Instructor’s Manual
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
different in the short run and long run. Although exchange rate overshooting can persist for significant periods,
fundamental forces tend to push the currency back to its long-run equilibrium path.
The chapter first considers how exchange rates are determined in the long run. The long-run determinants of
exchange rates include relative productivity levels, relative price levels, consumer preferences for domestic or
foreign goods, and trade barriers such as tariffs and quotas.
According to the purchasing power parity approach, changes in relative price levels determine changes in exchange
After completing this chapter, students should be able to:
• Identify the market fundamentals which underlie movements in exchange rates.
• Identify the long-run determinants of exchange rates and the short-run determinants of exchange rates
• Explain how market expectations affect currency values.
• Discuss how market fundamentals and market expectations interact to influence exchange rates.
Instructor’s Manual
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
10. Supply of Demand for Exchange rate
pounds pounds ($ per pound)
a. ——– decrease decrease
b. decrease increase increase
11. a. False
12. More expensive, less expensive, increased, decreased
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.
