# The Determination of Exchange Rates

```Multinational Financial
Management
Alan Shapiro
7th Edition
J.Wiley &amp; Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton
1
CHAPTER 2
THE DETERMINATION
OF EXCHANGE RATES
2
CHAPTER 2 OVERVIEW:
I.
EQUILIBRIUM EXCHANGE
RATES
II. ROLE OF CENTRAL BANKS
III. EXPECTATIONS AND THE
ASSET MARKET MODEL
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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.
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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
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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 Euros to
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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.
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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.
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Equilibrium Exchange Rates
2. Home Currency Depreciation
a.
b.
Foreign currency becomes
more valuable than the home
currency.
The foreign currency’s
value has appreciated against
the home currency.
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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
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Equilibrium Exchange Rates
Currency Appreciation
e1  e0

e0
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Equilibrium Exchange Rates
EXAMPLE: euro appreciation
If the dollar value of the euro goes from
\$0.64 (e0) to \$0.68 (e1), then the euro
has appreciated by
e1  e0

e0
= (.68 - .64)/ .64
= 6.25%
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Equilibrium Exchange Rates
EXAMPLE: US\$ Depreciation
We use the first formula,
(e0 - e1)/ e1
substituting
(.64 - .68)/ .68 = - 5.88%
which is the value of the US\$
depreciation.
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Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
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PART II.
THE ROLE OF CENTRAL
BANKS
I. FUNDAMENTALS OF CENTRAL
BANK INTERVENTION
A. Role of Exchange Rates:
AND THE WORLD ECONOMY
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THE ROLE OF CENTRAL BANKS
B.THE IMPACT OF EXCHANGE RATE CHANGES
1. Currency Appreciation:
-domestic prices increase relative to
foreign prices.
- Exports: less price competitive
- Imports: more attractive
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THE ROLE OF CENTRAL BANKS
2. Currency Depreciation
- domestic prices fall relative
to foreign prices.
- Exports: more price competitive.
- Imports: less attractive
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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.
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THE ROLE OF CENTRAL BANKS
2. Goal of Intervention:
-to alter the demand for
one currency by
changing the supply of
another.
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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
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Part III. EXPECTATIONS
I.
WHAT AFFECTS A CURRENCY’S
VALUE?
A. Current events
B.
C.
D.
Current supply
Demand flows
Expectation of future
exchange rate
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EXPECTATIONS
II. Role of Expectations :
A. Currency = financial
asset
B. Exchange rate =
simple relation of two
financial assets
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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.
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EXPECTATIONS
B.
Soundness of a Nation’s
Economic Policies
- a nation’s currency tends
to strengthen with sound
economic policies.
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EXPECTATIONS
IV. EXPECTATIONS AND
CENTRAL BANK BEHAVIOR
- exchange rates also
influenced by
expectations of central
bank behavior.
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EXPECTATIONS
A. Central Bank Reputations
B. Central Bank Independence
C. Currency Boards
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