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.
• To explain the movements in cross exchange
rates.
B4 - 2
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.”
B4 - 3
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.
B4 - 4
Fluctuation of the British Pound
Over Time
Approximate £
that could be
Approximate Approximate Purchased with
Spot Rate of £ Annual % D $10,000
$ 1.80 20 % £ 7000
1.75 15 6800
1.70 10 6600
1.65 5
6400
1.60 0
6200
1.55 -5
1.50 -10 6000
1.45 -15 5800
1.40 -20 5600
1992 1996 2000 1992 1996 2000 1992 1996 2000
B4 - 5
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 £
B4 - 6
Factors that influence Exchange Rate
B4 - 7
a) Relative Inflation Rates
Assume that both British and U.S. firms sell goods that can serve as
substitutes for each other. The sudden jump in U.S. inflation should cause
some U.S. consumers to buy more British products instead of U.S. products.
At any given exchange rate, there would be an increase in the U.S. demand
for British goods, which represents an increase in the U.S. demand for
British pounds.
In addition, the jump in U.S. inflation should reduce the British desire for
U.S. goods and thereby reduce the supply of pounds for sale at any given
exchange rate.
At the previous equilibrium exchange rate of $1.55, there will now be a
shortage of pounds in the foreign exchange market. The increased U.S.
demand for pounds and the reduced supply of pounds for sale together
place upward pressure on the value of the pound.
The new equilibrium value is $1.57. If British inflation increased (rather than
U.S. inflation), the opposite dynamic would prevail.
B4 - 8
Factors that Influence
Exchange Rates
a) Relative Inflation Rates
U.S. inflation
$/£ S1 U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1 British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
B4 - 9
b) Relative Interest Rates
Assume that U.S. and British interest rates are initially equal but then U.S.
interest rates rise while British rates remain constant. U.S. investors will
likely reduce their demand for pounds, because U.S. rates are now more
attractive than British rates.
Because U.S. rates now look more attractive to British investors with excess
cash, the supply of pounds for sale by British investors should increase as
they establish more bank deposits in the United States.
In response to this inward shift in the demand for pounds and outward shift
in the supply of pounds for sale, the equilibrium exchange rate should
decrease.
If U.S. interest rates decreased relative to British interest rates, then the
opposite shifts would be expected.
B4 - 10
Factors that Influence
Exchange Rates
b) Relative Interest Rates
U.S. interest rates
$/£ S0 U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0 British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
B4 - 11
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.
B4 - 12
Factors that Influence
Exchange Rates
Real Interest Rates
• real nominal
interest interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.
• The real interest rate is appropriate for international comparisons
of exchange rate movements because it incorporates both the
nominal interest rate and inflation, each of which influences
exchange rates. Other things held constant, a high U.S. real rate of
interest (relative to other countries) tends to boost the dollar’s
value.
B4 - 13
c) Relative Income Levels
Assume that the U.S. income level rises substantially while the British
income level remains unchanged.
Consider the impact of this scenario on (1) the demand schedule for
pounds, (2) the supply schedule of pounds for sale, and (3) the
equilibrium exchange rate.
First, the demand schedule for pounds will shift outward, reflecting the
increase in U.S. income and attendant increased demand for British
goods.
Second, the supply schedule of pounds for sale is not expected to
change.
Hence the equilibrium exchange rate of the pound should rise.
B4 - 14
Factors that Influence
Exchange Rates
c) Relative Income Levels
U.S. income level
$/£
U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1 No expected change for
D0
the supply of £.
Quantity of £
B4 - 15
Factors that Influence
Exchange Rates
d) Government Controls
• Governments may influence the
equilibrium exchange rate by:
¤ imposing foreign exchange barriers,
¤ imposing foreign trade barriers,
¤ intervening in the foreign exchange market,
and
¤ affecting macro variables such as inflation,
interest rates, and income levels.
B4 - 16
Factors that Influence
Exchange Rates
e) 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.
B4 - 17
How Factors Can Affect Exchange Rates
Trade-Related
Factors
BD demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for BD
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency for sale rate
between
foreign
Financial BD demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency BDT
Differential Foreign demand for BD
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency for sale
B4 - 18
Practice (ST-2)
A recent shift in the interest rate differential
between the United States and Country
Bangladesh had a large effect on the value of
Currency Bangladesh. However, the same shift
in the interest rate differential between the
United States and North Korea had no effect on
the value of North Korea. Explain why the
effects may vary.
B4 - 19
BD Exchange Rate against USD
B4 - 20
Capitalizing on Expected Exchange
Rate Movements
If spot exchange rates are priced properly, this implies that the
foreign exchange market is efficient, and speculators will be
unable to profit from expectations about exchange rate
movements.
However, if spot exchange rates are not priced properly, this
implies that the foreign exchange market is not efficient, and
there is potential for speculators to capitalize on the mispricing.
Some large financial institutions attempt to anticipate how the
equilibrium exchange rate will change in the near future based
on conditions identified in this chapter. These institutions may
then take a position in that currency in order to benefit from
their expectations.
B4 - 21
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
B4 - 22
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
B4 - 23
Practice
Smart Banking Corp. can borrow $5 million at
6 percent annualized. It can use the proceeds to
invest in Canadian dollars at 9 percent annualized
over a 6-day period. The Canadian dollar is worth
$.95 and is expected to be worth $.94 in 6 days.
Based on this information, should Smart Banking
Corp. borrow U.S. dollars and invest in Canadian
dollars? What would be the gain or loss in U.S.
dollars?
$.95=CD$1
Loss=50,210
B4 - 24
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
B4 - 25
Chapter Review
• Measuring Exchange Rate Movements
• Exchange Rate Equilibrium
¤ Demand for a Currency
¤ Supply of a Currency for Sale
¤ Equilibrium
B4 - 26
Chapter Review
• Factors that Influence Exchange Rates
¤ Relative Inflation Rates
¤ Relative Interest Rates
¤ Relative Income Levels
¤ Government Controls
¤ Expectations
¤ Interaction of Factors
¤ How Factors Have Influenced Exchange
Rates
B4 - 27
Assignment
Q & A- 2, 10
AQ- 19, 20.
B4 - 28