Chapter 4

EXCHANGE RATE
DETERMINATION
 SOME STYLISED FACTS
 The exchange rate follows approximately a
random walk with little or no drift
 The spot and forward rates tend to move in
the same direction and by approximately the
same amount
 There is no correspondence between
exchange rates and prices
 There is no strong relationship between the
exchange rate and the current account
 Rapid monetary expansion leads to rapid
currency depreciation
THE EQUILIBRIUM EXCHANGE
RATE

S(d/f)

Sf

S0

Df
Qf
FACTORS AFFECTING THE
SUPPLY AND DEMAND OF FX
 Relative inflation rates
 Relative interest rates
 Relative growth rates
 The government
 Expectation
THE EFFECT OF A HIGHER
DOMESTIC INFLATION RATE

S(d/f)

Sf

E1
S1
E
S0

Df
Qf
THE EFFECT OF HIGHER
DOMESTIC INTEREST RATE

S(d/f)
Sf

E
S0
S1
E1

Df

Qf
THE EFFECT OF HIGHER DOMESTIC
GROWTH RATE (CURRENT ACC.)

S(d/f)

Sf

S1 E1
S0 E

Df
THE EFFECT OF HIGHER DOMESTIC
GROWTH RATE (FINANCIAL ACC.)

S(d/f)
Sf

E
S0 E1
S1

Df

Qf
THE ROLE OF GOVERNMENT
 Govt. may influence the equilibrium
exchange rate by:
 Imposing foreign exchange barriers ,
 Impposing foreign trade barriers
 Intervening in the foreign exchange markeet
 Affecting macro variables such as inflation,
interest rates, income levels
EXPECTATIONS
 Foreign exchange markets react to any news
that may have a future effect
 Many institutional investors take currency
positions based on anticipated interest rate
movements in various countries
 Economic signals that affect exchange rates
can change quickly, such that speculators
may overreact initially and then find that
they have to make a correction
SPECULATION IN THE FX
MARKEET
 Speculators buy and sell currencies on the
basis of certain expectations about the
future movements of exchange rates
TYPES OF SPECULATION
 Destabilising speculation
Destabilising speculation occurs when
speculators buy a currency when it is
appreciating and sell it when it is
depreciating
 Stabilising speculation
Stabisilising speculation occurs when
speculators buy a currency when it is
depreciating and sell it when it is
appreciating