Topic 11 - Exchange Rate Changes

• Exchange rate


  The value of one currency in units of another currency
• Depreciation


  When a currency declines in value
• Appreciation


  When a currency increases in value
• Mixed trading


  When some currencies appreciate while others depreciate against a specific currency
• Measuring exchange rate movements

  1. Compare spot rates at two specific points in time

  2. Compute percentage change in the value of the foreign currency

  
• Supply curve for domestic assets

  Can be fixed (vertical) or upward sloping (amount can be changed)
• Demand curve for domestic assets

  Most important determinant is the relative expected return of domestic assets
• Lower current value of the dollar

  Higher quantity demanded of dollar assets
• Relative inflation rates

  Affect US demand for British goods and hence the British pound
• Relative inflation rates

  Affect British desire for US goods and hence the supply of the British pound
• Relative interest rates

  Affect US demand for British bank deposits and hence the British pound
• Relative interest rates


  Affect British desire for US bank deposits and hence the supply of the British pound
• Real interest rate


  Nominal interest rate adjusted for inflation
• Higher interest rates may discourage foreign investment if they reflect expectations of high inflation
• Fisher effect


  Relationship between real interest rates, nominal interest rates, and inflation
• Relative income levels

  Affect US demand for British goods and hence the British pound
• Government controls

  • Governments may influence the equilibrium exchange rate by:
  • Imposing foreign exchange barriers
  • Imposing foreign trade barriers
  • Intervening in the foreign exchange market
  • Affecting macro variables like inflation, interest rates, and income levels
• Expectations


  Foreign exchange markets react to any news that may have a future effect
• Speculation on the currencies of emerging markets can have a substantial impact on their exchange rates
• The sensitivity of an exchange rate to the factors is dependent on the volume of international transactions between the two countries
• Increase in domestic interest rate

  Domestic currency appreciates
• Increase in domestic interest rate due to expected inflation

  Domestic currency depreciates
• Higher domestic money supply


  Domestic currency depreciates
• Speculating on anticipated exchange rates

  Borrowing in the weaker currency and investing in the stronger currency, provided the interest rate difference is not too adverse
• Exchange rates are very volatile, and a poor forecast can result in a large loss