3 .

EXCHANGE RATE
DETERMINATION
 What is in this chapter
• Measuring Exchange Rate Movements
• Exchange Rate Equilibrium
– Demand for a Currency
– Supply of a Currency for Sale
– Equilibrium
• Factors that Influence Exchange Rates
– Relative Inflation Rates
– Relative Interest Rates
– Relative Income Levels
– Government Controls
– Expectations
– Interaction of Factors
– How Factors Have Influenced Exchange Rates
• Speculating on Anticipated Exchange Rates
Measuring Exchange Rate Movements

• An exchange rate measures the value of

one currency in units of another currency.
• When a currency declines in value, it is said
to depreciate. When it increases in value, it
is said to appreciate.
• On the days when some currencies
appreciate while others depreciate against
the dollar, the dollar is said to be “mixed in
trading.”
• The percentage change (% ∆ ) in the value of a
foreign currency is computed as

St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % ∆ represents appreciation
of the foreign currency, while a negative
% ∆ represents depreciation.
Example
PKR 86.70 / USD = St (rate on 1.3.2010)
PKR 85.00 / USD = St- (rate on 1.2.2010)

St – St-1
St-1

86.70-85.00

85.00

= USDappreciated2%against PKRoveramonth

OR

= PKRdepreciated2%againstUSDoveramonth
 Fluctuation of the British Pound Over Time

Approximate £
that could be
Approximate Approximate Purchased with
Spot Rate of £ Annual % ∆ $10,000
$ 1.80 20 % £ 7000
1.75 15 6800
1.70 10 6600
1.65 5
6400
1.60 0
6200
1.55 -5
1.50 -10 6000
1.45 -15 5800
1.40 -20 5600
1992 1996 2000 1992 1996 2000 1992 1996 2000
 Exchange Rate Equilibrium
• An exchange rate represents the price
of a currency, which is determined by
the demand for that currency relative to
the supply for that currency.
Value of £
S: Supply of £
$1.60
$1.55 equilibrium
exchange rate
$1.50
D: Demand for £

Quantity of £
Factors that Influence Exchange Rates

Relative Inflation Rates

$/£ U.S. inflation ↑

S1
S0
⇒ ↑ U.S. demand for
r1 British goods, and
r0 hence £.
D1 ⇒ ↓ British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
Relative Interest Rates

$/£ U.S. interest rates ↑

S0
S1
⇒ ↓ U.S. demand for
r0 British bank deposits,
r1 and hence £.
D0 ⇒ ↑ British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
Relative Interest Rates

• A relatively high interest rate may

actually reflect expectations of relatively
high inflation, which discourages foreign
investment.
• It is thus useful to consider real interest
rates, which adjust the nominal interest
rates for inflation.
Relative Interest Rates

• real nominal
interest ≈ interest – inflation rate
rate rate
• This relationship is sometimes called
the Fisher effect.
 Factors that Influence
Exchange Rates
Relative Income Levels

$/£ U.S. income level ↑

S0 ,S1
⇒ ↑ U.S. demand for
r1
British goods, and
r0 hence £.
D1 ⇒ No expected change for
D0
the supply of £.
Quantity of £
 Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the
equilibrium exchange rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market,
and
– affecting macro variables such as inflation,
interest rates, and income levels.
 Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any news
that may have a future effect.
• Institutional investors often take currency
positions based on anticipated interest rate
movements in various countries.
• Because of speculative transactions, foreign
exchange rates can be very volatile.
Expectations

Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
 Factors that Influence
Exchange Rates
Interaction of Factors
• Trade-related factors and financial factors
sometimes interact. Exchange rate
movements may be simultaneously
affected by these factors.
• For example, an increase in the level of
income sometimes causes expectations of
higher interest rates.
 Factors that Influence
Exchange Rates
Interaction of Factors

• Over a particular period, different

factors may place opposing pressures
on the value of a foreign currency.
• The sensitivity of the exchange rate to
these factors is dependent on the
volume of international transactions
between the two countries.
 How Factors Can Affect Exchange
Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
 Factors that Influence
Exchange Rates
How Factors Have Influenced Exchange Rates
• Because the dollar’s value changes by different
magnitudes relative to each foreign currency,
analysts often measure the dollar’s strength
with an index.
• The weight assigned to each currency is
determined by its relative importance in
international trade and/or finance.
 Value of Foreign Currency Index Over
Time
With Respect to the Dollar
large Higher
250 $↓ due to U.S.
balance Persian
← strengthens $ weakens →

relatively high of trade Gulf War interest

200 U.S. inflation deficit rates
& growth
150
U.S. interest rates ↓
100 high U.S. relatively high U.S.
interest rates, a interest rates, &
50 somewhat depressed lower balance of
U.S. economy, & low trade deficit
inflation
0
1972 1976 1980 1984 1988 1992 1996 2000

Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc.
Speculating on Anticipated Exchange
Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
Speculating on Anticipated Exchange
Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000