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