CHAPTER-04

Exchange Rate Determination

Q: Measurement of Exchange Rate

An exchange rate measures the value of one currency in units of another

currency. With the changes of economic conditions exchange rates can change. It

may be positive or negative. A decline in exchange rate or negative change of

exchange rate is often referred to as depreciation. An increase in exchange rate or

positive change of exchange rate is often referred to as appreciation.

Depreciation indicates weak position and appreciation indicates strong position of

the currency.

Q: Measurement of Exchange Rate Movements

The movements of exchange rate can be calculated by using the following formula:

Percent in foreign currency value= (S S1)/S1

Where, S= Spot rate, i.e. the recent market rate of the currency, S1= the spot rate at

the earlier date

Example: The rent of a room in a hotel is 100 Euros. You had visited Europe and

stayed in that hotel in 2009 & 2010. Your cost was $105 in 2009 and $126 in 2010.

The hotel received same amount of Euros on both dates. What is the percentage of

euro exchange rate movements?

Percent in foreign currency value = S-S1/S1 =126-105/105 =21/105 =20%,

Where S= Spot rate= $105, S1 the spot rate at the earlier date=$126

Q: Equilibrium Exchange Rate:

The price at which the demand of a currency is equal to the supply of that

currency in a particular point in time is called equilibrium exchange rate. Of

course, conditions can change over time, causing the supply or demand for a

given currency to adjust, and thereby causing movement in the currency price.

Q: Demand for a Currency

The demand for other currency will be increased if the people find the other

currency is relatively cheaper than their own currency. It is because people will

take fewer local currencies to obtain the desired amount of foreign currency. The

Demand for a Currency can be shown by the following diagram.

Figure: demand schedule for U.S

The demand schedule shows the quantity of dollar that would be demanded at

various exchange rates. The demand schedule is downward sloping because

Bangladeshi corporations will be encouraged to purchase more U.S goods when

the Dollar is worth less, as it will take fewer Takas to obtain the desired amount

of Dollars.

Q: Supply of a Currency for Sale

There is a positive relationship between the value of one currency and the supply

of that currency i.e. with the increase of the value of one currency the supply of

that currency will also be increased and vice-versa. It can be shown by the

following diagram.

Figure: Supply schedule

The Figure shows the quantity of dollars for sale corresponding to each possible

exchange rate. When the dollar value is high, U.S consumers and firms are more

likely to purchase Bangladeshi goods. Thus, they supply a greater number of

dollars to the market, to be exchanged for Takas. Conversely, when the dollars is

valued low, the supply of dollars for sale is smaller, reflecting less U.S desire to

obtain Bangladeshi goods.

Q: Equilibrium

Equilibrium exchange rate is a rate at which the quantity demand for currency is

equal to the supply of that currency. Equilibrium exchange rate can be shown by

the following diagram.

From the figure we can see that at an exchange rate of tk.70, the quantity of

dollars demanded would exceed the supply of dollars for sale. Consequently, the

banks that provide foreign exchange services would experience a shortage of

dollars at that exchange rate. At an exchange rate of tk.80, the quantity of dollars

demanded would be less than the supply of dollars for sale. Therefore, banks

providing foreign exchange services would experience a surplus of dollars at that

exchange rate. In this figure, the equilibrium exchange rate is tk.75 because this

rate equates the quantity of dollars demanded with the supply of dollars for sale.

Q: Factors that Influence Exchange Rates

The following equation summarizes the Factors that Influence Exchange Rates:

C = f(INF , INT, INC, GC, EXP)

C = Percentage change in the spot rate

INF = Changes in the differential between local inflation and the foreign

countrys inflation

INT = Changes in the differential between local interest rate and the foreign

countrys interest rate

INC = Changes in the differential between local income level and the foreign

countrys income level

GC = Changes in government controls

EXP = Changes in expectation of future exchange rates

Q: Relative Inflation Rates

Changes in relative inflation rates can affect international trade activity, which

influences the demand for and supply of currencies and therefore influences

exchange rates.

Q: How Inflation affects the Exchange Rates?

