Pf is assumed to be
independent of e.)

Decreases
(Pd = Pf e; e Pd)

Volume of
imports

Increases
[Domestic buyers pay Pd (instead of Pf) to buy imports.
Pd QM]

Value of
imports

Increases
[QM and Pf unchanged
(QM Pf) ]

Uncertain, depending on EM
[QM and Pd (QM Pd)? ]

P.191
Test Yourself 13.5
In domestic currency

In foreign currency

Price of
exports

Remains unchanged
(Pd is assumed to be
independent of e.)

Increases

Volume of
exports

Decreases
[Foreigners pay Pf (instead of Pd) to buy exports. Pf QX]

Value of
exports

Decreases
[QX and Pd unchanged
(QX Pd) ]

(Pf = Pd

1
; e Pf)
e

Uncertain, depending on EX
[QX and Pf (QX Pf)? ]

P.197
Fig 13.17
Since both rice and cars are imported goods, they are recorded as debits in the goods account.
P.198
Test Yourself 13.6
The balance of the income account is called net (factor) income from abroad. To calculate
GNP, we need to add this balance to GDP.

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p.200
Test yourself
13.7
Transactions

Credit

Debit Goods

Services

Income

Current
transfers

a. A branch of a Hong Kong


company operating in Canada
distributes a profit of HK$1
million to its head office in
Hong Kong.

b. A Hong Kong retailer imports


HK$1.5 million worth of
computers from the United
States.
c. Cathay Pacific transports
goods for a Japanese company
for HK$2 million.

d. A rich man donates HK$5


million to a university in the
mainland of China.

P.205
Test Yourself 13.8
Market
BoP

Change in reserve assets

Accounting
BoP

In surplus

To settle the market imbalance, the central bank


buys foreign currencies from the market. As a
result, reserve assets increase.

Balanced

Balanced

The central bank does not have to settle any


imbalance. As a result, reserve assets remain
unchanged.

Balanced

In deficit

To settle the market imbalance, the central bank


sells foreign currencies to the market.
As a result, reserve assets decrease.

Balanced

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P.206
Test Yourself 13.9
Balance (in $ million)
Current Account 1. Goods
-500
2. Services
600
3. Income
400
4. Current transfers
-150
Current Account Balance
350
Capital and Financial Account
1. Balance excluding reserve assets
200
2. Change in reserve assets
-550
Capital and Financial Account Balance
-350
Market BoP
Accounting BoP

550
0

P.210-212
Exercises
Multiple Choice Questions
1. A
Option A is correct. It is the definition of exchange rate.
Option B is incorrect. It is the definition of terms of trade.
Option C is incorrect. Under a fixed exchange rate system, the exchange rate is
determined by the central bank.
Option D is incorrect. Banks gain from buying foreign currencies at a lower price and
selling them at a higher price. Hence, customers buy foreign currencies from banks at a
higher price and sell foreign currencies to banks at a lower price.
2.

C
The increase in exchange rate of a foreign currency implies the appreciation
(revaluation) of the foreign currency under a flexible (fixed) exchange rate system and
the depreciation (devaluation) of the domestic currency under a flexible (fixed)
exchange rate system.

3.

D
When the Hong Kong dollar appreciates against the Japanese yen, the prices of imports
from Japan in HKDs will fall and those in Japanese yen remain unchanged.

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On the other hand, the prices of exports to Japan in HKDs remain unchanged and those
in Japanese yen will rise.
4.

A
For imports from UK to HK:
ePd (= Pf e)QM the change in the expenditure on imports in HKDs (=
QM Pd) is uncertain, depending on the domestic elasticity of demand for imports;
and the expenditure on imports in British pounds (= QM Pf) decreases.
For exports from HK to UK:
ePf [= Pd 1/(e)]QXthe change in the revenue from exports in British
pounds (= QX Pf) is uncertain, depending on the foreign elasticity of demand for
HKs exports; and the revenue from exports in HKDs (= QX Pd) increases.

5.

B
Only the three note-issuing banks can transact USDs (not other foreign currencies) with
the Exchange Fund at the linked rate.

6.

A
Option A is correct. The appreciation of the USD against the AUD will lead to an
appreciation of the HKD against the AUD. Thus, prices of HK products in AUDs rise
and the number of Australian tourists visiting HK drops.
Option B is incorrect. Since prices of HKs exports to Australia in AUDs rise, the
volume of HKs exports to Australia drops.
Option C is incorrect. Since prices of Australian exports to HK in HKDs fall, the volume
of Australian exports to HK rises.
Option D is incorrect. The total value of HKs exports to Australia in HKDs
(= QX Pd) falls, while the change in the total value of HKs imports from Australia
in HKDs (= QM Pd) is uncertain. Hence, the change in the trade balance is
uncertain.

7.

B
Option A is incorrect. It is recorded as a debit in the goods account of the current
account.
Option B is correct. It is recorded as a credit in the income account of the current
account.
Option C is incorrect. It is recorded as a credit in the capital and financial account.
Option D is incorrect. It is recorded as a debit in the capital and financial account.

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8.

