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International Finance

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  1. International Finance Exchange Rate Determination Bill Reese

  2. Learning Objectives • In this unit we will learn: • The factors that influence changes in exchange rates • How these factors can influence the supply of and demand for a currency

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

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

  5. Exchange Rate Determination

  6. 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

  7. Demand Schedule for Pounds

  8. Supply Schedule for Pounds

  9. Equilibrium Exchange Rate

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

  11. 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 Britian (fewer pounds for sale) • Demand and supply curves shift • Value of £ increases

  12. Rising U.S. Inflation

  13. 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 and supply curves shift • Value of £ decreases

  14. Rising U.S. Interest Rates

  15. 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

  16. Rising U.S. Income Level

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

  18. 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