CHAPTER 4
Exchange Rate Determination
A. Measuring Exchange Rate Movements
B. Exchange Rate Equilibrium
C. Factors That Influence Exchange
Rates
D. Government Controls
E. Expectations
F. Supplemental factors
G. Speculating on Anticipated Exchange
Rates
Chapter Overview
This chapter will:
A. Explain how exchange rate movements
are measured
B. Explain how the equilibrium
exchange rate is determined
C. Examine factors that determine the
equilibrium exchange rate
Chapter 4 Objectives

Geographical extent of the foreign exchange
market
◦ Major world trading starts in Sydney, Tokyo, move
west to Hong Kong and Singapore, passes on to
Bahrain, then shifts to Frankfurt, Zurich, London,
then to NYC and Chicago and ends in San Francisco
and LA.
Geographical extent of the foreign exchange market

Foreign exchange dealer’s day (in Europe):
◦ Trading activities in the past few hours in NYC and
far east.
◦ New economic and political development.
◦ The bank’s own exchange position.
Foreign Exchange Market
Continuous operation: 24 hours a day except weekends.
low margins of relative profit compared with other markets of
fixed income.
 Use of leverage to enhance profit margins with respect to account
size
 Average daily turnover in global foreign exchange markets is
estimated at $3.98 trillion.
 Trading in the world's main financial markets accounted for $3.21
trillion of this. This approximately $3.21 trillion in main foreign
exchange market turnover was broken down as follows:
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◦
◦
◦
◦
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$1.005 trillion in spot transactions
$362 billion in forwards.
$1.714 trillion in foreign exchange swaps.
$129 billion estimated gaps in reporting
On the spot market, the most heavily traded products were:
◦ EURUSD: 27%
◦ USDJPY: 13%
◦ GBPUSD (also called cable): 12%
Foreign Exchange Market
Most traded currency

A foreign exchange rate is the price of one
currency expressed in terms of another
currency.

Direct quote: is a home currency price of a
unit of foreign currency, e.g. SF1.60/$.
◦ SF1.60/$ read as “1.60 Swiss francs per dollar”.
◦ $1000 is equivalent to $1000*SF1.60/$=$1600

Indirect quote: is a foreign currency price of
a unit of home currency, e.g. $0.63/SF.
◦ $0.63/SF read as “$0.63 per Swiss francs”.
◦ $1000is equivalent to $1000 / ($0.63/SF)=$1600.
More discussion about exchange
rate
1. Basic Movements in Rates
-when one currency depreciates against
another, the other must appreciate.
Let St-1 = the original rate
S = the current rate
Percent Δ in foreign currency value =(S- St-1)/St-1
a. Appreciation: increase in currency value.
b. Depreciation: decrease in currency value.
Quiz: $1.5/€$1.6/€. Is it appreciated or
depreciated to $, and to €?
A. Measuring Exchange Rate
Movements
How exchange rates reach equilibrium?
1. Demand for a Currency
a. derived from the local buyers who are willing and
able to purchase foreign goods but who must
convert their local currencies, such as,
i. foreign country’s (GB) interest rate is high
ii. Home country’s inflation (US) is high  domestic
products’ prices (US) increase.
iii. Residents (US) get richer.
b. An indirect relationship exists between the
cost of foreign currency and amount
demanded
 When foreign currency (GBP) gets cheaper, the demand
for it is higher.
c. Graphically, a downward-sloping demand
curve
B. Exchange Rate Equilibrium
Demand Schedule for British Pounds
Exhibit 4.2 page 87
2. Supply of a Currency for Sale
a. derived from the foreigners who are willing
and able to supply foreign currency that
must be converted first in order to
purchase local goods.
i. foreign country’s interest rate (US) is high
ii. Home country’s inflation (GB) is high  domestic
products’ prices increase.
iii. Residents (GB) get richer.
b. A direct relationship exists between
cost of the foreign currency and the
amount supplied.
c. Graphically, an upward-sloping supply
curve
B. Exchange Rate Equilibrium
Supply Schedule of British Pounds for Sale
Exhibit 4.3 page 88
3. Equilibrium
Supply of a currency = Demand of a
currency.
What will happen, if supply is greater than
demand? And vice versa?
B. Exchange Rate Equilibrium
Equilibrium Exchange Rate Determination
Exhibit 4.4 page 89
e=f(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP) – p89.
ΔINF: inflation differentials between two countries.
ΔINT: interest rate differentials.
ΔINC: income level differentials.
ΔGC: change in government controls.
ΔEXP: change in expectations of future exchange rate.
1. Relative Inflation Rates
2. Relative Interest Rates
a. Real Interest Rates
3. Relative Income Levels
C. Factors That Influence
Exchange Rates
1.
Relative Inflation Rates

As a rule of thumb, a country with a consistently lower
inflation rate exhibits a rising currency value, as its
purchasing power increases relative to other currencies.

