Arora Anjali, Sharma Raj Sumeet

12/6/2022

YORK UNIVERSITY Dr. Farrokh Zandi

Schulich School of Business Fall 2022
ECON 5030A&C.03
Group Assignment- India and Hong Kong
(Anjali Arora, 219323922)
(Sumeet Raj Sharma, 219324052)
___________________________________________________________________________

India (Floating Exchange Rate) and Hong Kong (Fixed Exchange Rate)

Question 1: Currency Appreciation and International Trade (Word limit: 1200- 1500
words. NO diagram is needed -70 Marks)

Over the last 12 months the US central bank’s (The Federal Reserves) policy rate has risen by
a whopping amount of 4 percentage point from near zero to 4 percent and as a result the US
Dollar has appreciated against all major currencies.

Given this scenario, you are to discuss how any TWO export-driven economies (of your
choice) in Asia will be impacted by this dollar appreciation. One of these countries must be
operating on a floating (flexible) exchange rates system and the other one must have its
currency fixed against the US dollar.

(a) Using the short-run theory of the exchange rate as discussed in class, discuss how the
recent monetary policy by the US Federal Reserves, as referred to above, relative to
monetary policy in other countries has caused the US dollar to appreciate. Apply the
relevant equation (model) but NOT a diagram.

The recent shift in the Federal Reserve’s policy has led to a whopping rise in the interest rate
from near 0 to 4%. To analyze this shift in the monetary policy with other countries, we need
to keep in mind that interest rate shift has a direct relation to the exchange rate of other
countries as well explained through Uncovered Interest Parity.

This can be rewritten as:

In this case, the exchange rates will adjust until the interest rate parity holds.
IRP means that RoR$ = RoRHKD.
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

We can assume, the left-hand side is the rate of return on domestic bonds (USA), and the
right-hand side is the foreign interest rate depicting the rate of return on foreign bonds.

In the short run, the increase in the monetary policy attracted foreign investment and business
leading to a capital inflow. This led to an increase in demand for the US currency resulting in
the US dollar appreciating in relation to other countries. This currency appreciation has
resulted from a contractionary monetary policy set in motion by the Federal Reserves.

Now, if we take the case of two countries that have committed to maintaining a fixed
exchange rate – we can investigate Hong Kong and the effect of the recent monetary policy
on the country. Considering, Hong Kong has pegged its exchange rate that implies that the
central bank needs to intervene in the foreign exchange market to maintain the credibility of
the exchange rate.
In this case, the exchange rates will adjust until the interest rate parity holds i.e., Domestic
Interest Rate = Foreign Interest Rate and the exchange rate remains unchanged.

When the US Federal Banks increase the interest rate, the US bonds become more attractive
and investors might tend to move their money to the US bonds from Hong Kong bonds,
leading to US dollar appreciation. Looking at the fixed exchange rate, and if the investors
believed that the expected interest rate would remain fixed, then the investors’ expected
exchange rate should be set equal to the current fixed spot exchange rate. In other words,
under credible fixed exchange rates, E$/HKDe = E$/HKD.

With E$/HKDe = E$/HKD, the right side of the above expression becomes zero, and the interest
rate parity condition under fixed exchange rates becomes

Which can be further simplified into:

The central bank at this point gives up its monetary policy as a policy instrument and the
domestic interest rate must be equal to the foreign interest rate and the exchange rate remains
unchanged.

Now, we can investigate the effect of recent monetary policy on a country with a flexible
exchange rate i.e., India. Looking at this, India has monetary independence i.e., the Indian
government does not need to worry about defending a particular exchange rate and the
government will not intervene. The Federal Reserve increasing the interest rate by 4% will
make the US bonds more attractive and investors and businessmen will continuously hedge
making the US dollar appreciate, then investors might take out money from Indian bonds and
invest in US bonds as they would provide more returns. This will lead to a decrease in USA
exports as the cost of domestic goods will be more expensive relative to Foreign Goods,
increasing imports.
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

An increase in the domestic interest rate relative to the foreign interest rate leads to an
appreciation of the domestic currency.

