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EXCHANGE RATE

DETERMINATION

PREPARED BY

SUKH ANGAD SINGH

10BSP1052

SECTION B

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` Measuring Exchange Rate Movements

` Exchange Rate Equilibrium Demand for a Currency

Supply of a Currency for Sale

Equilibrium

` Factors that Influence Exchange Rates Relative Inflation Rates Relative Interest Rates

Relative Income Levels

Government Controls

Expectations

Interaction of Factors How Factors Have Influenced Exchange Rates

` Speculating on Anticipated Exchange Rates

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` An exchange rate measures the value of one

currency in units of another currency.

` When a currency declines in value, it is said to

depreciate.When it increases in value, it is said toappreciate.

` On the days when some currencies appreciate

while others depreciate against the dollar, the

dollar is said to be mixed in trading.

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` The percentage change (% ( in the value of aforeign currency is computed as

St

St-1

St-1where Stdenotes the spot rate at time t.

A positive % ( represents appreciationof the foreign currency, while a negative

% ( represents depreciation.

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Value of

Quantity of

D: Demand for

$1.55

$1.50

$1.60

S: Supply of

equilibriumexchange rate

` An 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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$/

Quantity of

S0

D0

r0

U.S. inflation o o U.S. demand for

British goods, and

hence .

D1

r1

S1

Relative Inflation Rates

q British desire forU.S.goods, and hence the

supply of .

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$/

Quantity of

r0

S0

D0

S1

D1

r1

U.S. interest rates o q U.S. demand for

British bank deposits,

and hence .

Rel ti e I terestRates

o British desire forU.S.bank deposits, and

hence the supply of .

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Relative InterestRates

It is thus useful to considerreal interestrates, which adjust the nominal interest

rates for inflation.

A

relatively high interest rate mayactually reflect expectations of relatively

high inflation, which discourages foreign

investment.

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Relative InterestRates

This relationship is sometimes called

the Fisher effect.

real nominalinterest } interest inflation raterate rate

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$/

Quantity of

S0

D0

r0

U.S. income level o o U.S. demand for

British goods, and

hence .

D1

r1

Relati e I me Levels

No expected change forthe supply of .

,S1

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Govern ent Controls

` Governments 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

` Foreign exchange markets react to any news that

may have a future effect.

` Institutional investors often take currency positionsbased on anticipated interest rate movements in

various countries.

` Because of speculative transactions, foreign

exchange rates can be very volatile.

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Expectations

Signal Impact on $

PoorU.S. economic indicators Weakened

Fed chairman suggests Fed is Strengthenedunlikely to cut U.S. interest rates

A possible decline in German Strengthenedinterest rates

Central banks expected to Weakenedintervene to boost the euro

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Interaction of Factors

` Trade-related factors and financial factors

sometimes interact. Exchange rate movements

may be simultaneously affected by these factors.` For example, an increase in the level of income

sometimes causes expectations of higher interest

rates.

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Interaction of Factors

The sensitivity of the exchange rate to

these factors is dependent on thevolume of international transactions

between the two countries.

Over a particular period, different

factors may place opposing pressures

on the value of a foreign currency.

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Trade-RelatedFactors

1. InflationDifferential

2. Income

Differential3. Govt Trade

Restrictions

Financial

Factors

1. Interest RateDifferential

2. Capital Flow

Restrictions

U.S. demand for foreigngoods, i.e. demand for

foreign currency

Foreign demand forU.S.goods, i.e. supply of

foreign currency

U.S. demand for foreign

securities, i.e. demandfor foreign currency

Foreign demand forU.S.securities, i.e. supply of

foreign currency

Exchangerate

betweenforeign

currencyand thedollar

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Exchange at

$0.52/NZ$

4.Holds$20,912,320

2.HoldsNZ$40 million

Exchange at

$0.50/NZ$

Chicago Bank expects the exchange rate of the NewZealand dollar to appreciate from its present level of$0.50 to $0.52 in 30 days.

1.Borrows$20 million

Borrows at 7.20%

for 30 days

Lends at 6.48%for 30 days 3.Receives

NZ$40,216,000

Returns $20,120,000Profit of $792,320

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Chicago Bank expects the exchange rate of the NewZealand dollar to depreciate from its present level of$0.50 to $0.48 in 30 days.

Exchange at

$0.48/NZ$

4.HoldsNZ$41,900,000

2.Holds$20 million

Exchange at

$0.50/NZ$

1.BorrowsNZ$40 million

Borrows at 6.96%

for 30 days

Lends at 6.72%for 30 days 3.Receives

$20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000

or $800,640