Scribd
Upload
45 views

Exchange Rate Determination

Exchange rate movements are measured by percentage changes in currency values over time. The equilibrium exchange rate is determined by currency demand and supply. Key factors influencing exchange rates include relative inflation, interest rates, income levels, and government controls. Unique currency supply and demand conditions between pairs of countries affect cross exchange rates. Financial institutions speculate on anticipated exchange rate movements.

Uploaded by

Nguyễn Thuỳ Dung
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
45 views

Exchange Rate Determination

Exchange rate movements are measured by percentage changes in currency values over time. The equilibrium exchange rate is determined by currency demand and supply. Key factors influencing exchange rates include relative inflation, interest rates, income levels, and government controls. Unique currency supply and demand conditions between pairs of countries affect cross exchange rates. Financial institutions speculate on anticipated exchange rate movements.

Uploaded by

Nguyễn Thuỳ Dung
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 14

Exchange Rate

Determination
CHAPTER 4
1. Explain how exchange rate movements are measured.
2. Explain how the equilibrium exchange rate is determined.

Chapter 3. Examine factors that determine the equilibrium exchange


rate.
Objectives 4. Explain the movement in cross exchange rates.
5. Explain how financial institutions attempt to capitalize on
anticipated exchange rate movements.
Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points in time, S and St-1

S  St 1
Percent  in foreign currency value 
S t 1

A positive percent change indicates that the currency has appreciated. A


negative percent change indicates that it has depreciated.
Exhibit 4.1 How Exchange Rate
Movements and Volatility Are Measured
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
Exchange demand schedule. (See Exhibit 4.2)

Rate Supply of a currency increases when the value of the


currency increases, leading to an upward sloping supply
Equilibrium schedule. (See Exhibit 4.3)
Equilibrium equates the quantity of pounds demanded
with the supply of pounds for sale. (See Exhibit 4.4)
In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.
Factors Influence Exchange Rates
e  f (INF , INT , INC , GC , EXP )

where
e  percentage change in the spot rate
INF  change in the differential between U.S. inflation
and the foreign country' s inflation
INT  change in the differential between the U.S. interest rate
and the foreign country' s interest rate
INC  change in the differential between the U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectations of future exchange rates
Factors Influence Exchange Rates
Relative Inflation: Increase in U.S. inflation leads to increase in U.S. demand for
foreign goods, an increase in U.S. demand for foreign currency, and an increase in
the exchange rate for the foreign currency. (See Exhibit 4.5)
Relative Interest Rates: Increase in U.S. rates leads to increase in demand 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. (See Exhibit
4.6)
Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate
Factors Influence Exchange Rates (cont.)
Relative Income Levels: Increase in U.S. income leads to increased in U.S.
demand for foreign goods and 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.
Factors Influence Exchange Rates (cont.)
Expectations: If investors expect interest rates in one country
to rise, they may invest in that country leading to a rise in
the demand for foreign currency and an increase in the
exchange rate for foreign currency.
 Impact of signals on currency speculation. Speculators may
overreact to signals causing currency to be temporarily overvalued
or undervalued.
Factors Influence Exchange Rates
(cont.)
Interaction of Factors: some factors place upward pressure
while other factors place downward pressure. (See Exhibit
4.8)
Influence of Factors across Multiple Currency Markets:
common for European currencies to move in the same
direction against the dollar.
Exhibit 4.8 Summary of How Factors Can Affect
Exchange Rates
Movements in Cross 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.
Anticipation of Exchange Rate Movements

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.
The “Carry Trade” – Where investors attempt to capitalize on the differential in interest rates
between two countries.
Summary
Exchange rate movements are commonly measured by the percentage change in their values over a specified
period, such as a month or a year.
The equilibrium exchange rate between two currencies at any point in time is based on the demand and
supply conditions. Changes in the demand for a currency or the supply of a currency for sale will affect the
equilibrium exchange rate.
The key economic factors that can influence exchange rate movements through their effects on demand and
supply conditions are relative inflation rates, interest rates, and income levels, as well as government controls.
Unique international trade and financial flows between every pair of countries dictate the unique supply and
demand conditions for the currencies of the two countries, which affect the equilibrium cross exchange rate.
The movement in the exchange rate between two non-dollar currencies can be determined by considering
the movement in each currency against the dollar and applying intuition.

You might also like