(b) You need to gather some facts for each of these two countries:

(i) identify (supported by data) these countries’ key (2- 3 at most) exports.
Examples include commodities, such as oil, gas, coffee, tea, and rice, etc. or
manufacturing goods, such as consumer products, capital goods, auto, or
services, such as tourism, etc.).
The top exports of India are:
• Refined Petroleum ($25.3B),
• Packaged Medicaments ($17.8B),
• Diamonds ($16B),
• Rice ($8.21B)
• Jewellery ($7.57B).
The top exports of Hong Kong are:
• Gold ($33B)
• Broadcasting Equipment ($7.28B)
• Gas Turbines ($6.57B)
• Integrated Circuits ($5.94B)
• Telephones ($4.58B).
(ii) identify (supported by data) their key (2-3) imports.

The top imports of India are:

• Crude Petroleum ($59B)
• Gold ($21.9B)
• Coal Briquettes ($20.9B)
• Diamonds ($15.8B)
• Petroleum Gas ($13.8B).
The top imports of Hong Kong are:
• Integrated Circuits ($162B)
• Broadcasting Equipment ($43.1B)
• Office Machine Parts ($30.7B)
• Gold ($20.1B)
• Telephones ($18.2B).
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

(iii) identify (supported by data) their key trade partners, which could be the US itself
or not.

India

Exports:
• United States ($49.7B)
• China ($18.5B)
• United Arab Emirates ($18.1B)
• Hong Kong ($9.18B)
• Germany ($8.8B) and
Imports:
• China ($64.2B)
• United States ($26.6B)
• United Arab Emirates ($22.1B)
• Saudi Arabia ($16.8B)
• Iraq ($14.4B).
Hong Kong

Exports:
• China ($25.9B)
• United Kingdom ($14.8B)
• India ($14.2B)
• Switzerland ($12.1B)
• Netherlands ($5.72B)
Imports:
• China ($262B)
• Chinese Taipei ($50B)
• Singapore ($41.7B)
• South Korea ($30.9B)
• Japan ($27.2B)
(c) Having done the above, you will then be using your theoretical knowledge to do a
full analysis of:

(iv) the impact of the US dollar appreciation on these two countries' exports, and
imports. [In answering this part, you should bear in mind the role of the exchange rate
regimes (ONE PEGGED AND THE OTHER FLEXIBLE), the destination of the
exports of these countries (the identified trade partners), and the origin of their imports.
Also, NO distinction between short and long run is necessary.]. Does a stronger US
dollar create winners and losers in these two Asian economies?
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

An exchange rate appreciation can make a country’s exports more expensive and imports
cheaper depending. Since the Hong Kong dollar is pegged to the USD, a US dollar
appreciation should have no change in the real exchange rate between the two countries. The
HKD appreciation will not affect their trade balance with US as there will be no relative
increase in prices. The trade with other countries will be affected and this can be seen by
looking at the Marshall-Lerner condition, an appreciation of the domestic currency leads to
boosting imports by residents and curbing exports as foreign residents will buy less. This will
lead to a disruption of the trade balance with countries other than the US.

• An increase in the real exchange rate, (ε) (a real appreciation), leads to an increase in
imports, IM. (Blanchard, 377)
• An increase in domestic income, Y (equivalently, an increase in domestic output—
income and output are still equal in an open economy), leads to an increase in
imports. (Blanchard, 377)
So, a US dollar appreciation leads to a Hong Kong dollar appreciation creating a losing
situation for the country.
The opposite will happen with India which has a flexible exchange rate, as their currency will
depreciate when the US dollar appreciates. To analyze the exports of an economy with a
floating exchange rate i.e., India we can look through the Mundell-Fleming condition which
states that the export prices are set in the currency of their own country and fluctuates on a
relatively lower level than exchange rates. The lower price of Indian goods should lead to a
shift in the demand for Indian exports increasing the exports of the country.

An increase in foreign income, Y*, leads to an increase in exports. (Blanchard, 377)

From an import perspective, a depreciation of foreign currency (Indian rupee) leads to a drop
in demand for foreign goods i.e., a decrease in imports. We will also assume, that the same
impact from the US dollar appreciation has taken place with the trading partners leading to
the status quo remaining the same. This will in terms lead to an increase in inflationary
pressure and gaining a competitive advantage from a trade perspective. This will lead to
improving the trade balance and creating winners.
(v) What is the expected overall impact of the US dollar appreciation on the GDP of
these economies? Explain.
It has been established that Hong Kong's currency is pegged against the US dollar. Our
assumption above regarding import and exports clarifies that net exports, NX depends on
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

domestic output Y, foreign output Y*, and the real exchange rate, (ε) So, the increase in
policy rate for Hong Kong leading to the US dollar appreciating, in turn, domestic output
increases through which increase in import occurs thus decreasing net exports.

