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Meaning of Exchange Rate and Measuring Changes in Exchange Rates

Value of one currency in units of another currency A decline in a currencys value is referred to as depreciation and an increase in currencys value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Determination of Exchange Rates

Determinants of Exchange Rates The Purchasing Power Parity or PPP happens to be one of the most significant approaches to determine exchange rate. PPP is primarily based on the Law of One Price. However, this law is based on the assumption that identical goods are sold at equal prices. This law lays down that exchange rate of currencies have to compensate for the differences in prices of goods.

This approach lays down the fact the exchange rate has to compensate fo the difference in inflation rate. PPP is not a very reliable determinant since changes in technology, commercial policies, labor force and tastes change the national productivity, which in turn changes the real exchange rate.

BALANCE OF PAYMENT Factors behind the supply of and demand for foreign exchange to deter mine the price of a foreign currency.

Again, it should be stressed that the factors determining the demand for Euros are also the factors determining the supply of dollars, and the facto rs determining the supply of Euros also determine the demand for dollars The balance of payments is a systematic array of all the factors that determine the foreign exchange rate.

That array follows long established conventions and is all-inclusive and mutually exclusive among the individual factors.

Asset Market Approach The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

Demand for Foreign Currency

Price for Foreign Currency

D $2.00

$1.50 D
50m 75 m Units of Foreign Currency ()

Supply of Foreign Currency

Supply for Foreign Currency


$1.50 S
50 m 75 m Units of Foreign Currency ()

Equilibrium Exchange Rate

Exchange Rate


Units of Foreign Currency()

What Changes the Equilibrium Rate?

Political & economic risk:
Higher political or economic risk in the domestic country results in increased demand and reduced supply of foreign currency.

Changes in future expectations:

Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention:
Maintain weak currency to improve export competitiveness.

Forecasting in Practice
Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.

Some multinational firms have their own in-house forecasting capabilities.

Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

Factors that influence the Exchange Rate

Expectations of the Market Political Events Relative Inflation Rates Relative Interest Rates Relative Income Levels Exchange rate is the results of an interaction of these factors

Market Expectations
Expectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 2001 Weak Dollar today 2005 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies

Political Events
Fall of Berlin Wall and unification of East and West Germany Rumors about resignation of Mikhail Gorbachov Tiannanmon Square Persian Gulf War September 11, 2001

Relative Inflation
High inflation relative to a foreign country, decline in value of currencyWhy? Low inflation relative to a foreign country, increase in value of currencyWhy?

Relative Interest Rates

High interest rates in home country relative to a foreign country may cause domestic currency to appreciateWhy?

Relative Income Levels

Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency Why?

Exchange Rate Determination

An interaction of factors Is it possible for a country with high real returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?