Exchange Rate Dynamics Under a Currency Board When Policy Rates are Zero

HKIMR Working Paper No. 21/2017

20 Pages Posted: 20 Sep 2017

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Ka-Fai Li

Hong Kong Monetary Authority

Chi-Fai Lo

The Chinese University of Hong Kong

Date Written: September 18, 2017

Abstract

In a target-zone exchange rate system, both fundamentals and exchange rate expectations, reflected in interest rate differentials between the domestic and anchor currency, determine the exchange rate. However, the scope to capture exchange rate expectations is limited when policy rates are close to their zero lower bound, especially in a narrow-band target zone or currency board. Cook and Yetman (2014) introduce a new mechanism, based on a central bank’s balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. To investigate how interest rate differentials and balance sheets (monetary base) affect exchange rate dynamics, this paper uses a target-zone model with asymmetric mean-reverting fundamental dynamics to test the data for the Hong Kong dollar (HKD) pegged with the US dollar (USD) under a zero-interest rate environment. The empirical results suggest that the restoring force and long-term mean of the exchange rate dynamics are cointegrated with the monetary base, as well as HKD-USD interest rate differentials. Appreciation (depreciation) expectations of the HKD reflected in the dynamics are positively (negatively) related to capital inflows (interest rate differentials).

Keywords: Target zone model, currency board, Hong Kong dollar

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Li, Ka-Fai and Lo, Chi-Fai, Exchange Rate Dynamics Under a Currency Board When Policy Rates are Zero (September 18, 2017). HKIMR Working Paper No. 21/2017. Available at SSRN: https://ssrn.com/abstract=3038732 or http://dx.doi.org/10.2139/ssrn.3038732

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Ka-Fai Li

Hong Kong Monetary Authority ( email )

55/F 2 IFC, 8 Finance Street
Central
Hong Kong
Hong Kong

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

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