CHAPTER 12

Exchange rate and Their Determination

Objectives;
1. To know the factors that affects exchange rate.
2. To determine the cause of demand in foreign exchange.
3. To know the Factors that shifts the demand for foreign exchange.
4. To know the supply of foreign exchange and it’s relation to foreign goods
and services.
5.To know the factors that shifts the supply of foreign market.
“ The exchange rate is determine from day to day by supply and demand of home
currency in terms of foreign currency. Each transaction is two-sided, and sales are equal to
purchases. Any change in the conditions of demand or supply reflects itself in a change in
the exchange rate, and at the ruling rate the balance of payments from day to day, or
from moment to moment’’

- joan robinson, 1947

The demand for foreign currency is derive from the demand for foreign goods and
services. This relationship can be apply in reverse. For example, when the residents of a
foreign country buy U.S. products, this create a demand for dollars.
Let’s return to our example in chapter 11 in which a U.S. importer is purchasing British
Jaguars. To purchase the jaguars, the importer needs to obtain British pounds by
exchanging dollars for pounds. This raises the question how many dollars must the importer
exchange to obtain the requisite number of pound? In this example the exchange rate is
the amount of dollars the importer will have to sell in order to obtain a British pound.
 In general, The Exchange rate is the price of one country’s
currency in terms of another. The demand for British pound relative to
the supply of pounds determine the exchange rate just as the demand
for gasoline relative to the supply of gasoline determines the price of
gasoline.

An appreciation is an increase in the value of currency.

A depreciation is a decrease in the value of currency.
when the exchange rate is quoted as a direct quote- domestic
currency per unit of foreign currency- an increase in the ratio means
depreciation of dollar.
when the exchange rate is quoted as units foreign currency per
unit of domestic currency- an indirect quote-an increase in the ratio
means appreciation of the dollar.
To measure the percentage appreciation or depreciation of the spot rate over time
using direct quotes, the following equation is used:
% in Spot Rate = [(beginning rate – ending rate)/ beginning rate] x 100

The demand for foreign Exchange

The demand for foreign exchange is the demand for currency of one country by
residents of another country.
Let’s examine the demand for foreign exchange in more detail to learn what
factors specifically affect the demand. Suppose a U.S. importer wants to buy
jaguars, and let’s assume that a jaguar cost 30,000 British pounds. The dollar price of
jaguar depends upon the exchange rate. If the exchange rate were three dollars
per pound, the jaguar cost the importer $90,000. while there might be some
demand for jaguars in the U.S. at this price, the quantity demanded would be fairly
small. If the exchange rate fell to two dollars per pound, then the dollar price of
jaguar would fall to $60,000, and the quantity demanded would be somewhat
higher at this exchange rate. If the exchange rate were one dollar per pound, the
car in question cost only $30,000 and the quantity demanded in U.S. would be even
larger.
SHIFTS IN THE DEMAND FOR FOREIGN EXCHANGE
The two most important factors that shift the U.S. Demand for British pounds are
changes in U.S. income and prices in the U.S. relative to the prices in the U.K.
• Changes in the Domestic income if U.S. income changes, the demand for British goods
will change along with the demand for most of other products, both foreign and
domestic. As U.S. income increases, the demand for all good rises, including the
demand for imported British goods.
In, general when the U.S. GDP rises rapidly, the personal disposable income of U.S. citizens
also rises, and the demand for jaguars, and other British goods, increases, importers will
demand more cars to satisfy the U.S. consumer and, therefore, demand more British
pounds. On the other hand, jaguars may go sold when the U.S. has a recession. With lower
consumer demand, the importer will demand cars and fewer British pounds.
• Changes in relative prices.
The second factor that determines the demand for foreign exchange is changes in
relative prices between two countries. What would happen if the prices for all goods and
services in rose Britain? If Britain prices increase (the pound price of jaguar rises) with no
change in exchange rate, then the imported price of jaguars and other British goods would
rises in the U.S. market. If U.S. goods were competitive with British goods, then U.S. consumer
begin to substitute the U.S. produce goods and services for the British counterparts. As a
result of substituting U.S. –produce goods for British produced-goods causes decline in the
demand for British pounds.
in summary, if domestic prices rises relative to foreign prices, then the demand for
foreign exchange will increase. If foreign prices rise relative to domestic prices, the demand
for foreign exchange will decrease.
INCOME CHANGES TRADE
The rate of growth of domestic income would tend to affect imports
while rate of foreign economic growth would tend to affect exports.

The Supply of foreign exchange is the amount of foreign exchange

supplied in Foreign market. It is related to changes in foreign income
and changes in relative prices. If foreign income rise then the demand
for imports in foreign countries means that foreign residents will need to
sell their domestic currency. This creates a supply of foreign exchange.
Likewise an increase in foreign prices relative to domestic prices will
induce foreigners to import more and sell their currency to purchase
foreign exchange. A drop in foreign income or an increase in domestic
prices relative to foreign prices would tend to cause a reduction in the
supply of foreign exchange.
SHIFTS IN THE SUPPLY OF FOREIGN EXCHANGE
As was true with the demand for foreign exchange, the Supply of foreign exchange can
shift in response to changes in the factors that influence it. The two most important factors
that shift the supply of foreign exchange are changes in foreign income and relative prices.
As decrease or increase in British income would cause a rightward or leftward shift of the
supply of pounds. This change in supply means that at any given exchange rate, the
quantity of pounds available changes. Changes in the relative price of British or American
goods can also shift the supply curve.
 Equilibrium in the Foreign Exchange
Market
The concepts of demand and supply of foreign exchange can now be
combined to explain the concept of the equilibrium exchange rate.
The equilibrium exchange rate is the exchange rate where the quantity
demanded of foreign exchange equals the quantity supplied.
For many individuals the term "exactly" may be troubling because exchange
rates fluctuate over the course of a trading day and considerably more than
that over longer period of time.
 THE DOLLAR AS A VEHICLE CURENCY

In this Chapter the dollar and pound treated as equivalent currencies. For
example, if the U.S. importers wanted to buy British products, then the U.S.
importer would have to acquire pounds. In reality, however, many U.S.
importers can purchase foreign goods with Dollars, The dollar’s role in
international trade and finance goes even further. Exporters in many
countries price their products in international market in dollars, rather than
in a local currency. A familiar example is crude oil, which is always quoted
as dollar terms. This enables countries to trade with one another in dollar
terms. For instance if Mexican importer wanted to buy Brazilian products,
the transaction might occur in dollars. It has been estimated 90% of foreign
Exchange trader involve dollar.
Exchange-Rate Volatility and International Trade

Changes in the exchange rate make international trade different from interregional
trade within a large country such as the U.S. or Brazil.
In the short run, exchange rate changes can be migrated to a certain extent
through the use of forward or futures markets for foreign exchange. However, using
these markets is not free and the reduction of risk can only be purchased at some
cost. In addition, changes in exchange rate are difficult to forecast in the long run
and impede the ability of individual s and business to make plans over anytime
horizon longer than six months
Fluctuations in exchange rates have also led to a cottage industry in forecasting
exchange-rate changes. Even within our simplified demand and supply model
such an exercise is difficult because a successful exchange-rate forecast would
need, at minimum, reasonably accurate forecasts of changes in the two countries
GDP as well as similar forecasts of changes in their price levels.
The basic supply and demand model described in this chapter is a useful
representation of the world producers and consumers face in the long run.
However, short-run changes in exchange rates are frequently caused by other
factors that we have not yet included in the model.