1. International Finance
Exchange Rate Determination

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

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

4. Exchange Rate Determination

5. 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

6. Demand Schedule for Pounds

7. Supply Schedule for Pounds

8. Equilibrium Exchange Rate

9. Factors that Influence XRs
Liquidity of the currency
Illiquid market means large transactions may influence price

10. 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

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

12. 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

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

14. 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

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

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

17. 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