Session 19 What Determines Exchange Rate ?

Movements of Exchange Rate 1. Long-term Trends The movement of exchange rate over the entire period. 2. Medium-term Trends The movement of exchange rate over periods of several years. 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 even minute to minute.)

Exchange Rates in the Short-run This 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 Thai Bond Interest = 10 % Exchange Money Malaysia Bond 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 Rate Singapore 1 USD / 25 SGD Singapore $ 1 USD / 20 SGD Hong Kong 1 USD / 25 HKD Hong Kong 1 USD/ 30 HKD Expected Future Spot 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-run Price Level U.S. Suppose : $1 = £1 (at the outset) U.K. = £1 = $1 > $1 > £1 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 £1 Bank $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 Thailand Australia U.S. 75 baht/ $1AUS 50 baht/ $1US

Inflation Rate U.S.Thai = $1 = 25 Baht Export = $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 values tend to depreciate in the foreign exchange market. (i.e., from “1 dollar/25 baht” to “1 dollar/15 bath”)

U.S.Thai = $1 = 25 Baht Export = $ 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 values tend 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