International Finance

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Exchange Rate Determination Bill Reese

2 Learning Objectives

 In this unit we will learn:  The factors that influence changes in exchange rates  How these factors can influence the supply of and demand for a currency

3 Exchange Rate Determination

 Measuring exchange rate movements  Always in relation to another currency   Appreciate vs. depreciate Percent Δ = S t – S t-1 S t

4 Exchange Rate Determination

 Measured over some period of time  Longer times → greater movements   Some currencies are more volatile than others Example…

Exchange Rate Determination

6 Exchange Rate Equilibrium

 Demand for a currency  Quantity demanded increases as price of currency decreases  Supply of a currency for sale  Quantity supplied increases as price of currency increases

Demand Schedule for Pounds

Supply Schedule for Pounds

Equilibrium Exchange Rate

10 Factors that Influence XRs

 Liquidity of the currency  Illiquid market means large transactions may influence price

11 Factors that Influence XRs

 Relative inflation rates  Increase in U.S. inflation  Increased demand for British goods (greater demand for pounds)  Decreased demand for U.S. goods in Great Britian (fewer pounds for sale)  Demand and supply curves shift  Value of £ increases

Rising U.S. Inflation

Factors that Influence XRs

 Relative interest rates  Increase in U.S. interest rates  Less interest in investing in G.B. (decreased demand for pounds)  Increased interest by British investors in investing in U.S. (more pounds for sale)  Demand and supply curves shift  Value of £ decreases

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Rising U.S. Interest Rates

15 Factors that Influence XRs

 Relative income levels  Increase in U.S. income level  Increased demand for British goods (increased demand for pounds)  No change in supply of pounds for sale  Demand curve shifts  Value of £ increases

Rising U.S. Income Level

17 Factors that Influence XRs

 Government Controls  Imposing FX barriers  Imposing trade barriers  Intervening in FX markets  Policies affecting inflation, interest rates and income levels

18 Factors that Influence XRs

 Expectations vs. Changes  If FX market is efficient  Only unexpected changes and changes in expectations have effect  Interaction of factors  Rarely does anything happen in isolation  Levels of factor changes