Lecture Objectives

• Explain how exchange rate movements are measured.

• Explain how the equilibrium exchange rate is determined.
• Examine factors that determine the equilibrium exchange rate.
• Explain the movement in cross exchange rates.
• Explain how financial institutions attempt to capitalize on anticipated
Lecture 5 exchange rate movements.

Exchange Rate Determination

and Intervention

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Exchange Rate Equilibrium (1 of 2)

The exchange rate represents the price of a currency, or the rate at which one
currency can be exchanged for another.
Demand for a currency increases when the value of the currency decreases,
leading to a downward sloping demand schedule. (See Exhibit 4.2)
Supply of a currency for sale increases when the value of the currency
increases, leading to an upward sloping supply schedule. (See Exhibit 4.3)
Equilibrium equates the quantity of pounds demanded with the supply of
pounds for sale. (See Exhibit 4.4)

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Exhibit 4.2 Demand Schedule for British Pounds Exhibit 4.3 Supply Schedule of British Pounds for Sale

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Exhibit 4.4 Equilibrium Exchange Rate Determination Exchange Rate Equilibrium (2 of 2)

Change in the Equilibrium Exchange Rate
• Increase in demand schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
• Decrease in demand schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Increase in supply schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Decrease in supply schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
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Factors That Influence Exchange Rates (1 of 5) Factors That Influence Exchange Rates (2 of 5)
The equilibrium exchange rate will change over time as supply and demand Relative Inflation Rates: Increase in U.S. inflation leads to increase in U.S.
schedules change. demand for foreign goods, an increase in U.S. demand for foreign currency,
e = f (ΔINF , ΔINT, ΔINC, ΔGC , ΔEXP) and an increase in the exchange rate for the foreign currency. (See Exhibit 4.5)
where Relative Interest Rates: Increase in U.S. rates leads to increase in demand
e = percentage change in the spot rate
for U.S. deposits and a decrease in demand for foreign deposits, leading to an
increase in demand for dollars and an increased exchange rate for the dollar.
ΔINF = change in the differential between U. S . inflation and the foreign (See Exhibit 4.6)
country's inflation
ΔINT = change in the differential between the U.S. interest rate and the • Real Interest Rates
foreign country's interest rate o Fisher Effect:
ΔINC = change in the differential between the U.S. income level and the
foreign country's income level Real interest rate  Nominal interest rate  Inflation rate
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates

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Exhibit 4.5 Impact of Rising U.S. Inflation on the Exhibit 4.6 Impact of Rising U.S. Interest Rates on
Equilibrium Value of the British Pound the Equilibrium Value of the British Pound

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Factors That Influence Exchange Rates (3 of 5) Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound
Relative Income Levels: Increase in U.S. income leads to an increase in U.S.
demand for foreign goods, an increased demand for foreign currency relative to
the dollar, and an increase in the exchange rate for the foreign currency. (See
Exhibit 4.7)
Government Controls via:
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets
• Affecting macro variables such as inflation, interest rates, and income levels

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Factors That Influence Exchange Rates (4 of 5) Factors That Influence Exchange Rates (5 of 5)
Expectations: Interaction of Factors: Some factors place upward pressure while other
• Impact of favorable expectations: If investors expect interest rates in one factors place downward pressure. (See Exhibit 4.8)
country to rise, they may invest in that country, leading to a rise in the Influence of Factors across Multiple Currency Markets: common for
demand for foreign currency and an increase in the exchange rate for foreign European currencies to move in the same direction against the dollar.
currency. Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot
• Impact of unfavorable expectations: Speculators can place downward market is liquid then its exchange rate will not be highly sensitive to a single
pressure on a currency when they expect it to depreciate. large purchase or sale.
• Impact of signals on currency speculation: Speculators may overreact to
signals, causing currency to be temporarily overvalued or undervalued.

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Exhibit 4.8 Summary of How Factors Affect Movements in Cross Exchange Rates (1 of 2)
Exchange Rates
• If currencies A and B move in same direction, there is no change in the cross
exchange rate.

• When currency A appreciates against the dollar by a greater (smaller) degree

than currency B, then currency A appreciates (depreciates) against B.

• When currency A appreciates (depreciates) against the dollar, while currency

B is unchanged against the dollar, currency A appreciates (depreciates)
against currency B by the same degree as it appreciates (depreciates)
against the dollar.

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Movements in Cross Exchange Rates (2 of 2) Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (1 of 2)
Explaining Movements in Cross Exchange Rate.
• Changes are affected in the same way as types of forces
explained earlier for those that affect demand and supply
conditions between two currencies.

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Exhibit 4.9 Example of How Forces Affect the Capitalizing on Expected Exchange Rate Movements (1 of 2)
Cross Exchange Rate (2 of 2)
Institutional speculation based on expected appreciation: When financial
institutions believe that a currency is valued lower than it should be in the
foreign exchange market, they may invest in that currency before it
appreciates.
Institutional speculation based on expected depreciation: If financial
institutions believe that a currency is valued higher than it should be in the
foreign exchange market, they may borrow funds in that currency and convert it
to their local currency now before the currency’s value declines to its proper
level.
Speculation by individuals: Individuals can speculate in foreign currencies.

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Capitalizing on Expected Exchange Rate Movements (1 of 2) Capitalizing on Expected Exchange Rate Movements (1 of 2)

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Capitalizing on Expected Exchange Rate Movements (2 of 2) Capitalizing on Expected Exchange Rate Movements (2 of 2)
Example: Hampton Investment Co. is a U.S. firm that executes a carry trade in
The “Carry Trade” — Where investors attempt to capitalize on the differential
in interest rates between two countries. which it borrows euros (interest rates are presently low in the eurozone) and

• Impact of appreciation in the investment currency: Increased trade invests in British pounds (interest rates are presently high in the United Kingdom).
volume can have a major influence on exchange rate movements over a Hampton uses $100,000 of its own funds and borrows an additional 600,000
short period. euros. It will pay 0.5% on its euros borrowed for the next month and will earn 1.0%
• Risk of the Carry Trade: Exchange rates may move opposite to what the on funds invested in British pounds. Assume that the euro’s spot rate is $1.20 and
investors expected. that the British pound’s spot rate is $1.80 (so the pound is worth 1.5 euros at this
time). Hampton uses today’s spot rate as its best guess of the spot rate one month
from now. What is Hampton’s expected profits from its carry trade?

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