Question

How would the exchange rate of Hong Kong Dollars, the interest rate and the money supply in Hong Kong adjust under the currency board system? Assume the Federal Reserve in the United States has decided to reduce the US interested rate (20 marks)

Answer 1

A currency board is system where the domestic currency, the Hong Kong dollar in our case, is pegged with a foreign currency, US dollar in our case, at a fixed exchange rate. The domestic country gives up the monetary policy for the most part and only keeps some amount of the external currency as reserves to maintain the exchange rate the fixed level.

If US decides to reduce its interest rates, it will reduce the demand of USD in the international market. That will result in the USD depreciating. The HKD will face appreciation pressure. Since its a cuboard, the central bank of Hong Kong cant print money or change the money supply in the market. But it does allow unlimited conversion between USD and HKD. As USD is depreciating and its demand is going down, people in HKD will convert USDs for HKDs, effectively increasing HKD supply and reducing USD supply in Hong Kong. This will put depreciation pressure on HKD now. This will continue will both currencies are back at the same pegged exchange level. The same will happen with interest rate. It will start rising in HongKong but will then come down to remain in sync with the US rates.

This is how money supply and interest rates adjust under currency board system.