Exchange Rate Determination

Meaning of Exchange Rate and Measuring Changes in Exchange Rates  Value of one currency in units of another currency  A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation.  If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated  If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation  Percentage change in value US $ New Value of Foreign Currency per unit of $- Old value of foreign currency per $ X 100 Old value of Foreign Currency per $  Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency X 100 Old value of $ per unit of Foreign Currency

Exchange Rate Equilibrium  Forces of Demand and Supply  Demand for foreign currency negatively related to the price of foreign currency  Supply of foreign currency positively related to the price of foreign currency  Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency Price for Foreign Currency Units of Foreign Currency (£) $1.50 $2.00 D D 50m 75 m

Supply of Foreign Currency Supply for Foreign Currency Units of Foreign Currency (£) $1.50 $ m75 m S S

Equilibrium Exchange Rate Exchange Rate Units of Foreign Currency(£) S S D D $1.6775

Factors that influence the Exchange Rate  Expectations of the Market  Political Events  Relative Inflation Rates  Relative Interest Rates  Relative Income Levels Exchange rate is the results of an interaction of these factors

Market Expectations  Expectations about future exchange rate changes on the basis of current and future political and economic conditions  1960s Strong $  Between 1960s and 1970s: weak $  Strong $ in 1999 – 2001  Weak Dollar today 2005  1995 European Exchange Rate Mechanism  Devaluation of Asian Currencies

Political Events  Fall of Berlin Wall and unification of East and West Germany  Rumors about resignation of Mikhail Gorbachov  Tiannanmon Square  Persian Gulf War  September 11, 2001

Relative Inflation  High inflation relative to a foreign country, decline in value of currency—Why?  Low inflation relative to a foreign country, increase in value of currency—Why?

Relative Interest Rates  High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

Relative Income Levels  Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

Exchange Rate Determination  An interaction of factors  Is it possible for a country with high real returns to have a low currency value?  Is it possible for a country with low real returns to have a high currency value?

Movements in Cross Exchange Rates  If currencies A and B move in same direction, there is no change in the cross exchange rate.  When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B.  When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar, currency A appreciates (depreciates) against currency B by the same degree as it appreciates against the dollar. 15

Anticipation of Exchange Rate Movements  Bank speculation based on expected appreciation  Bank speculation based on expected depreciation  Speculation by individuals 16