Chapter 4
Exchange Rate Determination
Lecture Outline
Measuring Exchange Rate Movements
Exchange Rate Equilibrium
Demand for a Currency
Supply of a Currency for Sale
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
Movements in Cross Exchange Rates
Explaining Movements in Cross Exchange Rates
Anticipation of Exchange Rate Movements
Bank Speculation Based on Expected Appreciation
Bank Speculation Based on Expected Depreciation
Speculation by Individuals
Chapter Theme
This chapter provides an overview of the foreign exchange market. It is designed to
illustrate (1) why a market exists, and (2) why exchange rates change over time.
Topics to Stimulate Class Discussion
1. Why did exchange rates change recently?
2. Show the class a current exchange rate table from a periodical—identify spot and
forward quotations. Then show the class an exchange rate table from a date a month ago,
or three months ago. The comparison of tables will illustrate how exchange rates change,
and how forward rates of the earlier date will differ from the spot rate of the future date for
a given currency.
3. Make up several scenarios and ask the class how each scenario would, other things
equal, affect the demand for a currency, the supply of a currency for sale, and the
equilibrium exchange rate. Then integrate several scenarios together to illustrate that in
reality other things are not held constant, which makes the assessment of exchange rate
movements more difficult.
POINT/COUNTER-POINT:
How Can Persistently Weak Currencies Be Stabilized?
POINT: The currencies of some Latin American countries depreciate against the U.S.
dollar on a consistent basis.The governments of these countries need to attract more capital
flows by raising interest rates and making their currencies more attractive. They also need
to insure bank deposits so that foreign investors who invest in large bank deposits do not
need to worry about default risk. In addition, they could impose capital restrictions on
local investors to prevent capital outflows.
COUNTER-POINT: Some Latin American countries have had high inflation, which
encourages local firms and consumers to purchase products from the U.S. instead. Thus,
these countries could relieve the downward pressure on their local currencies by reducing
inflation. To reduce inflation, a country may have to reduce economic growth temporarily.
These countries should not raise their interest rates in order to attract foreign investment,
because they will still not attract funds if investors fear that there will be large capital
outflows upon the first threat of continued depreciation.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do
you support? Offer your own opinion on this issue.
Answer: There is no perfect solution, but recognize the tradeoffs. The proposal to raise
interest rates is not a good solution in the long run, because it will cause higher loan rates,
and may slow down the economies in the long run. Effective anti-inflationary policies are
needed to prevent further depreciation. However, the elimination of inflation that is caused
by a wage-price spiral may cause some pain among the workers in the country, as some
form of wage controls may be needed. The government has various means of reducing
inflation, but all of them can have adverse effects on the economy in the short run.
Answers to End of Chapter Questions
1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The
expected spot rate one year from now is assumed to be $1.66. What percentage
depreciation does this reflect?
Answer: ($1.66 – $1.73)/$1.73 = –4.05%
Expected depreciation of 4.05% percent
2. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high
relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S.
demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium
value of the Canadian dollar?
Answer: Demand for Canadian dollars should increase, supply of Canadian dollars for
sale should decrease, and the Canadian dollar’s value should increase.
3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to
British interest rates. Other things being equal, how should this affect the (a) U.S. demand
for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound?
Answer: Demand for pounds should increase, supply of pounds for sale should decrease,
and the pound’s value should increase.
4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much
higher rate than does the Canadian income level. Other things being equal, how should this
affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale,
and (c) equilibrium value of the Canadian dollar?
Answer: Assuming no effect on U.S. interest rates, demand for dollars should increase,
supply of dollars for sale may not be affected, and the dollar’s value should increase.
5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government
relaxes its controls on imports by Japanese companies. Other things being equal, how
should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c)
equilibrium value of the yen?
Answer: Demand for yen should not be affected, supply of yen for sale should increase,
and the value of yen should decrease.
6. Effects of Real Interest Rates. What is the expected relationship between the relative
real interest rates of two countries and the exchange rate of their currencies?
Answer: The higher the real interest rate of a country relative to another country, the
stronger will be its home currency, other things equal.
7. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected
economist about future interest rates could affect the value of the dollar today. Why do
some forecasts by well-respected economists have no impact on today’s value of the
dollar?
Answer: Interest rate movements affect exchange rates. Speculators can use anticipated
interest rate movements to forecast exchange rate movements. They may decide to
purchase securities in particular countries because of their expectations about currency
movements, since their yield will be affected by changes in a currency’s value. These
purchases of securities require an exchange of currencies, which can immediately affect
the equilibrium value of exchange rates.
If a forecast of interest rates by a respected economist was already anticipated by market
participants or is not different from investors’ original expectations, an announced forecast
does not provide new information. Thus, there would be no reaction by investors to such
an announcement, and exchange rates would not be affected.
1. 8. Factors Affecting Exchange Rates. What factors affect the future movements in
the value of the euro against the dollar?
Answer: The euro’s value could change because of the balance of trade, which reflects
more U.S. demand for European goods than the European demand for U.S. goods. The
capital flows between the U.S. and Europe will also affect the U.S. demand for euros and
the supply of euros for sale (to be exchanged for dollars).
9. Interaction of Exchange Rates. Assume that there are substantial capital flows among
Canada, the U.S., and Japan. If interest rates in Canada decline to a level below the U.S.
interest rate, and inflationary expectations remain unchanged, how could this affect the
value of the Canadian dollar against the U.S. dollar? How might this decline in Canada’s
interest rates possibly affect the value of the Canadian dollar against the Japanese yen?
Answer: If interest rates in Canada decline, there may be an increase in capital flows from
Canada to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S.
interest rates, while U.S. investors reduce their investments in Canada’s securities. This
places downward pressure on the Canadian dollar’s value.
Japanese investors that previously invested in Canada may shift to the U.S. Thus, the
reduced flow of funds from Japan would place downward pressure on the Canadian dollar
against the Japanese yen.
10. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures
are announced. Foreign exchange traders often react to this announcement and even
attempt to forecast the figures before they are announced.
a. Why do you think the trade deficit announcement sometimes has such an impact on
foreign exchange trading?
Answer: The trade deficit announcement may provide a reasonable forecast of future trade
deficits and therefore has implications about supply and demand conditions in the foreign
exchange market. For example, if the trade deficit was larger than anticipated, and is
expected to continue, this implies that the U.S. demand for foreign currencies may be
larger than initially anticipated. Thus, the dollar would be expected to weaken. Some
speculators may take a position in foreign currencies immediately and could cause an
immediate decline in the dollar.
b. In some periods, foreign exchange traders do not respond to a trade deficit
announcement, even when the announced deficit is very large. Offer an explanation for
such a lack of response.
Answer: If the market correctly anticipated the trade deficit figure, then any news
contained in the announcement has already been accounted for in the market. The market
