The Determination of

Exchange Rates
 Part I.
Equilibrium Exchange Rates
I. SETTING THE EQUILIBRIUM
A. The exchange rate
is the price of one unit of foreign currency
expressed as a certain price in local
currency.
For example Rs.60/$ means the one $ in
India is worth Rs.60.
 Equilibrium Exchange Rates

B. How Do Indians Purchase

Americans Goods?
1. Foreign Currency Demand:
-derived from the demand for foreign country’s
goods, services, and financial assets.

e.g. Indians demand American goods such as Dell

computers
 The Demand for $ in India
Rs./$

D
Rs.61/ $

Rs.60/ $

Rs.59/ $

Qty
At higher exchange rates, Indians demand
less $ and vice versa.
Equilibrium Exchange Rates

2. Foreign Currency Supply:

- derived from the foreign country’s
demand for local goods.
- Foreign buyers must convert their
currency in order to purchase.
e.g. US demand for Indian goods
such as Indian Software means
Americans must convert $
to Indian Rupees in order to buy.
 The Supply of $ in India
Rs./ $

Rs.61/$ S
Rs.60/$

Rs.59/$

Qty
At higher exchange rates, Americans supply
more $ and vice versa.
Equilibrium Exchange Rates

3. Equilibrium Exchange Rate

occurs where the quantity
supplied equals the quantity
demanded of a foreign currency
at a specific local price.
 The Rs./ $ Equilibrium Rate
Rs./ $
Equilibrium
D

S
Rs.60

Qty
 Equilibrium Exchange Rates
C. How Exchange Rates Change
1. Increased demand
as more foreign goods are demanded,
more of the foreign currency is demand at
each possible exchange rate

2. The price of the foreign currency in

local currency increases.
Equilibrium Exchange Rates
3. Home Currency Depreciation
a. Foreign currency more
valuable than the home
currency.
b. Conversely, the foreign
currency’s value has
appreciated against the
home currency.
 The Indian Rupee Depreciates
When
Rs./ $
D’
D
Rs.61/ $
S

Rs.60/ $

Q1 Q2 Qty
 Equilibrium Exchange Rates
D. Computing a Currency
Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value
Equilibrium Exchange Rates

EXAMPLE: $ Appreciation
If the rupee value of the $ goes from
Rs.46.10 (e0) to Rs.47.10 (e1), then the $ has
appreciated by

(47.10 - 46.10)/ 46.10 = 2.17%

 Equilibrium Exchange Rates

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value
Equilibrium Exchange Rates

EXAMPLE: Indian rupee Depreciation

Use the formula

(e0 - e1)/ e1
substituting
(46.10 – 47.10)/47.10 = - 2.12%
is the Indian rupee depreciation.
Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
4. Political and Economic risk
Expectations and Future Exchange
Rates
• Currency value does not depend on
current events and current demand and
supply flows only
• They also depend on expectations or
forecasts about future exchange rate
movements
 The Nature of Money and
Currency Values
• The value of money depends on its
purchasing power. It also provides
liquidity.
• Therefore it represents a store of value
and it also provides a store of liquidity.
 The Nature of Money and
Currency Values (cont.)
• The value of a currency depends upon
the country’s expected rate of inflation
• The demand for liquidity of a currency is
determined by the volume of
transactions in that currency
• The demand for assets denominated in
that currency is determined by the risk
return pattern on investment in that
nations economy and wealth of its
residents
 The Nature of Money and
Currency Values (cont.)
• The expected rate of inflation largely
depends upon the country’s future
monetary policy
• The volume of transactions in the
currency and the risk-return pattern on
investment in that nations economy
largely depends upon expected economic
growth and political & economic stability
 Central Bank Reputations and
Currency Values
• As a nation’s monetary authority, the job
of the central bank is to use the
instruments of monetary policy including
the sole power to create money, to
achieve price stability, low interest rates
and a target currency value.
Price Stability and Central Bank
Independence
• Central banks should adopt rules for
price stability that are verifiable,
unambiguous and enforceable
• For these the central bank must have the
independence and also accountability
 Sample Problem
Suppose the U.S. dollar appreciates
against the Russian ruble by 500%.
How much did the ruble depreciate
against the dollar?
 Sample Problem

Depreciation of the ruble:

(e0  e1 )
x
e1
e1 e0
 5
e0 e0

Sample Problem

e1 e0
  5
e0 e0
e1
11  5 1
e0
e1  6e0
(e0  e1 )
 x
e1
e0  6e0
 x
6e0
5
 x
6
x  83%