Lecture No 16

Exchange Rate Determination

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 Chapter Outline

• Measuring exchange rate movements

• Exchange rate equilibrium
• Factors affecting exchange rates
• Movements in cross exchange rates
• Capitalizing on expected exchange rate
movements

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 Lecture Outline
• Factors affecting exchange rates
¤ Relative Inflation
¤ Relative Interest Rates
¤ Relative Income Level
¤ Government Controls
¤ Expectations
 Interaction of Factors
 Influence of Factors across Multiple Currency
Markets
 Impact of Liquidity on Exchange Rate
Adjustments
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 Factors that Influence
Exchange Rates
• Factors affecting exchange rates
e = f(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP), where
e = percentage change in spot rate
ΔINF = change in the differential between a country’s
inflation (e.g. US) and a foreign country’s inflation
ΔINT = change in the differential between the U.S. interest
rate and the foreign country’s interest rate
ΔINC = change in the differential between the U.S. income
level and the foreign country’s income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
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 Factors that Influence
Exchange Rates
Relative Inflation Rates
U.S. inflation 
$/£ S1   U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.

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 Factors that Influence
Exchange Rates
Relative Interest Rates
U.S. interest rates 
$/£ S0   U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0   British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.

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 Factors that Influence
Exchange Rates
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which discourages foreign
investment.
• It is thus useful to consider real interest
rates, which adjust the nominal interest
rates for inflation.

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 Factors that Influence
Exchange Rates
Relative Interest Rates
• real nominal
interest  interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.

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 Factors that Influence
Exchange Rates
Relative Income Levels

$/£ U.S. income level 

  U.S. demand for
S0
British goods, and
r1
r0 hence £.
D1  No expected change for
D0
the supply of £.
Quantity of £

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 Factors that Influence
Exchange Rates
Relative Income Levels – No or Opposite Effect

$/£ U.S. income level 

S0   U.S. demand for
S1 British goods, and
rr10 hence £.
D1
 The supply of £ may
D0
however, increase due to
Quantity of £
British DFI and portfolio
investment in US .
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 Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the
equilibrium exchange rate by:
¤ imposing foreign exchange barriers,
¤ imposing foreign trade barriers,
¤ intervening in the foreign exchange market,
and
¤ affecting macro variables such as inflation,
interest rates, and income levels.
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 Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any
news that may have a future effect.
• Institutional investors often take currency
positions based on anticipated interest rate
movements in various countries.
• Because of speculative transactions,
foreign exchange rates can be very volatile
both in developed and emerging markets.
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 Factors that Influence
Exchange Rates
Expectations
Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
likely to raise U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
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 Factors that Influence
Exchange Rates
Currency Crisis and its Impact
• Currency Crisis is a sharp decline in a
currency’s value against foreign currencies
• In Feb, 2014, Argentina, India, and Turkey faced
currency crisis mainly due to uncertainty about
political and economic future.
• The politico-economic uncertainty leads to loss
of local and foreign investor confidence further
worsening the crisis.
• Speculators may intentionally try to capitalize on
a currency crisis by borrowing it.
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 Factors that Influence
Exchange Rates
Interaction of Factors
• Trade-related factors and financial factors
sometimes interact. Exchange rate
movements may be simultaneously
affected by these factors.
• For example, an increase in the level of
income sometimes causes expectations of
higher interest rates.

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 Factors that Influence
Exchange Rates
Interaction of Factors
• Over a particular period, different factors
may place opposing pressures on the
value of a foreign currency.
• The sensitivity of the exchange rate to
these factors is dependent on the volume
of international transactions between the
two countries (e.g trade vs portfolio flows).

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 How Factors Can Affect Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial Factors U.S. demand for foreign currency
1. Interest Rate securities, i.e. demand and the
Differential for foreign currency dollar
2. Capital Flow
Restrictions Foreign demand for U.S.
3. Exchange Rate securities, i.e. supply of
Expectations foreign currency
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 Factors that Influence
Exchange Rates
Influence of Factors across Multiple Currency
Markets
• Each exchange rate has its own market,
meaning its own demand and supply
conditions (C$, €, £, etc.).
• In some periods, other currencies and $
move together because of a particular
underlying factor in US having similar
impact on the demand and supply (e.g. low
relative US interest rate)
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 Factors that Influence
Exchange Rates
Impact of Liquidity on Exchange Rate
Adjustments
• The liquidity of a currency affects the
exchange rate’s sensitivity to specific
transactions – the greater the liquidity, the
lesser the volatility
• Exchange rate of currency’s with liquid
spot market are less sensitive to a single
large purchase or sale due to presence of a
large number of buyers and sellers
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