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International Finance
Exchange Rate Determination
Bill Reese
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Learning Objectives
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In this unit we will learn:
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The factors that influence changes in exchange
rates
How these factors can influence the supply of and
demand for a currency
Exchange Rate Determination
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Measuring exchange rate movements
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Always in relation to another currency
Appreciate vs. depreciate
Percent Δ = St – St-1
St
Exchange Rate Determination
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Measured over some period of time
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Longer times → greater movements
Some currencies are more volatile than others
Example…
Exchange Rate Determination
Exchange Rate Equilibrium
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Demand for a currency
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Supply of a currency for sale
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Quantity demanded increases as price of
currency decreases
Quantity supplied increases as price of currency
increases
Demand Schedule for Pounds
Supply Schedule for Pounds
Equilibrium Exchange Rate
Factors that Influence XRs
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Liquidity of the currency
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Illiquid market means large transactions may
influence price
Factors that Influence XRs
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Relative inflation rates
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Increase in U.S. inflation
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Demand and supply curves shift
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Increased demand for British goods (greater demand for
pounds)
Decreased demand for U.S. goods in Great Britian
(fewer pounds for sale)
Value of £ increases
Rising U.S. Inflation
Factors that Influence XRs
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Relative interest rates
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Increase in U.S. interest rates
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Demand and supply curves shift
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Less interest in investing in G.B. (decreased demand for pounds)
Increased interest by British investors in investing in U.S. (more
pounds for sale)
Value of £ decreases
Rising U.S. Interest Rates
Factors that Influence XRs
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Relative income levels
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Increase in U.S. income level
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Demand curve shifts
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Increased demand for British goods (increased demand
for pounds)
No change in supply of pounds for sale
Value of £ increases
Rising U.S. Income Level
Factors that Influence XRs
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Government Controls
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Imposing FX barriers
Imposing trade barriers
Intervening in FX markets
Policies affecting inflation, interest rates and
income levels
Factors that Influence XRs
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Expectations vs. Changes
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If FX market is efficient
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Interaction of factors
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Only unexpected changes and changes in expectations
have effect
Rarely does anything happen in isolation
Levels of factor changes