Determination of Exchange
Rates
International Finance
Dr. A. DeMaskey
1
Learning Objectives
How are exchange rate movements
measured?
 How is the equilibrium exchange rate
determined?
 What factors affect the equilibrium exchange
rate?
 How do central banks intervene in the foreign
exchange market?
 How do expectations affect exchange rates?

2
Measuring Exchange Rate
Movements
 Appreciation
 Depreciation
 Percent
Change in the Foreign
Currency Value
 Percent Change in the Home
Currency Value
3
Exchange Rate Equilibrium
 Demand
 Supply
 Equilibrium
Exchange Rate
4
Equilibrium Exchange Rate
Dollar Value of £
S£
$1.50
D£
Quantity of £
5
Macro-Economic Factors
Influencing Exchange Rates
 Relative
Inflation Rates
 Relative
Interest Rates
 Relative
Income Levels
6
Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound
Dollar Value of £
S£
$1.50
D£
Quantity of £
7
Impact of Rising U.S. Interest Rates on
the Equilibrium Value of the British Pound
Dollar Value of £
S£
$1.50
D£
Quantity of £
8
Impact of Rising U.S. Income on the
Equilibrium Value of the British Pound
Dollar Value of £
S£
$1.50
D£
Quantity of £
9
Government Controls
 Foreign
Exchange Barriers
 Foreign Trade Barriers
 Government Intervention in Foreign
Exchange Market
 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
positions based on anticipated interest rate
movements in various countries.
 Because of speculative transactions, foreign
exchange rates can be very volatile.

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Role of Expectations
Signal
Impact on $
Poor U.S. economic indicators
Fed chairman suggests Fed is
unlikely to cut U.S. interest rates
A possible decline in German
interest rates
Central banks expected to
intervene to boost the euro
12
Interaction of Factors
 Trade-Related
Factors
 Financial Factors
 Trade-related factors and financial
factors sometimes interact.
13
Factors Affecting Exchange
Rates
Inflation Differential
U.S. Demand
For Foreign Goods
U.S. Demand
For FC
Foreign Demand
For U.S. Goods
Supply of FC
For Sale
Income Differential
Gov’t Trade Restrictions
Interest Rate Differential
Capital Flow Restrictions
U.S. Demand
For Foreign
Securities
U.S. Demand
For FC
Foreign Demand
For U.S. Securities
Supply of FC
For Sale
Exchange Rate
Between the
Foreign Currency
And the Dollar
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Government Intervention
 Reasons
 Direct
Sterilized
 Non-Sterilized

 Indirect
Government Policy
 Government Barriers

15
Central Bank Intervention
Nonsterilized Intervention
To Strengthen the C$
Federal Reserve
$
C$
Banks Participating
In the Foreign
Exchange Market
Sterilized Intervention
To Strengthen the C$
Federal Reserve
$
Treasury Securities
C$
Banks Participating
In the Foreign
Exchange Market
$
Financial
Institutions
That Invest
In Treasury
Securities
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Effect of Expectations
 Currency values are determined
 Inflation
 Interest rates
 Economic and political stability
 GDP growth
 Reputation of central bank
by:
 In
reality, however, exchange rates are
affected by expectations of these
variables.
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Asset-Market Model
 Currencies behave like other financial assets:
 A nation’s currency can be thought of an asset whose
value is determined by the (expected) economic
performance of that nation...

Economic Factors Affecting the Value of a
Currency:



Store of Value
Demand for Liquidity
Demand for Assets Denominated
in the Currency
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Central Bank Behavior
 Reputable
central banks:
Are trusted by markets to maintain a
currency’s purchasing power through sound
monetary policy.
 Tend to be independent.
 Have currencies that are more highly valued
than those issued by less reputable banks.

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Currency Board System
A currency board is a system for maintaining
the value of the local currency with respect to
some other specified currency.
 Characteristics




No Central Bank
No Discretionary Monetary Policy
For example, Hong Kong has tied the value of
the Hong Kong dollar to the U.S. dollar
(HK$7.8 = $1) since 1983.
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Dollarization
 Dollarization
refers to the replacement of
a local currency with U.S. dollars.
 Dollarization goes beyond a currency
board, as the country no longer has a
local currency.
 For example, Ecuador implemented
dollarization in 2000.
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