The Determination of Exchange Rates

The Determination of Exchange
Rates
Basics
What are exchange rates?
Exchange rates are simply

prices of foreign
currencies
Exchange Rates are Quoted Two Ways
1. Direct Quote:
• Home currency ($) price of one unit of foreign currency.
• €1 = $1.20
2. Indirect Quote:
• Foreign currency price of one unit of home currency ($).
• $1 = €0.83
These are reciprocals of
each other
Notations
• If one writes that the exchange rate between the euro and the
dollar is 1.1 $/€ it means that it takes 1.1 USD to buy 1 EUR.
• However, the currency is often written as €/$=1.1. This means the
same thing as a little algebra will give you: €=$1.1.
• All but four currency pairs involving the US dollar are quoted
indirectly. For example, the USD/ZAR, USD/MXN, USD/JPY,…
• The four pairs with direct quotes are the EUR/USD, GBP/USD,
AUD/USD, and the NZD/USD. Traditionally all four currency units
were worth more than the USD. But this is no longer the case for
the AUD and NZD and was not the case for the EUR in the early
2000’s.
Currency pair names
• The base currency is stated first so
that the “Euro-Dollar” means Dollars American Terms European Terms Cross-Rates
for 1 Euro. EUR/USD “Euro- USD/JPY- “Dollar- EUR/NOK “Euro-
• Similarly “Dollar-Yen” means Yen for 1 Dollar” Yen” Nockie”
US Dollar. AUD/USD “Aussid- USD/CAD “Dollar- EUR/SEK “Euro-
• European terms means the quote is Dollar” Cad” Stockie”
indirect. NZD/USD “Kiwi- USD/SEK “Dollar- GBP/JPY
• American terms means the quote is Dollar” Stockie” “Sterling-Yen”
direct. GBP/USD “Sterling” or USD/NOK EUR/GBP “Euro-
“Cable” “Dollar-Nockie” Sterling”
Using
Exchange
Rates
Appreciation and Depreciation
• Define:
• S0 = exchange rate at time 0.
• S1 = exchange rate at time 1.
• The percent change in the dollar price of a foreign currency
is:
Example:
• Suppose the $/€ exchange rate is S0 = $1.34.
• Later, it changes to S1 = $1.42.
• What is the percentage change of the €?
The € increase 5.97% against the dollar.

(in dollar terms, the € became 5.97% more expensive)
However, this also means that the dollar declined against the €.
(i.e., in € terms, the US dollar became less expensive)

Another Example….
• In 1995, the yen went from $0.0125 to
$0.0095238.
• How much did the yen change against the dollar?

(0.0095238-0.0125)/0.0125=-23.81%
• How much did the dollar change against the yen?

(1/0.0095238-1/0.0125)/(1/0.0125)=+31.25%
Or (0.0125-0.0095238)/0.0095238
Last Example
• July 19, 1985 the Italian lira depreciated by 17% against the dollar.
What was the appreciation of the dollar against the lira?
• We are given:
(the dollar price of the lira was devalued by 17%)
• We are asked to find:

(dollar appreciation against the lira
was 20.48%)
Exchange Rate Systems
Basic Exchange Rate Systems
Pegged
System
Terminolog
y
Main FX factors
Why Do
Exchange
Rates
Change?
Current Supply and Demand
$ Price of £
S£
S0
The exchange rate is

the price that equates D£
supply and demand.
Q0 Quantity of £
Exchange
Rates
Change
When…
Inflation Factor: Suppose Prices Increase in
the US…
• US goods become relatively more expensive than British
goods.
• Supply of £—British will want fewer US goods:
Buy Fewer Demand for Supply of

Dollars Dollars Declines £ Declines
• Demand for £—Americans will want more UK goods:
Demand for
Buy More £
£ Increases
Impact of US Inflation on Price of £
$ Price of £ New S£
S£
S1
S0
New D£
D£
Q1 Q0 Quantity of £
Inflation in
the US…
Interest Rate Factor: Suppose Interest Rates
Increase in the US…
• US investments yield relatively more than UK investments.
• Supply of £: UK investors desire more US financial assets:
Buy More Demand for Supply of £

Dollars Dollars Increases Increases
• Demand for £: US investors desire fewer UK financial assets:

