Exchange Rate
Determination
Chapter 4
1
Chapter Objectives
This chapter will:
A. Explain how exchange rate movements are
measured
B. Explain how the equilibrium exchange rate is
determined
C. Examine factors that determine the equilibrium
exchange rate
D. Explain the movement in cross exchange rates
2
Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over
two points in time, S and St-1
St St 1
Percent in foreign currency value
St 1
Refer to Exhibit 4.1 p. 104
3
Exchange Rate Equilibrium
The exchange rate represents the price of a
currency, or the rate at which one currency can
be exchanged for another
Demand for a currency increases when the
value of the currency decreases, leading to a
downward sloping demand schedule
Supply of a currency increases when the value
of the currency increases, leading to an
upward sloping supply schedule
In liquid spot markets, exchange rates are not
highly sensitive to large currency transactions
4
Exhibit 4.2 Demand Schedule for British
Pounds
5
Exhibit 4.3 Supply Schedule of British Pounds for Sale
6
Exhibit 4.4 Equilibrium Exchange Rate
Determination
7
Factors That Influence Exchange
Rates
e f (INF , INT , INC , GC, EXP)
where
e percentage change in the spot rate
INF change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC change in government controls
EXP change in expectatio ns of future exchange rates
8
Factors That Influence Exchange
Rates
Relative Inflation: Increase in U.S. inflation leads
to increase in U.S. demand for foreign goods,
an increase in U.S. demand for foreign
currency, and an increase in the exchange rate
for the foreign currency
Relative Interest Rates: Increase in U.S. rates
leads to increase in demand for U.S. deposits
and a decrease in demand for foreign deposits,
leading to a increase in demand for dollars and
an increased exchange rate for the dollar
◦ Fisher Effect:
Real interest rate Nominal interest rate Inflation rate
9
Factors That Influence Exchange
Rates
Relative Income Levels: Increase in U.S.
income leads to increased in U.S. demand for
foreign goods and increased demand for
foreign currency relative to the dollar and an
increase in the exchange rate for the foreign
currency
Government Controls via:
◦ Imposing foreign exchange barriers
◦ Imposing foreign trade barriers
◦ Intervening in foreign exchange markets
◦ Affecting macro variables such as inflation, interest
rates, and income levels
10
Factors That Influence Exchange
Rates
Expectations: If investors expect interest
rates in one country to rise, they may invest
in that country leading to a rise in the
demand for foreign currency and an increase
in the exchange rate for foreign currency
◦ Impact of signals on currency speculation.
Speculators may overreact to signals causing
currency to be temporarily overvalued or
undervalued
11
Factors that Influence Exchange
Rates
Interaction of Factors: some factors place
upward pressure while other factors place
downward pressure
Influence of Factors across Multiple Currency
Markets: common for European currencies to
move in the same direction against the dollar
12
Movements in Cross Exchange Rates
If currencies A and B move in same direction,
there is no change in the cross exchange rate
When currency A appreciates against the dollar by
a greater (smaller) degree than currency B, then
currency A appreciates (depreciates) against B
When currency A appreciates (depreciates) against
the dollar, while currency B is unchanged against
the dollar, currency A appreciates (depreciates)
against currency B by the same degree as it
appreciates against the dollar
Refer to Example p. 114
13
Exhibit 4.8 Summary of How Factors Can
Affect Exchange Rates
14
Anticipation of Exchange Rate
Movements
Bank speculation based on expected
appreciation
Refer to Example p. 116
Bank speculation based on expected
depreciation
Refer to Example p. 117
Speculation by individuals
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