Determinants of Exchange Rate

Identifying the factors and their influence

Group 8 9/19/15 International Finance

Determinants of Exchange Rates

Submitted to
Syeda Mahrufa Bahar

Course Instructor

International Finance

Prepared by
Group 8, 20th Batch

Abashesh Biswas (08)

Avirup Sarkar (38)
Sabbir Hossen (39)
Md. Mansib Intisar Khan (44)
Nafis Elahi (50)

Institute of Business Administration

University of Dhaka
September 19, 2015
Table of Contents
Question 24 ............................................................................................................................................. 3
Question 25 ............................................................................................................................................. 5
Blades Inc.: Case Solution ....................................................................................................................... 5
Question 1 ........................................................................................................................................... 5
Question 2 ........................................................................................................................................... 5
Question 3 ........................................................................................................................................... 6
Question 4 ........................................................................................................................................... 6
Question 5 ........................................................................................................................................... 6
References .............................................................................................................................................. 6
Question 24
Weighing factors that influence the exchange rates

Exchange rates can be influenced by several economic and non-economic factors. These factors can
be divided into short term and long term factors. From an extensive review of literature, the following
factors can be identified as the key weighing factors that can affect the exchange rates.

Economic factors

Short-term

Rate of economic growth

Inflation rate

Interest rate in the country and abroad

Current account balance

Capital account balance

Currency speculation

Long-term

Level of economic development of the country

Competitiveness of the economy

Technical and technological development

Size of the foreign debt

Budget deficit

Relative domestic and foreign prices

Capital flows

Non-economic factors

Political risk

Natural disasters

Policy approaches

Psychological factors

Figure: Weighing factors that affect the exchange rates (Twarowska & Kąkol, 2014).
Question 24: Assume that the level of capital flows between the U.S. and the country of Zeus is
negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade
between the U.S. and the country of Zeus. The main import by the U.S. is basic clothing purchased by
U.S. retail stores from Zeus, while the main import by Zeus is special computer chips that are only
made in the U.S. and are needed by many manufacturers in Zeus. Suddenly, the U.S. government
decides to impose a 20% tax on the clothing imports. The Zeus government immediately retaliates by
imposing a 20% tax on the computer chip imports. Second, the Zeus government immediately imposes
a 60% tax on any interest income that would be earned by Zeus investors if they buy U.S. securities.
Third, the Zeus central bank raises its local interest rates so that they are now higher than interest
rates in the U.S. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against
the dollar as a result of all the government actions described above? Explain.

Answer: Due to decreased trade volume form the US’s part an increased import from the Zeus’s part,
the value of Zee (Currency of Zeus) will depreciate.
Question 25
The country of Luta has large capital flows with the U.S. It has no trade with the U.S, and will not have
trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. Its rate of
inflation is 5%, the same as the U.S. inflation rate. You expect that the inflation rate in Luta will rise to
8% this coming year, while the U.S. inflation rate will remain at 5%. You expect that Luta’s interest
rate will rise to 9% during the next year. You expect that the U.S. interest rate will remain at 6% this
year. Do you think Luta’s currency will appreciate, depreciate, or remain unchanged against the dollar?
Briefly explain.

As the interest rate level in Luta is higher, the investors will consider the currency comparatively
attractive. This will appreciate the currency of Luta against US Dollar. Moreover, due to high capital
flows, the currency of Luta should appreciate compared to US Dollar.

Blades Inc.: Case Solution

Question 1

How are percentage changes in a currency’s value measured? Illustrate your answer numerically by
assuming a change in the Thai baht’s value from a value of $0.022 to $0.026.

ANSWER: The percentage change in a currency’s value is measured as follows:

𝑆−𝑆𝑡−1
% 𝐶ℎ𝑎𝑛𝑔𝑒 =
𝑆𝑡−1
S = Spot Rate
S t-1 = Previous Spot Rate

If the outcome of the equation is positive, the currency is appreciating and if the outcome is negative,
the currency is depreciating. So, let’s calculate

.026−.022
= .022

= 0.1818

Hence, THB will appreciate by 18.18%.

Question 2

What are the basic factors that determine the value of a currency? In equilibrium, what is the
relationship between these factors?

ANSWER: Demand and supply of currency are the key factors that determine the value of a currency.
The value of currency rises and falls depending on the demand and supply. If the supply is higher than
the demand, then the value falls and vice versa. In a state of equilibrium, demand should equal supply.
Question 3

How might the relatively high levels of inflation and interest rates affect the baht’s value? (Assume a
constant level of U.S. inflation and interest rates.)

ANSWER: increased inflation level will depreciate the THB in terms of dollars. Due to increased
inflation, the demand for dollar will go up against the THB which will depreciate the Thai currency. In
addition to that, high inflation level will also reduce the demand for THB and eventually leading to
depreciation of the currency. On the other hand, increased interest rates will appreciate the THB’s
value. As increased interest level will attract more new investors, the demand for THB will go up. This
will eventually appreciate the currency.

Question 4

How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from
Thailand, will affect the baht’s value? Would Blades be affected by the change in value, given the
primary Thai customer’s commitment?

ANSWER: The withdrawal of funds will lead to depreciation of the currency. This happens due to the
increased supply of the currency. As for Blades Inc., the change in the value will turn in lower
revenue for the company.

Question 5

Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country in order
to prevent further changes in the currency’s value. How could it accomplish this objective using
interest rates?

ANSWER: by increasing the interest rate level, the Thai government will be able to raise the demand
of THB. This will make the THB and securities denominated in THB very attractive to the investors.
Eventually, the trend of withdrawals of funds will stop.

References
Twarowska, K. & Kąkol, M., 2014. ANALYSIS OF FACTORS AFFECTING FLUCTUATIONS IN THE
EXCHANGE RATE OF POLISH ZLOTY AGAINST EURO. Portoroz, Slovenia , Management, Knowledge
and Learning .