Monday, 10 October 2011

Economics note: International trade III: Exchange rate system

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Exchange rate system
Foreign currencies are not the medium of exchange in local market, so they are bought and sold in terms of local currency at the ratio of exchange rate. It refers to the price of foreign currency in terms of domestic currency.
For example, the exchange rate of 1 RMB is 1.2 HKD.
Exchange rate systems
1)       Fixed (pegged) exchange rate system
The exchanged rate is fixed by central bank. i.e. central bank sell/buy foreign currency to the local market at a fixed rate. Revaluation happens when government rise the official exchange rate, while devaluation happens when government drops the official exchange rate.
2)       Flexible exchange rate system
The exchange rate if controlled by market force. i.e., the exchange rate is determined by the equilibrium price from demand and supply of the market. When the price of the currencies rise under market force, it's called appreciation, in opposite it's called depreciation.
3)       Linked exchange rate system (in HK)
Since the currency does not have intrinsic value, the value of currency under free market depends on the economic power like productivity, and the acceptability of the currency of small economy is usually small. As a result, the linked exchange rate system is adopted in 1983 to stabilize the exchange rate of HKD.
The official rate of USD $1 = HKD $7.8 while the actual rate floats between 7.75 and 7.85 HKD. When the exchange rate is out of the range, HKMA sell/buy HKD and buy/sell USD when the exchange rate is lower than 7.75(strong-side convertibility)/higher than 7.85(weak-side convertibility). Since it's a currency board system, the HKD is fully backed by USD.
It implies that the exchange rate of HKD against other currencies (except USD) is determined the exchange rate of USD against other currencies. For example, if Euro appreciates against USD, HKD depreciate against Euro as well.
Effects on change in exchange rate on trading
1)       In terms of local currency
When local currency depreciates, in terms of local currency the price of good doesn't change (non-price factor) but the demand of goods (since price of goods in terms of foreign currency decreases), there's a net increase in total gain.

2)       In terms of foreign currency
When local currency depreciates, in terms of foreign currency the price of goods rises (price factor), and the equilibrium quantity move along the demand, so the change in total expenditure is unknown, depending on the elasticity.

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