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International Finance Exchange Rate Determination Bill Reese 1 Learning Objectives In this unit we will learn: 2 The factors that influence changes in exchange rates How these factors can influence the supply of and demand for a currency Exchange Rate Determination Measuring exchange rate movements 3 Always in relation to another currency Appreciate vs. depreciate Percent Δ = St – St-1 St Exchange Rate Determination Measured over some period of time 4 Longer times → greater movements Some currencies are more volatile than others Example… Exchange Rate Determination Exchange Rate Equilibrium Demand for a currency Supply of a currency for sale 6 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 Liquidity of the currency 10 Illiquid market means large transactions may influence price Factors that Influence XRs Relative inflation rates Increase in U.S. inflation Demand and supply curves shift 11 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 Relative interest rates Increase in U.S. interest rates 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) Demand and supply curves shift 13 XRs Value of £ decreases Rising U.S. Interest Rates Factors that Influence XRs Relative income levels Increase in U.S. income level Demand curve shifts 15 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 Government Controls 17 Imposing FX barriers Imposing trade barriers Intervening in FX markets Policies affecting inflation, interest rates and income levels Factors that Influence XRs Expectations vs. Changes If FX market is efficient Interaction of factors 18 Only unexpected changes and changes in expectations have effect Rarely does anything happen in isolation Levels of factor changes