From the above equation, we can understand that the increase in interest rate would have a
negative impact on the economy. This negative effect is due to an increase in the interest rate
which leads to a decrease in investment spending and as a result decrease in the demand for
domestic goods. The decrease in demand is because investors and businesses want to borrow
less and subsequently invest less in their businesses. So, the overall negative effect on the
economy through investments and net exports lead to Hong Kong’s GDP declining.

Looking at a country with a floating exchange rate i.e., India, we know that a US dollar
appreciation leads to a depreciation of the Indian rupee in turn an increase in net exports. The
increase in net exports has a positive effect on the GDP i.e., GDP increase. This increase in
net exports leads to an overall positive effect on the economy and would lead to the GDP
increasing. (Blanchard, 2021)

In conclusion, from a GDP perspective, the Indian economy will increase and the Hong Kong
economy will decrease.

(vi) What is the expected impact of the US dollar appreciation on the inflation rate of
these economies? Explain.

Inflation is influenced by the exchange rate which is affected by the interest rates. Looking at
the US dollar appreciation, the output of Hong Kong is below potential which can be seen
through the increase in real exchange rates with all countries apart from the US. This means
high-interest rates have a negative impact on consumer spending and economic growth. Thus,
there is an overall decrease in GDP which will lead to a trade deficit. This concludes that the
inflation rates will be lower than expected for Hong Kong.

Whereas for India, GDP will rise due to an appreciation of the US dollar. The output will be
above potential as seen by a decrease in the real exchange rate. The low-interest rate has a
positive impact on consumer spending and economic growth. Through this, we can see an
increase in GDP due to a trade surplus. Hence, India will have a higher-than-expected
inflation rate. (Blanchard, 2021)

Question 2: The Phillips Curve (30 marks)

Examining the behaviour of inflation and unemployment- known as the Phillips curve (PC)-
the following conclusions can be reached: While low unemployment still pushes inflation up
and high unemployment pushes it down, the slope of the Phillips curve, i.e., the effect of the
unemployment rate on inflation given expected inflation, has substantially declined in the
recent past. The following is recent evidence of this flattening development.
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

The above chart shows the relationship between civilian unemployment rate and wage
inflation. The observations are divided into three distinct periods: the 1960s in red; the 1970s,
80s and 90s in blue; and 2000 to 2015 in black.
Referring to the above statement please answer the following questions:

(a) “The modern variation of the Phillips curve depends on gap variables: a positive
correlation between the level of U.S. inflation on the one hand and the output gap
as well as expected inflation on the other hand.” Interpret this statement by using
a mathematical relationship.

The Phillips curve establishes the relationship between unemployment and inflation
and states that they have an inverse relationship. The modern variation of the Phillips
curve depends on a positive relationship between the output gap and inflation, we will
look at it from the perspective of output and inflation rather than unemployment and
inflation.

The unemployment rate is equal to the natural rate, u n, employment is given by

Nn = L (1 - u n)

Output is equal to Y n = L (1 - un).

 Arora Anjali, Sharma Raj Sumeet
12/6/2022

Y n is also called potential output.

The deviation of output from its natural level as:

Y- Yn=L((1-u) -(1-u)) =-L(u-un)

This gives us a simple relation between the deviation of output from potential and the
deviation of unemployment from its natural rate (Blanchard, 179). The difference
between output and potential output represented by (Y – Yn) is called the output gap.
If unemployment is below the natural rate, output is above potential, and the output gap
is positive. This is represented by the below equation:


Π = πe + (L) (Y − Yn)

In the equation, π = Inflation level

π e = Expected inflation
N = Employment
L = Labour force
a = Coefficient
Y= GDP
Yn = Natural GDP

(b) Evidence suggests that the Phillips curve has flattened over the last 2 decades,
notwithstanding the post Covid- 19 environment.

(i) What does the flattening of the Phillips curve mean?

The flattening of the Philips curve refers to the correlation between the unemployment and
inflation rate becoming more stable i.e., decreased sensitivity of inflation to unemployment
rate.

(ii) What is the possible explanation(s) for the PC to have become flatter in recent
years?

