Chapter 4

EXCHANGE RATE
DETERMINATION

1
Exchange Rate Movement:
Measurement

Movements:
 Depreciation
A decline in a currency’s value.
 Appreciation
An increase in a currency’s value.

2
Exchange Rate Movement:
Measurement (cont.)

Percent ∆ in S - St-1
foreign =
currency value St-1

Where:
S = spot rate as of the more recent date
St-1 = spot rate as of the earlier date

3
Exchange Rate Equilibrium
Exchange rate equilibrium is determined by the
demand for a currency relative to supply.
 Demand for a Currency

4
Exchange Rate Equilibrium (cont.)

 Supply of a currency for Sale

5
Exchange Rate Equilibrium (cont.)

 Equilibrium Exchange Rate Determination

6
Factors that Influence Exchange
Rates

7
Factors that Influence Exchange
Rates (cont.)

 Relative Inflation Rates

Changes in relative inflation rates can affect
international trade activity, then it influences the
demand and supply of currencies.
Ex.
The sudden jump in US inflation should cause an
increase in the US demand for British goods and
therefore also cause an increase in the US
demand for British pounds.
In addition, the jump in US inflation should reduce
the British desire for US goods and therefore
reduce the supply of pounds for sale.
8
 Factors that Influence Exchange
Rates (cont.)

1. the demand schedule for pounds should shift outward

2. the supply schedule of pounds for sale should shift
inward
3. the new equilibrium value of the pound will increase
9
Factors that Influence Exchange
Rates (cont.)
 Relative Interest Rates
Changes in relative interest rates affect
investment in foreign securities, which
influences the demand and supply of currencies.
Ex.
If US interest rates rise while British interest rates remain
constant, it brings the US corporations will likely reduce
their demand for pounds, since the US rates are now more
attractive relative to British rates, and there is less desire
for British bank deposits.
Since US rates will now look more attractive to British
corporations with excess cash, the supply of pounds for
sale by British corporations should increase as they
establish more bank deposits in the US
10
Factors that Influence Exchange
Rates (cont.)

1. the demand schedule for pounds should shift inward

2. the supply schedule of pounds for sale should shift
outward
3. the new equilibrium exchange rate should decrease

Real Interest Rate = Nominal Interest Rate – Inflation Rate

11
Factors that Influence Exchange
Rates (cont.)

 Relative Income Levels

The higher the income level of a country, the
higher the demand of foreign goods (currency),
while the supply of the currency remain
constant.
Ex.
If income level of US substantially rises while the British
income level remains unchanged, the demand of British
goods by US people will increase, so that the demand of
British pounds should increase.

12
Factors that Influence Exchange
Rates (cont.)

1. the demand schedule for pounds will shift outward

2. the supply schedule of pounds for sale is not expected
to change
3. the equilibrium exchange rate of the pound is expected
to rise
13
Factors that Influence Exchange
Rates (cont.)

 Government Control
Through:
1. The imposition of foreign exchange barriers.
2. The imposition of foreign trade barriers.
3. Intervening (buying and selling currencies) in the
foreign exchange markets.
4. Affecting macro variables, such as inflation, interest
rate, income level.

14
Factors that Influence Exchange
Rates (cont.)

 Expectation
Market expectations of future exchange rates
can affect the demand and supply of
currencies.
Ex. Any news of a potential surge in US inflation may
cause currency traders to sell dollars. They try to
anticipate a future decline in the dollar’s value.

15
Factors that Influence Exchange
Rates (cont.)
 Interaction of Factors

16