Exchange Rate Determination

International Finance (MB 74)

Outline

Defining Exchange Rate

Measuring Exchange Rate Movements
– Appreciation/Depreciation of a currency
Exchange Rate Equilibrium
Factors that influence Exchange Rate
Movements
Meaning of Exchange Rate and
Measuring Changes in Exchange Rates

 Value of one currency in units of another currency

 A decline in a currency’s value is referred to as
depreciation and an increase in currency’s value is
called appreciation.
 If currency A can buy you more units of foreign
currency, currency A has appreciated and foreign
currency depreciated
 If currency A can buy you less units of foreign
currency, currency A has depreciated and foreign
currency appreciated
Appreciation/Depreciation

 Percentage change in value US $

New Value of Foreign Currency
per unit of $ - Old value of foreign currency per $
-------------------------------------------------- X 100
Old value of Foreign Currency per $

 Percentage change in value of Foreign

Currency
New Value of $ per units of
Foreign Currency - Old value of $ per unit of foreign currency
-------------------------------------------------- X 100
Old value of $ per unit of Foreign Currency
Exchange Rate Equilibrium

Forces of Demand and Supply

Demand for foreign currency negatively
related to the price of foreign currency
Supply of foreign currency positively
related to the price of foreign currency
Forces of demand and supply together
determine the exchange rate
Demand for Foreign Currency
Price for Foreign Currency

D
$2.00

$1.50
D
50m 75 m Units of Foreign Currency (£)
Supply of Foreign Currency
Supply for Foreign Currency

S
$2.00

$1.50
S

50 m 75 m Units of Foreign Currency (£)

Equilibrium Exchange Rate
Exchange Rate

D
S

$1.6775

S D
Units of Foreign
Currency(£)
Factors that influence the
Exchange Rate
Expectations of the Market
Political Events
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
Exchange rate is the results of an interaction
of these factors
Market Expectations

 Expectations about future exchange rate changes

on the basis of current and future political and
economic conditions
 1960s Strong $
 Between 1960s and 1970s: weak $
 Strong $ in 1999 – 2001
 Weak Dollar today 2005
 1995 European Exchange Rate Mechanism
 Devaluation of Asian Currencies
Political Events

Fall of Berlin Wall and unification of East

and West Germany
Rumors about resignation of Mikhail
Gorbachov
Tiannanmon Square
Persian Gulf War
September 11, 2001
Relative Inflation

High inflation relative to a foreign country,

decline in value of currency—Why?
Low inflation relative to a foreign country,
increase in value of currency—Why?
Relative Interest Rates

High interest rates in home country relative

to a foreign country may cause domestic
currency to appreciate—Why?
Relative Income Levels

Increase in domestic income relative to

foreign income may lead to a decline in the
value of domestic currency– Why?
Exchange Rate Determination

An interaction of factors

Is it possible for a country with high real
returns to have a low currency value?
Is it possible for a country with low real
returns to have a high currency value?