tut #20 - exchange rates (answers) deb_21jan2014

HWA CHONG INSTITUTIONYear Two H2 Economics 2013

Tutorials #19-21: Macroeconomics III – Balance of Payments, Exchange Rates & International Economics

TUTORIAL #20: EXCHANGE RATE SYSTEMS & POLICIES

Section A: Complete BEE questions in Chapter #19 lecture notes

Pls see answers at the end of lecture notes in tutor’s copy. Also, pls go through any concepts or clarifications for this topic. You may proceed to complete the tutorial if the pace of your class is fast.

Section B: Data Handling Practice

Question 1: DHS 2012 Prelims

Table 4: Selected economic indicators of China, 2007 – 2010Year 2007 2008 2009 2010GDP (constant 2000, US$ billion) 2456.7 2692.5 2940.2 3246Nominal interest rate (%) 4.7 3.6 5.2 2.5Nominal exchange rate (yuan per US$) 7.77 6.83 6.83 6.78Real effective exchange rate (REER) index,2005 = 100

105.6 115.3 119.2 118.7

Big Mac price in China (yuan) 11.0 12.5 12.5 13.2Big Mac price in US (US$) 3.22 3.57 3.57 3.73Average hourly wages (in US$) 1.06 1.36 1.62 1.84Gross domestic savings (% of GDP) 50.5 51.8 52.7 51.7

Composition (% of GDP) %Private consumption 36.0 34.9 33.9 35Gross fixed capital formation 39.1 40.8 46 45.4Government consumption 13.5 13.3 13.4 13.4Exports of goods and services 38.4 35 26.7 29.6Imports of goods and services 29.6 27.3 22.3 25.6

Source: Various

(a) (i) Describe the trend in China’s real effective exchange rate between 2007 and 2010. [2]

Note to tutors: This is a typical trend reading question1m – General trend. 1m – Trend refinement

Students need to learn to use the correct description for exchange rates – appreciate or depreciate. NOT increase or decrease.1m – Trend refinement

General trend: China’s REER has increased which implies that Ch inese ina’s yuan REER has appreciated from 2007 to 2010.

Refinement: – If given index number, should calculate Appreciate by 12.4% from 2007-2010 OR Appreciate at a falling rate between 2007 and 2010. (too time-consuming to

calculate) OR There was a slight depreciation from 2009-2010. (though accepted as it wasn’t so

significant, the 1st 2 points are preferred)

Hwa Chong Institution. All Rights Reserved. Tutor’s Copy1



(ii)

With reference to Table 4, is the yuan undervalued or overvalued against the U.S. dollar? Explain.[3]

This question tests candidates’ understanding of the term “undervaluation” (See Chap #19 Bee Qn) and ability to select and process information, specifically to calculate the PPP exchange rate using the Big Mac index as an approximate value.

Identification [1]: The yuan is undervalued against the US$. [1]

Reason and reasoning using evidence in Table 4 [2]:

Method 1 (easiest method)The PPP exchange rate (ER) is calculated as a ratio of the price of a basket of goods and services in one currency against the price of that same basket of goods and services in another currency. In this case, PPP is calculated as:

PPP ER of US in yuan = price of Big Mac(¿Yuan)price of Big Mac (¿US $)

Big Mac price in China (yuan) 11.0 12.5 12.5 13.2Big Mac price in US (US$) 3.22 3.57 3.57 3.73PPP exchange rate (yuan per US$)* (calculated)

3.42 3.5 3.5 3.54

Nominal exchange rate (yuan per US$) 7.77 6.83 6.83 6.78* There is no need to show all the working of the PPP ER values for all the years.

The numerical value of the PPP ER of yuan against US$ US in yuan (using the Big Mac Index) is consistently lower than the nominal ER. This means that at the PPP ER, every 1 US$ can be exchanged for less yuan, unlike at the nominal ER, where every 1 US$ can be exchanged for more yuan. Hence, at the PPP ER, the yuan would have been a much stronger currency against the US$ than the nominal ER, which indicates that the yuan is undervalued against the US$. E.g. in 2010, the Big Mac Index measured 3.54 yuan per US$ compared to the nominal ER of 6.78 yuan per US$.

