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? To explain how exchange rate movements are

measured;
? To explain how the equilibrium exchange rate is
determined; and
? To examine the factors that affect the
equilibrium exchange rate.

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V ën exchange rate measures the value of one
currency in units of another currency.
V When a currency declines in value, it is said to
depreciate. When it increases in value, it is said
to appreciate.
V On the days when some currencies appreciate
while others depreciate against a particular
currency, that currency is said to be ´mixed in
trading.µ

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V The percentage change (% Æ in the value of a
foreign currency is computed as
S S
1
S
1
where S denotes the spot rate at time .
V ë positive % Æ represents appreciation of the
foreign currency, while a negative % Æ
represents depreciation.

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[ate Exchange Rate ënnual % Æ
1/1/2000 $1.001/½ ²
1/1/2001 $.94/½ ² 6.1%
1/1/2002 $.89/½ ² 5.3%
1/1/2003 $1.05/½ +18.0%
1/1/2004 $1.26/½ +20.0%
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V ën exchange rate represents the price of a

currency, which is determined by the demand
for that currency relative to the supply for that
currency.
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|alue of £

: Supply of £

$1.60
Equilibrium exchange
$1.55
rate
$1.50

[: [emand for £

Quantity of £
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V The liquidity of a currency affects the sensitivity
of the exchange rate to specific transactions.
V With many willing buyers and sellers, even large
transactions can be easily accommodated.
V Conversely, illiquid currencies tend to exhibit
more volatile exchange rate movements.

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  *
 3
 3
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ô å percentage change in the spot rate

Æc
å change in the relative inflation rate
Æc  å change in the relative interest rate
Æc  å change in the relative income level
Ƨ å change in government controls
Æm
å change in expectations of future
exchange rates
 
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Relative Inflation Rates

$/£ U.S. inflation Ý

S1
Ý U.S. demand for British
S0
r1 goods, and hence £.
r0
[1

British desire for U.S.
[0
goods, and hence the
Quantity of £ supply of £.
 
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Relative Interest Rates

$/£ U.S. interest rates Ý

S0

U.S. demand for British
S1
r0 bank deposits, and hence
r1 £.
[0
Ý British desire for U.S.
[1
bank deposits, and hence
Quantity of £ the supply of £.

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Relative Interest Rates
‡ ë relatively high interest rate may actually reflect
expectations of relatively high inflation, which
may discourage foreign investment.

‡ It is thus useful to consider the real interest

rate, which adjusts the nominal interest rate for
inflation.

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Relative Interest Rates
‡ real nominal
interest u interest ² inflation rate
rate rate
‡ This relationship is sometimes called the Fisher
effect.

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§overnment Controls
V §overnments 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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Expectations
V Foreign exchange markets react to any
news that may have a future effect.
News of a potential surge in U.S. inflation
may cause currency traders to sell dollars.
V Many institutional investors take currency
positions based on anticipated interest
rate movements in various countries.

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Expectations
‡ Economic signals that affect exchange rates can
change quickly, such that speculators may
overreact initially and then find that they have to
make a correction.

‡ Speculation on the currencies of emerging

markets can have a substantial impact on their
exchange rates.


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Trade-Related
Factors
1. Inflation U.S. demand for foreign goods, i.e.
[ifferential demand for foreign currency
2. Income
[ifferential Foreign demand for U.S. goods, i.e.
3. §ov·t Trade supply of foreign currency
Restrictions
Exchange rate
between foreign
currency and the
dollar

Financial U.S. demand for foreign securities,

Factors i.e. demand for foreign currency
1. Interest Rate
[ifferential Foreign demand for U.S. securities,
i.e. supply of foreign currency
2. Capital Flow
Restrictions
 
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Interaction of Factors
V The various factors sometimes interact and
simultaneously affect exchange rate
movements.
V For example, an increase in income levels
sometimes causes expectations of higher
interest rates, thus placing opposing pressures
on foreign currency values.

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Interaction of Factors
‡ The sensitivity of an exchange rate to the factors
is dependent on the volume of international
transactions between the two countries.

Large volume of international trade

relative inflation rates may be more influential
Large volume of capital flows interest rate
fluctuations may be more influential

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Interaction of Factors
â ën understanding of exchange rate equilibrium
does not guarantee accurate forecasts of future
exchange rates because that will depend in part
on how the factors that affect exchange rates
will change in the future.
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V Many commercial banks attempt to capitalize
on their forecasts of anticipated exchange rate
movements in the foreign exchange market.
V The potential returns from foreign currency
speculation are high for banks that have large
borrowing capacity.
V Exchange rates are very volatile, and a poor
forecast can result in a large loss.