Chapter

Exchange Rate Determination

South-Western/Thomson Learning 2003

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.
B4 - 2

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.
B4 - 3

Fluctuation of the British Pound

Over Time
Approximate
Spot Rate of
$ 1.80
1.75
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1992

1996

Approximate
Annual %

20 %
15
10
5
0
-5
-10
-15
-20
1992
2000

Approximate
that could be
Purchased with
$10,000
7000
6800
6600
6400
6200
6000
5800
5600

1996

2000

1992

1996

2000
B4 - 4

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.
Value of
$1.60
$1.55
$1.50

S: Supply of
equilibrium
exchange rate
D: Demand for
Quantity of

B4 - 5

Factors that Influence

Exchange Rates
Relative Inflation Rates
$/
r1
r0

S1
S0
D1
D0
Quantity of

U.S. inflation
U.S. demand for
British goods, and
hence .
British desire for U.S.
goods, and hence the
supply of .
B4 - 6

Factors that Influence

Exchange Rates
Currency

Inflation

Price

Rise

Same Same

Rise

Demand

Demand for
Currency

Supply for
Currency

Fall

Fall

Rise

Rise

Rise

Fall

B4 - 7

Factors that Influence

Exchange Rates
Relative Interest Rates
$/
r0
r1

S0
S1
D0
D1
Quantity of

U.S. interest rates

U.S. demand for
British bank deposits,
and hence .
British desire for U.S.
bank deposits, and
hence the supply of .
B4 - 8

Factors that Influence

Exchange Rates
Currency

Existing

Change

Supply

Demand

5%

8%

Fall

Rise

7%

7%

Rise

Fall

Currency

Existing

Change

7%

7%

5%

5%

$ (Can)

4%

9%

B4 - 9

Factors that Influence

Exchange Rates
Relative Income Levels
$/
r1
r0

U.S. income level

U.S. demand for
S0 ,S1
British goods, and
hence .
D1
No expected change for
D0
the supply of .
Quantity of

B4 - 10

Factors that Influence

Exchange Rates
Relative Economic Growth Rates

Nation with stronger economic growth will attract

investment seeking to acquire domestic assets.

In turn this will increase demand for domestic

currency.

Will result into a stronger domestic currency,

other things being equal.

B4 - 11

Factors that Influence

Exchange Rates
Political and Economic Risk

Investors prefer to hold lesser amount of riskier

assets.

Low risk currencies are more preferred than high

risk currencies.

Risk is associated with political and economic

factors.

B4 - 12

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.
B4 - 13

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.
B4 - 14

Factors that Influence

Exchange Rates
Interaction of Factors

Trade-related factors and financial factors

sometimes interact. Exchange rate
movements may be simultaneously
affected by these factors.

For example, an increase in the level of

income sometimes causes expectations of
higher interest rates.
B4 - 15

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.
B4 - 16

How Factors Can Affect Exchange Rates

Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Govt Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions

U.S. demand for foreign

goods, i.e. demand for
foreign currency
Foreign demand for U.S.
goods, i.e. supply of
foreign currency
U.S. demand for foreign
securities, i.e. demand
for foreign currency

Exchange
rate
between
foreign
currency
and the
dollar

Foreign demand for U.S.

securities, i.e. supply of
foreign currency
B4 - 17

The Asset Market Model of Exchange Rate

The value today of a given currency, say, the
dollar, depends on whether or not and how
strongly people still want the amount of dollars
and dollar denominated assets they held
yesterday.
The exchange rate between two currencies
represent the price that just balances the
relative supplies of and the demands for
assets denominated in those currencies.
Shifts in preferences can lead to massive
shifts in currency values.
B4 - 18

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

1. Borrows
$20 million
Exchange at
$0.50/NZ$
2. Holds
NZ$40 million

Borrows at 7.20%
for 30 days
Returns $20,120,000
Profit of $792,320

Lends at 6.48%
for 30 days

4. Holds
$20,912,320
Exchange at
$0.52/NZ$
3. Receives
NZ$40,216,000
B4 - 19

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

1. Borrows
NZ$40 million
Exchange at
$0.50/NZ$
2. Holds
$20 million

Borrows at 6.96%
for 30 days

4. Holds
NZ$41,900,000

Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at
or $800,640
$0.48/NZ$
Lends at 6.72%
for 30 days

3. Receives
$20,112,000
B4 - 20