Method 2In 2007, one Big Mac in China costs 11 yuan, while it costs US$ 3.22 in US. Using the nominal exchange rate, one Big Mac should have cost 25 yuan instead of 11 yuan, which is about 2.27 times more than what it should have been priced at. This trend continues between 2008 and 2010, where the Big Mac is consistently priced at about 2 times lower than what it should have been in China. This means that for a given income, after converting into the respective currencies based on the nominal exchange rate, Chinese citizens are actually able to exchange about 2 times more of Big Mac than US citizens, implying that the nominal exchange rate of USyuan against yuan USD is of a higher lower value than what it should have been. (Also implies that nominal exchange rate of yuan against USD is of a lower value that what it should have been) This signifies that the yuan is undervalued against the dollar. [2]




Additional note to students for understanding (NOT required for question)Limitations: using the PPP to calculate if the yuan is undervalued against the dollar is not a very accurate method, since PPP only applies to tradable goods, and a Big Mac is not tradable. In fact, the value of a Big Mac comes not from the hamburger itself, but the services associated with the hamburger. These include the wages of employees serving the Big Mac and the rent of the restaurant in which it is eaten, both of which are determined by local factors. Since the hamburger itself is the only tradable portion of the Big Mac, only a small fraction of the Big Mac’s value should be determined by PPP.




Question 2: SAJC 2012 Prelims

Table 1: Annual Exchange Rate of the Pound and the Euro£/USD EURO/USD

2008 0.5447 0.68322009 0.6409 0.71902010 0.6473 0.75462011 0.6235 0.7188

Source: US Federal Reserve Board, 2011

(a) (i) Compare between the yearly exchange rate of the UK pound per US dollar and of the Euro per US dollar during the period from 2008 to 2011.

Suggested answer:

Both the UK pound (14.5%) and the Euro (5%) depreciated against the US dollar from 2008 to 2011 (1).

However, the UK pound has depreciated more than the Euro (1). [or]

The UK pound has consistently been stronger than the Euro i.e. 1 USD can buy more Euro compared to UK pound throughout 2008 to 2011 (1).

SAJC’s answer – Why we don’t accept.

Possible similarity 1:From 2008 to 2010, both pound and Euro depreciated since the amount of GBP per USD and Euro per USD increased, thus reflecting a fall in external purchasing power of both pound and Euro.(no need to explain)

Possible similarity 2:However, in 2011 (only look at a single year), both pound and Euro appreciated against USD since the amount of GBP and Euro per USD decreased.

Difference:In 2009 (only look at a single year), UK pound depreciated to a greater extent compared to Euro against USD.

[2]

(ii) With the aid of a diagram, explain the possible reasons for the change in the exchange rate of the UK pound in 2010.

[4]

Even without the case material, since the question asks for possible reasons, it is still fine to give generic answers that affect the bilateral exchange rate between UK and US.

State: UK pound depreciated slightly against USD in 2010.

Reasons: Hwa Chong Institution. All Rights Reserved. Tutor’s Copy

5



(1) A fall in demand for pounds: 2009 – 2010: Subprime mortgage crisis in US leading to slow growth in US. Assuming US had a slower growth relative to the UK, this would mean the

Americans would buy lesser British exports. When demand for British exports fell, the derived demand for UK pounds

would fall also, leading to the depreciation.(2) A rise in supply for pounds At the same time, the British’s income was higher than the US, the British

would buy more American exports and thus they had to sell pounds for USD. This led to a rise in supply of pounds and caused it to depreciate.

Figure 1Price of £ in USD

P1

P2

Quantity of £

Suggested answer (with full case material)

Identify change: UK pound has depreciated against USD.Identify change: depreciation of exchange rate

Reason 1: Table 2 shows worsening of current account of UK from 2009 -2010Worsening current account would mean that there is increasing net outflow which translates to increase in supply of UK pounds and/or fall in demand of UK pounds.

