Chapter

Exchange Rate Determination

South-Western/Thomson Learning 2003

Chapter Objectives
To explain how exchange rate movements
are measured;

To explain how the equilibrium exchange

rate is determined; and

To examine the factors that affect the

equilibrium exchange rate.

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Measuring
Exchange Rate Movements
An exchange rate measures the value of one
currency in units of another currency.

When a currency declines in value, it is said

to depreciate. When it increases in value, it is
said to appreciate.

On the days when some currencies

appreciate while others depreciate against
the dollar, the dollar is said to be mixed in
trading.
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Measuring
Exchange Rate Movements
The percentage change (% in the value
of a foreign currency is computed as
St St-1
St-1
where St denotes the spot rate at time t.

A positive % represents appreciation of

the foreign currency, while a negative %

represents depreciation.
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Exchange Rate Equilibrium

An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
$1=Tk

Quantity of foreign
exchange
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Factors that Influence

Exchange Rates
Relative Inflation Rates
Bangladesh inflation
Bdesh demand for US goods, and
hence demand for US $ increases.

US desire for Bdesh goods, and hence

the supply of US $ decreases.

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Effect of inflation
Price of US $1 in taka
S2

S1

70
65
D2
D1

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Factors that Influence

Exchange Rates
Relative Interest Rates
Bdesh interest rates
Bdesh demand for US bank deposits ,
and hence demand for US $ decreases.
US desire for Bdesh deposits, and
hence the supply of US $ increases.

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Effect of Higher Interest Rate

Price of US $1 in taka
S1

S2

70
65
D1
D2

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Factors that Influence

Exchange Rates
Relative Interest Rates

A relatively high interest rate may actually

reflect expectations of relatively high
inflation, which discourages foreign
investment.

It is thus useful to consider real interest

rates, which adjust the nominal interest
rates for inflation.
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Factors that Influence

Exchange Rates
Relative Interest Rates

real
nominal
interest interest inflation rate
rate
rate

This relationship is sometimes called the

Fisher effect.

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Factors that Influence

Exchange Rates
Relative Income Levels
Bdesh income level
Bdesh demand for US goods, and
hence demand for US$ increases.
No expected change for the supply of US$.

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Effect of increased local national

income

13

Price of US $1 in taka

S1
68
65

D2
D1

Quantity of
foreign exchange
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Factors that Influence

Exchange Rates
Government Controls

Governments may influence the equilibrium

exchange rate by:
imposing foreign exchange barriers,
imposing foreign trade barriers,
intervening in the foreign exchange market,
and
affecting macro variables such as inflation,
interest rates, and income levels.
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Government Control:
1. tariff

Effects of Tariff
Price

Supply

P5
PiT
Pi

Pi T
Pi

Demand
Quantity

Q1 Q 2 Q 5 Q 3

Q4
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Effects of Tariff on Foreign Exchange

Market
Tariff reduces the demand for foreign exchange and so

the demand curve shifts left to increase the value of

domestic currency. Effectiveness, however, depends on
the elasticity of the demand curve of the commodity
market. Demand curves of our main import commodities
are inelastic, firstly. Secondly, those experience
increasing trend. In that case the demand curve would
rather shift right both in the commodity market as well as
the foreign exchange market. However, since the time of
liberalization the current trend here is tariff reduction.
This results in rightward shifting of the demand for
foreign exchange, and exchange rate increases.
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2. Quota
Quota means quantitative restriction. A
quantitative restriction is imposed on import to
have the almost same effects of tariff. Difference
between tariff and quota is that the government
revenue does not take place in case of quota.
Effectiveness of quota depends on the strength
of commercial policy. Unorganized economy
often lacks it.

Foreign exchange rate becomes favorable due to

the introduction of quota.
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3. Infant Industry Argument:

If import duty or quota is used to protect local industry
then it is called infant industry argument. Import may be
completely withheld. Domestic industry involves in
higher scale of production and gets the advantage of
large scale economy and learning effect. Supply curve
shifts right and government withdraws the protection
gradually. Thus, it is expected that such protection is
not needed in the long term. Unlike emerging tigers,
most countries experience a failure of infant industry
arguments as it encourages inefficiency in production.
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4. Subsidies
A subsidy is a government payment to domestic
producers to increase the competitiveness in the
export market. It takes the form of cash grant, low
interest loans, tax breaks, and other indirect
incentives to the firm by the government. This is
commonly called as dumping. Increased export leads
to a rightward shift of supply curve. Domestic
currency becomes stronger.

Subsidy is also used to substitute import by making

the domestic production cheaper through subsidy.
This is typically the issue of agricultural subsidy
which was responsible behind the failure of GATT.
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Others methods of government control

5. Voluntary Export Restrains: VER is a quota on
trade imposed by the exporting country, typically at
the request of the importing countrys government.
Domestic currency becomes weaker.

6. Local Content Requirement: It is a requirement

that some specific fraction of a good be produced
domestically. This also reduces import. Foreign
exchange rate becomes favorable.

7. Administrative Policies: Import procedure can be

made lengthy by means of complicated
administrative policies to discourage import.
Foreign exchange rate becomes favorable.
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Factors that Influence

Exchange Rates
Expectations

Foreign exchange markets react to any

news that may have a future effect.

Institutional investors often take currency

positions based on anticipated interest rate
movements in various countries.

Because of speculative transactions,

foreign exchange rates can be very volatile.
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Factors that Influence

Exchange Rates
Interaction of Factors

Over a particular period, different factors

may place opposing pressures on the
value of a foreign currency.

The sensitivity of the exchange rate to

these factors is dependent on the volume
of international transactions between the
two countries.
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Chapter Review
Factors that Influence Exchange Rates

Relative Inflation Rates

Relative Interest Rates
Relative Income Levels
Government Controls
Expectations
Interaction of Factors
How Factors Have Influenced Exchange
Rates
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