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 Exchange Rate
Change in the Equilibrium Exchange Rate
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
Impact of Liquidity on Exchange Rate Adjustments
Movements in Cross Exchange Rates
Capitalizing on Expected Exchange Rate Movements
Institutional Speculation Based on Expected Appreciation
Institutional Speculation Based on Expected Depreciation
Speculation by Individuals
The “Carry Trade”
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.