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Exchange Rate
Determination
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Measuring Exchange RateMovements
1
1 aluecurrency vforeigninPercent−
−−
=∆
t
t
S
S S
Depreciation: decline in a currency’s valueAppreciation: increase in a currency’s value
Comparing foreign currency spot rates over twopoints in time, S and St!
" positive percent change indicates that the foreigncurrency has appreciated#" negative percent change indicates that it has
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Measuring Exchange RateMovements
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Measuring Exchange RateMovements
• Suppose RM$% exchange rate goesfrom RM''$% to RM(#)*$%#
• % appreciates +y:
(#)* '- $ '
. (&/#
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Exercise
• "ssume the spot rate of the 0ritishpound is %!#1
•
2he expected spot rate ! year fromnow is assumed to +e %!#33#• 4hat percentage depreciation does
this re5ect6
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"nswer
• !#33 7 !#1&- $ !#1&
. '#'(
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Exchange Rate E8uili+rium
2he exchange rate represents the priceof a currency, or the rate at which onecurrency can +e exchanged for
another#Demand for a currency increaseswhen the value of the currency
decreases, leading to a downwardsloping demand schedule# See Exhi+it(#)-
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Exhi+it (#)
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Exchange Rate E8uili+rium
• Supply of a currency for sale increases when the value of thecurrency increases, leading to an
upward sloping supply schedule# SeeExhi+it (#&-
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Exhi+it (#&
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Exchange Rate E8uili+rium
• Equilibrium e8uates the 8uantity ofpounds demanded with the supply ofpounds for sale# See Exhi+it (#(-
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Exhi+it (#(
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9actors that in5uenceexchange rates
ratesexchangefutureof nsexpectatioinchange
controlsgovernmentinchange
levelincomescountry'foreigntheand levelincomeU.S.e between thaldifferentiin thechange
rateinterestscountry'foreigntheand
rateinterestU.S.e between thaldifferentiin thechange
inflationscountry'foreigntheand
inflationS. between U.aldifferentiin thechange
ratespotin thechange percentage
where
),,,,
=∆
=∆
=∆
=∆
=∆
=
∆∆∆∆∆=
EXP
GC
INC
INT
INF
e
EXP GC INC INT INF f e
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9actors that in5uenceexchange rates
Relative Ination Rates: ncrease in;#S# in5ation leads to increase in ;#S#demand for foreign goods, an increase
in ;#S# demand for foreign currency,and an increase in the exchange ratefor the foreign currency# See Exhi+it
(#
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Exhi+it (#<
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9actors that in5uenceexchange rates
• Relative Interest Rates: ncreasein ;#S# rates leads to increase indemand for ;#S# deposits and a
decrease in demand for foreigndeposits, leading to a increase indemand for dollars and an increased
exchange rate for the dollar# SeeExhi+it (#3-
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Exhi+it (#3
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9actors that in5uenceexchange rates
• Relative Income Levels: ncreasein ;#S# income leads to increased in;#S# demand for foreign goods and
increased demand for foreigncurrency relative to the dollar and anincrease in the exchange rate for the
foreign currency# See Exhi+it (#1-
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Exhi+it (#1
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9actors that in5uenceexchange rates
Government Controls via:mposing foreign exchange +arriersmposing foreign trade +arriers
ntervening in foreign exchange mar=ets">ecting macro varia+les such as in5ation,
interest rates, and income levels#
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9actors that in5uenceexchange rates
Epectations:
Impact of favorable epectations: f investorsexpect interest rates in one country to rise, they mayinvest in that country leading to a rise in the demand
for foreign currency and an increase in the exchangerate for foreign currency#
Impact of unfavorable epectations: Speculatorscan place downward pressure on a currency when they
expect it to depreciate#Impact of si!nals on currency speculation#Speculators may overreact to signals causing currencyto +e temporarily overvalued or undervalued#
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