Reference to diagram: This could suggest a rise in SS of pound in the forex market from SGBP to S1GBP.

Since pound depreciated, it is likely that both the fall in DD for and rise in SS of pound reinforced each other and led to a depreciation of pound.

Reason 2: Extract 6 describes a loss of confidence in UK pounds Loss of confidence in UK pounds will lead to selling of UK pounds as mentioned in Extract 6 para 1 that ‘they (investors) would prefer to move into a different currency’. In addition, there would also be a fall in demand for UK pounds due to the lack of confidence, Extract 6 para 2 ‘investors continue to flee the currency’.

Reference to diagram: With reference to Fig 1, this had led to a fall in demand for pound from DGBP to D1GBP




Question 3: ACJC 2012 Prelims

Figure 2: Chinese Yuan (CNY) per Brazilian Real (BRL)

Source: Yahoo.com 2012

Table 3: Brazil-China Trade Balance (USD Millions)Year Exports to

China(A)Share

relative to total

exports (%)

Imports from

China (B)

Share relative to

total imports

(%)

Bilateral Trade Flow (A+B)

Net Exports

(A-B)

2008 16523 8.3 20044 11.6 36567 -3522

2009 21004 13.7 15911 12.5 36915 5093

2010 30786 15.2 25593 14.1 56379 5193

2011 28160 15.6 23420 14.1 51580 4740

Source: Brazilian Ministry of Development, Industry and Foreign Trade, 2012

(a) With reference to Figure 2 and Table 3,

(i) State the trend of the Brazilian Real against the Chinese Yuan between January 2009 and January 2011.

Brazilian Real It has apdepreciated against the Chinese yuan from Jan 2009 to Jan 2011..

[1]

(ii) Describe the trend of Brazil’s trade balance with China from 2009 to 2011.

Brazil’s trade balance with China has always been in a surplus from 2009 to 2011.

However, the trade balance surplus has decreased generally from 2009 to 2011 and hence its position has worsened.

Note to tutors: 3 year period is too short for description of trend.

[2]


Price of BRL in CNY

Time



(iii) In the light of the above trends, explain how the change in exchange rate has affected Brazil’s trade balance with China.

[2]

As Brazilian Real depreciated against the Chinese yuan, the price of Brazilian exports decreases in Chinese yuan and the price of Chinese imports increases in Brazilian real. If the demand for exports and imports is price elastic, the total revenue from Brazilian exports will increase and Brazil’s import expenditure from China will decrease. Hence it explains the consistent trade surplus Brazil has.

This first answer is not acceptable because the focus is about how the BOT has changed rather than about it being in consistent trade surplus. Moreover, with depreciation, the BOT should improve (if ML condition holds), but the stats from 2009-2011 showed a worsening.

As the Brazilian real has generally appreciated against Chinese yuan from Jan 2009 to 2011, this causes price of Brazilian’s exports in yuan to be relatively more expensive and imports to be relatively cheaper in Brazilian real. Assuming Marshall-Lerner condition holds (|PEDx+PEDm|>1), net exports will decrease generally over the same period. OR

Although the Brazilian real has depreciated and this causes the price of export in foreign currencies to be lower, it is not enough to compete with the relatively lower priced goods in China due to China’s comparative advantage in the production of goods and services. Hence it explains why Brazil’s trade balance with China has worsened.Note to tutors: This question can be a potential 4 marks question (provided it shows >4 years trend). Students may recognize that although Brazilian real has appreciated from Jan 2009 to Jan 2010, there is still an increase in its trade balance over the same period. Ask the students to explain the possible reason(s).




Section C: Essay Practice

Question 1: TYS 2006 Q6

In October 2005 the Monetary Authority of Singapore stated that its policy of allowing the Singapore dollar to strengthen against a basket of currencies would be maintained.