Inflation is defined as the rate (%) at which the general
price level of goods and services is rising, causing
purchasing power to fall.
Inflation occurs when most prices are rising by some
degree across the whole economy.
Countries with low inflation in the past decades: Japan,
Germany, Switzerland, U.S. and Canada.
Countries with higher inflation in the past: Mexico, Brazil,
Russia, and many more. Those countries typically see
depreciation in their currency in relation to the currencies
of their trading partners. This is also usually accompanied
by higher interest rate.



C. Factors That Influence
Exchange Rates
1. Relative
inflation Rate
When US’ inflation increases, while GB’s does not, then the demand
of £ increases and the supply of £ decreases. The new £ price at
equilibrium is $1.70/£.
a. US inflation increases  domestic products’ prices increase
demand of GB’s products increases  demand of £ increases 
demand line shifts outward.
b. US inflation increases  GB’s demand of US products decrease 
GB’s supply of £ decreases  supply line shift upward.
c. The new set of supply and demand lines cross at new equilibrium.
d. £ appreciate and $ depreciate.
Discussion: When GB’s inflation increases, what will happen?
C. Factors That Influence Exchange Rates
2. Relative Interest Rates
When US’ interest rate increases,
while GB’s does not, then the
demand of £ decreases and the
supply of £ increases. The new £
price at equilibrium is $1.45/£.
a. US interest rate increases 
Saving in $ increases  Saving in
£ decreases  demand of £
decreases  demand line shifts
inward.
b. US interest rate increases  GB’s
c. The new set of supply and
saving in $ increases  demand of
demand lines cross at
$ increase  GB’s supply of £
new equilibrium. This is
increases  supply line shift
the new currency price.
downward.
d. £ depreciate and $
appreciate.
Discussion: When GB’s interest rate increases, what will
happen?
C. Factors That Influence Exchange Rates
2-a. Real Interest Rates
1. We should consider real interest rates, not
nominal interest rate.
2. Fisher effect:
real interest rate = nominal interest rate –
inflation
i. Higher interest rates attract foreign capital
and cause the exchange rate to rise.
ii. The impact of higher interest rates is
mitigated, however, if inflation in the
country is much higher than in others.
C. Factors That Influence Exchange Rates
3. Relative Income Level
When US’ income level increases,
while GB’s does not, then the
demand of £ increases and the
supply of £ is unchanged. The new £
price at equilibrium is $1.60/£.
a. US income increases  demand of
foreign products increases
demand of £ increases 
demand line shifts outward.
b. US income increases  GB is
unaffected  GB’s supply of £ is
unaffected  supply line is
unaffected.
c. The new set of supply and
demand lines cross at
new equilibrium. This is
the new currency price.
d. £ appreciate and $
depreciate (surprising?)
Discussion: When GB’s income level increases, what will
happen?
C. Factors That Influence Exchange Rates
Governments influence the equilibrium exchange
rate in many ways, including
1. imposing foreign exchange barriers,
2. imposing foreign trade barriers,
3. intervening (buying and selling
currencies) in the foreign exchange
markets,
4. affecting macro variables such as
inflation, interest rates, and income levels.
D. Government Controls (chapter 6)
1. The Role of Information
a. Impact of Signals on Currency
Speculation
1.) commonly driven by signals of
future interest rate movements
2.) by other factors such as
signals of the future economic
conditions that affect exchange
rates
E. Expectations

Current-account deficits
◦ Current account is the balance of trade between a
country and its trading partners, reflecting all payments
between countries for goods, services, interest and
dividends.
◦ Current account deficit shows the country is spending
more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the
deficit.
◦ The country requires more foreign currency than it
receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its
products.
◦ The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and
services are cheap enough for foreigners, and foreign
assets are too expensive to generate sales for domestic
interests.
F – Supplemental factors

Public debt:
◦ Countries will engage in large-scale deficit financing
to pay for public sector projects and governmental
funding.
◦ While such activity stimulates the domestic
economy, nations with large public deficits and
debts are less attractive to foreign investors.
◦ The reason? A large debt encourages inflation, and
if inflation is high, the debt will ultimately be paid
off with cheaper real dollars in the future.
◦ In the worst case scenario, a government may print
money to pay part of a large debt, but increasing
the money supply inevitably causes inflation.
F – Supplemental factors

Political stability and economic
performance:
◦ Foreign investors inevitably seek out stable
countries with strong economic performance in
which to invest their capital.
◦ A country with such positive attributes will draw
investment funds away from other countries
perceived to have more political and economic risk.
◦ Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital
to the currencies of more stable countries.
F – Supplemental factors
2. Interaction of Factors
Many commercial banks attempt to
capitalize on their forecasts of
anticipated exchange rate movements
in the foreign exchange market
F. Speculating on Anticipated
Exchange Rates
Chicago bank expects the exchange rate
of the NZ$ to appreciate from $0.50 to
$0.52 in 30 days.
 Chicago bank can borrow $20m on a short
term basis.


