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
Institutional Speculation Based on Expected Appreciation
Institutional Speculation Based on Expected Depreciation
Speculation by Individuals
The “Carry Trade”
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Exchange Rate Determination 2
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.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exchange Rate Determination 3
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.