Exchange Rate Determination

1. Exchange Rate Determination International Finance (MB 74)

2. Outline • Defining Exchange Rate • Measuring Exchange Rate Movements • Appreciation/Depreciation of a currency • Exchange Rate Equilibrium • Factors that influence Exchange Rate Movements

3. Meaning of Exchange Rate and Measuring Changes in Exchange Rates • Value of one currency in units of another currency • A decline in a currency’s value is referred to as depreciation and an increase in currency’s 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

4. Appreciation/Depreciation • Percentage change in value US $ New Value of Foreign Currency per unit of $ - Old value of foreign currency per $ -------------------------------------------------- X 100 Old value of Foreign Currency per $ • Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency -------------------------------------------------- X 100 Old value of $ per unit of Foreign Currency

5. Exchange Rate Equilibrium • Forces of Demand and Supply • Demand for foreign currency negatively related to the price of foreign currency • Supply of foreign currency positively related to the price of foreign currency • Forces of demand and supply together determine the exchange rate

6. Demand for Foreign Currency Price for Foreign Currency D $2.00 $1.50 D 75 m 50m Units of Foreign Currency (£)

7. Supply of Foreign Currency Supply for Foreign Currency S $2.00 $1.50 S Units of Foreign Currency (£) 50 m 75 m

8. Equilibrium Exchange Rate Exchange Rate D S $1.6775 S D Units of Foreign Currency(£)

9. 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

10. 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

11. 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

12. Relative Inflation • High inflation relative to a foreign country, decline in value of currency—Why? • Low inflation relative to a foreign country, increase in value of currency—Why?

13. Relative Interest Rates • High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

14. Relative Income Levels • Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

15. 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?