(a) Using a diagram, explain what might cause a country’s exchange rate to appreciate in a floating exchange rate system. [10]

(b) Discuss the extent to which problems are likely to result from an appreciation of Singapore’s exchange rate. [15]

Key Points from the Examiner’s Report:

(+) (-) Use appropriate supply and demand analysis within

correctly drawn and, of equal importance, well-labelled diagrams.

Top answers explained the underlying reasons for both demand and supply side movements that would lead to an appreciation of the currency.

Unable to elaborate the factors well.

The most common error was to argue that contractionary monetary policy would reduce the supply curve of a currency.

(a)

Note: There is no need to use SG as example. Students can choose to use another context and may even choose different context for different factors that results in appreciation of a currency.

Simple Schematic PlanINTRODUCTION

BODY Explain how an appreciation occurs in a free floating system using demand and supply analysis:

demand increases or supply falls or bothNote: Should students choose Sg as eg, student should understand that SG is using managed float exchange rate system. However, we can still accept the answer as we are assuming that S$ appreciates within the exchange rate band such that MAS will not intervene

Explain the underlying reasons for demand and supply to shiftCONCLUSION

INTRODUCTION (USE ‘KIA’)Key Words

Exchange Rate/Appreciation/Floating System

The exchange rate of a currency refers to its value measured/expressed in terms of a foreign currency (or another currency). A currency appreciation occurs if its value increases relative to a foreign currency. This means the same unit of the currency can now be exchanged into more foreign currency.In a floating exchange rate system the value of a currency is determined purely by the forces of demand & supply and there is no government intervention to manage or fixed the exchange rate at pre-determined levels.

IssueApproach

There are key underlying factors that determine demand and supply of a currency in the foreign exchange market which shall be elaborated on these key determinants.

BODYBasic Demand and Supply PrincipleThe equilibrium rate in a floating exchange rate system is determined by the demand & supply of currency. An




appreciation of a currency will be caused by the increase in demand of currency or a fall in supply of currency or both.

FC – foreign currency, DC – Domestic Currency, Ddm – Demand for domestic currency, Sdm – Supply of domestic currency

The demand for a foreign currency is a derived demand. This means the demand for a foreign currency comes from the need to exchange one currency into a into another for 2 key purposes:

Trade: Domestic currency must be exchanged into foreign currencies to pay for foreign goods. For example, to pay for Singapore exports foreigners will need to exchange their currencies into SGD thus creating demand for our currency. Similarly, Singapore buyers of foreign goods would need to exchange SGD into foreign currencies e.g. RM to shop in JB, Malaysia. With reference to figure 1, the demand curve for a currency will shift rightwards if there is an increased in the demand for the country’s exports. Ceteris paribus, the currency will appreciate.

Foreign investment: The domestic currency has to be changed into foreign currencies to purchase foreign assets such as bonds and equities; deposit money in foreign banks and invest in foreign property or businesses. With reference to figure 1, if there is an increased in inflow of FDI the demand curve for the domestic currency will shift rightwards causing the value of the currency to appreciate in the foreign exchange market.

SupplyOn the other hand, a fall imports would mean a fall in supply of the domestic currency in the foreign exchange market. This is because less domestic currency is supplied because less is needed to be exchanged into foreign currencies to pay for imports. Thus with reference to figure 2, the supply curve for DC would shift to the left.

The Leftward shift of the supply curve causes the currency to appreciate. Similarly a fall in outflow of FDI would result in a leftward shift of the supply curve for the domestic currency in the foreign exchange market.

However, there are underlying factors that influence both the trade and investment flows and hence the demand and supply for the currency in the foreign exchange market.

These key underlying determinants include: Fall in inflation rate relative to the country’s trade partners Rise in interest rates relative to rest of the world Anticipation of exchange rate changes (i.e. currency speculation)

1.Fall in inflation rates relative to trade partners

A fall in Singapore’s inflation rate relative to UK will cause Singapore’s exports to be relatively cheaper.

