Suppose the United States and Hong Kong have a flexible exchange rate system. Explain whether each...

Suppose the United States and Hong Kong have a flexible exchange rate system. Explain whether each of the following events will lead to an appreciation or depreciation of the U.S. dollar and HK dollar. Please explain in words and graphically.

(a) U.S. real interest rates decrease below Hong Kong real interest rates.

(b) The Hong Kong inflation rate decreases relative to the U.S. inflation rate.
(c) A decrease in U.S. income combines with no change in Hong Kong income. (d) A decrease in U.S. income combines with a decrease in Hong Kong income.

Solutions

Expert Solution

In all the following graphs, exchange rate (P) and quantity of USD (Q) are depicted along vertical and horizontal axis, respectively. D0 and S0 are initial demand and supply of USD, intersecting at point A with initial exchange rate P0 and quantity of USD Q0.

(a)

Lower relative interest rate in US will reduce foreign investment in the US, which will decrease the demand for USD, shifting USD demand curve to left and decreasing both exchange rate and quantity of USDs. Exchange rate will decrease, depreciating USD.

In following graph, D0 shifts left to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of USD Q1.

(b)

Lower relative inflation rate in Hong Kong will increase US demand for imports from Hong Kong. Higher US imports will increase the demand for HKD and increase the supply of USD (as US will sell USD to buy HKD, to pay for imports), shifting USD supply curve to right, decreasing exchange rate and increasing quantity of USD. Exchange rate will decrease, depreciating USD.

In following graph, S0 shifts right to S1, intersecting D0 at point B with lower exchange rate P1 and higher quantity of USD Q1.

(c)

Lower in US income will reduce US import demand. This will decrease the demand for HKD and decrease the supply of USD), shifting USD supply curve to left, increasing exchange rate and decreasing quantity of USDs. Exchange rate will increase, appreciating USD.

In following graph, S0 shifts left to S1, intersecting D0 at point B with higher exchange rate P1 and lower quantity of USD Q1.

(d)

Decrease in US income will reduce US import demand. This will decrease the demand for HKD and decrease the supply of USD, shifting USD supply curve to left, increasing exchange rate and decreasing quantity of USDs. At the same time, decrease in income in Hong Kong will decrease Hong Kong’s import demand for US goods, thereby decreasing US exports. This will decrease the demand for USD, shifting USD demand curve to left and decreasing both exchange rate and quantity of USDs. The net effect is a definite increase in quantity of USD, but net effect on exchange rate is indeterminate.

In following graph, D0 shifts left to D1 and S0 shifts left to S1, intersecting at point B with new exchange rate P1 and higher quantity of USD Q1.

Rahul Sunny answered 1 month ago

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