Exchange Rate Determination

Bill Reese

International Finance

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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 Δ = St – St-1

St-1

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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

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

Supply Schedule for Pounds

Equilibrium Exchange Rate

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

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

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

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

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