CHAPTER 4

Exchange Rate Determination

© 2000 South-Western College Publishing

 Chapter Objectives

• To explain how exchange rate movements

are measured;
• To explain how the equilibrium exchange
rate is determined; and
• To examine the factors that affect the
equilibrium exchange rate.

2
 Measuring Exchange Rate
Movements
• An exchange rate measures the value of one
currency in units of another currency.
• A decline in a currency’s value is referred to
as depreciation, while an increase is referred
to as appreciation.
• % ∆ in foreign currency value = (S - St-1) / St-1
• A positive % ∆ represents appreciation of the
foreign currency, while a negative % ∆
represents depreciation.
3
 Exchange Rate Equilibrium
Value of £
S
equilibrium
exchange
rate

Quantity of £

• An exchange rate represents the price of a

currency, which is determined by the
demand for that currency relative to supply.
4
Factors that Influence Exchange Rates
Value of £ S2
S
r2
r
D2
D
Quantity of £

• Relative Inflation Rates

¤ A relative increase in U.S. inflation will increase
the U.S. demand for British goods, and hence
the U.S. demand for British pounds.
¤ In addition, the British desire for U.S. goods,
and hence the supply of pounds, will drop.
Factors that Influence Exchange Rates
Value of £ S
S2
r
r2
D
D2
Quantity of £

• Relative Interest Rates

¤ A relative rise in U.S. interest rates will
decrease the U.S. demand for British pounds.
¤ In addition, the supply of pounds by British
corporations will increase.
6
Factors that Influence Exchange Rates
Real Interest Rates
¤ A relatively high interest rate may reflect
expectations of relatively high inflation, which
may discourage foreign investment.
¤ Real interest rates adjusts nominal interest
rates for inflation:
real nominal
interest = interest – inflation
rate rate rate
This relationship is sometimes called the
Fisher effect.
7
Factors that Influence Exchange Rates
Value of £ S
r2
r
D2
D
Quantity of £

• Relative Income Levels

¤ A relative increase in the U.S. income level will
increase the U.S. demand for British goods,
and hence the demand for British pound.
¤ The supply of pounds does not change.
8
Factors that Influence Exchange Rates

• Government Controls
¤ Governments can influence the equilibrium
exchange rate in many ways, including :
­ the imposition of foreign exchange barriers,
­ the imposition of foreign trade barriers,
­ intervening in the foreign exchange market,
and
­ affecting macro variables such as inflation,
interest rates, and income levels.

9
Factors that Influence Exchange Rates

• 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 too.
¤ Because of speculative transactions,
foreign exchange rates can be very
volatile.

10
 Factors that Influence Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential
2. Capital Flow Foreign demand for U.S.
securities, i.e. supply of
Restrictions foreign currency
Factors that Influence Exchange Rates
• Interaction of Factors
¤ Trade­related factors and financial factors
sometimes interact. For example, an increase
in income levels sometimes causes
expectations of higher interest rates.
¤ Over a particular period, different factors may
place opposing pressures on the value of a
foreign currency. The sensitivity of the
exchange rate to these factors is dependent on
the volume of international transactions
between the two countries.
12
How Factors Have Influenced Exchange Rates
high U.S. interest rates, a high U.S.
somewhat depressed U.S. interest rates
Dollar’s Index
180 economy, and low inflation

140
Persian Gulf War
100
high U.S. large balance of
inflation trade deficit
60
1972 1977 1982 1987 1992 1997
Year

¤ Because the dollar’s value changes by different

magnitudes relative to each foreign currency,
analysts measure the dollar’s strength with an
index.
13
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows
$20 million

14
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows
$20 million

Exchange at
$0.50/NZ$

2. Holds
NZ$40 million
15
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows
$20 million

Exchange at
$0.50/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
16
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
17
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows
NZ$40 million

18
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows
NZ$40 million

Exchange at
$0.50/NZ$

2. Holds
$20 million
19
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows
NZ$40 million

Exchange at
$0.50/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
20
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
21
 Impact of Factors that Influence
Exchange Rates on an MNC’s Value
Inflation rates
Interest rates
Income levels
Government
controls
Expectations
m
n 
[
∑ E ( CFj , t ) × E ( ER j , t )
 j =1
] 

Value = ∑  
t =1 ( 1 + k) t 
 
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent
22
Chapter Review

• Measuring Exchange Rate Movements

• Exchange Rate Equilibrium
¤ Demand for a Currency
¤ Supply of a Currency for Sale

23
 Chapter Review
• Factors that Influence Exchange Rates
¤ Relative Inflation Rates
¤ Relative Interest Rates
¤ Relative Income Levels
¤ Government Controls
¤ Expectations
¤ Interaction of Factors
¤ How Factors Have Influenced Exchange Rates
• Speculating on Anticipated Exchange Rates
• How Exchange Rate Determination Affects an
MNC’s Value
24