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Primeasia University
Assignment on
Change in Equilibrium Exchange rate

Course Code: FIN402

Course Title: International Finance

Submitted to:

Mohammad Nazrul Islam

Assistant Professor
School of business
Primeasia University

Submitted By:

Maria Akter
ID:173008045
Primeasia University

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Table of content

SN Content Page No
1. Introduction 2
2. Exchange rate 2
3. Demand for currency 2
4. Floating exchange rates 2
5. Foreign exchange market 3
6. Purchasing Power 4
7. Change in equilibrium exchange rate 4
8. Change equilibrium rate and interest rates 6
9. Conclusion 6

Introduction

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Assessing the level of exchange rates encounters a number of difficulties. The most
immediate one is to define what is meant by "equilibrium" exchange rates. There are two
polar views on this issue. The first one considers that, to the extent that they are determined
by market forces, observed exchange rates are always at a market equilibrium. This short-
term, market equilibrium relies on fundamentals and on expectations about fundamentals.
Why then worry about this short-run equilibrium? The reason is that this market-equilibrium
exchange rate can be submitted to noise and speculative bubbles, hence it can largely differ
from its "fundamental" value.

Exchange rate
The equilibrium exchange rate is the interaction of the supply of a currency and the demand
for a currency

As in any market, the foreign exchange market will be in equilibrium when the quantity
supplied of a currency is equal to the quantity demanded of a currency. If the market has a
surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.
Like any surplus, this will place downward pressure on the price. If the exchange rate is
flexible, then the exchange rate will decrease until the quantity supplied is equal to the
quantity demanded.

Demand for currency

When the exchange rate of a currency increases, other countries will want less of that
currency. When a currency appreciates (in other words, the exchange rate increases), then the
price of goods in the country whose currency has appreciated are now relatively more
expensive than those in other countries. Since those goods are more expensive, less is
imported from those countries, and therefore less of that currency is needed.

Floating exchange rates

We are used to thinking about buying things with a currency, so many new learners are
confused about what the price should be in the market for a currency. Buthe price of an
orange is never given in oranges; it’s given in some other currency. Just like an orange, a
dollar can’t be bought with itself, but instead it needs to be bought with some other currency.
A common misperception is to confuse 1) the things that cause shifts in the supply or demand
of a currency with 2) changes in quantity supplied or quantity demanded. To keep this
straight, ask yourself “why is this change happening?” If a change is happening in response to
a change in the exchange rate, then you are moving along a curve. If a change is happening in
response to something else, the entire curve shifts.
It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good
idea. Take your time labeling the foreign exchange market carefully using the elements of a
market:

Demand - the demand for the currency that is being exchanged

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Supply - the supply of the currency that is being exchanged

Quantity - the quantity of the currency that is being exchanged

Price - some other currency that is being used to buy the currency that is being
exchanged


One reason to demand a currency on the foreign exchange market is the belief that the value
of the currency is about to increase. One reason to supply a currency—that is, sell it on the
foreign exchange market—is the expectation that the value of the currency is about to
decline. For example, imagine that a leading business newspaper, like the Wall Street
Journal or the Financial Times, runs an article predicting that the Mexican peso will
appreciate in value. The likely effects of such an article are illustrated in

Foreign exchange market

the foreign exchange market, supply and demand typically both move at the same time.
Groups of participants in the foreign exchange market like firms and investors include some
who are buyers and some who are sellers. An expectation of a future shift in the exchange
rate affects both buyers and sellers—that is, it affects both demand and supply for a currency.

The shifts in demand and supply curves both cause the exchange rate to shift in the same
direction; in this example, they both make the peso exchange rate stronger. However, the
shifts in demand and supply work in opposing directions on the quantity traded. In this
example, the rising demand for pesos is causing the quantity to rise while the falling supply
of pesos is causing quantity to fall. In this specific example, the result is a higher quantity.
But in other cases, the result could be that quantity remains unchanged or declines.

This example also helps to explain why exchange rates often move quite substantially in a
short period of a few weeks or months. When investors expect a country’s currency to
strengthen in the future, they buy the currency and cause it to appreciate immediately. The
appreciation of the currency can lead other investors to believe that future appreciation is
likely—and thus lead to even further appreciation. Similarly, a fear that a
currency might weaken quickly leads to an actual weakening of the currency, which often
reinforces the belief that the currency is going to weaken further. Thus, beliefs about the
future path of exchange rates can be self-reinforcing, at least for a time, and a large share of
the trading in foreign exchange markets involves dealers trying to outguess each other on
what direction exchange rates will move next.

PURCHASING POWER PARITY

Over the long term, exchange rates must bear some relationship to the buying power of the
currency in terms of goods that are internationally traded. If at a certain exchange rate it was
much cheaper to buy internationally traded goods—such as oil, steel, computers, and cars—
in one country than in another country, businesses would start buying in the cheap country,
selling in other countries, and pocketing the profits.

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For example, if a U.S. dollar is worth $1.60 in Canadian currency, then a car that sells for
$20,000 in the United States should sell for $32,000 in Canada. If the price of cars in Canada
was much lower than $32,000, then at least some U.S. car-buyers would convert their U.S.
dollars to Canadian dollars and buy their cars in Canada. If the price of cars was much higher
than $32,000 in this example, then at least some Canadian buyers would convert their
Canadian dollars to U.S. dollars and go to the United States to purchase their cars. This is
known as arbitrage, the process of buying and selling goods or currencies across
international borders at a profit. It may occur slowly, but over time, it will force prices and
exchange rates to align so that the price of internationally traded goods is similar in all
countries.

The purchasing power parity exchange rate has two functions. First, PPP exchange rates are
often used for international comparison of GDP and other economic statistics. Imagine that
you are preparing a table showing the size of GDP in many countries in several recent years,
and for ease of comparison, you are converting all the values into U.S. dollars. When you
insert the value for Japan, you need to use a yen/dollar exchange rate. But should you use the
market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In
summer 2008, the exchange rate was 108 yen/dollar, but in late 2009 the U.S.

Change in equilibrium exchange rate

The equilibrium exchange rate is the rate which equates demand and supply for a particular
currency against another currency.

Example
If we assume the UK and France both produce goods that the other wants, they will wish to
trade with each other. However, French producers require payment in Euros and the British
producers require payments in pounds Sterling. Both need payment in their

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own local currency so that they can pay their own production costs in their local currency.
The foreign exchange market enables both French and British producers to exchange
currencies so that trades can take place.

The market will create an equilibrium exchange rate for each currency, which will exist
where demand and supply of currencies equates.

Change equilibrium rate and interest rates

Changes in a country’s interest rates also affect its currency, through its impact on the
demand and supply of financial assets in the UK and abroad. For example, higher interest
rates relative to other countries, makes the UK attractive the investors, and leads to an
increase in the demand for the UK’s financial assets, and an increase in the demand for
Sterling.

Conversely, lower interest rates in one country relative to other countries leads to an increase
in supply, as speculators sell a currency in order to buy currencies associated with rising
interest rates. These speculative flows are called hot money, and have an important short-term
effect on exchange rates.

Conclusion:
It argues that a variety of equilibrium exchange rates can be defined and their behaviour will
vary according to different definitions of the exchange rate, and over short, medium and long-
term horizons.

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