Session 19

What Determines Exchange Rate ?

Movements of Exchange Rate1. Long-term Trends

The movement of exchange rate over the entire period.

2. Medium-term Trends

The movement of exchange rate over periods of severalyears. These are sometimes counter to the longer trends.

3. Short-term Variability

The movement of exchange rate over short periods. These are the exchange rates from month to month (and indeed, from day to day , hour to hour, and evenminute to minute.)

Exchange Rates in the Short-runThis depends on the demands and supplies of assets denominated in different currencies.

1. The basic return on the bond itself (the interest rate)

2. The expected gain and loss on the currency exchanges

The Role of Interest Rates

ThaiBond

Interest = 10 %Exchange

Money

MalaysiaBond

Interest = 5%

High Demand for the “Thai” currency will occur.

The amount of “Thai” currency will be reduced from the system.

The value of “Thai” currency will appreciate. ( i.e. from 1 dollar/25 baht to 1 dollar/24)

What happen to Malaysia currency ?

The value of “Malaysia” currency will depreciate.

The Role of the Expected Future Spot Exchange Rate

Current Spot RateSingapore

1 USD / 25 SGDSingapore

$ 1 USD / 20 SGD

Hong Kong1 USD / 25 HKD

Hong Kong1 USD/ 30 HKD

Expected FutureSpot Rate

High Demand for the “Singapore” currency will occur.

The amount of “Singapore” currency will be reduced from the system.

The value of “Singapore” currency will appreciate. ( i.e. from “1 USD /25 SGD” to “1 USD/24 SGD”)

Exchange Rates in the Long-runPrice Level

U.S.

Suppose : $1 = £1 (at the outset)

U.K.

= £1

= $1 > $1

> £1

Export

Export

(i.e., + transport cost, tariff, bribe, and etc)

Continue on the next slide

U.S.

Importing Price > £1(Let’s say “£1 + XXX”)

U.K.

£1 + XXX £1Bank

$1 + XXX

£1 + XXX

Afterward

Suppose : 25 Bath = Australia $1 = U.S. $1 (at the outset)

= Australia $1

= U.S. $1

75 Baht

50 Baht

ThailandAustralia

U.S.

75 baht/ $1AUS

50 baht/ $1US

Inflation Rate

U.S. Thai

= $1 = 25 BahtExport

= $2

Inflation = 50 Baht

Thai people buy less

The market system will impact on the exchange rate.

Countries with relatively high inflation rates have currencies whose valuestend to depreciate in the foreign exchange market.(i.e., from “1 dollar/25 baht” to “1 dollar/15 bath”)

U.S. Thai

= $1 = 25 BahtExport

= $ 0.5

Deflation = 12.5 Baht

Thai people buy more

The market system will impact on the exchange rate.

Countries with relatively low inflation rates have currencies whose valuestend to appreciate in the foreign exchange market.(i.e., from “1 dollar/25 baht” to “1 dollar/30 bath”)

10 baht/1 dollars

11 baht/1 dollars

The values of baht tend to depreciate.

15 baht /1 dollars