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Exchange Rate Determination

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  1. Exchange Rate Determination International Business (MB 40)

  2. Outline • Defining Exchange Rate • Measuring Exchange Rate Movements • Appreciation/Depreciation of a currency • Exchange Rate Equilibrium • Factors that influence Exchange Rate Movements

  3. 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

  4. 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

  5. Factors that influence the Exchange Rate • Political Events • Expectations of the Market • Relative Inflation Rates • Relative Interest Rates • Relative Income Levels Exchange rate is the results of an interaction of these factors

  6. 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

  7. 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 $ now • 1995 European Exchange Rate Mechanism • Devaluation of Asian Currencies

  8. 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?

  9. Relative Interest Rates • High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

  10. Relative Income Levels • Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

  11. Exchange Rate Determination • An interaction of factors • Is it possible for a country with high real returns to have a low currency value?