1. Exchange Rate Determination Bill Reese International Finance 1

2. Learning Objectives In this unit we will learn:  The factors that influence changes in exchange rates  How these factors can influence the supply of and demand for a currency 2

3. Exchange Rate Determination Measuring exchange rate movements  Always in relation to another currency  Appreciate vs. depreciate  Percent Δ = S t – S t-1 S t-1 3

4. Exchange Rate Determination Measured over some period of time  Longer times → greater movements  Some currencies are more volatile than others  Example… 4

5. Exchange Rate Determination

6. 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

7. Demand Schedule for Pounds

8. Supply Schedule for Pounds

9. Equilibrium Exchange Rate

10. Factors that Influence XRs Liquidity of the currency  Illiquid market means large transactions may influence price 10

11. 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 Britian (fewer pounds for sale)  Demand and supply curves shift Value of £ increases 11

12. Rising U.S. Inflation

13. 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

14. Rising U.S. Interest Rates

15. 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

16. Rising U.S. Income Level

17. 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

18. 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 18