International Finance Exchange Rate Determination

Exchange Rate Determination Measuring exchange rate movements Always in relation to another currency Appreciate vs. depreciate Percent Δ = St – St-1 St-1

Exchange Rate Determination Measured over some period of time Longer times → greater movements Some currencies are more volatile than others Example…

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

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

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 Britain (fewer pounds for sale) Demand and supply curves shift Value of £ increases

Rising U.S. Inflation Demand curve increases (shifts to right) Supply curve decreases (shifts to left)

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

Rising U.S. Interest Rates Demand curve decreases (shifts to left) Supply curve increases (shifts to right)

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

Rising U.S. Income Level Demand curve increases (shifts to right) No change in supply curve Note quantity of pounds for sale increases

Factors that Influence XRs Government Controls Imposing FX barriers Imposing trade barriers Intervening in FX markets Policies affecting inflation, interest rates and income levels

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