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Ka-fu WongUniversity of Hong Kong

Ka-fu WongUniversity of Hong Kong

Who determines the value of Renminbi?The Chinese government, the US government, or the

market?

ECON1001: Introduction to Economics, 2006 Fall

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How is the price of an ordinary good (say, a bottle of wine) determined?

Supply

Demand

Price

Quantity

Market

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How is the price of a currency (say, Reminbi) determined?

Supply

Demand

US$/yuan

Yuan

Market

Price regulation(ceiling or

floor)

Quantity regulation

Add supply

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Devaluation, Revaluation of Reminbi

Supply

Demand

US$/yuan

Yuan

DevaluationReminbi becomes cheaper

RevaluationReminbi becomes more expensive

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Depreciation, Appreciation of Japanese Yen

Supply

Demand

US$/yen

yen

New supply

DepreciationYen becomes cheaper Appreciation

Yen becomes more expensive

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How is the price of a currency (say, Reminbi) determined?

Arbitrage: Purchasing Power Parity Uncovered interest parity Covered interest parity

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Chong Yuet Ming Amenties Centre

Chong Yuet Ming Amenties Centre

SWIRE HallSWIRE Hall

Haking Wong BldgHaking Wong Bldg

Main Library AnnexMain Library Annex

Four Student Canteens at HKU

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CYM MacDonald SWIRE MacDonald

Prices of Big Mac

7.80 15.60Case 1

What would you do?

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What would you do?

Choose the cheaper MacDonald for lunch.

Buy Big Mac from CYM and sell at SWIRE.

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Effect of our action

More supply of Big Mac, less demand for Big MacAt SWIRE

Price of Big Mac falls.

Greater demand for Big Mac, less supply for Big Mac

At CMY

Price of Big Mac increases.

Choose the cheaper MacDonald (CMY) for lunch.

Buy Big Mac from CMY and sell at SWIRE.

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CYM MacDonald SWIRE MacDonald

What would you do in the absence of transaction costs?

PCYM PSWIRECase 2

PCYMPSWIRECase 3

>

<

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Punch line:

Arbitrage activities continue until prices equalize.

Arbitrage is a strong driving force to equalize prices.

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HK MacDonald US MacDonald

Prices of Big Mac (assume 1USD = 7.8 HKD)

HKD 7.80 USD 1Case 4

HKD 15.60 USD 1Case 5

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HK MacDonald US MacDonald

Prices of Big Mac (assume 1USD = e HKD)

PHK e PUSCase 7

PHK e PUSCase 8

>

<

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Arbitrage activities continue until prices equalize

That is,

PHK = e PUS and

e = PHK / PUS

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Prices of the same good at different locations, when expressed in the same currency, have to equalize. That is,

Purchasing Power Parity

Exchange rate implied by PPP

e = PHK / PUS

PHK = e PUS

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If e is fixed, PUS has to adjust when there is a change in PHK .

Purchasing Power Parity

Three variables in the relation:

Knowing any two of them, we can compute the third.

PHK = e PUS

e PHK PUS

If PUS is fixed, e has to adjust when there is a change in PHK .

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Other arbitrage opportunities across space

International phone call: HK direct to Beijing (Price= P1) HK to Canton province, from where the call is

redirected to Beijing (Price= P2) Arbitrage opportunities exists when P1 P2,

or P1-P2 0. Arbitrage activities (though illegal) will drive P1-

P2 towards zero.

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Arbitrage opportunities across space

A

B

XP2

P1

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Other arbitrage opportunities across space

Buying or selling Japanese Yen HKD direct to JPY (Price= P1) HKD to Swedish Krona and Swedish Krona to

Yen (Price= P2) Arbitrage opportunities exists when P1 P2,

or P1-P2 0. Arbitrage activities will drive P1-P2 towards zero.

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Arbitrage across time

Today Tomorrow

142 150Stockprices

If cost of interest is zero,

<

one would like to buy stock today, hold it for a day and sell it tomorrow. Profit= 8.

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Arbitrage across time in real life

In real life, interest rate is nonzero and we do not know tomorrow’s stock price for sure.

Thus, economic theory has to adjust for these factors but still uses this idea of arbitrage.

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What does PPP tell us about exchange rates?

“Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.” (http://www.economist.com/markets/bigmac/about.cfm, subscription required)

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Big Mac Index, The Economist, May 25th 2006

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Why is Big Mac Index so far off from the actual exchange rates?

Adjustment of prices slow in general (price rigidity)

Noise need to use econometrics (economic statistics) to test the theory

Other factors (and also noise) that determines the exchange rate.

Transportation takes time (some goods are perishable)

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There are a lot of countries that do not allow its exchange There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s advantages and disadvantages of regulating one’s exchange rate?exchange rate?

Supply

Demand

US$/yuan

Yuan

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There are a lot of countries that do not allow its exchange There are a lot of countries that do not allow its exchange rate to be determined by the market. Why? What are the rate to be determined by the market. Why? What are the advantages and disadvantages of regulating one’s advantages and disadvantages of regulating one’s exchange rate?exchange rate?

S

D

S

D

S

D

US domestic China domestic

Foreign exchange market

Yuan

$/Yuan

Yuan$

At least three markets in each country: goods, labor. and money.

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Why would the US want to see a revaluation of Reminbi?

Supply

Demand

US$/yuan

Yuan

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What would be the consequence of a 20% revaluation of Reminbi on (1) China, (2) Hong Kong, (3) US and western countries, (4) Japan and the newly industrialized countries, (5) Developing countries

Supply

Demand

US$/yuan

Yuan

20% revaluation

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Consider all options for China to reform its regime. Why did China choose the basket peg over its alternatives?

Exchange Arrangements with No Separate Legal Tender Currency Board Arrangements Other Conventional Fixed Peg Arrangements Pegged Exchange Rates within Horizontal Bands Crawling Pegs Exchange Rates within Crawling Bands Managed Floating with No Predetermined Path for the

Exchange Rate Independently Floating

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What is your prediction of the Reminbi exchange rate in a few years time? Give your reasons.

7.8 yuan = 1 USD? About 4 %?

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References:

Taylor, Alan M. and Mark P. Taylor (2004): “The Purchasing Power Parity Debate,” NBER Working Paper No. 10607.

Chang, Gene (2006) “How Much is Chinese Currency Undervalued? A Quantitative Estimation,” Mimeo, Shanghai University of Finance and Economics.

McKinnon, Ronald (2006): “China’s Exchange Rate Appreciation in the Light of the Earlier Japanese Experience,” Mimeo, Stanford University

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