UK residents will demand more of Spore’s exports (Dd for S$ increases, SS of £ increases). At the same time, Spore will import less goods & services from UK, as

2. Rise in interest rates relative to rest of the world

If the interest rates in Brazil rise relative to those in foreign countries, other countries’ residents would be induced to deposit their funds here to earn the higher rate of interest.

This causes an increase in the demand for the Brazilian real

3. Anticipations of an exchange rate rise

When foreign exchange dealers, importers and exporters expect or speculate a rise in the exchange rate of a country’s currency (e.g. USD) in the near future, they will buy the currency now before the exchange rate actually rises.

The demand for the currency (E.g. USD) will rise.




they are now more expensive.

(SS for S$ falls, dd for £ falls.) Ceteris paribus, the SING$ will appreciate against £.

At the same time, Brazilians would be discouraged to deposit their funds in elsewhere. This causes the supply for the Brazilian real to fall. As a result, yuan will appreciate vis-a-vis foreign currencies.

At the same time, those who want to sell the currency will wait until the rate of exchange rises, as anticipated.

This means that the supply for the currency (E.g. USD) will fall.

Ceteris paribus, the currency (e.g. USD) will appreciate.

CONCLUSIONIn a free market such as a pure floating exchange rate system where there is no government intervention, the price or value of a currency will appreciate if the demand rises or supply falls or both until it reaches a new equilibrium level.

(b)Key Points from the Examiner’s Report:

(+) (-) Use appropriate economic analysis, such as the

Marshall-Lerner condition, to explain and discuss whether an appreciation might or might not lead to problems for the Singapore economy.

Showed very clear understanding of the benefits for a small island economy of a controlled appreciation in terms of the cost implications for imported goods.

Must have at least two Key Performance Indicators and link to an appreciating currency.

Unexplained or underdeveloped statements about the possible impact of an appreciation of the currency without applying to Singapore’s context. These were usually assertions that export prices would rise and hence that there would be an ensuing balance of payments deficit.

Simple Schematic PlanINTRODUCTION

BODYThesis Statement: Potential Macroeconomic problems may result from an appreciation of Spore exchange rate.

Worsening of the BOP as BOT and FDI will fall

Slower growth and higher unemployment

Antithesis Statement: However, Macroeconomic problems are not likely to result from an appreciation of Spore exchange rate.

BOP may not worsen as BOT and FDI may not fall

May reduce demand-pull and import-price push inflation

CONCLUSION

Suggested Answers

INTRODUCTIONThe Singapore government has adopted a gradual and modest appreciation policy as the key macro-economic policy to achieve non-inflationary economic growth. This essay seeks to discuss the impact or potential macro-problems such as BOP deficit, slowdown in economic growth related to appreciation or the strong currency policy.

Thesis Statement 1: An appreciation of SGD may lead to a worsening BOP position.

Antithesis Statement: An appreciation of SGD may not lead to a worsening BOP position.




(1) Current Account Worsen due to fall in BOT

An appreciation of the exchange rate likely to result in worsening balance of trade.

Assuming demand for exports is price elastic (justify): Px (in foreign currency) rises, Qx falls more than

proportionate X in foreign currency will fall.

Assuming demand for imports is price inelastic (justify) Pm (in domestic currency) drops, Qm rises less

than proportionate M in SGD will fall.

Note: To see the impact on BOT, there is a need to have both X and M in SGD. 2 ways to do it:

1. Convert the X in foreign currency to SGD and since it is an appreciation which means need more foreign currency to buy the same amount of SDG, X in SGD will indeed fall.

2. Or, Qx in foreign currency falls (regardless it’s price elastic or inelastic) will mean a fall in demand for Singapore’s exports in SGD and thus shrink the X in SGD.

To sum up: X↓ – M↓ = BOT will be worsened if X↓> M↓ And this is indeed the case if Marshall-Lerner

condition which is the sum of elasticities of exports and imports are greater than 1.