D
Current account balance
= Domestic exports of goods + Re-exports of goods Imports of goods
+ Exports of services Imports of services + Net income from abroad
+ Net current transfers
$600 = X + $280 $420 + $300 $250 + (-$10) + $100
X = $600

10. A
Option B is incorrect. A balance of payment surplus will lead to an increase in the
reserve assets.
Option C is incorrect. The central bank will sell foreign currency to the market.
Option D is incorrect. The market BoP may not be balanced.
P. 211-212
Short Questions
1. a. The exchange rate of a currency is the price of the currency in terms of
another currency. (2 marks)
b. The domestic prices of a countrys exports are assumed to be not affected by the
exchange rate. (1 mark)
When domestic currency appreciates or foreign currency depreciates (e), the
foreign prices of a countrys exports [= Pd 1/(e)] rise. (2 marks)
The foreign prices of a countrys imports are assumed to be not affected by the
exchange rate. (1 mark)
When domestic currency appreciates or foreign currency depreciates (e), the
domestic prices of a countrys imports (= Pf e) fall. (2 marks)
2.

a.
b.

The market exchange rate of the US dollar relative to the Hong Kong dollar
cannot deviate significantly from the linked rate. (2 marks)
The changes in market exchange rates of foreign currencies other than the US
dollar relative to the HK dollar closely follow those relative to the US dollar. When
the US dollar appreciates (depreciates) against other currencies, the HK dollar will
appreciate (depreciate) simultaneously by similar percentages. (2 marks)

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3.

Agree.
The market BoP is equal to the sum of all market transactions with other economies
excluding the transactions of central banks. (1 mark)
The accounting BoP is equal to the sum of all transactions with other economies,
including the transactions of central banks. (1 mark)
Despite that the market BoP may not be balanced, the amount of imbalance is
accommodated by the central bank through transactions of reserve assets.
(1 mark)
When there is a market BoP surplus (deficit), the central bank will buy (sell) an
equivalent amount of foreign currency from (to) the foreign exchange market to absorb
the surplus (accommodate the deficit). Hence, the accounting BoP must be balanced and
reserve assets held by the central bank increase (decrease) by the same amount as the
BoP surplus (deficit). (3 marks)

4.

a.

b.

c.

The exchange rate of a currency is the price of the currency in terms of


another currency at a certain moment. For example, saying that the exchange rate is
$10 per month is meaningless. Hence, it is a stock. (2 marks)
The current account balance is the balance of values of external inflows and
outflows of goods, services, factor incomes and current transfers in a specified
period. Specifying the period concerned is necessary because different time spans
imply a different magnitude. For example, a current account balance of $10 million
a day is larger than $10 million a year. Hence, it is a flow. (2 marks)
Foreign exchange reserves are the amount of foreign assets and gold held by a
central bank at a certain moment. For example, saying that a foreign exchange
reserve is $100 million per month is meaningless. Hence, it is a stock. (2 marks)

P.212
Structured Questions
1. a. When HKMA buys USDs from the market, there is an outflow of USDs
from the market and reserve assets held by HKMA increase. This is recorded as a
debit in the capital and financial account. Hence, the transaction is not recorded in
the current account. It does not affect the market BoP as the transaction of a central
bank (the central banking functions are performed by HKMA in Hong Kong) is
excluded from the calculation of the market BoP. (3 marks)
b. The transaction is recorded as a credit in the goods account. It improves the market
BoP. (2 marks)
c. The transaction is recorded as a credit in the current transfers account. It improves
the market BoP. (2 marks)
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2.

d.

The transaction is recorded as a debit in the services account. It worsens the market
BoP. (2 marks)

a.

According to the information given, more units of HKDs are needed in


exchange for a unit of CADs. This means the HKD has depreciated. Since the
changes in market exchange rates of foreign currencies other than the USD against
the HKD closely follow those against the USD, the USD must also have
depreciated against the CAD. (2 marks)

b.

When the CAD appreciates, the domestic prices of HKs imports from Canada rise
(Pd = Pf e and e), and the volume of imports (QM) falls. (2 marks)
HKs expenditure on imports in HKDs (= Pd QM) decreases when HKs
demand for Canadian imports is elastic. This is because the percentage drop in QM
is larger than the percentage rise in Pd, and the drop in expenditure due to the drop
in QM is larger than the rise in expenditure due to the rise in Pd. As a result, HKs
expenditure on imports from Canada in HKDs decreases. (3 marks)
$ (in HKDs)

Increase in import expenditure


Decrease in import expenditure

Pd2

B
A

Pd1

DM
0

QM2

Quantity
of imports

QM1

(2 marks)

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c.

When the CAD appreciates, the foreign prices of HKs exports to Canada in CADs
drop (Pf = Pd

1
and e), and the volume of exports (QX) rises. (2 marks)
e

The domestic prices of HKs exports remain unchanged. (1 mark)


As Pd remains unchanged and QX rises, the expenditure on HKs exports to Canada
will increase. (2 marks)

(2 marks)
d.

As illustrated in part (c), when the HKD depreciates, the volume of exports rises
and the total value of exports in HKDs will rise (QX and Pd unchanged).
(1 mark)
However, as illustrated in part (b), when the HKD depreciates, the volume of
imports falls and the change in the total value of imports in HKDs is uncertain,
depending on HKs price elasticity of demand for imports.
(1 mark)
Hence, the effect of depreciation of the HKD on the BoP is uncertain.
(1 mark)

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