The Determination of Exchange Rates

Part I. Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM A. The exchange rate

is the price of one unit of foreign currency expressed as a certain price in local currency.

For example $.99/€ means the euro in the U.S. is worth $.99.

Equilibrium Exchange Rates

B. How Do Americans Purchase German Goods?1. Foreign Currency Demand:

• derived from the demand for foreign country’s goods, services, and financial assets.

e.g. Americans demand German goods such as Mercedes autos

The Demand for € in the U.S.

Qty

$1.10/ €

$/€

D

At higher exchange rates, Americans demand less euros and vice versa.

$1.20/ €

$1.00/ €

Equilibrium Exchange Rates

2. Foreign Currency Supply:• derived from the foreign country’s demand for

Indian goods. • Foreign buyers must convert their currency in

order to purchase.

e.g. German demand for Indian goods such as Maruit Cars means Germans must convert

euros to Indian rupees in order to buy.

The Supply of € in the U.S.

$/ €

Qty

$1.10/€

S$1.20/€

$1.00/€

At higher exchange rates, Germans supply more euros and vice versa.

Equilibrium Exchange Rates

3. Equilibrium Exchange RateOccurs where the quantity supplied equals the quantity demanded of a foreign currency at a

specific local price.

The $/ € Equilibrium Rate

Qty

$1.10

S

$/ €

DEquilibrium

Equilibrium Exchange Rates

C. How Exchange Rates Change1. Increased demand

as more foreign goods are demanded, more of the foreign currency is demand at each possible exchange rate

2. The price of the foreign currency in local currency increases.

Equilibrium Exchange Rates

3. Home Currency Depreciation a. Foreign currency more

valuable than the home currency.

b. Conversely, the foreign currency’s value has

appreciated against the home currency.

The US$ Depreciates When

Qty

$1.10/ €

S

$/ €

D

D’

$1.20/ €

Q1 Q2

Equilibrium Exchange Rates

D. Computing a Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

Equilibrium Exchange Rates

EXAMPLE: € AppreciationIf the dollar value of the € goes from $1.10

(e0) to $1.20 (e1), then the € has appreciated by

(1.20 - 1.10)/ 1.10 = 9.1%

Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

Use the formula

(e0 - e1)/ e1

substituting(1.10 – 1.20)/1.20 = - 8.3%

is the US$ depreciation.

Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:1. Inflation rates

2. Interest rates

3. GNP growth rates

Sample ProblemSuppose the U.S. dollar appreciates

against the Russian ruble by 500%. How much did the ruble depreciate against the dollar?

Sample Problem

Depreciation of the ruble:

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Sample Problem

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