Exchange Rate Determination

Meaning of Exchange Rate and Measuring Changes in Exchange Rates

Value of one currency in units of another currency

A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation.

If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated

If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation

Percentage change in value US $New Value of Foreign Currency per unit of $ - Old value of foreign currency per $

-------------------------------------------------- X 100

Old value of Foreign Currency per $

Percentage change in value of Foreign Currency

New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency

-------------------------------------------------- X 100

Old value of $ per unit of Foreign Currency

Exchange Rate Equilibrium

Forces of Demand and SupplyDemand for foreign currency negatively

related to the price of foreign currencySupply of foreign currency positively

related to the price of foreign currencyForces of demand and supply together

determine the exchange rate

Demand for Foreign Currency

Price for Foreign Currency

Units of Foreign Currency (£)

$1.50

$2.00

D

D

50m 75 m

Supply of Foreign Currency

Supply for Foreign Currency

Units of Foreign Currency (£)

$1.50

$2.00

50 m 75 m

S

S

Equilibrium Exchange Rate

Exchange Rate

Units of ForeignCurrency(£)

S

SD

D

$1.6775

Factors that influence the Exchange Rate

Expectations of the MarketPolitical Events Relative Inflation RatesRelative Interest RatesRelative Income Levels

Exchange rate is the results of an interaction of these factors

Market Expectations

Expectations about future exchange rate changes on the basis of current and future political and economic conditions

1960s Strong $Between 1960s and 1970s: weak $Strong $ in 1999 – 2001Weak Dollar today 20051995 European Exchange Rate MechanismDevaluation of Asian Currencies

Political Events

Fall of Berlin Wall and unification of East and West Germany

Rumors about resignation of Mikhail Gorbachov

Tiannanmon SquarePersian Gulf WarSeptember 11, 2001

Relative Inflation

High inflation relative to a foreign country, decline in value of currency—Why?

Low inflation relative to a foreign country, increase in value of currency—Why?

Relative Interest Rates

High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

Relative Income Levels

Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

Exchange Rate Determination

An interaction of factorsIs it possible for a country with high real

returns to have a low currency value?Is it possible for a country with low real

returns to have a high currency value?

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 against the dollar.

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Anticipation of Exchange Rate Movements

Bank speculation based on expected appreciation

Bank speculation based on expected depreciation

Speculation by individuals

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