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exchange rate in this range, the foreign exchange value of its h units of home currency remains less than or equal to f\since (h)(f/h)=f]. In other words, with the rate in this range, no exchange that the authority could be called on to make would more than exhaust its holdings of foreign currency. (Notice, by the way, that the net worth of the monetary authority assets less liabilities] varies inversely with the exchange rate, being equal to f when the exchange rate is zero [ƒ— (h)(0) = f} and being equal to zero when the exchange rate is fih [ƒ — (h)(f/h) = 0].)
Evidently, any such fixed rate policy is effective in the sense that the market rate must be the fixed rate. Under the fixed rate policy, the monetary authority would supply the market with any amount of home currency that is demanded at the fixed rate; in other words, at that rate. supply would be perfectly elastic, as shown in Figure 3. Regardless of the demand for home currency, then, the exchange rate would be the one announced.
Now consider matters under a strict version of Hong Kong's official float policy. Suppose again that the au- thority starts out holding units of foreign currency with h units of home currency outstanding. The monetary au- thority's policy is now to buy and sell any amount of its currency at the exchange rate that the market determines. However, what rate would the market determine? Evi- dently, under this policy, it could be any rate between zero and fih.
To establish that any such rate could be an equilibrium. we only need to verify that the home currency`s supply and demand would be equal at that rate. Consider any particular rate in the interval [0. f/h). Under the float policy, supply at that rate would look just like the perfectly elastic supply curve in Figure 3 because, according to the policy, the authority is willing to buy and sell unlimited amounts at the market rate. At the particular rate, then, regardless of the nature of the demand for home currency. demand would be satisfied. Therefore, the posited rate- any rate between zero and f/h-would be an equilibrium. or ruling, exchange rate under the official policy.
To demonstrate in this way that under Hong Kong's official float policy the exchange rate had to be indeter- minate cannot be the end of things. For somehow the exchange rate was being determined. Therefore, our analysis is, at best, incomplete. In principle, our analysis. could be regarded as defective either because we have mischaracterized how things are supposed to have worked under the official policy or else because the Exchange Fund actually pursued a policy different from
Figure 3
The Supply of Hong Kong Currency Under a Fixed or a Floating Rate Policy
Exchange rate*,
's pliore gr Curre De
Supply of home currency
Units of home currency
me currency
the officially professed one. We favor the latter possibility. We think that the Hong Kong dollar's exchange rate was determined throughout the float period by a series of discreet deviations from the official policy. In practice. the policy is likely to have more closely resembled a fixed rate policy than a strict version of the official policy. In our view, the observed exchange rate was determined by signals given by the Exchange Fund. signals which in effect revealed the exchange rate at which the authority was willing to buy and sell Hong Kong dollars. This was feasible since the Exchange Fund was able to supply unlimited quantities of Hong Kong dollars and since it was continually engaging in transactions with the dealers who announced exchange rates.
In this pure system, the monetary authority can be rewarded as acting as a warehouse for foreign currency, always having at least enough foreign-denomi- rated assets to convert its tarai outstanding stock of notes in practice, however. many countnes' monetary authorities have managed to peg a rate of exchange of domestic curencs for foreign currency while holding foreign exchange reserves that are smaller in value than the stock of outstanding domestic notes. Such a system can be administered if the monetary authority has a commitment from the fiscal authority to run prospective government surpluses sufficient to cover the obligations of the monetary authority in the event of a run. We assume that the Hong Kong system is a pure one, which is to say that the monetary branch of the Hong Kong Exchange Fund operates independently of the fiscal branch and cannot expect future govemment surpluses or deficits either to augment or to umpair the funds available to back the currency.
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