Exchange Rate Determination

Rashedul Hasan

Measuring Exchange Rate Movement

Exchange rate movement affect an MNC’s value because they can affect the amount of cash inflows received from exporting or from subsidiary, and the amount of cash outflows needed to pay for imports. An exchange rate measures the value of one currency in unit of another currency.

As economic condition changes, exchange rate can change substantially. A decline in a currency value referred to as depreciation. When the British Pound depreciates against the U.S. dollar, this means that the U.S. dollar is strengthening relative to the pound.

The increase in a currency value is often referred to as appreciation.

The percentage change (% )) in the value of a foreign currency is computed as

St – St-1

St-1

where

St denotes the spot rate at recent date.

St-1 denotes the spot rate at time t.

A positive % represents appreciation of the foreign currency, while a negative % represents depreciation.

Value of £

Quantity of £

D: Demand for £

$1.55

$1.50

$1.60S: Supply of £

equilibrium exchange rate

Exchange Rate Equilibrium

An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

Factors that influence Exchange Rate

The equlibrium exchange rate will change over time as supply and demand schedules change. The factors that cause currency supply and demand schedules to change are disscussed bellow.

The following equation summarize the factors that can influence a currency’s spot rate

• e = f ( INF, INT, INC, GC EXP)

• where, • e = % change in spot rate INF = change in the differential between U.S.

inflation and the foreign country’s inflation INT = change in the differential between U.S.

interest rate and the foreign country’s interest rate

INC = change in the differential between U.S.income level and the foreign country’s income level

GC = change in Government control EXP = change in expectations of future

exchange rate

$/£

Quantity of £

S0

D0

r0

U.S. inflation U.S. demand for British

goods, and hence £.

D1

r1

S1

Factors that InfluenceExchange Rates

Relative Inflation Rates

British desire for U.S. goods, and hence the supply of £.

Relative Inflation Rates

If the U.S. Inflation suddenly increased while British inflation remained same. The sudden jump in U.S. inflation should cause an increase in the U.S. demand for British goods and therefore also cause an incease in the U.S. demand for British Pounds. On the other hand, the jump in U.S. inflation should reduce the British desire for U.S. goods and therefore reduce the supply of pounds for sale.

$/£

Quantity of £

r0

S0

D0

S1

D1

r1

U.S. interest rates U.S. demand for British

bank deposits, and hence £.

Factors that InfluenceExchange Rates

Relative Interest Rates

British desire for U.S. bank deposits, and hence the supply of £.

Relative Interest Rates

If the U.S. interest rates rise while British interest rates remain constant, the U.S. investors will likely reduce their demand for pounds, since U.S. rate are now more attractive and there is less desire for British bank deposit. Moreover the U.S. rates will now look more attractive to British investors with excess cash. The supply of pound for sale by British investors should increase as they establish more bank deposits in the U.S. due to an inward shift in the demand for pound and outward shift in the supply of pound for sale, the equlibrium exchange rate should be decreased.

Relative Interest Rates

A relatively high interest rate may actually reflect expectations of relatively high inflation. Because high inflation can place downward pressure on the local currency, which discourages foreign investment.

It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation. • Real Interest rate = Nominasl interest rate – Inflation

rate

This relationship is sometimes called the Fisher effect.

$/£

Quantity of £

S0

D0

r0

U.S. income level U.S. demand for British

goods, and hence £.

D1

r1

Factors that InfluenceExchange Rates

Relative Income Levels

No expected change for the supply of £.

,S1

Relative Income Level

If the U.S. income level rises substantially while the British income level remain unchanged, the impact of that situation will as follows,

The demand schedule for pounds will shift outwards as the demand for British goods will increase

The equilibrium exchange rate of the pound is expected to rise.

Government Controls

Governments may influence the equilibrium exchange rate by:

• imposing foreign exchange barriers,

• imposing foreign trade barriers,

• intervening in the foreign exchange market, and

• affecting macro variables such as inflation, interest rates, and income levels.

Expectations

A fifth factor affecting exchange rate is market expectations of future exchange rate. Like other financial market,

Foreign exchange markets react to any news that may have a future effect.

Institutional investors such as, Commercial Bank, Insurance Company etc. often take currency positions based on anticipated interest rate movements in various countries.

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions

Financial Factors1. Interest Rate Differential2. Capital Flow Restrictions

How Factors Can Affect Exchange Rates

U.S. demand for foreign goods, i.e. demand for

foreign currency

Foreign demand for U.S. goods, i.e. supply of

foreign currency

U.S. demand for foreign securities, i.e. demand

for foreign currency

Foreign demand for U.S. securities, i.e. supply of

foreign currency

Exchange rate

between foreign

currency and the dollar