Exchange Rate Determination

&
Forecasting
 Factors Impact Exchange Rate

Basically exchange rates are determined by the

demand and supply of one currency relative to the
demand and supply of another.
3 Factors have impact on future exchange rate
movements in a country’s currency
 Country’s price inflation
 Country’s interest rate
 Market psychology
 Country’s Price Inflation (Prices and Exchange
Rates)
How prices are related to exchange rate movements,
could be discussed through law of one price and
purchasing power parity theory.
Country’s Price Inflation (Prices and Exchange Rates)

The Law of One Price

The law of once price states that in competitive
markets free of transportation costs and barriers to
trade, identical products sold in different countries
must sell for the same price when their price is
expressed in terms of the same currency.
 Country’s Price Inflation (Prices and Exchange Rates)

 For Eg.
 If exchange rate between the British pound sterling and dollar is
£1=$2.
 A jacket that retails for $80in New York should sell for £40 in
London.
 If jacket cost £30 in London. At this price, it would pay a trader to
buy jackets in London and sell them in New York.
 The company initially could make a profit of $20 on each jacket by
purchasing it for £30 in London and selling it for $80 in New York.
 However, increased demand for jackets in London would raise price
in London, and increased supply of jackets in New York would lower
their price in New York.
 This would continue until prices were equalized.
Country’s Price Inflation (Prices and Exchange Rates)

Purchasing Power Parity

If law of one price were true for all goods and
services, the purchasing power parity(PPP) exchange
rate could be found from any individual set of prices.
By comparing the prices of identical products in
different currencies, it would be possible to
determine the real or PPP exchange rate that would
exist if markets were efficient.
Symbolically
E$/¥ =P$/P¥
Country’s Price Inflation (Prices and Exchange Rates)

Thus if basket of goods cost $200 in the US and

¥20,000 in Japan, PPP theory predicts that the
dollar/yen exchange rate should be $200/¥20,000
i.e $0.01 per yen.
The PPP theory also argue that the exchange rate will
change if relative prices change.
For eg.
Imagine there is no price inflation in the US, while
prices in Japan are increasing by 10% a year.
Country’s Price Inflation (Prices and Exchange Rates)Prices and
Exchange Rates

Therefore basket of goods still costs $200 in US, but

it costs ¥22,000 in Japan.
Thus according to PPP theory the exchange rate
should change as a result.
E$/¥ =$200/¥22,000, thus $0.0091=¥1
Because of 10% price inflation, the Japanese yen has
depreciated by 10% against the dollar.
 Country’s Price Inflation (Prices and Exchange Rates)Prices and
Exchange Rates

 Money Supply and Price Inflation

 Price inflation occurs when the quantity of money in circulation
rises faster than the stock of goods and services.
 A Government increasing the money supply is analogous to
giving people more money.
 An increase in money supply makes it easier for banks to
borrow from the Government and for individuals and
companies to borrow from banks.
 The resulting increase in credit causes increase in demand for
goods and services.
 So now we have a connection between the growth in a country’s
money supply, price inflation and exchange rate movements.
 Country’s Price Inflation (Prices and Exchange Rates)

Another way of looking at the same phenomenon is that an

increase in a country’s money supply, which increases the
amount of currency available, changes the relative demand
and supply conditions in the foreign exchange market.
If US money supply is growing more rapidly than US
output, dollars will be relatively more plentiful than the
currencies of countries where monetary growth is closer to
output growth.
As a result of this relative increase in the supply of dollars,
the dollars will depreciate on the foreign exchange market
against the currencies of countries with slower monetary
growth.
 Interest Rates and Exchange Rates

Economic theory tells that interest rates reflect

expectations about likely future inflation rate.
In countries where inflation is expected to be high,
interest rates also will be high, because investors
want compensation for the decline in the value of
their money.
This relationship was first formalized by economist
Irvin Fisher and is referred to as Fisher effect.
 Interest Rates and Exchange Rates

The Fisher effect states that a country’s “nominal

interest rate (i) is the sum of the required “real” rate
of interest (r ) and expected rate of inflation over the
period for which the funds are to be lent (I).
More formally, i=r+I
Eg.
If the real rate of interest in a country is 5% and
annual inflation is expected to be 10%, the nominal
interest rate will be 15%.
 Interest Rates and Exchange Rates

Let us see how is applies in a world of many

countries and unrestricted capital flows.
When investors are free to transfer capital between
countries, real interest rates will be the same in every
country.
If differences in real interest rates did emerge
between countries, arbitrage would soon equalize
them.
 Interest Rates and Exchange Rates

Eg. If real interest rate in Japan is 10% and only 6% in

the US, it would pay investors to borrow money in US
and invest in Japan.
This would continue until the two sets of real interest
rates were equalized.
We know from PPP theory that there is a link between
inflation and exchange rates, and because interest
rates reflect expectations about inflation, it follows
that there must also be link between interest rates and
exchange rates.
This link is know as international Fisher effect.
 Interest Rates and Exchange Rates

The international Fisher effect states that for any two

countries, the spot exchange rate should change in
an equal amount but in the opposite direction to the
difference in nominal interest rates between two
countries.

S1-S2
------- *100 = i$ - i¥
S2
Investor Psychology and Bandwagon Effects

According to a number of studies, investor

psychology and bandwagon effects play an important
role in determining short run exchange rate
movements.
However, it is hard to predict
Investor psychology can be influenced by political
factors and by microeconomic events, such as the
investment decisions of individual firms, many of
which are only loosely linked to , macroeconomic
fundamentals.
 Exchange Rate Forecasting

Approaches to Forecasting
 Fundamental Analysis
 Technical Analysis
 Exchange Rate Forecasting

Fundamental Analysis:
Fundamental analysis draws on economic theory to
construct sophisticated econometric models for
predicting exchange rate movements.
The variables included in this model include relative
money supply growth rates, inflation rates, and
interest rates.
 Exchange Rate Forecasting

Technical Analysis:
Technical analysis uses price and volume data to
determine past trends, which are expected to
continue into the future.
 References

Hill, Charles W.L., Hult Thomas M. G. Rohit

Mehtani (2019). International Business: Competing
in the Global Marketplace, 11/e; New Delhi: McGraw
Hill Education
Daniels, John D and Radebaugh, Lee H et.al. (2014).
International Business: Environments and
Operations, 12/e; New Delhi: Pearson Education