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Exchange Rate Determination
International Corporate Finance
P.V. Viswanath
Outline
 The concept of an equilibrium Exchange Rate
 Basic factors affecting exchange rates
 Calculating currency appreciation/depreciation with
a given exchange rate change
 Central bank intervention
 Role of expectations
 Equilibrium Approach to Exchange Rates
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Equilibrium Exchange Rates
• An exchange rate is the price of one nation’s currency in
terms of another currency.
• Exchange rates are market clearing prices that equilibrate
supply and demand in exchange markets.
• A spot rate is the price of the currency for immediate
delivery
• A forward rate is the price for delivery at a specified future
date.
• The bid rate is the rate at which a dealer is willing to buy
• The ask rate is the rate at which a dealer is willing to sell.
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Supply and Demand
Dollar price
of one euro
S
e0
D
Q0
Quantity of euros per period
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Flow Theory of Exchange Rates
 Factors affecting supply of foreign currency
 Foreign country’s demand for home country’s exports
(goods and services) supplies foreign currency
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Demand for exports (in units of goods) is decreasing as a function of
foreign currency price.
Supply of foreign currency equals total revenue. Total revenue as a
function of foreign currency price is decreasing if demand is elastic.
Foreign currency price is decreasing in exchange rate.
Hence supply of foreign currency is increasing as a function of
exchange rate.
 Home country’s demand for foreign country’s imports
demands foreign currency

Normally downward sloping as a function of exchange rate
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Factors affecting equilibrium rates
 Terms of trade (price of exports relative to price of imports)

The higher the relative price of exports, the less the demand for
foreign currency (the greater the supply of foreign currency).
 Relative inflation in home and foreign countries.

If there is inflation in the foreign country, the demand curve for the
home country’s goods will move to the left – more will be demanded
at a given exchange rate; this will raise the exchange rate, i.e. the
number of units of home currency per unit of foreign currency.
 Foreign Investment in Home Country
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Relative Real Interest Rates
Relative Economic Growth Rates
Political and Economic Risk
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Calculating Exchange Rate Changes
Amount of Euro
appreciati on

New dollar val ue of euro - Old dollar val ue of euro
Old dollar val ue of euro
If the value of the euro rises from $0.93 to $0.99 per euro, the
amount of euro appreciation is computed as
(0.99 – 0.93)/0.93 = 6.45%
Amount of dollar
depreciati on

