topic 2 exchange rate determination

8/19/2019 Topic 2 Exchange Rate Determination

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Exchange Rate

Determination


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Measuring Exchange RateMovements

1

1 aluecurrency vforeigninPercent−

−−

=∆

t

t

S

S S

Depreciation: decline in a currency’s valueAppreciation: increase in a currency’s value

Comparing foreign currency spot rates over twopoints in time, S and St!

" positive percent change indicates that the foreigncurrency has appreciated#" negative percent change indicates that it has


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• Suppose RM$% exchange rate goesfrom RM''$% to RM(#)*$%#

• % appreciates +y:

(#)* '- $ '

. (&/#


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Exercise

• "ssume the spot rate of the 0ritishpound is %!#1

•

2he expected spot rate ! year fromnow is assumed to +e %!#33#• 4hat percentage depreciation does

this re5ect6


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"nswer

• !#33 7 !#1&- $ !#1&

. '#'(


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Exchange Rate E8uili+rium

2he exchange rate represents the priceof a currency, or the rate at which onecurrency can +e exchanged for

another#Demand for a currency increaseswhen the value of the currency

decreases, leading to a downwardsloping demand schedule# See Exhi+it(#)-


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Exhi+it (#)


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• Supply of a currency for sale increases when the value of thecurrency increases, leading to an

upward sloping supply schedule# SeeExhi+it (#&-


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Exhi+it (#&


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• Equilibrium e8uates the 8uantity ofpounds demanded with the supply ofpounds for sale# See Exhi+it (#(-


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Exhi+it (#(


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9actors that in5uenceexchange rates

ratesexchangefutureof nsexpectatioinchange

controlsgovernmentinchange

levelincomescountry'foreigntheand levelincomeU.S.e between thaldifferentiin thechange

rateinterestscountry'foreigntheand

rateinterestU.S.e between thaldifferentiin thechange

inflationscountry'foreigntheand

inflationS. between U.aldifferentiin thechange

ratespotin thechange percentage

where

),,,,

=∆

=∆

=∆

=∆

=∆

=

∆∆∆∆∆=

EXP

GC

INC

INT

INF

e

EXP GC INC INT INF f e


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Relative Ination Rates: ncrease in;#S# in5ation leads to increase in ;#S#demand for foreign goods, an increase

in ;#S# demand for foreign currency,and an increase in the exchange ratefor the foreign currency# See Exhi+it

(#


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Exhi+it (#<


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• Relative Interest Rates: ncreasein ;#S# rates leads to increase indemand for ;#S# deposits and a

decrease in demand for foreigndeposits, leading to a increase indemand for dollars and an increased

exchange rate for the dollar# SeeExhi+it (#3-


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Exhi+it (#3


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• Relative Income Levels: ncreasein ;#S# income leads to increased in;#S# demand for foreign goods and

increased demand for foreigncurrency relative to the dollar and anincrease in the exchange rate for the

foreign currency# See Exhi+it (#1-


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Exhi+it (#1


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Government Controls via:mposing foreign exchange +arriersmposing foreign trade +arriers

ntervening in foreign exchange mar=ets">ecting macro varia+les such as in5ation,

interest rates, and income levels#


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Epectations:

Impact of favorable epectations: f investorsexpect interest rates in one country to rise, they mayinvest in that country leading to a rise in the demand

for foreign currency and an increase in the exchangerate for foreign currency#

Impact of unfavorable epectations: Speculatorscan place downward pressure on a currency when they

expect it to depreciate#Impact of si!nals on currency speculation#Speculators may overreact to signals causing currencyto +e temporarily overvalued or undervalued#


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topic 2 exchange rate determination

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