Chapter

4
Exchange Rate Determination
 Chapter Objectives

 To explain how exchange rate movements are

measured;
 To explain how the equilibrium exchange rate is
determined; and
 To examine the factors that affect the equilibrium
exchange rate.
 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 foreign currencies
appreciate while others depreciate against the
domestic currency, the domestic currency is said
to be “mixed in trading.”
 Measuring
Exchange Rate Movements
 The percentage change (%  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 %  represents appreciation of the
foreign currency, while a negative % 
represents depreciation.
Fluctuation of the British Pound
Over Time

Approximate Approximate
Spot Rate of £ Annual % 
20 %
$/£ 1.80
1.75 15
1.70 10
1.65 5
1.60 0
1.55 -5
1.50 -10
1.45 -15
1.40 -20
1992 1996 2000 1992 1996 2000
 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 £
The Determinants of Foreign
Exchange Rates
Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Interest rate parity

Is there a well-developed Is there a sound and secure

and liquid money and capital banking system in-place to support
market in that currency? Spot currency trading activities?
Exchange
Rate
Asset Approach Balance of Payments
1. Relative real interest rates
1. Current account balances
2. Prospects for economic growth
2. Portfolio investment
3. Supply & demand for assets
3. Foreign direct investment
4. Outlook for political stability
4. Exchange rate regimes
5. Speculation & liquidity
5. Official monetary reserves
6. Political risks & controls
Foreign Exchange Rate Determination
 It is important to remember that these three
theories are not competing, but rather are
complementary to each other.
 Without the depth and breadth of the various
approaches combined, our ability to capture the
complexity of the global market for currencies is
lost.
 Factors that Influence
Exchange Rates
Parity Conditions
Relative Inflation Rates
$/£ U.S. inflation 
S1
S0
  U.S. demand for British
r1 goods, and hence £.
r0
D1   British desire for U.S.
D0 goods, and hence the
Quantity of £ supply of £.
 Factors that Influence
Exchange Rates
Relative Interest Rates

$/£ U.S. interest rates 

S0
S1
  U.S. demand for British
r0 bank deposits, and hence £.
r1
D0   British desire for U.S.
D1
bank deposits, and hence
Quantity of £ the supply of £.
 Factors that Influence
Exchange Rates
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

$/£ U.S. income level 

S0 ,S1
  U.S. demand for British
r1
goods, and hence £.
r0
D1  No expected change for the
D0
supply of £.
Quantity of £
 The Balance of Payments
(BOP) Approach
 Fixed Exchange Rate Countries:
 Under a fixed exchange rate system, the government bears the
responsibility to ensure a BOP near zero.
 To ensure a fixed exchange rate, the government must intervene
in the foreign exchange market and buy or sell domestic
currencies (or sell gold) to bring the BOP back to near zero.
 It is very important for a government to maintain significant
foreign exchange reserve balances to allow it to intervene in the
foreign exchange market effectively.
 The Balance of Payments
(BOP) Approach
 Floating Exchange Rate Countries:
 Under a floating exchange rate system, the government
of a country has no responsibility to peg its foreign
exchange rate.
 The fact that current and capital account balances do
not sum to zero will automatically (in theory) alter the
exchange rate in the direction necessary to obtain a
BOP near zero.
 The Balance of Payments
(BOP) Approach
 Managed Floats:
 Countries operating with managed floats, while still relying on
market conditions for day-to-day exchange rate determination,
often find it necessary to take action to maintain their desired
exchange rate values.
 They seek to alter the market’s valuation of a specific exchange
rate by influencing the motivators of market activity, rather
through direct intervention in the foreign exchange markets.
 The primary action taken by such governments is to change
relative interest rates.
 The Asset Market Approach

 The asset market approach assumes that whether

foreigners are willing to hold claims in monetary
form depends on an extensive set of investment
considerations or drivers (among others):
 Relative real interest rates
 Prospects for economic growth
 Capital market liquidity
 A country’s economic and social infrastructure
 Political safety
 Corporate governance practices
 The Asset Market Approach
 Foreign investors are willing to hold securities and
undertake foreign direct investment in highly developed
countries based primarily on relative real interest rates and
the outlook for economic growth and profitability.
 The asset market approach is also applicable to emerging
markets, however in these cases a number of additional
variables contribute to exchange rate determination
(previous slide).
 Factors that Influence
Exchange Rates
Governments influence the equilibrium exchange
rate in many ways, including
 imposing foreign exchange barriers;
 imposing foreign trade barriers;
 intervening (buying and selling currencies) in
the foreign exchange markets, and
 affecting macro variables such as inflation,
interest rates, and income levels.
 Factors that Influence
Exchange Rates
Expectations
 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.

 How Factors Can Affect Exchange Rates
Trade-Related
Factors
Demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for Exchange
3. Gov’t Trade domestic goods, i.e. rate
Restrictions supply of foreign currency between
foreign
currency &
Financial Demand for foreign domestic
Factors securities, i.e. demand for currency
1. Interest Rate foreign currency
Differential Foreign demand for
2. Capital Flow domestic securities, i.e.
Restrictions supply of foreign currency
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand
dollar to appreciate from its present level of $0.50 to $0.52 in 30
days.
Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand
dollar to depreciate from its present level of $0.50 to $0.48 in 30
days.
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
Impact of Exchange Rates on an MNC’s Value
Inflation Rates, Interest Rates,
Income Levels, Government Controls,
Expectations

m 
n 
E  CF j, t   E  ER 
j, t 
 
Value =   j 1 
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