Chapter 4

Exchange Rate Determination

 Measuring Exchange Rate
Movements

• A decline in a currency’s value is known as

depreciation.
• An increase in currency value is known as
appreciation.
• The percentage change in the value of the foreign
currency is then computed as follows:
 Exchange Rate Equilibrium

• An exchange rate (at a given time) represents the

price of a currency, or the rate at which one currency
can be exchanged for another.
• The price of a currency is determined by the demand
for that currency relative to its supply.
Exchange Rate Equilibrium
 Factors That Influence
Exchange Rates

• Relative inflation rates

• Relative interest rates
• Relative income levels
• Government controls
• Expectations
• Interaction of factors
• Influence of factors across multiple currency markets
• Impact of liquidity on exchange rate adjustment
Factors That Influence
Exchange Rates
Factors That Influence
Exchange Rates
Factors That Influence
Exchange Rates
 Movements In Cross
Exchange Rates

• A change in the equilibrium cross exchange rate over

time is due to the same types of forces identified
earlier in the chapter that affect the demand and
supply conditions between the two currencies.
 Capitalizing On
Expected Exchange Rate
Movements
• Institutional speculation based on expected
appreciation/depreciation
• Speculation by individuals
• The “carry trade”
– Impact of appreciation in the investment currency
– Risk of the carry trade