1 INTERNATIONAL FINANCE Exchange Rate Determination 2 Exchange

2 Exchange Rate Determination • Measuring exchange rate movements • Always in relation to

3 Exchange Rate Determination • Measured over some period of time • Longer times

5 Exchange Rate Equilibrium • Demand for a currency • Quantity demanded increases as

9 Factors that Influence XRs • Liquidity of the currency • Illiquid market means

10 Factors that Influence XRs • Relative inflation rates • Increase in U. S.

12 Factors that Influence XRs • Relative interest rates • Increase in U. S.

14 Factors that Influence XRs • Relative income levels • Increase in U. S.

16 Factors that Influence XRs • Government Controls • Imposing FX barriers • Imposing

17 Factors that Influence XRs • Expectations vs. Changes • If FX market is

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1 INTERNATIONAL FINANCE Exchange Rate Determination

2 Exchange Rate Determination • Measuring exchange rate movements • Always in relation to another currency • Appreciate vs. depreciate • Percent Δ = St – St-1

3 Exchange Rate Determination • Measured over some period of time • Longer times → greater movements • Some currencies are more volatile than others • Example…

Exchange Rate Determination

5 Exchange Rate Equilibrium • Demand for a currency • Quantity demanded increases as price of currency decreases • Supply of a currency for sale • Quantity supplied increases as price of currency increases

Demand Schedule for Pounds

Supply Schedule for Pounds

Equilibrium Exchange Rate

9 Factors that Influence XRs • Liquidity of the currency • Illiquid market means large transactions may influence price

10 Factors that Influence XRs • Relative inflation rates • Increase in U. S. inflation • Increased demand for British goods (greater demand for pounds) • Decreased demand for U. S. goods in Great Britain (fewer pounds for sale) • Demand supply curves shift • Value of £ increases

Rising U. S. Inflation

12 Factors that Influence XRs • Relative interest rates • Increase in U. S. interest rates • Less interest in investing in G. B. (decreased demand for pounds) • Increased interest by British investors in investing in U. S. (more pounds for sale) • Demand supply curves shift • Value of £ decreases

Rising U. S. Interest Rates

14 Factors that Influence XRs • Relative income levels • Increase in U. S. income level • Increased demand for British goods (increased demand for pounds) • No change in supply of pounds for sale • Demand curve shifts • Value of £ increases

Rising U. S. Income Level

16 Factors that Influence XRs • Government Controls • Imposing FX barriers • Imposing trade barriers • Intervening in FX markets • Policies affecting inflation, interest rates and income levels

17 Factors that Influence XRs • Expectations vs. Changes • If FX market is efficient • Only unexpected changes and changes in expectations have effect • Interaction of factors • Rarely does anything happen in isolation • Levels of factor changes