Name : Noor Amalina Binti Ismail 225899

Name :Nur Farah AinBintiZakaria 227042

Title : Determinant of Exchange Rate (Short Run & Long Run)

Introduction
Exchange rates are prices that are determined by supply and demand. For some countries the
exchange rate is the single most important price in the economy because it determines the
international balance of payments. (Levich, 2001) There is no general theory of exchange rate
determination, but Eiteman et al (2001) divide the potential exchange rate determinants into five
areas: parity conditions, infrastructure, speculation, cross-border foreign direct investment and
portfolio investment, and political risks. Although no model has been consistent in predicting
short-term foreign exchange rate behavior, there are several major concepts that play a role in
determining the long-term behavior of foreign exchange rates. The first concept is based on the
idea that the current price of an asset reflects all available information; and therefore, only
unexpected events cause exchange rates to fluctuate. (Levich, 2001)
What Determines Exchange Rates In the Short Run?
1) Relative Levels of Interest Rates
The level of the nominal (money) interest rate is a first approximation of the rate of return on
assets that can be earned in a particular country. Thus, differences in the level of nominal interest
rates between economies are likely to affect international investment flows, as investors seek the
highest rate of return. When interest rates in the United States are significantly higher than
interest rates abroad, the foreign demand for U.S. securities and bank accounts will increase,
which increases the demand for the dollars needed to buy those assets, thus causing the dollar to
appreciate relative to foreign currencies. In contrast, if interest rates in the United States are on
average lower than interest rates abroad, the demand for foreign securities and bank accounts
strengthens and the demand for U.S. securities and bank accounts weakens. This weakness will
cause the demand for foreign currencies needed to buy foreign assets to increase and the demand
for the dollar to decrease, resulting in a depreciation of the dollar relative to foreign currencies.
To illustrate the effects of relative interest rates as a determinant of exchange rates, refer
to Figure 2.1. It shows the demand and supply schedules for pounds. Initially, the equilibrium
exchange rate is $1.50 per pound. Referring to Figure 2.1 (a), assume that an expansionary
monetary policy of the U.S. Federal Reserve results in a fall in interest rates to three percent,
while interest rates in the United Kingdom are at six percent. American investors will be
attracted to the relatively high interest rates in the United Kingdom and will demand more
pounds to buy UK Treasury bills. The demand for pounds thus rises to D1 in the figure.
Concurrently, the UK investors will find investing in the United States less attractive than before,
so fewer pounds will be offered to buy dollars for purchases of U.S. securities. The supply of
pounds thus decreases to S1 in the figure. The combined effect of these two shifts is to cause the

dollar to depreciate to $1.60 per pound. Alternatively, if interest rates werelower in the United
Kingdom than in the United States, the dollar would appreciate against the pound as Americans
made fewer investments in the United Kingdom and the UK investors made more investments in
the United States. Things may not always be so simple, though, concerning the relation between
interest rates, investment flows, and exchange rates. It is important to distinguish between the
nominal interest rate and the real interest rate (the nominal interest rate minus the inflation
rate).
Figure 2.1 (a) Relative Interest Rate

2) Expected Change in the Exchange Rate

Differences in interest rates may not be all investors need to know to guide their decisions. They
must also consider that the return actually realized from an investment is paid out over some
future period. This time frame means that the realized value of that future payment can be altered
by changes in the exchange rate itself over the term of the investment. Simply put, investors must
think about possible gains or losses on foreign currency transactions in addition to interest rates
on assets. Expectations about the future path of the exchange rate itself will figure prominently in
the investors calculation of what he or she will actually earn from an investment denominated in
another currency. Even a high interest rate would not be attractive if one expects the
denominating currency to depreciate at a similar or greater rate and erase all economic gain.
Conversely, if the denominating currency is expected to appreciate, the realized gain would be
greater than what the interest rate alone would suggest, and the asset appears more lucrative.
Figure 2.1 (b) illustrates the effects of investor expectations of changes in exchange rates
over the term of an investment. Assume that the equilibrium exchange rate is initially $1.50 per
pound. Suppose that UK investors expect that in three months the exchange value of the dollar
will appreciate against the pound. Thus, by investing in three-month U.S. Treasury bills, UK
investors can anticipate a foreign currency gain: today, selling pounds for dollars when dollars
are relatively cheap, and, in three months, purchasing pounds with dollars when dollars are more
valuable (pounds are cheap). The expectation of foreign currency gain will make U.S. Treasury
bills seem more attractive, and the UK investors will purchase more of them. In the figure, the

