chap 4 jeff madura

7/17/2019 chap 4 jeff madura

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Exchange Rate Determination4

Chapter

South-Western/Thomson Learning 2003


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Chapter Objectives

To explain how exchange rate movementsare measured;

To explain how the equilibrium exchangerate is determined; and

To examine the actors that aect theequilibrium exchange rate!


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"easuring

Exchange Rate "ovements #n exchange ratemeasures the value o one

currenc$ in units o another currenc$!

%hen a currenc$ declines in value& it is saidto depreciate! %hen it increases in value& it is

said to appreciate!

On the da$s when some currenciesappreciate while others depreciate against

the dollar& the dollar is said to be 'mixed in

trading!(


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"easuring

Exchange Rate "ovements The percentage change )* in the value

o a oreign currenc$ is computed as

+t, +t-.

+t-.

where Stdenotes the spot rate at time t.

# positive * represents appreciation othe oreign currenc$& while a negative *

represents depreciation!


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Exchange Rate Equilibrium

#n exchange rate represents the price o acurrenc$& which is determined b$ the

demand or that currenc$ relative to the

suppl$ or that currenc$!


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U.S. inflation U.S. demand for British goods, and

hence .

/actors that 0nluence

Exchange RatesRelative Inflation Rates

British desire for U.S. goods, and hence

the supply of .


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U.S. interest rates U.S. demand for British bank deposits,

and hence .


Exchange RatesRelative Interest Rates

British desire for U.S. bank deposits, and

hence the supply of .


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Relative Interest Rates


Exchange Rates

0t is thus useul to consider real interestrates& which adjust the nominal interest

rates or inlation!

# relativel$ high interest rate ma$ actuall$relect expectations o relativel$ highinlation& which discourages oreign

investment!


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Relative Interest Rates


Exchange Rates

This relationship is sometimes called the

Fisher effect!

real nominalinterest

interest , inlation rate rate rate


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U.S. income level U.S. demand for British goods, and

hence .


Exchange RatesRelative Income Levels

No epected change for the supply of .


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Government Controls

1overnments ma$ inluence the equilibrium

exchange rate b$2! imposing foreign echange barriers,! imposing foreign trade barriers,! intervening in the foreign echange market,

and! affecting macro variables such as inflation,

interest rates, and income levels.


Exchange Rates


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Expectations

/oreign exchange mar3ets react to an$

news that ma$ have a uture eect!

0nstitutional investors oten ta3e currenc$positions based on anticipated interest rate

movements in various countries! ecause o speculative transactions&

oreign exchange rates can be ver$ volatile!


Exchange Rates


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Expectations


Exchange Rates

"ed chairman suggests "ed is Strengthenedunlikely to cut U.S. interest rates

# possible decline in $erman Strengthenedinterest rates

%entral banks epected to &eakenedintervene to boost the euro

Signal 'mpact on (

)oor U.S. economic indicators &eakened


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Interaction of Factors

Trade-related actors and inancial actors

sometimes interact! Exchange ratemovements ma$ be simultaneousl$

aected b$ these actors!

/or example& an increase in the level oincome sometimes causes expectations o

higher interest rates!


Exchange Rates


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Interaction of Factors


Exchange Rates

The sensitivit$ o the exchange rate to

these actors is dependent on the volumeo international transactions between the

two countries!

Over a particular period& dierent actorsma$ place opposing pressures on thevalue o a oreign currenc$!


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How Factors Have Influenced Exchange Rates

ecause the dollar5s value changes b$

dierent magnitudes relative to eachoreign currenc$& anal$sts oten measure

the dollar5s strength with an index!

The weight assigned to each currenc$ isdetermined b$ its relative importance in

international trade and6or inance!


Exchange Rates


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0mpact o Exchange Rates on an "7C5s 8alue

( ) ( )[ ]( )

+

=

n

tt

m

tt

!*+

*,,

*

-%"+alue

E )C/j,t 9 : expected cash lows in

currenc$jto be received b$ the !+! parent at the

end o period t

E )ERj,t 9 : expected exchange rate at

which currenc$jcan be converted to dollars at

0nlation Rates& 0nterest Rates&0ncome


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"easuring Exchange Rate "ovements

Exchange Rate Equilibrium! /emand for a %urrency! Supply of a %urrency for Sale! 0uilibrium

Chapter Review


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Chapter Review

/actors that 0nluence Exchange Rates! -elative 'nflation -ates

! -elative 'nterest -ates! -elative 'ncome 1evels! $overnment %ontrols! pectations

! 'nteraction of "actors! 2ow "actors 2ave 'nfluenced change

-ates


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Chapter Review

=ow Exchange Rates #ect an "7C5s8alue

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chap 4 jeff madura