Exchange Rate Determination
Rashedul Hasan
Measuring Exchange Rate Movement
Exchange rate movement affect an MNC’s
value because they can affect the amount of
cash inflows received from exporting or
from subsidiary, and the amount of cash
outflows needed to pay for imports. An
exchange rate measures the value of one
currency in unit of another currency.
As economic condition changes, exchange
rate can change substantially. A decline in a
currency value referred to as depreciation.
When the British Pound depreciates against
the U.S. dollar, this means that the U.S.
dollar is strengthening relative to the pound.
The increase in a currency value is often
referred to as appreciation.
The percentage change (% )) in the value of
a foreign currency is computed as
St – St-1
St-1
where
St denotes the spot rate at recent date.
St-1 denotes the spot rate at time t.
A positive % represents appreciation of the
foreign currency, while a negative % 
represents depreciation.
Exchange Rate Equilibrium
An exchange rate represents the price of a currency, which
is determined by the demand for that currency relative to
the supply for that currency.
Value of £
$1.60
$1.55
$1.50
S: Supply of £
equilibrium
exchange rate
D: Demand for £
Quantity of £
Factors that influence Exchange Rate
The equlibrium exchange rate will change over
time as supply and demand schedules change.
The factors that cause currency supply and
demand schedules to change are disscussed
bellow.
The following equation summarize the factors
that can influence a currency’s spot rate
• e = f (  INF,  INT,  INC,  GC  EXP)
• where,
• e = % change in spot rate
•  INF = change in the differential between U.S.
inflation and the foreign country’s inflation
•  INT = change in the differential between U.S.
interest rate and the foreign country’s interest
rate
•  INC = change in the differential between
U.S.income level and the foreign country’s
income level
•  GC = change in Government control
•  EXP = change in expectations of future
exchange rate
Factors that Influence
Exchange Rates
Relative Inflation Rates
$/£
r1
r0
S1
S0
D1
D0
Quantity of £
U.S. inflation 

 U.S. demand for British
goods, and hence £.

 British desire for U.S.
goods, and hence the
supply of £.
Relative Inflation Rates
If the U.S. Inflation suddenly increased while
British inflation remained same. The sudden jump
in U.S. inflation should cause an increase in the
U.S. demand for British goods and therefore also
cause an incease in the U.S. demand for British
Pounds. On the other hand, the jump in U.S.
inflation should reduce the British desire for U.S.
goods and therefore reduce the supply of pounds
for sale.
Factors that Influence
Exchange Rates
Relative Interest Rates
$/£
r0
r1
S0
S1
D0
D1
Quantity of £
U.S. interest rates 

 U.S. demand for British
bank deposits, and hence £.

 British desire for U.S.
bank deposits, and hence
the supply of £.
Relative Interest Rates
If the U.S. interest rates rise while British interest rates
remain constant, the U.S. investors will likely reduce
their demand for pounds, since U.S. rate are now more
attractive and there is less desire for British bank
deposit. Moreover the U.S. rates will now look more
attractive to British investors with excess cash. The
supply of pound for sale by British investors should
increase as they establish more bank deposits in the U.S.
due to an inward shift in the demand for pound and
outward shift in the supply of pound for sale, the
equlibrium exchange rate should be decreased.
Relative Interest Rates
A relatively high interest rate may actually reflect
expectations of relatively high inflation. Because high
inflation can place downward pressure on the local
currency, which discourages foreign investment.
It is thus useful to consider real interest rates, which
adjust the nominal interest rates for inflation.
• Real Interest rate = Nominasl interest rate – Inflation
rate
This relationship is sometimes called the Fisher effect.
Factors that Influence
Exchange Rates
Relative Income Levels
$/£
r1
r0
U.S. income level 
S0 ,S1   U.S. demand for British
goods, and hence £.
D1
D0
Quantity of £

No expected change for the
supply of £.
Relative Income Level
If the U.S. income level rises substantially while
the British income level remain unchanged, the
impact of that situation will as follows,
The demand schedule for pounds will shift
outwards as the demand for British goods will
increase
The equilibrium exchange rate of the pound is
expected to rise.
Government Controls
Governments may influence the equilibrium
exchange rate by:
• imposing foreign exchange barriers,
• imposing foreign trade barriers,
• intervening in the foreign exchange market,
and
• affecting macro variables such as inflation,
interest rates, and income levels.
Expectations
A fifth factor affecting exchange rate is market
expectations of future exchange rate. Like other
financial market,
Foreign exchange markets react to any news that
may have a future effect.
Institutional investors such as, Commercial Bank,
Insurance Company etc. often take currency
positions based on anticipated interest rate
movements in various countries.
How Factors Can Affect Exchange Rates
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
U.S. demand for foreign
goods, i.e. demand for
foreign currency
Foreign demand for U.S.
goods, i.e. supply of
foreign currency
U.S. demand for foreign
securities, i.e. demand
for foreign currency
Foreign demand for U.S.
securities, i.e. supply of
foreign currency
Exchange
rate
between
foreign
currency
and the
dollar