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  • 8/7/2019 Exchange Rate Determination (1)

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    Exchange Rate Determination

    International Finance (MB 74)

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    Outline

    Defining Exchange Rate

    Measuring Exchange Rate Movements Appreciation/Depreciation of a currency

    Exchange Rate Equilibrium

    Factors that influence Exchange Rate

    Movements

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    Meaning of Exchange Rate and

    Measu

    ring Changes in Exchange Rates

    Value of one currency in units of anothercurrency

    A decline in a currencys value is referred to asdepreciation and an increase in currencys valueis called appreciation.

    If currency A can buy you more units of foreign

    currency, currency A has appreciated and foreigncurrency depreciated

    If currency A can buy you less units of foreigncurrency, currency A has depreciated and foreign

    currency appreciated

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    Appreciation/Depreciation

    Percentage change in value US $NewValue of Foreign Currency

    per unit of $ - Old value of foreign currency per $

    -------------------------------------------------- X 100Old value of Foreign Currency per $

    Percentage change in value of Foreign

    CurrencyNewValue of $ per units ofForeign Currency - Old value of $ per unit of foreign currency

    -------------------------------------------------- X 100Old value of $ per unit of Foreign Currency

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    Exchange Rate Equilibrium

    Forces ofDemand 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

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    Demand for Foreign Currency

    Price for Foreign Currency

    Units of Foreign Currency ()

    $1.50

    $2.00

    D

    D

    50m 75 m

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    Supply of Foreign Currency

    Supply for Foreign Currency

    Units of Foreign Currency ()

    $1.50

    $2.00

    50 m 75 m

    S

    S

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    Equilibrium Exchange Rate

    Exchange Rate

    Units of Foreign

    Currency()

    S

    SD

    D

    $1.6775

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    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

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    Market Expectations

    Expectations about future exchange rate changeson the basis of current and future political and

    economic conditions 1960s Strong $

    Between 1960s and 1970s: weak $

    Strong $ in 1999 2001

    WeakDollar today 2005 1995 European Exchange Rate Mechanism

    Devaluation of Asian Currencies

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    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

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    Relative Inflation

    High inflation relative to a foreign country,

    decline in value of currencyWhy?

    Low inflation relative to a foreign country,

    increase in value of currencyWhy?

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    Relative Interest Rates

    High interest rates in home country relative

    to a foreign country may cause domestic

    currency to appreciateWhy?

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    Relative Income Levels

    Increase in domestic income relative to

    foreign income may lead to a decline in the

    value of domestic currency Why?

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    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?

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