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Exchange Rate Determination

Chapter Objectives
This chapter will:

A. Explain how exchange rate movements are measured

B. Explain how the equilibrium exchange rate is determined

C. Examine factors that determine the equilibrium

exchange rate

D. Explain the movement in cross exchange rates

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 Measuring Exchange Rate Movements

1. Depreciation: decline in a currency’s value

2. Appreciation: increase in a currency’s value

3. Comparing foreign currency spot rates over two

points in time, S and St-1

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

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 Exchange Rate Equilibrium

1. The exchange rate represents the price of a currency,

or the rate at which one currency can be exchanged
for another.
2. Demand for a currency increases when the value of
the currency decreases, leading to a downward
sloping demand schedule.
3. Supply of a currency increases when the value of the
currency increases, leading to an upward sloping
supply schedule.
4. In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.

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 Exhibit 4.2 Demand Schedule for British Pounds

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 Exhibit 4.3 Supply Schedule of British Pounds for Sale

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 Exhibit 4.4 Equilibrium Exchange Rate Determination

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 Factors That 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
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 Factors That Influence Exchange Rates
1. 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.
2. 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 a increase
in demand for dollars and an increased exchange rate
for the dollar.
a. Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate
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 Factors That Influence Exchange Rates

3. 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.
4 Government Controls via:
a. Imposing foreign exchange barriers
b. Imposing foreign trade barriers
c. Intervening in foreign exchange markets
d. Affecting macro variables such as inflation, interest rates,
and income levels.

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 Factors That Influence Exchange Rates
Imposing foreign trade barriers
e.g. Protective tariffs –
US imposing nearly 350% tariff on foreign tobacco
Sneakers produced by New Balance, the last large shoemaker to have
its entire production process in the U.S., is protected by a 48%
tariff on foreign shoe imports.
This is part of the reason why popular brands of shoes such as Nike
and Adidas have higher prices
e.g. Import Quotas
in 2012, Bush Administration, in a further escalation of trade tensions
between the United States and China, announced Tuesday it had
decided to impose quotas on three types of textile products in an
effort to give the U.S. textile industry temporary breathing room from
a flood of Chinese imports.

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 Factors That Influence Exchange Rates

e.g. Import Quotas

The decision will affect Chinese imports of knit fabric, dressing
gowns and robes and bras.

Imposing foreign exchange controls

Following of fixed exchange rates
Banning use of foreign currency within the country
Restrictions on amount of currency imported or exported
Restricting currency exchange to Government approved
exchangers

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 Factors That Influence Exchange Rates

5. 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.
a. Impact of signals on currency speculation. Speculators may
overreact to signals causing currency to be temporarily
overvalued or undervalued.

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 Factors that Influence Exchange Rates

1. Interaction of Factors: some factors place upward

pressure while other factors place downward pressure.
e.g. during Mexican Peso Crisis, Income levels of
mexican oil companies came down due to lower oil prices
in international markets;
Inflation raised to 52% giving upward pressure
2. Influence of Factors across Multiple Currency
Markets: Common for European currencies to move in
the same direction against the dollar.

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 Movements in Cross Exchange Rates

1. If currencies A and B move in same direction, there is

no change in the cross exchange rate.
2. When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then
currency A appreciates (depreciates) against B.
3. 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
against the dollar.

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 Exhibit 4.8 Summary of How Factors Can
Affect Exchange Rates

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 Anticipation of Exchange Rate Movements
1. Bank speculation based on expected appreciation
Banks would prefer to invest in that currency before it
Appreciates
They would hope to liquidate this investment after
appreciation to benefit from higher selling price of
currency
2. Bank speculation based on expected depreciation
If commercial banks believe that present currency value is
higher than what it should be in market, they would borrow
currency
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 Anticipation of Exchange Rate Movements
2. Bank speculation based on expected depreciation
They would further convert to their local currency before
currency value declines
They would hope to repay loan in that currency after it
depreciates, so that they would be able to buy that currency
for a lower price compared to initial price of conversion

3. Speculation by individuals
Individuals can speculate by taking positions in currency
futures or options markets
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 Anticipation of Exchange Rate Movements
3. Speculation by individuals
They can set up accounts at many different foreign
exchange trading websites like fxcm.com, with initial
amounts as low as $ 300
Speculators can go through demos to understand process of
speculating in forex market
Value of currency can substantially change overnight;
while other local markets are closed or have very limited
trading – individuals are attracted by potential for large
gains
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