supply of pounds in the foreign-exchange market shifts rightward from S0 to S1 and the dollar
appreciates to $1.45 per pound today. In this way, future expectations of an appreciation of the
dollar can be self-fulfilling for todays value of the dollar

Figure 2.1 (b) Expected Change in Exchange Rate

What Determines Exchange Rates In the Long Run?

Factor in the long run-value of the exchange rate are due to reactions of traders in the foreignexchange markets to changes in four key determinants : relative price level, relative product
productivity levels, consumer preferences for domestic and foreign goods and thus changes in
the demand for exports and imports.
1) Price level
The domestic price level increase significantly in Singapore and remains constant in
Malaysia. This causes Singapore consumer to desire relatively low-priced in Malaysia goods.
The demand for ringgit will increase. Conversely, as the Malaysia consumers will purchase less
relatively high-priced Singapore goods, the supply of ringgit will decrease. The increase in the
demand for ringgit and the decrease in the supply of ringgit result in depreciation of dollars to

RM 2.9 per dollar. This analysis suggest that the increase in the Singapore price level relative to
price levels in other countries causes the dollar to depreciation in the long run. According to Ong
Kai Kiat (2015), many Singaporeans might be showing great pleasure over the weak of MYR
because they can shopping trips neighbor Johor are now significantly cheap. However a weak
Malaysian economy is worst news for Singapore as our largest trading partner. They will demand
more ringgit and will lead dollar to depreciation.
2) Productivity Levels
Productivity growth measures the increase in a countrys output for given level of input.
If one country able to produce more the output and become more productivity than other
countries, it can produce goods cheaper than its foreign competitors can. Productivity gains are
vital to the economy because they allow us to accomplish more with less. Capital and labor are
both scarce resources, so maximizing their impact is always a core concern of modern business.
Productivity enhancements come from technology advances, such as computers and the
internet, supply chain and logistics improvements, and increased skill levels within the
workforce. Suppose Malaysia productivity growth faster than that of Singapore. As Malaysia
good become relatively less expensive, Singapore demands more Malaysia goods, which result
in an increase in the supply of dollar. Malaysia demand fewer Singapore good, which become
relatively more expensive, causing the demand of dollar to decrease. Therefore, the ringgit
appreciations.Simply, in the long run, as a country becomes more productive relative to other
countries, its currency appreciations.
According to Minister of International Trade and Industry Malaysia, Dato Seri Mustapha
Mohamed Malaysia recorded a productivity growth of 4.6% in tandem with the 5.1% Gross
Domestic Products (GDP) growth and 0.6% increase in employment in 2011.
3) Preferences for Domestic or Foreign Goods.
Suppose that Singapore consumers develop stronger preferences for Malaysia-manufactured
goods such as foods and tourist attraction. The stronger demand for Malaysia good results in
Singaporeans demanding more ringgit to purchase these goods. As the demand for ringgit rises,
the dollar depreciates to ringgit. Conversely, if Malaysia consumers demanded additional

Singaporean computer software and machinery, the dollar will tend appreciate against the ringgit.
We conclude that an increase demand for a countrys exports causes its currency to appreciate in
the long run; conversely, increased demand for imports results in a depreciation in the domestic
currency.
4) Trade barriers
Barriers to free trade also affect exchange rates. Suppose that Malaysia government
imposes a tariffs on Singapore computer software , the tariffs discourages Malaysians from
purchasing Singapore computer software. The tariff causes the demand for dollar to decrease
with results in an appreciation of the ringgit per dollar. As a result, trade barriers such as tariffs
and quotas causes a currency appreciation in the long run for the country imposing the barriers.