New euro value of dollar - Old euro value of dollar
Old euro value of dollar
The value of the dollar drops from 1/0.93 euros to 1/0.99.
Hence the amount of dollar depreciation is computed as
(1/0.93 – 1/0.99)/(1/0.93) = 6.06%
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Asset Market Model of Exchange Rates
 A stock of currency in one country can be thought of as a
claim on the assets, whose prices are denominated in that
currency, for a given price level. Hence it is, itself an asset –
a financial asset.
 Since an exchange rate is the value of one currency in terms
of another, it can be thought of as the ratio of the prices of
two financial assets.
 Hence exchange rates are affected by the same forces that
affect asset values.
 Assets, by their very nature, are forward looking, and their
value is determined by market expectations. Hence,
exchange rates, too, are affected by market expectations.
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Asset Market Model of Exchange
Rates
 The Asset Market Model has predictions that are differ from those of
the flow theory.
 For example, a fiscal deficit might cause people to expect a future
expansion of the money supply and hence an immediate depreciation
of the currency.
 In the standard theory, the fiscal deficit would lead to greater
borrowing from abroad. This leads to a greater demand for the local
currency and a strengthening of the currency.
 This result obtains because it is assumed that people do not alter their
savings and their demands for funds.
 In practice, it is likely that people will increase their savings in
anticipation of higher taxes in the future; this will reduce the
domestic demand for the home currency and lead to a drop in the
value of the home currency.
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Monetary Theory of Exchange Rates
 Currencies are, primarily monies. Hence, a theory of
exchange rates would do well to consider the nature of a
money.
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Money provides liquidity – it can be exchanged for goods and
services, or for other assets.
Money represents a store of value and a store of liquidity.
The demand for money is affected by the demand for assets
denominated in that currency – the higher the expected real return
and the lower the riskiness of a country’s assets, the greater is the
demand for its currency to buy those assets.
Factors that increase the demand for the home currency also increase
the price of home currency on the foreign exchange market.
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The Nature of Money and Currency Values
 The economic factors that affect a currency’s
foreign exchange value include:
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Its usefulness as a store of value, determined by its
expected rate of inflation
The demand for liquidity, determined by the volume of
transactions in that currency
The demand for assets denominated in that currency,
determined by the risk-return pattern on investment in
that nation’s economy and by the wealth of its residents.
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How money supply affects exchange rates
MV  Py
M = money supply; P = price level; y = real GNP; v = money
velocity.
img g
y
v
i = inflation rate; m  growth rate of money supply; gy = growth rate
of real GNP; gv = change in velocity of money
PPP says:
e1  e0
  ih  i f
e0
Combining previous identity with PPP, we get:
e1  e0
 ih  i f  ( m h  m f )  ( g yh  g yf )  ( g vh  g vf )
e0
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Central Bank Reputations and
Currency Values
 The central bank uses instruments of monetary
policy to create price stability, low interest rates or a
target currency value.
 Most money today is fiat money – nonconvertible
paper money, not tied to any commodity value.
 Hence, trust in the central bank translates into trust
in the currency’s future value.
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Price Stability and Central Bank
Independence
 In order to retain public credibility, central banks have to be
like company managements or boards of directors:
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They need to adopt rules for price stability that are verifiable,
unambiguous and enforceable.
This requires independence and accountability.
Central banks that lack independence are often forced by the
government to pursue political goals, such as lower interest rates or
higher economic growth.
Often the bank is forced to monetize the deficit.
 Paradoxically, though, these goals are achievable only to the
extent that the central bank is trusted – and a consistent
attempt to put political objectives over economic ones will
cause people to lose trust in the central bank.
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Central Bank Independence & Inflation
(Exhibit continues on next slide)
Shapiro/Multinational Financial Management, 7e
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Central Bank Independence and Growth
Shapiro/Multinational Financial Management, 7e
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Maintaining Trust in the Currency
 Currency Board
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There is no central bank. The currency board issues
notes and coins that are convertible on demand at a fixed
rate into a foreign reserve currency
The currency board holds high-quality, interest-bearing
securities denominated in the reserve currency
Its reserves are equal to 100% or more of its notes and
coins in circulation.
A currency board forces a government to follow a
responsible fiscal policy. It cannot force the central bank
to monetize the deficit.
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Maintaining Trust in the Currency
 Dollarization
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This is the complete replacement of the local currency
with the U.S. dollar
The central bank loses seignorage.
However, monetary discipline is easier to maintain – with
a currency board, the market might not believe in the
government’s commitment to maintain full reserves.
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Real Exchange Rates and Relative
Competitiveness
 As the real (inflation-adjusted) value of the dollar rises, the
dollar prices of imported goods and raw materials drop.
 Hence, the prices of imports and of products that compete
with imports drop.
 The foreign currency prices of US goods rise – US exports
become less competitive in world markets and US import
substitutes become less competitive in the US.
 Unemployment is generated in the traded-goods sector and
resources are shifted from the traded- to the nontradedgoods sector.
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Foreign Exchange Market Intervention
 Some governments will prefer an overvalued
domestic currency – lower import prices and
potentially lower prices.
 Others will prefer an undervalued currency – better
for employment in the traded goods sector.
 Others might prefer a correctly valued currency, but
might not believe that the market rate is correct.
 For all of these reasons, governments engage in
foreign exchange market intervention.
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Maintaining a non-equilibrium rate
Shapiro/Multinational Financial Management, 7e
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Maintaining a non-equilibrium rate
 The equilibrium level of the exchange rate in Fig. 2.2 is e1,
at which Q1 euros are demanded and supplied.
 If the US and German governments decide to maintain the
old rate, e0, there will be an excess demand for euros equal
to Q3-Q2.
 Either the American Central Bank or the European Central
Bank will have to intervene in the market to supply this
additional quantity of euros.
 The US will face a perpetual balance-of-payments deficit
equal to (Q3-Q2)e0 dollars, or equivalently a German
balance-of-payments surplus.
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Maintaining a non-equilibrium rate
 If the US government intervenes by selling euros and
buying dollars, dollars will become more scarce relative to
euros and the dollar will appreciate relative to the euro, as
