Misplaced Pages

#517482

67-525: Unlike a fixed exchange rate system, the government or central bank does not actively interfere in the foreign exchange market by controlling supply and demand of the currency in order to influence the exchange rate. The exchange rate is instead stabilized by an exchange mechanism, whereby the Hong Kong Monetary Authority (HKMA) authorises note-issuing banks to issue new banknotes provided that they deposit an equivalent value of US dollars with

134-439: A pegged exchange rate , is a type of exchange rate regime in which a currency 's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies , or another measure of value, such as gold . There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in

201-455: A country's central bank typically uses an open market mechanism and is committed at all times to buy and sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back

268-463: A final conversion rate against the euro from the local currencies of countries joining the Eurozone . Timeline of the fixed exchange rate system: Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far above

335-467: A fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against

402-424: A fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment . Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate. The belief that the fixed exchange rate regime brings with it stability

469-470: A fixed exchange-rate regime is the possibility of the central bank running out of foreign exchange reserves when trying to maintain the peg in the face of demand for foreign reserves exceeding their supply. This is called a currency crisis or balance of payments crisis, and when it happens the central bank must devalue the currency. When there is the prospect of this happening, private-sector agents will try to protect themselves by decreasing their holdings of

536-399: A free hand. For instance, by using reflationary tools to set the economy growing faster (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper. Additionally, the stubbornness of a government in defending

603-438: A large part of their GDP . A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation . However, in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the values of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which

670-525: A payments deficit). If the central bank were to conduct open market operations in the domestic bond market in order to offset these balance-of-payments-induced changes in the money supply — a process called sterilization – it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country). But under perfect capital mobility, any such sterilization would be met by further offsetting international flows. Increased government expenditure shifts

737-514: A predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime . This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms

SECTION 10

#1732847843518

804-449: A trade deficit occurs under a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur. Another major disadvantage of

871-478: Is net exports , e is the nominal exchange rate (the price of foreign currency in terms of units of the domestic currency), Y is GDP, and Y* is the combined GDP of countries that are foreign trading partners. Higher domestic income (GDP) leads to more spending on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the country's exports and thus higher net exports. A higher e leads to higher net exports. where CA

938-553: Is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming . The model is an extension of the IS–LM model . Whereas the traditional IS-LM model deals with economy under autarky (or a closed economy), the Mundell–Fleming model describes a small open economy. The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to

1005-549: Is downward sloped and the LM curve is upward sloped, as in the closed economy IS-LM analysis; the BoP curve is upward sloped unless there is perfect capital mobility, in which case it is horizontal at the level of the world interest rate. In this graph, under less than perfect capital mobility the positions of both the IS curve and the BoP curve depend on the exchange rate (as discussed below), since

1072-496: Is focussed on currency linkages. A monetary union is considered to be the crowning step of a process of monetary co-operation and economic integration . In the form of monetary co-operation where two or more countries engage in a mutually beneficial exchange, capital among the countries involved is free to move, in contrast to capital controls . Monetary co-operation is considered to promote balanced economic growth and monetary stability, but can also work counter-effectively if

1139-433: Is intended. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market by selling its reserves. This places greater demand on the market and causes the local currency to become stronger, hopefully back to its intended value. The reserves they sell may be the currency it is pegged to, in which case the value of that currency will fall. Another, less used means of maintaining

1206-478: Is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control . A fixed exchange rate regime should be viewed as a tool in capital control. Mundell%E2%80%93Fleming model Heterodox The Mundell–Fleming model , also known as the IS-LM-BoP model (or IS-LM-BP model ),

1273-532: Is over 7 times the amount of money supplied in circulation or about 48% of Hong Kong dollars M3 at the end of April 2016. Since 5 September 1998, the HKMA has provided an explicit convertibility undertaking to all licensed banks in Hong Kong to convert Hong Kong dollars in their clearing accounts into US dollars at the fixed exchange rate of HK$ 7.75 to US$ 1 . Starting from 1 April 1999, the convertibility rate in respect of

1340-408: Is set equal to zero. In contrast, under fixed exchange rates e is exogenous and the balance of payments surplus is determined by the model. Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates,

1407-474: Is that a large open economy has the characteristics of both an autarky and a small open economy. In particular, it may not face perfect capital mobility, thus allowing internal policy measures to affect the domestic interest rate, and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above). In the IS-LM model, the domestic interest rate is a key component in keeping both

SECTION 20

#1732847843518

1474-399: Is the current account and NX is net exports. That is, the current account is viewed as consisting solely of imports and exports. where i ∗ {\displaystyle i^{*}} is the foreign interest rate, k is the exogenous component of financial capital flows, z is the interest-sensitive component of capital flows, and the derivative of the function z is

