Wk2 DQ1

Discussion Question 1

Discuss how the equilibrium exchange rate is determined and, what factors effect it. Please

provide an example of how to measure the movement of this exchange rate.

Just like we sell some product in market, the equilibrium exchange rate of currency is

determined by demand for that currency relative to supply[ CITATION Cui13 \l 1033 ]. For

example,

If US business became relatively more competitive, then the chances of demand for American

goods is greater; such increase in demand for US goods would cause an appreciation or increase

in value of the dollar.

On the other hands, if markets were worried about the future of the US economy, then the

investors would tend to sell dollars, that lead to a fall in the value of the dollar.

Determination of exchange rates using supply and demand diagram

Pound to US $

In this example, a rise in demand for pound sterling has led to an increase in the value of the

pound to US $ from 1 to $1.5 to 1 = $1.70.

Factors that affects equilibrium rate

The equilibrium exchange rate will change over time as supply and demand schedules

changes[ CITATION Jef08 \l 1033 ]. The factors that promote for equilibrium exchange rate are

as follows:-

Relative Inflation rate

Due to change in relative inflation rate, the international trade activity will suffer and influences

the demand and supply of currencies for establishing new equilibrium exchange rate. If British

inflations rate increased rather than U.S. inflation, the opposite forces would occur.

Relative Interest Rates

The changes in relative interest rates brings changes for investment in foreign securities that

influences the demand for and supply of currencies and develop new exchange rates. For

examples, let assume U.S. interest rate rise while British interest rates remain constant. In such

situation, U.S. investors will likely to reduce their demand for pounds, since U.S. rate are now

more attractive as compare to British rates and less hope to deposits cash in British bank.
In the figure, due to this, US rate will now loo more attractive to British investors with excess

cash and the supply of pounds for sale by British investors will increase as the investors will save

cash in the United States. So, an inward shift in the demand for pounds and an outward shift for

the supply of pounds for sale and create decrease for equilibrium exchange rate of pounds.

Real Interest Rates

We have no doubt that a relative high interest rate will attract foreign inflows to invest in

securities offering high yields. On the other hands, it also may rise the inflation. Due to

inflation, it will decrease the value of local currency to purchase goods or services. Therefore,

the foreign investors may less interest for investing in securities denominated in that currency.

And we use real interest rate to adjusts the nominal interest for inflation.
As investors take accounts of real interest rate, the value they can use will decrease. Also, the

new exchange rate will shift downward for supply and increase demand and shift it in the left

side.

Government Control

The governments of foreign countries also control the equilibrium exchanges rate via

various method. They can impose foreign exchange barriers, foreign trade barriers, intervene in

foreign exchange market for buy and sell of currencies and focus to maintain macro variables

such as inflation, interest rate, and income levels.

Speculation

As speculators believe sterling pound rise in the future, they will demand more today to make

profit. Due to this, increase in demand for pound, the value of pound will rise as compare to US
dollars. So, the movements in the exchange rate do not reflect economic fundamental but also

traced by the sentiments of the financial market.

Examples that measure the movement of equilibrium exchange rate

The prices of Nepalese rupees with India raw and US dollars. The percentage change in the value

of foreign currency is computed as,

Percent change in foreign currency value = (S- St 1)/ St 1 where S is denoted as spot rate at

recent date and St 1 is denoted as spot rate at the previous date.

Value of Euro Monthly % Value of US Monthly %

change in Euro dollar change in dollar
Jan. 1 115.12 0 109.05 0
Feb. 1 117.58 2.14% 108.55 -0.46%
March 1 113.59 -3.39% 107.20 -1.24%
April 1 111.19 -2.11% 104.05 -2.94%
May 1 112.76 1.41% 102.95 -1.06%
June 1 116.7 3.49% 103.4 0.44%
July 1 118.82 1.82% 103.65 0.24%
Standard
deviation of
monthly changes 2.46% 1.17%
Sources:[ CITATION For161 \l 1033 ]

References

Cui, Y. (2013). How is the RMB exchange rate misaligned? A recent application of behavioral

equilibrium exchange rate (beer) to china. Journal of East Asian Economic Intergration,

17(3), 281-310.

Foreign Exchange Rates. (2016, July 14). Retrieved from Nepal Rastra bank:

https://nrb.org.np/detailexchrate.php?

YY=2017&MM=01&DD=14&YY1=2017&MM1=07&DD1=14

Madura, J. (2008). International Financial Management. Thomson.

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