LO 10.4 - How currency exchange rates are determined and their relative merits.

- Exchange rates are determined by the demand and supply for different currencies
- Three factors impact future exchange rate movements:
+ Price inflation
+ Interest rate
+ Market psychology

1. Price:
 Law of One Price
In competitive markets free of transportation costs and barriers, similar products in different
countries must sell for the same price when expressed in terms of same currency.
 Purchasing Power Parity (PPP):
- Efficient market has no free flow of goods and services barriers
- Price of “basket of goods” should be equivalent in each country
 Money Supply and Price Inflation
- Changes in relative prices will result in a change in exchange rates
- When growth in money supply is greater than output, inflation will occur

2. Interest rates:
- If inflation is high, interest rates will also be high
- International Fisher Effect: Spot exchange rate should change in equal amount but in
opposite direction to the difference in nominal interest rates between two countries.

3. Investor Psychology:
Bandwagon effect:
Happens when traders' expectations become self-fulfilling prophesies
 Traders can join the bandwagon and move exchange rates based on group expectations
 Influence short term exchange rate movements