Chapter 4

Exchange Rate Determination

 Measuring
Exchange Rate Movements

 An exchange rate
 measures the value of one currency in units of another
currency.
 When a currency declines in value, it is said to
depreciate.
 When it increases in value, it is said to appreciate.
 On the days when some currencies appreciate while
others depreciate against the dollar, the dollar is said
to be “mixed in trading.”
Measuring
Exchange Rate Movements
 The percentage change (% D) in the value of a foreign currency is
computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the foreign currency,
• while a negative % D represents depreciation.
• E.g if C$ was =$.7 on Jan 1st and $.71 on Jan 2nd percentage change
is.01/.7*100*100=1.428%
• Percentage movement on daily , weekly , monthly , quarterly or
annual basis can be calculated to suit one’s needs
Exchange Rate Equilibrium
 An exchange rate represents the price of a currency,
which is determined by the demand for that
currency relative to the supply for that currency.

Value of £
S: Supply of £
$1.60
$1.55 equilibrium
exchange rate
$1.50
D: Demand for £

Quantity of £
Liquidity and equilibrium rate
 If currency is liquid equilibrium rate is maintained
 If currency is not liquid equilibrium rate often changes
Factors influencing exchange rate
 Inflation-higher the inflation currency of that country weakens
 Interest rate-higher the interest rate currency of that country
strengthens(subject to inflation)
 Income levels-higher the income ,currency of that country strengthens
if local consumption occurs. It may weaken if more imports occur
 Governmental controls-more the control currency of that country
weakens
 Expectation of market- rosier the expectation the currency appreciates
 Speculation- going long currency to be appreciated and going short on
currency to be depreciated
 All these factors interact with each other and determine exchange rate
 MCQ
 2002
 1. The value of the Australian dollar
(A$) today is £0.41. Yesterday, the
value of the Australian dollar was
£0.38. The Australian dollar----- by
_______%.against
 A. depreciated; 7.90
 B. appreciated; 7.90
 C.depreciated; 7.30
 D.appreciated; 7.30
 
 .41-.38/.38=7.9%=B
 2013
 2. An increase in UK interest
rates relative to euro interest
rates is likely to ________ the
UK demand for euros and
_________ the supply of euros
for sale.
 a. reduce; increase
 b. increase; reduce
 c. reduce; reduce
d. increase; increase
A
 MCQ
 3.2026 4 2066
 In general, when  The exchange rates of
speculating on exchange smaller countries are
rate movements, the very stable because the
speculator will borrow the
market for their currency
currency that is expected
is very liquid.
to appreciate and invest in
the country whose  a. true.
currency is expected to  b. false.
depreciate.
B
 a. true.
 b. false.
 B
 MCQ
5 The equilibrium exchange rate of pounds is $1.70. At an exchange rate of $1.72 per pound:
 A.U.S. demand for pounds would exceed the supply of pounds for sale and there would
be a shortage of pounds in the foreign exchange market.
 b. U.S. demand for pounds would be less than the supply of pounds for sale and there
would be a shortage of pounds in the foreign exchange market.
 c. U.S. demand for pounds would exceed the supply of pounds for sale and there would
be a surplus of pounds in the foreign exchange market.
 d. U.S. demand for pounds would be less than the supply of pounds for sale and there
would be a surplus of pounds in the foreign exchange market.
 e. U.S. demand for pounds would be equal to the supply of pounds for sale and there
would be a shortage of pounds in the foreign exchange market.
 D
 1.72

1.70
 S D
Factors that Influence
Exchange Rates
Relative Inflation
Rates’;p If Indian. inflation increases
 Increased Indian demand
$/Rs S1 for US goods, and hence
S0
$1 demand for $ is more, Rs
$ weakens
D1  Decreased US desire
0
D0 for Indian goods, and
Quantity of $ hence the supply of $ is
less. Hence $
strengthens
 Factors that Influence
Exchange Rates
Relative Interest Rates

Indian. interest rates increase

$/Rs
S0  Less Indian. demand for US bank
S1 deposits, and hence $ demand
$0 less(more demand for Indian
deposits and Rs strengthens)
$1
D0  More US desire for Indian
D1 bank deposits, and hence
the supply of $ more as they
Quantity of $ want to buy rupees by
selling $ , Rs strengthens
Factors that Influence
Exchange Rates
Effect of inflation (Relative Interest Rates)
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which discourages foreign
investment.
• It is thus useful to consider real interest
rates, which adjust the nominal interest
rates for inflation.
Factors that Influence
Exchange Rates
Relative Interest Rates
• real nominal
interest  interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.
Factors that Influence
Exchange Rates
Relative Income Levels

Indian income level increases

 More Indian demand for US goods, and
hence $ demand increases
 No expected change for the supply of $
 More Indian consumption /higher interest
may occur leading to strengthening of Rs,
thus contrary trend may occur
 Thus HC may weaken or strengthen
Factors that Influence
Exchange Rates
Government Controls
 Governments may influence the equilibrium exchange
rate by:
 imposing foreign exchange barriers-HC weakens usually
 imposing foreign trade barriers,-HC weakens usaully
 intervening in the foreign exchange market, and
affecting macro variables such as inflation, interest
rates, and income levels.- Contrary trend may develop
Factors that Influence
Exchange Rates
Expectations of the market
 Foreign exchange markets react to any news that may
have a future effect.
 Institutional investors often take currency positions
based on anticipated interest rate movements in
various countries.
 Because of speculative transactions, foreign exchange
rates can be very volatile.
Factors that Influence
Exchange Rates
Expectations-some examples
Signal Usual Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
European Central banks expected to
intervene to boost the euro Weakened
Factors that Influence
Exchange Rates
Interaction of Factors
 Trade-related factors and financial factors sometimes
interact. Exchange rate movements may be
simultaneously affected by these factors.
 For example, an increase in the level of income
sometimes causes expectations of higher interest rates.
Factors that Influence
Exchange Rates
Interaction of Factors
• Over a particular period, different factors
may place opposing pressures on the
value of a foreign currency.
• The sensitivity of the exchange rate to
these factors is dependent on the volume
of international transactions between the
two countries.
Impact of Exchange Rates on an MNC’s Value
Inflation Rates, Interest Rates,
Income Levels, Government Controls,
Expectations

m
n 
 
E CFj , t ) E ER j , t ) 
 j 1 
Value =   
t =1  1  k ) t

 
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
 MCQ

8 Any event that reduces the euro area demand for

Japanese yen should result in a(n) _______ in the value
of the Japanese yen with respect to _______, other
things being equal.
 a. increase; euro
 c. decrease; noneuro currencies
 b. increase; noneuro currencies
 D.decrease; euro
 D
 MCQ
9News of a potential surge in U.S. inflation and zero
Chilean inflation places _______ pressure on the value
of the Chilean peso. The pressure will occur _______.
 a. upward; only after the U.S. inflation surges
 B.downward; only after the U.S. inflation surges
 c. upward; immediately
 d. downward; immediately
C
 MCQ
10 If a country experiences high inflation relative to the
UK, its exports to the UK should _______________, its
imports should ___________, and there is __________
pressure on its currency's equilibrium value.
 a. decrease; increase; upward
 b. decrease; decrease; upward
 c. increase; decrease; downward
 D.decrease; increase; downward
 e. increase; decrease; upward
d
 MCQ
11 Since supply and 12Relatively high Japanese
demand for a currency inflation may result in an
are constant (primarily increase in the supply of
due to government yen for sale and a
intervention), currency reduction in the demand
values seldom fluctuate. for yen.
 A.true.  A.true.
 b. false.  B.False
B A