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Exchange Rate Determination
Bill Reese
International Finance
1
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
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Exchange Rate Determination
Measuring exchange rate movements Always in relation to another currency Appreciate vs. depreciate Percent Δ = St – St-1
St-1
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Exchange Rate Determination
Measured over some period of time Longer times → greater movements Some currencies are more volatile than others Example…
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Exchange Rate Determination
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
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Demand Schedule for Pounds
Supply Schedule for Pounds
Equilibrium Exchange Rate
Factors that Influence XRs
Liquidity of the currency Illiquid market means large transactions may
influence price
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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
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Rising U.S. Inflation
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
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Rising U.S. Interest Rates
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
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Rising U.S. Income Level
Factors that Influence XRs
Government Controls Imposing FX barriers Imposing trade barriers Intervening in FX markets Policies affecting inflation, interest rates and
income levels
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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
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