1541-615: Is the mechanism in which two or more monetary policies or exchange rates are linked, and can happen at regional or international level. The monetary co-operation does not necessarily need to be a voluntary arrangement between two countries, as it is also possible for a country to link its currency to another countries currency without the consent of the other country. Various forms of monetary co-operations exist, which range from fixed parity systems to monetary unions . Also, numerous institutions have been established to enforce monetary co-operation and to stabilise exchange rates , including

1608-602: The European Monetary Cooperation Fund (EMCF) in 1973 and the International Monetary Fund (IMF) Monetary co-operation is closely related to economic integration , and are often considered to be reinforcing processes. However, economic integration is an economic arrangement between different regions, marked by the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies , whereas monetary co-operation

1675-426: The IS curve to the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate (value of the domestic currency) as foreign funds start to flow in, attracted by the higher interest rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it,

1742-462: The IS curve to the right. This will mean that domestic interest rates and GDP rise. However, this increase in the interest rates attracts foreign investors wishing to take advantage of the higher rates, so they demand the domestic currency, and therefore it appreciates. The strengthening of the currency will mean it is more expensive for customers of domestic producers to buy the home country's exports, so net exports will decrease, thereby cancelling out

1809-403: The IS-LM graph is actually a two-dimensional cross-section of a three-dimensional space involving all of the interest rate, income, and the exchange rate. However, under perfect capital mobility the BoP curve is simply horizontal at a level of the domestic interest rate equal to the level of the world interest rate. As explained below, whether domestic monetary or fiscal policy is potent, in

1876-412: The International Monetary Fund (IMF) in 1978 that gave a smaller role to gold in the international monetary system, this fixed parity system as a monetary co-operation policy was terminated. The Thai government amended its monetary policies to be more in line with the new IMF policy. One main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade . When

1943-571: The LM and BoP curves at their intersection point. The Mundell–Fleming model under a fixed exchange rate regime also has completely different implications from those of the closed economy IS-LM model. In the closed economy model, if the central bank expands the money supply the LM curve shifts out, and as a result income goes up and the domestic interest rate goes down. But in the Mundell–Fleming open economy model with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an incipient outward shift of

2010-400: The LM curve to shift to the right, and the domestic interest rate becomes lower (as low as the world interest rate if there is perfect capital mobility). Some of the results from this model differ from those of the IS-LM model because of the open economy assumption. Results for a large open economy, on the other hand, can be consistent with those predicted by the IS-LM model. The reason

2077-491: The LM curve to the right. This directly reduces the local interest rate relative to the global interest rate. That being said, capital outflows will increase which will lead to a decrease in the real exchange rate, ultimately shifting the IS curve right until interest rates equal global interest rates (assuming horizontal BOP). A decrease in the money supply causes the exact opposite process. An increase in government expenditure shifts

Linked exchange rate system in Hong Kong - Misplaced Pages Continue

2144-400: The LM curve would make capital flow out of the economy. The central bank under a fixed exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to

2211-460: The balance of payments surplus, CA is the current account surplus, and KA is the capital account surplus. where E (π) is the expected rate of inflation . Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending. where Y t-1 is GDP in the previous period. Higher lagged income or a lower real interest rate leads to higher investment spending. where NX

2278-495: The banknotes ) were sent out by note-issuing banks to peg the domestic currency against the US dollar at an internal fixed rate of HK$ 7.80 = US$ 1. The Hong Kong Monetary Authority (HKMA), Hong Kong's de facto central bank, authorised note-issuing banks to issue banknotes . These banks are required to have the same amount of US dollars to issue banknotes. The HKMA guarantees to exchange US dollars into Hong Kong dollars, or vice versa, at

2345-400: The "Mundell–Fleming trilemma ." Basic assumptions of the model are as follows: This model uses the following variables: The Mundell–Fleming model is based on the following equations: The IS curve: where NX is net exports . The LM curve: A higher interest rate or a lower income (GDP) level leads to lower money demand. The BoP (Balance of Payments) Curve: where BoP is

2412-603: The Aggregate Balance moved from 7.75 by 1 pip (i.e. $ 0.0001) per calendar day. It converged with the convertibility rate applicable to the issuance and redemption of Certificates of Indebtedness at 7.80 on 12 August 2000. The HKMA announced three refinements on 18 May 2005 to remove uncertainty about the extent to which the exchange rate may strengthen under the Linked Exchange Rate System: Fixed exchange rate A fixed exchange rate , often called

