LEARNING ACTIVITY 12.

1
Exchange Rate Determination
What factors influence the market for currency in the long run, medium run, and short run?

Short Run Medium Run Long Run

In the short run speculation in In the medium run, the business Market fundamentals like price,
assets and securities (based on cycle and cyclical factors output, interest rates, preferences,
interest rate differentials) impact influence exchange rate and trace policy
the exchange rate determination

Supply & Demand

Draw the market for British pounds, with the price of British pounds in dollars ($/£) on the vertical axis and
the quantity of British pounds (£) on the horizontal axis.

Describe the Supply. What does it mean?

The supply is what the British want to purchase.

What this means is that the supply is representative
of the UK’s supply of British pounds used to
purchase US products.

Describe the Demand. What does it mean?

The demand is the representative of the US wanting

to buy UK products. This means that the demand
symbolizes the US demand for pounds.

What kinds of things shift the Supply? What kinds of things shift the Demand?
Draw the shift and explain. Draw the shift and explain.

The supply is controlled by several things including The demand is controlled by several things
the overall attractiveness of US products. This can including the overall attractiveness of US products.
be impacted by changes in preference and spending This can be impacted by changes in preference and
habits. spending habits.
Activity 1

Explain the long run (LR) result (S, D & exchange rate) for the following changes by drawing a graph for
each one:
a. US inflation rises faster than UK b. US productivity growth is greater than UK

c. US preferences for UK products increases d. US imposes tariffs on UK products

Activity 2

Summarize your general findings in the chart. What is the impact of the following change in the long run
(LR)?
a. Relative price levels b. Relative productivity levels
As a country becomes more productive relative to
An increase in the US price level relative to price other countries, its currency appreciates.
levels in other countries causes the dollar to
depreciate in the LR.

c. Preferences for domestic or foreign goods d. Trade barriers

Trade barriers cause a currency appreciation in the

Increased demand for imports results in a long run for the country imposing the barriers
 depreciation of the domestic currency. An increased
demand for a country’s exports causes its currency
to appreciate in the LR.

Activity 3

Explain the short run (SR) result (S, D & exchange rate) for the following changes by drawing a graph for
each one:
a. US interest rates are low relative to UK interest b. US dollar is expected to appreciate against the
rates pound

Activity 4

Summarize your general findings in the chart. What is the impact of the following change in the short run
(SR)?
a. Relative interest rates b. Expected relative currency value

We expect to see appreciating currencies in Any LR factor that causes the expected future value
countries whose real interest rates are higher than of the dollar to appreciate will cause the dollar to
abroad because these countries will attract appreciate today (in the SR).
investment funds from all over the world.