Chapter 4

Exchange Rate Determination

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Chapter 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
exchange rate movements.

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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 
St  1

S= spot rate

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

negative percent change indicates that it has depreciated. (Exhibit 4.1)

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Exhibit 4.1 How Exchange Rate Movements and
Volatility Are Measured (US$)
Value of Canadian Monthly % Change Value of Euro Monthly %
Dollar (C$) in C$ Change in Euro
Jan. 1 $0.70 — $1.18 —
Feb. 1 $0.71 +1.43% $1.16 −1.69%
March 1 $0.70 −0.99% $1.15 −0.86%
April 1 $0.70 −0.85% $1.12 −2.61%
May 1 $0.69 −0.72% $1.11 −0.89%
June 1 $0.70 +043% $1.14 +2.70%
July 1 $0.69 −1.29% $1.17 +2.63%
Standard deviation 1.04% 2.31%
of monthly changes

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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

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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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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)
The equilibrium exchange rate will change over time as supply and demand
schedules change.
e = f (ΔINF , ΔINT, ΔINC, ΔGC , ΔEXP)
where
e = percentage change in the spot rate
ΔINF = change in the differential between U. S . inflation and the foreign
country's inflation
ΔINT = change in the differential between the U.S. interest rate and the
foreign country's interest rate
ΔINC = change in the differential between the U.S. income level and the
foreign country's income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates

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Factors That Influence Exchange Rates (2 of 5)
Relative Inflation Rates: 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)
• Real Interest Rates
o Fisher Effect:

Real interest rate  Nominal interest rate  Inflation rate

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

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

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Factors That Influence Exchange Rates (3 of 5)
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 (buying and selling)
• Affecting macro variables such as inflation, interest rates, and income levels

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Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound

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Factors That Influence Exchange Rates (4 of 5)
Expectations:
• Impact of favorable 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 unfavorable expectations: Speculators can place downward
pressure on a currency when they expect it to depreciate.
• Impact of a Currency Crisis: Expectations of a crisis trigger can make the
crisis worse
 Example; government’s attempt to impose foreign exchange restrictions
can cause more panic as investors try to get their money out
 Greece 2015; cash bank withdrawals have a daily limit of 60 euros
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Factors That Influence Exchange Rates (5 of 5)
Interaction of Factors: Some factors place upward pressure while other
factors place downward pressure. (See Exhibit 4.8)
* trade related- influenced more by inflation (slower)
* financial/capital flows- influenced more by interest rates (more
immediate), this flow is on the rise with large institutional investors
Influence of Factors across Multiple Currency Markets: common for
European currencies to move in the same direction against the dollar because
economic conditions are so “contagious”
Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot
market is liquid then its exchange rate will not be highly sensitive to a single
large purchase or sale (and vice versa)

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Exhibit 4.8 Summary of How Factors Affect
Exchange Rates

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Movements in Cross Exchange Rates (1 of 2)
- 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)
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.
 Inflation
 Interest rates
 Income levels
 Government controls
 Expectations

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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (1 of 2)

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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (2 of 2)

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Capitalizing on Expected Exchange Rate Movements (1 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
- margin, as little as 5% down

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Capitalizing on Expected Exchange Rate Movements (2 of 2)

The “Carry Trade” — Where investors attempt to capitalize on the differential

in interest rates between two countries
- borrow currency with low interest rate, invest in currency with high
interest rate
• Impact of appreciation in the investment currency: choice of currencies
to borrow and purchase not only influenced by exchange rates, but also by
exchange rate movements
 Investors prefer to borrow a currency they expect to weaken
• Risk of the Carry Trade: Exchange rates may move opposite to what the
investors expected.

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Summary (1 of 3)
• Exchange rate movements are commonly measured by the percentage
change in their values over a specified period, such as a month or a year.
 MNCs closely monitor exchange rate movements over the period in
which they have cash flows denominated in the foreign currencies of
concern.
• The equilibrium exchange rate between two currencies at any 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.

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Summary (2 of 3)
• The key economic factors that can influence exchange rate movements
through their effects on demand and supply conditions are relative inflation
rates, interest rates, income levels, and government controls. When these
factors lead to a change in international trade or financial flows, they affect
the demand for a currency or the supply of currency for sale and thus the
equilibrium exchange rate.
• If a foreign country experiences an increase in interest rates (relative to U.S.
interest rates), then the inflow of U.S. funds to purchase its securities should
increase (U.S. demand for its currency increases), the outflow of its funds to
purchase U.S. securities should decrease (supply of its currency to be
exchanged for U.S. dollars decreases), and there should be upward pressure
on its currency’s equilibrium value.
• All relevant factors must be considered simultaneously when attempting to
predict the most likely movement in a currency’s value.
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Summary (3 of 3)
• There are distinct international trade and financial flows between every pair
of countries. These flows dictate the unique supply and demand conditions
for the currencies of the two countries, which affect the equilibrium cross
exchange rate between their currencies.
 Movement in the exchange rate between two non-dollar currencies can
be inferred from the movement in each currency against the dollar.
• Financial institutions can attempt to benefit from the expected appreciation of
a currency by purchasing that currency.
• Analogously, they can benefit from expected depreciation of a currency by
borrowing that currency and exchanging it for their home currency.

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