EvaluationThe high import content of Singapore’s exports means that a stronger dollar will result in lower cost of production. One such export would be that of oil refined products. Thus the rise in price of exports due to the appreciation is offset by the fall in prices of imports such as raw material.

(2) Financial Account worsens due to fall in FDI

A stronger $S may deter foreign investors. Why? Make it more expensive to do business in Singapore thus MNCs e.g from USA might be inclined to choose other cheaper Asian locations.

(1) BOT may not be worsened

Often in the short-run, demand tends to be relatively price inelastic for exports and imports. This is because both domestic and foreign consumers require some time to react to price changes. There might also be contractual agreements which prevent other countries from switching away from Singapore’s exports. Thus Marshall-Lerner condition is not satisfied and BOT will not be worsened.

Furthermore competitiveness of our exports is not dependent on pricing alone but on quality as well. In fact, Singapore has been using supply-side policies together with exchange rate to ensure our exports stay competitive in both pricing and quality, making our exports to be highly price-inelastic.

EvaluationNot all sectors are affected equally. Export sectors with high import content are likely to benefit from a stronger dollar but service sectors with low import content such as the tourism sector might suffer. The counterargument is that the export of services is dependent on other factors not just price alone. For example, for the tourism medical sector, people might be willing to pay more for medical services in Spore for more reliable medical procedures.

(2) A strong SGD may not deter FDI

So far Singapore has been able to attract sufficient Foreign Direct Investment (FDI) to fuel economic growth. Foreign investors are attracted to invest here if there is confidence in the economy and good economic outlook.

This is bolstered by the appreciating S$. A strong currency inspires confidence in the economy. Investors are confident of making good returns/profits.

Evaluation:A strong currency alone is not sufficient to attract investment. A skilled labour force, low corporate tax rate, good infrastructure and political stability are also very important.




Thesis Statement 2: An appreciation of SGD causes BOT to fall leading to slower growth and higher unemployment

Anti-thesis Statement 2: It depends on the state of the economy – in fact strong SDG reduces both demand-pull and import-price push inflation

If BOT and FDI fall, it will mean a fall in AD → ↓NI by k → slow growth →↑unemployment as production falls + rise in inventories →↓demand for labour →↑retrenchment.

Illustrate with diagram:

From the above figure, we can see that a fall in BOT leading to a fall in AD from AD0 to AD1 leading to a fall in national income from Y0 to Y1, thru the multiplier effect, lowering actual growth.

As there is a fall in output, there will be a rise in inventory and this may lead to some workers being retrenched and thus raising the unemployment rate, thru an increase in cyclical unemployment.

Reduce Demand-pull inflationThe severity depends on the current state of the economy. If it is at full employment, then it may be beneficial by cooling demand-pull inflation.

From the above figure, we can see that a fall in BOT and FDI leading to a fall in AD from AD2 to AD3 leading to a fall in GPL from P2 to P3, lowering the inflation.

Help to reduce imported inflationSpore is a resource poor country and depends heavily on imported consumer goods thus a stronger dollar will alleviate imported inflation.

CONCLUSIONIn theory an appreciation of a currency is likely to erode export competitiveness. Historically, in extreme cases it might even threaten the survival of the entire export industry. However, in the context of Singapore, the policy of strengthening the currency has not produced such adverse outcomes so far. On the contrary, based on empirical evidence, the policy of pursuing a strong SGD has worked in Singapore’s favour. This is due primarily to the fact that most of Singapore’s consumption and producer goods are imported and thus a strong currency help to keep domestic price stable and also keep cost of imported inputs for our exporters low. In short, a gradual and modest appreciation policy, together with supply-policies that make the demand for our exports price inelastic, have not damaged our balance of trade.

Thus a strong SGD has helped the economy achieved low inflation and sustained economic growth. By Tinbergen principle, other policies need to be introduced for Singapore to reach the other goals.


GPL AS

P2

P3 AD3 AD2

P0

P1

AD1 AD0

Y1 Y0 YFE real NI

tut #20 - exchange rates (answers) deb_21jan2014

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