Buy Fewer Demand for £
£ Decreases
Impact of Interest Rates Price of £
Dollar Price of £
S£
This is new
exchange rate
S0
S1
New D£ D£
Q1 Q0 Quantity of £
Now, suppose interest rates
increase in the US
Increase in
Interest
Rates in
US…
Summary…
So Far
Other FX
factors
GDP growth rates
Other Current Account Deficit
Factors That Public Debt
Terms of Trade (a ratio comparing
Affect export prices to import prices)
Exchange Political and Economic Risk
Rates Central Bank Reputation
Risk
(Economic
& Political
Stability)
Economic
Growth
Central
Bank
Reputation
Reputation
and
Currency
Value
Current Account Deficit
• .A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that
it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign
currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand
for its products. The excess demand for foreign currency
lowers the country's exchange rate until domestic goods
and services are cheap enough for foreigners, and foreign
assets are too expensive to generate sales for domestic
interests.
Public Debt
• Countries will engage in large-scale deficit financing to
pay for public sector projects and governmental funding.
While such activity stimulates the domestic economy,
nations with large public deficits and debts are less
attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will
be serviced and ultimately paid off with cheaper real
dollars in the future.
Terms of Trade
• A ratio comparing export prices to import prices, the terms of
trade is related to current accounts and the balance of
payments. If the price of a country's exports rises by a greater
rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows greater demand for
the country's exports. This, in turn, results in rising revenues
from exports, which provides increased demand for the country's
currency (and an increase in the currency's value). If the price of
exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
The Bottom Line
• The exchange rate of the currency in which a portfolio holds the
bulk of its investments determines that portfolio's real return. A
declining exchange rate obviously decreases the purchasing
power of income and capital gains derived from any returns.
Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by
numerous complex factors that often leave even the most
experienced economists flummoxed, investors should still have
some understanding of how currency values and exchange rates
play an important role in the rate of return on their investments.
How Do Banks Get a Poor Record?
Central Bank Independence and Inflation
Why Do Governments Do This?
• To “monetize deficits” (i.e., finance budget deficits).
• To lower stimulate (short-term) growth at the expense of long-run
health of the economy:
• This can lead to inflation and, in extreme cases, hyperinflation.
• Germany in 1920 resorted to inflation to pay for WW1 reparations to the Allies.
In 1923, it took 4 of these beautiful

Herbert Bayer designed banknotes
to buy a loaf of bread.
Abusing Money Supply is Like Abusing
Drugs
• Currency value does not depend
on current events and current
Expectations demand and supply flows only
and Future • They also depend on expectations
or forecasts about future exchange
Exchange rate movements
Rates
The Nature
of Money
and
Currency
Values
The Nature
of Money
and
Currency
Values
(cont.)
The Nature
of Money
and
Currency
Values
(cont.)
• As a nation’s monetary authority,
the job of the central bank is to use
Central Bank the instruments of monetary policy
including the sole power to create
Reputations money, to achieve price stability,
and Currency low interest rates and a target
currency value.
Values
Price Stability
and Central
Bank
Independence
Sample Problem
Suppose the U.S. dollar appreciates against the
Russian ruble by 500%. How much did the ruble
depreciate against the dollar?
Sample Problem
Depreciation of the ruble:
(e0  e1 )
x
e1
e1 e0
 5
e0 e0
Sample Problem
e1 e0
  5
e0 e0
e1
1 1  5 1
e0
e1  6e0
( e0  e1 )
 x
e1
e0  6e0
 x
6e0
5
 x
6
x  83%
Summary
• Determinants of currency values:
• Increase in relative inflation (−)
• Increase in relative real interest rates (+)
Summary • Increase in relative economic growth (+
in short run; − in long run)
• Increase in relative risk (economic &
political stability) (−)
• Improvement in relative central bank
reputation (+)
• IMPORTANT—In reality exchange rates are
affected by expectations of these variables.
• Currencies behave like other
financial assets:
• A nation’s currency is an asset whose
An Analogy value is determined by the (expected)
economic performance of that nation...
for Currency • … just as a share of stock is an
asset whose value is determined
Values by the expected financial

performance of that firm.
• We can think of a currency as a “share
of stock” in the issuing country.

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The Determination of Exchange

Exchange rates are simply

The € increase 5.97% against the dollar.

(i.e., in € terms, the US dollar became less expensive)

• How much did the yen change against the dollar?

• How much did the dollar change against the yen?

(the dollar price of the lira was devalued by 17%)

• We are asked to find:

The exchange rate is

Buy Fewer Demand for Supply of

• Demand for £—Americans will want more UK goods:

Buy More Demand for Supply of £

• Demand for £: US investors desire fewer UK financial assets:

In 1923, it took 4 of these beautiful

Depreciation of the ruble:

Values by the expected financial

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