1. Factors influencing exchange rates: Supply and Demand for a Currency
Short – run … financial transactions
Market fundamentals
Current account balances
Real interest rates
Market expectations
News about future market fundamentals
Speculative opinion about future exchange rates

2. Factors influencing exchange rates
Medium – run
Real income … business cycle
Monetary policy and fiscal policy
Product availability
Long – run
Inflation rates
Consumer preferences for domestic or foreign products
Productivity changes affecting production costs … and prices
Profitability and riskiness of investments
Government trade policy

3. Impact of interest rate differentials: drop in US interest rate  $ depreciation
Dollars per Yen S0 B
.0080
.0075 A D1 D0

4. Impact of real income differentials: increase in US income  $ depreciation
Dollars per Pound B
1.60
1.50 A D1 D0

5. Purchasing power parity (PPP): The Law of One Price
A good should cost the same in all countries (aside from tariffs or transportation costs)
Exchange rates should make prices equal across countries
P = ER x P*
($/bourbon) = ($/£) x (£ /scotch) = ($/scotch)
If two countries have different inflation rates, exchange rates will move keep prices the same
The currency of the high inflation country will depreciate
(P/P*)   ER   ($/£) 

6. Impact of inflation rate differentials: high US inflation  $ depreciation
Dollars per Pound S0 B
1.70
1.50 A D1 D0

7. 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

8. Impact of expectations: expectation of $ depreciation $ depreciation
Dollars per Pound S0 B
1.70
1.50 A D1 D0

9. Alternative approaches to exchange rates
Monetary approach
Focus on exchange rates as the result of supply and demand for money at home and abroad
Demand depends on real income, prices, interest rates
Supply is controlled by central banks
Ms   $ depreciates
Real income   Md   $ appreciates
Interest rate   Md   $ depreciates ??!?