Phillips curve has flattened due to following reasons:

In recent years due to COVID, there was an increase in supply shock due to which a
stabilizing effect of the monetary policy in response to the supply shocks, reduced the
inflationary pressures of gap variables, reduction in the bargaining power of workers,
increased globalization and digitalization, increased migration made labour
supply more elastic, increase in the incarceration rate, demographic shifts leading to the
mismeasurement of the gap variable, anchoring of inflation expectation by the people and the
possible existence of a nonlinear relationship between inflation and the gap variable.
(Jørgensen & Lansing, 2021)

𝜋 = 𝜋̅ − 𝑎 (𝑈 − 𝑈𝑛) + Supply shock

 Arora Anjali, Sharma Raj Sumeet
12/6/2022

(iii) Does the fact that Inflation expectations have become steadily more anchored
have anything to do with the PC becoming flatter? Why? (Make sure to first explain
‘anchored’ expectations).

Anchored expectation possibly does play a role in making the Phillip curve flatter. This
means that the expected inflation or mean forecast of inflation remains stable and close to the
central bank’s inflation target i.e., 2%, and is insensitive to incoming data. Anchored
expectations implies that if different inflation rate is seen, the expected inflation rate will be
still 2%. Since, it is expected that inflation will be maintained at 2% by the Feds, leading to a
declining gap coefficient and responding to unemployment by repressing price changes and
concealing wage changes.

(iv) What does a flat Phillips curve mean for monetary policy? Don’t forget that the
relationship between inflation and the unemployment rate is a key input to the
design of monetary policy.

Change in Y causes less change in inflation with a flat Phillip curve. When the Phillip curve is
flat it implies that the unemployment rate is low and using monetary policy is easier as Fed
does not need to worry because the effect on the inflation rate is little. With fewer rate hikes,
full utilization of the resource is possible.
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

References

“Blanchard, Macroeconomics, 8th Edition.” Blanchard, Macroeconomics, 8th Editon,

https://www.pearson.com/nl/en_NL/higher-education/subject-
catalogue/economics/Macroeconomics-8e-Blanchard.html.

Jørgensen, P. L., & Lansing, K. J. (2021, August 9). Return of the original Phillips Curve. San
Francisco Fed. Retrieved December 5, 2022, from https://www.frbsf.org/economic-
research/publications/economic-letter/2021/august/return-of-original-phillips-curve/

Cato.org, https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-
monetary-policy

Dollar Dominance in Trade: Facts and Implications,

https://www.eximbankindia.in/blog/blog-
content.aspx?BlogID=9&BlogTitle=Dollar+Dominance+in+Trade%3A+Facts+and+Im
plications.

“Hong Kong (HKG) Exports, Imports, and Trade Partners.” OEC,

https://oec.world/en/profile/country/hkg

“India (IND) Exports, Imports, and Trade Partners.” OEC,

https://oec.world/en/profile/country/ind/.

Schoenholtz, Steve Cecchetti and Kim. “The Phillips Curve: A Primer.” Money, Banking and
Financial Markets, Money, Banking and Financial Markets, 15 Aug. 2017,
https://www.moneyandbanking.com/commentary/2017/5/29/the-phillips-curve-a-
primer.

Amadeo, Kimberly. “Why Countries Peg Their Currencies to the Dollar.” The Balance, The
Balance, 31 Mar. 2022, https://www.thebalancemoney.com/what-is-a-peg-to-the-
dollar-
3305925#:~:text=A%20dollar%20peg%20is%20when,on%20a%20floating%20excha
nge%20rate.
Exrate Trade. https://www.hkeconomy.gov.hk/en/pdf/wp/exrate_trade.pdf.
 Arora Anjali, Sharma Raj Sumeet
12/6/2022

“Hong Kong: Imports and Exports: World: All Commodities: Value (US$) and Value
Growth, Yoy (%): 2010 - 2021.” TrendEconomy, 14 Nov. 2022,
https://trendeconomy.com/data/h2/Hongkong/TOTAL.
“How the U.S. 'Exports Inflation' through a Strong Dollar.” Kenaninstitute.unc.edu,
https://kenaninstitute.unc.edu/kenan-insight/how-the-u-s-exports-inflation-through-a-
strong-dollar/.%20
“Japan: Imports and Exports: World: All Commodities: Value (US$) and Value Growth, Yoy
(%): 2010 - 2021.” TrendEconomy, 14 Nov. 2022,
https://trendeconomy.com/data/h2/Japan.