Exchange Rate Determination

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International Finance

• Exchange Rate Determination
• Bill Reese

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Learning Objectives

• In this unit we will learn
• The factors that influence changes in exchange
  rates
• How these factors can influence the supply of and
  demand for a currency

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Exchange Rate Determination

• Measuring exchange rate movements
• Always in relation to another currency
• Appreciate vs. depreciate
• Percent ? St St-1
• St

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Exchange Rate Determination

• Measured over some period of time
• Longer times ? greater movements
• Some currencies are more volatile than others
• Example

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Exchange Rate Determination
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Exchange Rate Equilibrium

• Demand for a currency
• Quantity demanded increases as price of currency
  decreases
• Supply of a currency for sale
• Quantity supplied increases as price of currency
  increases

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Demand Schedule for Pounds
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Supply Schedule for Pounds
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Equilibrium Exchange Rate
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Factors that Influence XRs

• Liquidity of the currency
• Illiquid market means large transactions may
  influence price

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Factors that Influence XRs

• Relative inflation rates
• Increase in U.S. inflation
• Increased demand for British goods (greater
  demand for pounds)
• Decreased demand for U.S. goods in Great Britian
  (fewer pounds for sale)
• Demand and supply curves shift
• Value of increases

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Rising U.S. Inflation
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Factors that Influence XRs

• Relative interest rates
• Increase in U.S. interest rates
• Less interest in investing in G.B. (decreased
  demand for pounds)
• Increased interest by British investors in
  investing in U.S. (more pounds for sale)
• Demand and supply curves shift
• Value of decreases

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Rising U.S. Interest Rates
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Factors that Influence XRs

• Relative income levels
• Increase in U.S. income level
• Increased demand for British goods (increased
  demand for pounds)
• No change in supply of pounds for sale
• Demand curve shifts
• Value of increases

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Rising U.S. Income Level
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Factors that Influence XRs

• Government Controls
• Imposing FX barriers
• Imposing trade barriers
• Intervening in FX markets
• Policies affecting inflation, interest rates and
  income levels

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Factors that Influence XRs

• Expectations vs. Changes
• If FX market is efficient
• Only unexpected changes and changes in
  expectations have effect
• Interaction of factors
• Rarely does anything happen in isolation
• Levels of factor changes