Chapter 2

The Determination of
Exchange Rates
 Part I.
Equilibrium Exchange Rates
I. SETTING THE EQUILIBRIUM
A. The exchange rate
is the price of one unit of foreign currency
expressed as a certain price in local
currency.
For example $.99/€ means the euro in the
U.S. is worth $.99.
 Equilibrium Exchange Rates

B. How Do Americans Purchase

German Goods?
1. Foreign Currency Demand:
-derived from the demand for foreign country’s
goods, services, and financial assets.

e.g. Americans demand German goods such as

Mercedes autos
 The Demand for € in the U.S.
$/€

D
$1.20/ €

$1.10/ €
$1.00/ €
Qty
At higher exchange rates, Americans demand
less euros and vice versa.
Equilibrium Exchange Rates

2. Foreign Currency Supply:

- derived from the foreign country’s
demand for local goods.
- Foreign buyers must convert their
currency in order to purchase.
e.g. German demand for US goods
such as Dell computers means
Germans must convert euros
to US $ in order to buy.
 The Supply of € in the U.S.
$/ €

$1.20/€
S
$1.10/€
$1.00/€
Qty
At higher exchange rates, Germans supply
more euros and vice versa.
Equilibrium Exchange Rates

3. Equilibrium Exchange Rate

occurs where the quantity
supplied equals the quantity
demanded of a foreign currency
at a specific local price.
 The $/ € Equilibrium Rate
$/ €
Equilibrium
D

S
$1.10

Qty
 Equilibrium Exchange Rates
C. How Exchange Rates Change
1. Increased demand
as more foreign goods are demanded,
more of the foreign currency is demand at
each possible exchange rate

2. The price of the foreign currency in

local currency increases.
Equilibrium Exchange Rates
3. Home Currency Depreciation
a. Foreign currency more
valuable than the home
currency.
b. Conversely, then the foreign
currency’s value has
appreciated against the
home currency.
 The US$ Depreciates When
$/ € D’
D
$1.20/ €
S

$1.10/ €

Q1 Q2 Qty
 Equilibrium Exchange Rates
D. Computing a Currency
Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value
Equilibrium Exchange Rates

EXAMPLE: € Appreciation
If the dollar value of the € goes from
$1.10 (e0) to $1.20 (e1), then the € has
appreciated by

(1.20 - 1.10)/ 1.10 = 9.1%

 Equilibrium Exchange Rates

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value
Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

Use the formula

(e0 - e1)/ e1
substituting
(1.10 – 1.20)/1.20 = - 8.3%
is the US$ depreciation.
Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
4. Expectations
 Sample Problem
Suppose the U.S. dollar appreciates
against the Russian ruble by 500%.
How much did the ruble depreciate
against the dollar?
 Sample Problem

Depreciation of the ruble:

(e0  e1 )
x
e1
e1 e0
 5
e0 e0

Sample Problem

e1 e0
 5
e0 e0
e1
11  5 1
e0
e1  6e0
(e0  e1 )
 x
e1
e0  6e0
 x
6e0
5
 x
6
x  83%