CHAPTER 12
EXCHANGE-RATE DETERMINATION
CHAPTER OVERVIEW
This chapter seeks to explain the factors that underlie currency movements. These factors include market
fundamentals and market expectations. The chapter notes that the determinants of exchange rate fluctuations are
According to the purchasing power parity approach, changes in relative price levels determine changes in exchange
rates over the long run. A currency maintains its purchasing power parity if it depreciates by an amount equal to the
excess of domestic inflation over foreign inflation.
In the short run, decisions to hold domestic or foreign assets play are a primary role in exchange rate determination.
According to the asset market approach to exchange rate determination, investors consider two key factors when
deciding between domestic and foreign investments: relative interest rates and expected changes in exchange rates.
Changes in these factors result in fluctuations in exchange rates that we observe in the short run.
Another factor influencing exchange rates is the phenomenon of exchange-rate overshooting. An exchange rate is
said to overshoot when its short-run response to a change in market fundamentals is greater than its long-run
response.
BRIEF ANSWERS TO STUDY QUESTIONS
1. Market fundamentals and market expectations. Long run exchange rates are best explained by factors
2. The nominal interest rate refers to the interest rate, unadjusted for inflation. The real interest rate equals the
3. The purchasing-power-parity theory predicts that a country’s currency will depreciate by an amount equal to
the excess of domestic inflation over foreign inflation. The theory also predicts that a country’s exchange rate
5. In the long run, four key factors account for changes in exchange rates: relative productivity levels, relative
price levels, preferences for domestic goods and foreign goods, and barriers to trade.
7. The dollar’s exchange rate will:
a. Depreciate
8. An exchange rate is said to overshoot when its short-run response (depreciation/appreciation) to a change in
market fundamentals is greater than its long-run response. Exchange rate overshooting occurs because
9. Currency forecasters generally use one of three methods to predict future exchange rates: (1) judgmental
analysis,(2) technical analysis, or (c) fundamental analysis.
10. Supply of Demand for Exchange rate
pounds pounds ($ per pound)
a. ——– decrease decrease
b. decrease increase increase
11. a. False
13. a. Dollar depreciates by 10 percent, to approximately $0.55 per franc.
14. a. – 2 percent in the U.S., 2 percent in the U.K.