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Measuring Exchange Rate Movements

Here are the key points about how rising prices of goods can impact exchange rates: - Rising domestic inflation relative to foreign inflation can cause a currency to depreciate. Higher inflation raises costs and prices in a country, making its exports less competitive on global markets and its imports more attractive, which decreases demand for its currency. - Anticipated future inflation is also important. If markets expect inflation to continue rising in the future, they will drive demand for that currency lower today through speculative selling. - Higher inflation raises expectations of future interest rate hikes by the central bank. Higher domestic rates attract more capital inflows from abroad, supporting the currency. But rate hikes are also a sign the economy is weakening,

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Nouman Ahmad
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224 views26 pages

Measuring Exchange Rate Movements

Here are the key points about how rising prices of goods can impact exchange rates: - Rising domestic inflation relative to foreign inflation can cause a currency to depreciate. Higher inflation raises costs and prices in a country, making its exports less competitive on global markets and its imports more attractive, which decreases demand for its currency. - Anticipated future inflation is also important. If markets expect inflation to continue rising in the future, they will drive demand for that currency lower today through speculative selling. - Higher inflation raises expectations of future interest rate hikes by the central bank. Higher domestic rates attract more capital inflows from abroad, supporting the currency. But rate hikes are also a sign the economy is weakening,

Uploaded by

Nouman Ahmad
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Measuring Exchange Rate Movements

An exchange rate measures the value of one


currency in units of another currency.

As economic conditions of a country change,


exchange rates can change substantially.
Measuring Exchange Rate Movements
►Pegged Currency: The currency value is set by the
government. Devaluation refers to a decrease in the
stated value of a pegged currency and an increase in
the value of pegged currency is known as revaluation.

►Floating Currency: The currency value is determined


by market forces i.e. market demand and supply of
currency.
A decline in a floating currency’s value is referred to
as depreciation, while an increase is referred to as
appreciation.

However, devaluation and depreciation and revaluation


and appreciation are used interchangeably
Measuring Exchange Rate Movements
Previous pound value £1 = $1.50
Current pound value £1 = $1.56
Amount of pound appreciation (or depreciation)

Current dollar value per pound – Previous dollar value per pound
= -----------------------------------------------------------------------------
Previous dollar value per pound

= (e1 – e0)  e0
= (1.56 – 1.50)  1.50 = .04 or 4%
Measuring Exchange Rate Movements
Previous pound value £1 = $1.50
Current pound value £1 = $1.56
Amount of dollar depreciation (or appreciation)

Current pound value per dollar – Previous pound value per dollar
= -----------------------------------------------------------------------------
Previous pound value per dollar

= (1/e1 – 1/e0)  1/e0 = (e0 – e1)  e1


= (1.50 – 1.56)  1.56 = -.0384 or – 3.84%
Measuring Exchange Rate Movements

Example: In July 19, 1985, the Italian lira devalued


by 17% against the dollar. By what percentage
dollar appreciated against the lira?
Exchange Rate Equilibrium

Value of £
S
equilibrium
exchange
rate

Quantity of £
An exchange rate represents the price of a
currency, which is determined by the demand for
that currency relative to supply.
Factors that Influence Exchange Rates
Value of £ S2
S
r2
r
D2
D
Quantity of £

Relative Inflation Rates


- A relative increase in U.S. inflation will increase
the U.S. demand for British goods, and hence
the U.S. demand for British pounds.
- In addition, the British desire for U.S. goods,
and hence the supply of pounds, will drop.
Factors that Influence Exchange Rates
S
S2
r
Value of £
r2
D
D2
Quantity of £

Relative Interest Rates


- A relative rise in U.S. interest rates will decrease
the U.S. demand for British pounds.
- In addition, the supply of pounds by British
corporations will increase.
Factors that Influence Exchange Rates
S

Value of £ rr2
D2
D
Quantity of £

Relative Income Levels


- A relative increase in the U.S. income level will
increase the U.S. demand for British goods,
and hence the demand for British pound.
- The supply of pounds does not change.
Factors that Influence Exchange Rates
Government Controls
- Governments can influence the equilibrium
exchange rate in many ways, including :
1. the imposition of foreign exchange
restrictions,
2. the imposition of foreign trade barriers,
3. intervening in the foreign exchange market,
and
4. affecting macro variables such as inflation,
interest rates, and income levels.
Factors that Influence Exchange Rates

Expectations

1. Foreign exchange markets react to any news


that may have a future effect.
2. Institutional investors often take currency
positions based on anticipated interest rate
movements in various countries too.
3. Because of speculative transactions, foreign
exchange rates can be very volatile.
Factors that Influence 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 for and the
1. Interest Rate foreign currency dollar
Differential
2. Capital Flow Foreign demand for U.S.
Restrictions securities, i.e. supply of
foreign currency
Factors that Influence Exchange Rates
Interaction of Factors
- Trade-related factors and financial factors sometimes
interact. For example, an increase in income levels
sometimes causes expectations of higher interest
rates.
- 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.
If the two countries engage in a large volume of
international trade but a very small volume of
international capital flows, the relative inflation rates
will likely be more influential.
Factors that Influence Exchange Rates

Interaction of Factors
However, if the two countries engage in a large
volume of capital flows, interest rate fluctuations
may be more influential.
An understanding of exchange rate equilibrium does
not guarantee accurate forecasts of future
exchange rates because that will depend in part on
how the factors that affect exchange rates will
change in the future. Even if analysts fully realize
how factors influence exchange rates, they may not
be able to predict how those factors will change.
Speculating on Anticipated Exchange Rates

Currency Lending rate Borrowing rate

U.S. dollars 6.72% 7.20%


NZ$ 6.48% 6.96%
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
$20 million
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
$20 million

Exchange at
$0.50/NZ$

2. Holds
NZ$40 million
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
$20 million

Exchange at
$0.50/NZ$
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 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
NZ$40 million
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
NZ$40 million

Exchange at
$0.50/NZ$

2. Holds
$20 million
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
NZ$40 million

Exchange at
$0.50/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
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 in NZ$1,668,000
Exchange at or in $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
Questions

If prices of goods start rising in US relative to the prices in Japan.


What will happen to the dollar yen exchange rate?

If a foreigner purchases large amount of US debentures or stocks,


what will happen to the demand and supply of dollar?

Describe how the following transactions should affect present and


future exchange rates?
a. A US company purchases whole year’s raw material from
France and payment is due in FF immediately.
b. A Korean Airlines company buys 6 Boeing 747s and Boeing
company arranges loan for Korean Airlines from a US bank
and the loan will be repaid after two years in the following
five years.
Questions

For each of the following scenarios, explain whether the value


of dollar will appreciate, depreciate or remain the same relative
to the Japanese yen. Assume that exchange rate is freely
floating and other factors are held constant.

The growth rate of national income is higher in the USA than in


Japan

Inflation is higher in US than in Japan

US imposes restrictions on foreign purchases of US real estate


and companies

Real interest rates is higher in USA than in Japan


Problems

Expo Bank can borrow US $50,000 at 8.3% annualized rate. It


can use the proceeds to invest in Chinese Yuan at 8.5%
annualized rate for 20 days. The Chinese Yuan worth $0.15 at
present and is expected to be worth $0.14 in twenty days.
Based on the above information, should Expo Bank borrow US
dollar and invest in Yuan? What will be the gain or loss in US
dollars?

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