Currency
$
NZ$
Lending Rate
Borrowing rate
6.72%
6.48%
7.20%
6.96%
Question 1: If Chicago bank anticipate NZ$ to appreciate, how shall it
trade?
Question 2: If Chicago bank anticipate NZ$ to depreciate, how shall it
trade?
Example on page 95

Answer:
◦ NZ$ will appreciate, so you should buy NZ$ now
and sell later. Borrow $ convert to NZ$ today 
lend it for 30 days  convert to $ 30 days later
payback the $ loan.
◦ Convert the borrowed $ to NZ$ today. So your NZ$
worth: $20m / 0.50 $/NZ$=40m NZ$.
◦ Lend NZ$ for 6.48% * 30/360=0.54% and get
40m NZ$ *(1+0.54%)=40,216,000 NZ$ 30 days later.
◦ Your borrowed $20m should be paid back for
20m *(1+7.2%* 30/360)=$20.12m. This equals to $20.12m
/ 0.52 $/NZ$=NZ$ 38,692,308.
◦ So the profit is:
40,206000-38,692,308 = NZ$1,523,692.
Your $ profit is: NZ$1,523,692 *0.52$/NZ$=$792,320.

Homework (page 98 – 100)
Questions 1,2,3,4,6,7,9,10, 12,
13,15,16,20, 23.

20. Speculation. Blue Demon Bank expects that the
Mexican peso will depreciate against the dollar from its
spot rate of $.15 to $.14 in 10 days. The following
interbank lending and borrowing rates exist:
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Lending Rate
U.S. dollar
8.0% 8.3%
Mexican peso 8.5% 8.7%
Borrowing Rate
Assume that Blue Demon Bank has a borrowing
capacity of either $10 million or 70 million pesos in the
interbank market, depending on which currency it wants to
borrow.


a.
How could Blue Demon Bank attempt to
capitalize on its expectations without using deposited
funds? Estimate the profits that could be generated from
this strategy.

b. Assume all the preceding information
with this exception: Blue Demon Bank
expects the peso to appreciate from its
present spot rate of $.15 to $.17 in 30
days. How could it attempt to capitalize
on its expectations without using
deposited funds? Estimate the profits that
could be generated from this strategy.

21. Speculation. Diamond Bank expects that
the Singapore dollar will depreciate against the
dollar from its spot rate of $.43 to $.42 in 60
days. The following interbank lending and
borrowing rates exist:




Lending Rate
Borrowing Rate
U.S. dollar
7.0%
7.2%
Singapore dollar
22.0%
24.0%


Diamond Bank considers borrowing 10 million
Singapore dollars in the interbank market and
investing the funds in dollars for 60 days.
Estimate the profits (or losses) that could be
earned from this strategy. Should Diamond Bank
pursue this strategy?


Q23: Assessing the Euro’s Potential Movements. You
reside in the U.S. and are planning to make a one-year
investment in Germany during the next year. Since the
investment is denominated in euros, you want to forecast
how the euro’s value may change against the dollar over
the one-year period. You expect that Germany will
experience an inflation rate of 1% during the next year,
while all other European countries will experience an
inflation rate of 8% over the next year. You expect that the
U.S. will experience an annual inflation rate of 2% during
the next year. You believe that the primary factor that
affects any exchange rate is the inflation rate. Based on
the information provided in this question, will the euro
appreciate, depreciate, or stay at about the same level
against the dollar over the next year? Explain.

24. Weighing Factors That Affect Exchange Rates.
Assume that the level of capital flows between the U.S. and
the country of Zeus is negligible (close to zero) and will
continue to be negligible. There is a substantial amount of
trade between the U.S. and the country of Zeus. The main
import by the U.S. is basic clothing purchased by U.S.
retail stores from Zeus, while the main import by Zeus is
special computer chips that are only made in the U.S. and
are needed by many manufacturers in Zeus. Suddenly, the
U.S. government decides to impose a 20% tax on the
clothing imports. The Zeus government immediately
retaliates by imposing a 20% tax on the computer chip
imports. Second, the Zeus government immediately
imposes a 60% tax on any interest income that would be
earned by Zeus investors if they buy U.S. securities. Third,
the Zeus central bank raises its local interest rates so that
they are now higher than interest rates in the U.S. Do you
think the currency of Zeus (called the zee) will appreciate
or depreciate against the dollar as a result of all the
government actions described above? Explain.
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
16. Impact of September 11. The
terrorist attacks on the U.S. on
September 11, 2001 were expected to
weaken U.S. economic conditions, and
reduce U.S. interest rates. How do you
think the weaker U.S. economic conditions
would affect trade flows? How would this
have affected the value of the dollar
(holding other factors constant)? How do
you think the lower U.S. interest rates
would have affected the value of the U.S.
dollar (holding other factors constant)?
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15.Impact of Crises. Why do you think
most crises in countries (such as the
Asian crisis) cause the local currency to
weaken abruptly? Is it because of trade or
capital flows?