1. Exchange Rate Determination
South-Western/Thomson Learning © 2003

2. 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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3. 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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4. 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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5. 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 £
S: Supply of £
$1.60
$1.55 equilibrium
exchange rate
$1.50
D: Demand for £
Quantity of £
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6. Factors that Influence
Exchange Rates
Relative Inflation Rates
$/£
U.S. inflation ↑
S1 ⇒ ↑ U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1 ⇒ ↓ British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
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7. Factors that Influence
Exchange Rates
Relative Interest Rates
$/£
U.S. interest rates ↑
S0 ⇒ ↓ U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0 ⇒ ↑ British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
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8. 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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9. 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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10. Factors that Influence
Exchange Rates
Relative Income Levels
$/£
U.S. income level ↑
⇒ ↑ U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1 ⇒ No expected change for
D0
the supply of £.
Quantity of £
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11. 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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12. 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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13. Factors that Influence
Exchange Rates
Expectations
Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
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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.
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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.
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16. How Factors Can Affect Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand for and the
1. Interest Rate foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
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