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CHAPTER 4
Exchange Rate Determination
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
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
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
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
Demand Schedule for British Pounds
Exhibit 4.2 page 87
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
Supply Schedule of British Pounds for Sale
Exhibit 4.3 page 88
B. Exchange Rate Equilibrium
3. Equilibrium
Equilibrium Exchange Rate Determination
Exhibit 4.4 page 89
C. Factors That Influence
Exchange Rates
1. Relative Inflation Rates
2. Relative Interest Rates
a. Real Interest Rates
3. Relative Income Levels
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.
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
2. Interaction of Factors
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