CHAPTER 2
THE
DETERMINATION
OF EXCHANGE
RATES
CHAPTER 2 OVERVIEW:
PART
I. EQUILIBRIUM EXCHANGE
RATES
 II. ROLE OF CENTRAL BANKS
 III. EXPECTATIONS AND THE
ASSET MARKET MODEL

Part I.
Equilibrium Exchange Rates
I. SETTING THE EQUILIBRIUM
A. Exchange Rates
market-clearing prices that
equilibrate the quantities
supplied and demanded of
foreign currency.
Equilibrium Exchange Rates
B. How Americans Purchase
German Goods
1. Foreign Currency Demand
-derived from the demand for
foreign country’s goods,
services, and financial
assets.
e.g. The demand for German
goods by Americans
Equilibrium Exchange Rates
2. Foreign Currency Supply:
a. derived from the foreign
country’s demand for
local goods.
b. They must convert their
currency to purchase.
e.g. German demand for US
goods means Germans
convert DM to US $ in
order to buy.
Equilibrium Exchange Rates
3. Equilibrium Exchange Rate:
occurs when the quantity
supplied equals the quantity
demanded of a foreign
currency at a specific local
price.
Equilibrium Exchange Rates
C. How Exchange Rates Change
1. Increased demand
as more foreign goods are
demanded, the price of the
foreign currency in local
currency increases and vice
versa.
Equilibrium Exchange Rates
2. Home Currency Depreciation
a. Foreign currency becomes
more valuable than the home
currency.
b. Conversely, the foreign
currency’s value has
appreciated against the home
currency.
Equilibrium Exchange Rates
3. Calculating a Depreciation:
Currency Depreciation
e0  e1

e1

where e0 = old currency value
e1 = new currency value
Note: Resulting sign is always negative
Equilibrium Exchange Rates
Currency Appreciation
e1  e0

e0
Equilibrium Exchange Rates
EXAMPLE: dm Appreciation
If the dollar value of the dm goes
from $0.64 (e0) to $0.68 (e1), then the
dm has appreciated by
e1  e0

e0
= (.68 - .64)/ .64
= 6.25%
Equilibrium Exchange Rates
EXAMPLE: US$ Depreciation
We use the first formula,
(e0 - e1)/ e1
substituting
(.64 - .68)/ .68 = - 5.88%
which was the US$
depreciation.
Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
THE ROLE OF CENTRAL BANKS
I. FUNDAMENTALS OF
CENTRAL BANK
INTERVENTION
A. Role of Exchange Rates:
LINKS BETWEEN
THE DOMESTIC AND THE
WORLD ECONOMY
THE ROLE OF CENTRAL BANKS
B. THE IMPACT OF EXCHANGE
RATE CHANGES
1. Currency Appreciation:
-domestic prices increase
relative to foreign prices.
- Exports: less competitive
- Imports: more attractive
THE ROLE OF CENTRAL BANKS
2. Currency Depreciation
- domestic prices fall relative
to foreign prices.
- Exports: more competitive.
- Imports: less attractive
THE ROLE OF CENTRAL BANKS
C. Foreign Exchange Market
Intervention
1. Definition: the official
purchases and sales of
currencies through the
central bank to influence
the home exchange rate.
THE ROLE OF CENTRAL BANKS
2. Goal of Intervention:
- to alter the demand for
one currency by
changing the supply of
another.
THE ROLE OF CENTRAL BANKS
D. The Effects of Foreign
Exchange Intervention
1. Effects of Intervention:
- either ineffective or
irresponsible
2. Lasting Effect:
- If permanent, change
results
Part III. EXPECTATIONS
I.
WHAT AFFECTS A
CURRENCY’S VALUE?
A. Current events
B. Current supply
C. Demand flows
* D. Expectation of future
exchange rate
EXPECTATIONS
II. Role of Expectations :
A. Currency = financial
asset
B. Exchange rate =
simple relation of two
financial assets
EXPECTATIONS
III. Demand for Money and
Currency Values: Asset
Market Model
A. Exchange rates reflect the
supply of and demand for
foreign-currency
denominated assets.
EXPECTATIONS
B. Soundness of a Nation’s
Economic Policies
- a nation’s currency tends
to strengthen with sound
economic policies.
EXPECTATIONS
IV. EXPECTATIONS AND
CENTRAL BANK BEHAVIOR
- exchange rates also
influenced by
expectations of central
bank behavior.
EXPECTATIONS
A. Central Bank Reputations
B. Central Bank Independence
C. Currency Boards