Chapter on "Economics: Macroeconomics"

Chapter 5 pages (2355 words) Sources: 1+

[EXCERPT] . . . .

iv) An American firm trying to purchase property in Hong Kong

The firm would benefit from such depreciation because most Hong Kong-based investors wishing to purchase property in the U.S. would want to take advantage of the low interest rates, and the relevant authority in Hong Kong, which operates a linked exchange rate system, would raise the interest rates in a bid to prevent capital flight. With the cost of borrowing so high, Hong Kong-based investors will opt to dispose of their long-term assets property so as to obtain funds to finance their investment in the U.S. The U.S. firm stands to benefit from low property prices in this way.

4. Suppose the U.S. dollar depreciates against other currencies. Under the linked exchange rate system, Hong Kong pegs its nominal exchange rate to the U.S. dollar

i) What would happen to the prices of goods and services in Hong Kong if domestic prices remain unchanged?

The linked exchange rate system is a currency board system where a currency's exchange rate is linked to that of another currency often referred to as the anchor currency. Such a regime calls for the full backing of the flow of the monetary base by foreign reserves. Hong Kong adopted the linked exchange rate regime in 1983, when the economy faced a financial crisis that caused its currency to depreciate from HK$6.5:U.S.$1 to HK$10:U.S.$1. The monetary authority then deemed it fit to link the HK dollar to the U.S. dollar at a rate of HK$7.80:U.S.$1 through full reserve backing, specify flow, and currency arbitrage. The linked exchange rate regime has been beneficial to Hong Kong's economy, helping it reduce exchange rate volatility and restore public confidence in the domestic currency. The main disadvantage of the regime, however, is that it denies Hong Kong the power to regulate capital movement. Moreover, with the continued depreciation of the dollar, questions are being raised as to whether the U.S. dollar is still the most appropriate anchor for the HK dollar.

Whereas the U.S. economy is able to withstand small shocks in the exchange rate, the Hong Kong economy is still not as strong. The weakening of the U.S. dollar has placed upward pressures on domestic prices in Hong Kong (including property prices, consumer prices, and wages), particularly because the bilateral nominal exchange rate has been unable to adjust. This has led to structural inflation and increases in unit labor costs as demonstrated below.

ii) The Short-Term Impact of the depreciation of the dollar on the Hong Kong economy

(a) The Money Market (b) the Bond Market

r price of bonds

Ms SSb

R1

P2

R2 P1

MD1 DD2

M MD2 Q1 Q2 DD1

Quantity

(c) Real GDP per Year

Price level

SRAS

LRAS

A

P2

CB

P1

Y1 Y2 GDP

Region ABC -- excess demand

The weakening of the U.S. dollar causes the HK dollar, on which it is pegged, to reduce in value. As a result, people will prefer to hold their money in bonds; and thus, the demand for money will fall, causing an inward shift in the demand curve and a subsequent decrease in interest rate from R1 to R2. The lower interest rate induces people to borrow HK dollars to finance the purchase of bonds. This will cause an increase in the demand for bonds, inducing increases in price. This increase in bond price coupled with low interest rates will cause an outward shift in the aggregate demand curve, and as a result, the domestic price level rises from P1 to P2.

iii) What happens if there is continued depreciation of the dollar?

Since the linked exchange rate system does not allow the Hong Kong Monetary Authority to intervene in the financial markets through monetary policy, the market is likely to adjust itself to eliminate excess demand (the region bound by triangle ABC) and restore the market to equilibrium at price P1 and income level Y3.

iv) Would this prediction still hold if Hong Kong abolished the linked exchange rate system

Yes it would, only that the decrease in the price level and the subsequent increase in income will not have been caused by market adjustment, but by monetary policy. If Hong Kong abolishes the linked exchange rate system and returns to the floating exchange rate regime, the Monetary Authority would increase interest rates or issue out government bonds in a bid to discourage borrowing and reduce the amount of money circulating in the economy. This would reduce aggregate demand and increase the degree of competitiveness of Hong Kong exports in the international market. Increases in exports as well as income gained from tourism and logistics would increase aggregate demand; and a result, GDP will rise.

References

Mankiw, N. (2014). Principles of Macroeconomics (7th ed.). Stamford, CT: Cengage Learning.

Reinert, K.A., Rajan, R.S., Glass, A.J. & Davis, L.S. (Eds.). (2009). The Princeton Encyclopedia of the World Economy. Princeton, NJ: Princeton University Press. READ MORE

How to Reference "Economics: Macroeconomics" Chapter in a Bibliography

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