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Exchange Rate Determination. International Finance (MB 74). Outline. Defining Exchange Rate Measuring Exchange Rate Movements Appreciation/Depreciation of a currency Exchange Rate Equilibrium Factors that influence Exchange Rate Movements.

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exchange rate determination

Exchange Rate Determination

International Finance (MB 74)

outline
Outline
  • Defining Exchange Rate
  • Measuring Exchange Rate Movements
    • Appreciation/Depreciation of a currency
  • Exchange Rate Equilibrium
  • Factors that influence Exchange Rate Movements
meaning of exchange rate and measuring changes in exchange rates
Meaning of Exchange Rate and Measuring Changes in Exchange Rates
  • Value of one currency in units of another currency
  • A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation.
  • If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated
  • If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated
appreciation depreciation
Appreciation/Depreciation
  • Percentage change in value US $

New Value of Foreign Currency

per unit of $ - Old value of foreign currency per $

-------------------------------------------------- X 100

Old value of Foreign Currency per $

  • Percentage change in value of Foreign Currency

New Value of $ per units of

Foreign Currency - Old value of $ per unit of foreign currency

-------------------------------------------------- X 100

Old value of $ per unit of Foreign Currency

exchange rate equilibrium
Exchange Rate Equilibrium
  • Forces of Demand and Supply
  • Demand for foreign currency negatively related to the price of foreign currency
  • Supply of foreign currency positively related to the price of foreign currency
  • Forces of demand and supply together determine the exchange rate
demand for foreign currency
Demand for Foreign Currency

Price for Foreign Currency

D

$2.00

$1.50

D

75 m

50m

Units of Foreign Currency (£)

supply of foreign currency
Supply of Foreign Currency

Supply for Foreign Currency

S

$2.00

$1.50

S

Units of Foreign Currency (£)

50 m

75 m

equilibrium exchange rate
Equilibrium Exchange Rate

Exchange Rate

D

S

$1.6775

S

D

Units of Foreign

Currency(£)

factors that influence the exchange rate
Factors that influence the Exchange Rate
  • Expectations of the Market
  • Political Events
  • Relative Inflation Rates
  • Relative Interest Rates
  • Relative Income Levels

Exchange rate is the results of an interaction of these factors

market expectations
Market Expectations
  • Expectations about future exchange rate changes on the basis of current and future political and economic conditions
  • 1960s Strong $
  • Between 1960s and 1970s: weak $
  • Strong $ in 1999 – 2001
  • Weak Dollar today 2005
  • 1995 European Exchange Rate Mechanism
  • Devaluation of Asian Currencies
political events
Political Events
  • Fall of Berlin Wall and unification of East and West Germany
  • Rumors about resignation of Mikhail Gorbachov
  • Tiannanmon Square
  • Persian Gulf War
  • September 11, 2001
relative inflation
Relative Inflation
  • High inflation relative to a foreign country, decline in value of currency—Why?
  • Low inflation relative to a foreign country, increase in value of currency—Why?
relative interest rates
Relative Interest Rates
  • High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?
relative income levels
Relative Income Levels
  • Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?
exchange rate determination15
Exchange Rate Determination
  • An interaction of factors
  • Is it possible for a country with high real returns to have a low currency value?
  • Is it possible for a country with low real returns to have a high currency value?