2479-570: The HKMA. The Government, through the HKMA, authorises three commercial banks to issue banknotes: Notes ( HK$ 10 only) are also issued by the HKMA itself because of the continuing demand for small value notes among the public. As a response to the Black Saturday crisis in 1983, the linked exchange rate system was adopted in Hong Kong on October 17, 1983 through the currency board system . The redemption of certificates of indebtedness (for backing

2546-689: The Netherlands, participated in an arrangement called the Snake . This arrangement is categorized as exchange rate co-operation. During the next 6 years, this agreement allowed the currencies of the participating countries to fluctuate within a band of plus or minus 2¼% around pre-announced central rates . Later, in 1979, the European Monetary System (EMS) was founded, with the participating countries in ‘the Snake’ being founding members. The EMS evolves over

2613-655: The US dollar. China buys an average of one billion US dollars a day to maintain the currency peg. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies. The gold standard is the pegging of money to a certain amount of gold. Currency board arrangements are the most widespread means of fixed exchange rates. Currency boards are considered hard pegs as they allow central banks to cope with shocks to money demand without running out of reserves. CBAs have been operational in many nations including: Monetary co-operation

2680-512: The closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate , free capital movement , and an independent monetary policy . An economy can only maintain two of the three at the same time. This principle is frequently called the " impossible trinity ," "unholy trinity," "irreconcilable trinity," "inconsistent trinity," "policy trilemma," or

2747-504: The currencies associated with large economies typically do not fix (peg) their exchange rates to other currencies. The last large economy to use a fixed exchange rate system was the People's Republic of China , which, in July 2005, adopted a slightly more flexible exchange rate system, called a managed exchange rate . The European Exchange Rate Mechanism is also used on a temporary basis to establish

Linked exchange rate system in Hong Kong - Misplaced Pages Continue

2814-420: The degree of capital mobility (the effect of differences between domestic and foreign interest rates upon capital flows KA ). After the subsequent equations are substituted into the first three equations above, one has a system of three equations in three unknowns, two of which are GDP and the domestic interest rate. Under flexible exchange rates , the exchange rate is the third endogenous variable while BoP

2881-409: The depreciated exchange rate shifts the BoP curve somewhat back down. Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate. When the latter goes up, the BoP curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the IS curve to the location where it crosses the new BoP curve at its intersection with

2948-436: The domestic currency and increasing their holdings of the foreign currency, which has the effect of increasing the likelihood that the forced devaluation will occur. A forced devaluation will change the exchange rate by more than the day-by-day exchange rate fluctuations under a flexible exchange rate system. Moreover, a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with

3015-399: The domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in

3082-416: The domestic interest rate is exogenously determined by the world interest rate, shows stark differences from the closed economy model. Consider an exogenous increase in government expenditure. Under the IS-LM model, the IS curve shifts rightward, with the LM curve intact, causing the interest rate and output to rise. But for a small open economy with perfect capital mobility and a flexible exchange rate,

3149-448: The domestic interest rate is predetermined by the horizontal BoP curve, and so by the LM equation given previously there is exactly one level of output that can make the money market be in equilibrium at that interest rate. Any exogenous changes affecting the IS curve (such as government spending changes) will be exactly offset by resulting exchange rate changes, and the IS curve will end up in its original position, still intersecting

3216-400: The domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate. In the 21st century,

3283-455: The exchange rate e is exogenously given, while the variable BoP is endogenous. Under the fixed exchange rate system, the central bank operates in the foreign exchange market to maintain a specific exchange rate. If there is pressure to devalue the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease

3350-404: The fixed benchmark rate (it is stronger than required), the government sells its own currency (which increases supply) and buys foreign currency. This causes the price of the currency to decrease in value (Read: Classical Demand-Supply diagrams). Also, if they buy the currency it is pegged to, then the price of that currency will increase, causing the relative value of the currencies to approach what

3417-410: The fixed exchange rate, the central bank must accommodate the capital flows (in or out) which are caused by a change of the global interest rate, in order to offset pressure on the exchange rate. If the global interest rate increases, shifting the BoP curve upward, capital flows out to take advantage of the opportunity. This puts pressure on the home currency to depreciate, so the central bank must buy

SECTION 50

#1732847843518

3484-408: The foreign exchange market. Again, this keeps the exchange rate at its targeted level. In the very short run the money supply is normally predetermined by the past history of international payments flows. If the central bank is maintaining an exchange rate that is consistent with a balance of payments surplus, over time money will flow into the country and the money supply will rise (and vice versa for

