Exchange Rate Determination International Finance (B 645)

Outline (Chapter 4)  Defining Exchange Rate  Measuring Exchange Rate Movements –Appreciation/Depreciation of a currency  Exchange Rate Equilibrium  Factors that influence Exchange Rate Movements

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

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

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

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 $ now  1995 European Exchange Rate Mechanism  Devaluation of Asian Currencies

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?