| Hong Kong's current US dollar linked exchange rate policy has been criticized because it lacks flexibility. Ho (1990) argues that it is worthwhile to peg the Hong Kong dollar to a trade-weighted currency basket.; This dissertation investigates the optimal currency basket for Hong Kong provided the 2 possible objectives of the policy-makers are: (1) minimize the variance of the balance of trade; (2) minimize the variance of national income.; First, I revise and extend Flanders and Helpman's (1979) model of elasticity-weighted currency basket. Because they concentrated their attention on the demand for the home country's exports, and ignore the home country's demand for imports, their model has an upward bias in the weight given the US dollar, the numeraire currency, and a downward bias in the weight given the other currencies. I also extend their model by relaxing two restrictive assumptions. These are: (1) the value of imports into the small economy is totally price inelastic, (2) there are no cross-price effects in the demand for the small economy's exports.; Second, I calculate the optimal currency baskets for Hong Kong both when the currencies of the less developed countries are included as well as when they are not included. I show that the trade-weighted currency basket suggested by Ho is not an optimal basket for either of the objectives stated above. I also show that, when only the currencies of the industrial countries are included in the basket, the US dollar linked policy is an approximately optimal policy if the authorities try to minimize the variance of the national income. |