3551-459: The home currency — that is, sell some of its foreign currency reserves — to accommodate this outflow. The decrease in the money supply, resulting from the outflow, shifts the LM curve to the left until it intersects the IS and BoP curves at their intersection. Once again, the LM curve plays a passive role, and the outcomes are determined by the IS-BoP interaction. Under perfect capital mobility,

3618-543: The member countries have (strongly) differing levels of economic development . Especially European and Asian countries have a history of monetary and exchange rate co-operation, however the European monetary co-operation and economic integration eventually resulted in a European monetary union . In 1973, the currencies of the European Economic Community countries, Belgium, France, Germany, Italy, Luxemburg and

3685-508: The monetary authority purchases foreign currency using domestic funds in order to shift the LM curve to the right. In the end, the interest rate stays the same but the general income in the economy increases. In the IS-LM-BoP graph, the IS curve has been shifted exogenously by the fiscal authority, and the IS and BoP curves determine the final resting place of the system; the LM curve merely passively reacts. The reverse process applies when government expenditure decreases. To maintain

3752-430: The money market and the goods market in equilibrium. Under the Mundell–Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows). The Mundell–Fleming model applied to a small open economy facing perfect capital mobility, in which

3819-453: The money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply. The model's workings can be described in terms of an IS-LM-BoP graph with the domestic interest rate plotted vertically and real GDP plotted horizontally. The IS curve

3886-473: The new BoP curve will be horizontal at the new world interest rate, so the equilibrium domestic interest rate will equal the world interest rate. If the global interest rate declines below the domestic rate, the opposite occurs. The BoP curve shifts down, foreign money flows in and the home currency is pressured to appreciate, so the central bank offsets the pressure by selling domestic currency (equivalently, buying foreign currency). The inflow of money causes

3953-677: The next decade and even results into a truly fixed exchange rate at the start of the 1990s. Around this time, in 1990, the EU introduced the Economic and Monetary Union (EMU), as an umbrella term for the group of policies aimed at converging the economies of member states of the European Union over three phases In 1963, the Thai government established the Exchange Equalization Fund (EEF) with

4020-467: The pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to the Mundell–Fleming model , with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability. In a fixed exchange rate system,

4087-449: The purpose of playing a role in stabilizing exchange rate movements. It linked to the U.S. dollar by fixing the amount of gram of gold per baht as well as the baht per U.S. dollar. Over the course of the next 15 years, the Thai government decided to depreciate the baht in terms of gold three times, yet maintain the parity of the baht against the U.S. dollar. Due to the introduction of a new generalized floating exchange rate system by

SECTION 60

#1732847843518

4154-433: The rate of 7.80. When the market rate is below 7.80, the banks will convert US dollars for Hong Kong dollars from the HKMA; Hong Kong dollar supply will increase, and the market rate will climb back to 7.80. The same mechanism also works when the market rate is above 7.80, and the banks will convert Hong Kong dollars for US dollars. The Hong Kong dollar is backed by one of the world's largest foreign exchange reserves , which

4221-449: The right, and the interest rate remains equal to the world rate of interest. One of the assumptions of the Mundell–Fleming model is that domestic and foreign securities are perfect substitutes. Provided the world interest rate i ⋆ {\displaystyle i^{\star }} is given, the model predicts the domestic rate will become the same level of the world rate by arbitrage in money markets. However, in reality,

4288-436: The rise in government spending and shifting the IS curve to the left. Therefore, the rise in government spending will have no effect on the national GDP or interest rate. An increase in the global interest rate shifts the BoP curve upward and causes capital flows out of the local economy. This depreciates the local currency and boosts net exports, shifting the IS curve to the right. Under less than perfect capital mobility,

4355-457: The sense of having an effect on real GDP, depends on the exchange rate regime. The results are summarized here. Flexible exchange rates: Domestic monetary policy affects GDP, while fiscal policy does not. Fixed exchange rates: Fiscal policy affects GDP, while domestic monetary policy does not. In a system of flexible exchange rates, central banks allow the exchange rate to be determined by market forces alone. An increase in money supply shifts

4422-420: The unchanged LM curve; now the domestic interest rate equals the new level of the global interest rate. A decrease in the global interest rate causes the reverse to occur. In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero;

4489-483: The world interest rate is different from the domestic rate. Rüdiger Dornbusch considered how exchange rate expectations have an effect on the exchange rate. Given the approximate formula: and if the elasticity of expectations σ {\displaystyle \sigma } , is less than unity, then we have Since domestic output is y = E ( i , y ) + T ( e , y ) {\displaystyle y=E(i,y)+T(e,y)} ,

#517482