desired.
 Typically, the government will not sell euros directly;
rather it will sell euro-denominated bonds, since that is the
form in which foreign currencies are normally kept.
 In any case, because of the paucity of dollars, the interest
rate will be affected – it will rise – and the government
may not desire this.
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Sterilized vs. Unsterilized Intervention
 In order to offset this, the government can buy Treasury bills and
increase the supply of money correspondingly. This is called
sterilization.
 The net result is that the supply of domestic money is kept
constant, and so the interest rate will not be affected.
 However, the public now holds fewer domestic securities and
more foreign securities.
 If investors consider domestic and foreign securities to be perfect
substitutes, then they will be happy to hold the new combination
without any change in the exchange rate. This means that the
desired lower exchange rate (stronger dollar) will not be achieved.
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Sterilized vs. Unsterilized Intervention
 However, if investors believe that domestic and foreign
securities are not perfect substitutes, then they will not want
to hold this new portfolio that is skewed towards foreign
securities.
 Investors will try to reduce their holdings of foreign
securities by selling them.
 Consequently, the euro must fall and the dollar must rise in
order to move the actual proportion of dollar to foreign
denominated security holdings to the desired level.
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Sterilized vs. Unsterilized Intervention
 Empirically, sterilized interventions do not seem to work. This
could be because investors don’t accept the premise of an
overvalued euro and hence are willing to hold the increased
supply of euro-denominated securities at the current exchange
rate.
 Unsterilized interventions can work; however, they do so by
causing a change in fundamental variables; in our example, there
would be deflation in the US if it bought up dollars (and sold
euros) and thus reduced the money supply.
 Hence if the underlying problem is an excess of dollars, then
unsterilized interventions can work.
 On the other hand, in this case, there is no need for foreign
exchange market intervention. Open market purchases of dollars
will suffice and the foreign exchange rate will automatically
adjust.
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Intervention to change the equilibrium
exchange rate
 If the currency is already in equilibrium, but the government
for political reasons desires to depreciate the currency, it
might engage in intervention, in the hope that a cheaper
dollar will increase demand for domestic goods.
 However, the intervention in this case will ultimately cause
inflation because the money supply will go up. This will
increase domestic wages and will erode the temporary gain
in competitiveness.
 This may drive the currency lower, if markets expect further
interventions, leading to an inflation-devaluation cycle.
 Sterilization in this case is not likely to work because
investors will simply absorb the increased supply of
domestic securities without depreciating the dollar.
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Nominal and Real Exchange Rates
 The real exchange rate is the exchange rate between real
units of purchasing power in two countries.
 That is, the real exchange rate is simply the nominal
exchange rate adjusted for inflation differences.
 If fundamental factors determine the real exchange rate, the
nominal exchange rate should simply reflect the real
exchange rate.
 Changes in the nominal interest rate that are caused by
changes in relative money supplies should have no impact
on the real interest rate.
 However, in practice, real and nominal exchange rates seem
to be correlated. This suggests that nominal exchange rates
affect real exchange rates.
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Dornbusch’s disequilibrium approach
to explaining exchange rate changes
 Suppose the US increases its money supply. In the long run, this will
cause US prices to be proportionately higher, and the value of the
dollar to be proportionately lower. In the short run, however, a larger
nominal money supply will mean a larger real money supply because
prices are sticky and don’t rise.
 Since this forces investors to hold more real money balances than
they desire, they will try to buy bonds to get rid of this excess cash.
This causes real US interest rates to be lower.
 Lower real interest rates will cause a more-than-proportionate drop in
the value of the dollar; i.e the dollar will drop in real terms. However,
this drop in real interest rates and the real exchange rate is temporary.
Once the price level adjusts, investors will reverse their purchases of
bonds. This will cause the real interest rate to rise, and the real
exchange rate along with it.
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The disequilibrium approach
 Along with the drop in the real interest rate, the nominal
interest rate drops as well, since price levels have not
changed.
 But why would investors be willing to hold US bonds at a
lower interest rate, relative to bonds denominated in other
assets? This can only happen if they expect the dollar to
appreciate.
 But an appreciation can occur only if the dollar initial falls
below its equilibrium real value, i.e. if it overshoots.
 Hence we have both real and nominal exchange rates
moving downwards in the beginning and then recovering,
thus causing a positive correlation between the two.
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The Disequilibrium Approach
Shapiro/Multinational Financial Management, 7e
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The Equilibrium Approach to
Exchange Rates
 The disequilibrium approach predicts that as domestic prices
rise, so should the exchange rate. This has not been
observed, in practice.
 The equilibrium approach concludes, rather, that:
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Exchange rates do not cause changes in relative prices; rather
exchange rates and relative prices are determined simultaneously.
The primary source of exchange rate changes, in practice, are not
monetary disturbances, as assumed by the disequilibrium approach,
but rather real disturbances.
Attempts by governments to affect the real exchange rate via foreign
exchange market intervention will fail; real exchange rates affect
nominal exchange rates and not vice-versa.
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The Equilibrium Approach to
Exchange Rates
 Real disturbances to supply or demand in the goods
market cause changes in relative prices, including
the real exchange rate.
 These changes in the real exchange rate often are
accomplished, in part, through changes in the
nominal exchange rate.
 Repeated shocks in supply or demand thus create a
correlation between changes in nominal and real
exchange rates.
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The Equilibrium Approach to
Exchange Rates
 Consider the following example.
 Suppose there is a fall in the demand for
domestic goods. This will cause the domestic
currency to depreciate in real terms.
 However, the currency will also depreciate in
nominal terms, as well, since there will be less
demand for the nominal currency.
 This will create a positive correlation between
real and nominal exchange rates.
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Summary
 The disequilibrium approach assumes that the central bank
can affect real exchange rates, while the equilibrium
approach assumes that real exchange rates can only be
affected by fundamentals and not by any kind of
intervention.
 If the equilibrium approach is correct, real exchange rates
should be less variable in an era of floating exchange rates;
in fact, this has not been the case.
 The real issues is not whether monetary policy has any
impact at all on real exchange rates, but whether that impact
is of first- or second-order importance.
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