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

Demand for Foreign Exchange Refers to the amount of foreign exchange that will be bought from the market at various exchange rates Corresponds to debit items on the balance of payments Demand for foreign exchange varies inversely with its price

Billions of pounds Demand for Foreign Exchange Dollars per pound Foreign exchange markets E D 0

Supply of Foreign Exchange Refers to the amount of foreign exchange that will be offered to the market at various exchange rates. Correspond to the credit items on the balance of payments. Supply for foreign exchange varies directly with its price

Billions of pounds Supply of Foreign Exchange Dollars per pound S 0 Foreign exchange markets E

Billions of pounds Exchange rate determination Dollars per pound S 0 Foreign exchange markets Dollar depreciation Dollar appreciation E D 0

Dollar Appreciation due to Decrease in Demand for Pound Dollars per pound S0S0 E D0D0

Dollar Appreciation due to Increase in Supply of Pound Dollars per pound S0S0 E D0D0

Dollar Depreciation due to Increase in demand for Pound Dollars per pound S0S0 E D0D0

Dollar Depreciation due to Decrease in Supply of Pound Dollars per pound S0S0 E D0D0

2 Exchange rates Factors influencing exchange rates  Market fundamentals  Bilateraltradebalances  Real income  Real interest rates  Inflation rates  Consumer preferences for domestic or foreign products  Productivity changes affecting production costs  Profitability andriskinessof investments

3 Exchange rates Factors influencing exchange rates  Market fundamentals (cont’d)  Product availability  Monetary policy and fiscal policy  Government trade policy  Market expectations  News about future market fundamentals  Speculative opinion about future exchange rates

MARKET FUNDAMENTALS & THE DOLLAR’S EXCHANGE VALUE Factor Dollar’s Exchange Value Increase in foreign demand for U.S. goods, services or assets Appreciation Increase in U.S. demand for foreign goods, services or assets Depreciation Increase in U.S. real incomeDepreciation Increase in U.S. interest ratesAppreciation Increase in U.S. price levelDepreciation Increase in U.S. productivity Appreciation Increase in U.S. import restrictionsAppreciation

4 Exchange rates When are these factors important?  Short run (days)  Dominated by financial transfers responding to  Differencesin real interest rates  Shifting expectations of future exchange rates  Medium run (months)  Primarily influenced by economic cycles

5 Exchange rates When are these factors important?  Long run (years)  Dominated by movements of goods, services, investment, which are influenced by:  Inflation rates  Investment profitability  Consumer tastes  Real income  Productivity  Trade policy  How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between thecountries

7 Factors influencing exchange rates Real income differentials  A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal)  Imports rise faster than exports, so demand for foreign currency rises faster than itssupply  Real income changes can also reflect other processes, which might lead to rising exports

9 Factors influencing exchange rates Real interest rates  Short term real interest rate differences influence international capital movements  Real interest rate is nominal minus inflation  Low short term rates lead to less demand for the currency and depreciation  High rates lead to greater demand for the currency and appreciation

13 Factors influencing exchange rates Market expectations  As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates  Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while

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