Exchange Rate Determination

International Finance (MB 74)

Outline
Defining Exchange Rate
Measuring Exchange Rate Movements
Appreciation/Depreciation of a currency

Exchange Rate Equilibrium Factors that influence Exchange Rate

Movements

Meaning of Exchange Rate and Measuring Changes in Exchange Rates

Value of one currency in units of another currency A decline in a currencys value is referred to as depreciation and an increase in currencys value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation
Percentage change in value US $
New Value of Foreign Currency per unit of $ Old value of foreign currency per $

-------------------------------------------------- X 100
Old value of Foreign Currency per $

Percentage change in value of Foreign Currency

New Value of $ per units of Foreign Currency
Old value of $ per unit of foreign currency

-------------------------------------------------- X 100
Old value of $ per unit of Foreign Currency

Exchange Rate Equilibrium

Forces of Demand and Supply
Demand for foreign currency negatively

related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency

Price for Foreign Currency

D $2.00 $1.50 D
50m 75 m Units of Foreign Currency ()

Supply of Foreign Currency

Supply for Foreign Currency

$2.00

$1.50 S
50 m 75 m Units of Foreign Currency ()

Equilibrium Exchange Rate

Exchange Rate

$1.6775

D
Units of Foreign Currency()

Factors that influence the Exchange Rate

Expectations of the Market
Political Events Relative Inflation Rates Relative Interest Rates Relative Income Levels

Exchange rate is the results of an interaction of these factors

Market Expectations
Expectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 2001 Weak Dollar today 2005 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies

Political Events
Fall of Berlin Wall and unification of East

and West Germany Rumors about resignation of Mikhail Gorbachov Tiannanmon Square Persian Gulf War September 11, 2001

Relative Inflation
High inflation relative to a foreign country,

decline in value of currencyWhy? Low inflation relative to a foreign country, increase in value of currencyWhy?

Relative Interest Rates

High interest rates in home country relative

to a foreign country may cause domestic currency to appreciateWhy?

Relative Income Levels

Increase in domestic income relative to

foreign income may lead to a decline in the value of domestic currency Why?

Exchange Rate Determination

An interaction of factors
Is it possible for a country with high real

returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?