If there is an increase of inflation in local currency then the demand for foreign

goods will increase as a result the local currency exchange rate will depreciate

and the foreign countrys exchange rate will appreciate. If Bangladeshi inflation

suddenly increased substantially while the American inflation remains the same

the demand and supply schedule of currency will be affected. The sudden jump in

Bangladesh inflation should cause an increase demand for American goods and

therefore also cause an increase in the Bangladeshi demand for dollars. In an

addition, the jump in Bangladeshi inflation should reduce the American desire for

Bangladeshi goods and therefore reduce the supply of pounds for sale. There

market reaction can be shown by the following diagram:

Figure: impact of rising bd inflation on the equilibrium value of American dollar.

This figure shows that the previous equilibrium exchange rate of tk 75, there will

be shortages of dollar in the foreign exchange markets. The increased bd demand

for dollar and the reduced supply of dollars for sale place upward pressure on the

value of the dollar.

Q: Relative Interest Rates

Changes in relative interest rates can affect investment in foreign securities,

which influences the demand for and supply of currencies and therefore

influences exchange rates.

Q: How Interest Rates affect the Exchange Rates?

If interest rate increases in the home country then the demand for other currency

will reduce, in that case the local currency will be appreciated and the foreign

countrys currency will be depreciated. Example: if Bangladeshi interest rates rise

while American interest rates remain constant then the Bangladeshi investors will

likely reduce their demand for American dollar, since Bangladeshi rates are now

more attractive relative to u.s rates, and there is less desire for u.s bank deposits.

Because Bangladeshi rates will now look more attractive to u.s investors with

excess cash, the supply of u.s dollar for sale by u.s investors should increase as

they establish more bank deposits in the Bangladesh. Due to an inward shift in the

demand for dollar and an outward shift in the supply of dollars for sale, the

equilibrium exchange rate should decrease.

Figure: impact of rising interest rate (bd) on the equilibrium value of u.s dollar.

From this figure we can see that the previous equilibrium point has changed is

now tk 73 in earlier. This is because for increasing interest rate in the Bangladesh.

If interest rate decreased relative to u.s interest rates, the opposite shifts would

be expected.

Q: Relative Income Levels

Changes in relative income levels can affect international trade activity, which

influences the demand for and supply of currencies and therefore influences

exchange rates.

Q: How Income Levels affect the Exchange Rates?

If income level increases in the local country relative to foreign country then the

demand for foreign goods will rise by the local countrys people. In that case the

exchange rate will change. For example: if Bangladeshi people income level rises

substantially while the u.s income level remains unchanged then there will be

impact on the following: 1) the demand schedule for u.s dollar. 2) The supply

schedule of u.s dollar for sale. 3) The equilibrium exchange rate. First, the

demand schedule for u.s dollar will shift outward, reflecting the increase in

Bangladeshi income and therefore increased demand for u.s goods. Second, the

supply schedule of u.s dollar for sale is not expected to change. Therefore, the

equilibrium exchange rate of u.s dollar is expected to rise which can be shown by

the following diagram:

Figure shows that the equilibrium exchange rate change to tk 78 which was tk 75.

This is because for increasing income level of Bangladeshi people.

Q: Government Controls:

Government of foreign countries can influence the equilibrium exchange rate in

many ways: 1) Imposing foreign exchange barriers, 2) Imposing foreign trade

barriers, 3) Intervening in the foreign exchange markets, 4) Affecting macro

variable such as inflation, interest rate and income levels. Example: interest

increase in Bangladesh then the demand for U.S goods will decrease. This can

increase the U.S supply of dollar for sale to obtain more taka. Yet, if the U.S

government placed heavy tax on interest income earned from foreign

investments, this could discourage the exchange of dollars for taka.

Q: Expectations:

Exchange rate can be influenced by market expectations of future exchange rates.

Like other financial markets, foreign exchange markets react to any news that

may have a future effect. For example: News of a potential surge in U.S. inflation

may cause currency traders to sell dollars, anticipating a future decline in the

dollars value. This response places immediate downward pressure on the dollar.