Module 1

Session 6: Exchange Rate

Determination
Session 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
Session Objectives

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
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