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Understanding Exchange Rate Determination in International Economics

Learn how exchange rate movements are measured, equilibrium rates determined, and factors influencing rates in international economics. Explore government controls, expectations, and speculating on anticipated rates.

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Understanding Exchange Rate Determination in International Economics

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  1. C H A P T E R 4 Exchange Rate Determination

  2. Chapter Overview A. Measuring Exchange Rate Movements B. Exchange Rate Equilibrium C. Factors That Influence Exchange Rates D. Government Controls E. Expectations F. Speculating on Anticipated Exchange Rates

  3. Chapter 4 Objectives This chapter will: A. Explain how exchange rate movements are measured B. Explain how the equilibrium exchange rate is determined C. Examine factors that determine the equilibrium exchange rate

  4. A. Measuring Exchange Rate Movements 1. Basic Movements in Rates -when one currency depreciates against another, the other must appreciate. Let St-1 = the original rate S = the current rate a. Appreciation b. Depreciation

  5. B. Exchange Rate Equilibrium How exchange rates reach equilibrium? 1. Demand for a Currency a. derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies. b. An indirect relationship exists between the cost of foreign currency and amount demanded. c. Graphically, a downward-sloping demand curve

  6. Demand Schedule for British Pounds Exhibit 4.2 page 87

  7. B. Exchange Rate Equilibrium 2. Supply of a Currency for Sale a. derived from the foreigners who are willing and able to supply foreign currency that must be converted first in order to purchase local goods. b. A direct relationship exists between cost of the foreign currency and the amount supplied. c. Graphically, an upward-sloping supply curve

  8. Supply Schedule of British Pounds for Sale Exhibit 4.3 page 88

  9. B. Exchange Rate Equilibrium 3. Equilibrium

  10. Equilibrium Exchange Rate Determination Exhibit 4.4 page 89

  11. C. Factors That Influence Exchange Rates 1. Relative Inflation Rates 2. Relative Interest Rates a. Real Interest Rates 3. Relative Income Levels

  12. D. Government Controls Governments influence the equilibrium exchange rate in many ways, including 1. imposing foreign exchange barriers, 2. imposing foreign trade barriers, 3. intervening (buying and selling currencies) in the foreign exchange markets, 4. affecting macro variables such as inflation, interest rates, and income levels.

  13. E. Expectations 1. The Role of Information a. Impact of Signals on Currency Speculation 1.) commonly driven by signals of future interest rate movements 2.) by other factors such as signals of the future economic conditions that affect exchange rates

  14. 2. Interaction of Factors

  15. F. Speculating on Anticipated Exchange Rates Many commercial banks attempt to capitalize on their forecasts of anticipated exchange rate movements in the foreign exchange market

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