Exchange Rates

As economic conditions change, exchange rates can change substantially A decline in a currencys value is often 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

Exchange Rates
Percent in foreign currency value SSt1/St1

Exchange Rate Equilibrium

One exchange rate/pt of time

Factors Influence Exchange Rate

Factors Influence Exchange Rates

Relative Inflation Rates
US Inflation US demand for British goods British desire for US goods

Factors Influence Exchange Rates

Relative Interest Rates US Interest Rates
US demand for British bank deposit British desire for US bank deposit

Factors Influence Exchange Rates

Relative interest rates
A Relatively high interest rate many actually reflect Expectations of relatively high inflation, which may discourage foreign investment It is thus to consider the real interest rate which adjusts the nominal interest rate for inflation.

Factors Influence Exchange Rates

Relative Interest Rates Real interest rate = Nominal interest rate inflation rate This relationship is sometimes called the Fisher effect
Important: Other factors constant ceteris peribus, there is high correlation between RIR and the dollars value

Factors Influence Exchange Rates

Relative Interest Rates Question What happens to exchange rate between $ and if the interests rate of a third country, for instance Canada, Changes?

Factors Influence Exchange Rates

Relative Income Level US income level
US demand for British goods No expected change for the supply of

Factors that Influence Exchange Rates

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.

Factors Influence Exchange Rates

Government Controls Recall the example in which U.S. interest rate rose relative to British interest rate The expected reaction was an increase in the British supply of pounds for sale to obtain more U.S. dollars (in order to capitalize on high U. S. money market yields) Yet, if the British government placed a heavy tam on interest income earned form foreign investments this could discount age the exchange of pounds for dollars

Factors Influence Exchange Rates

Expectations Foreign exchange markets react to any news that may have a future effect
News of a potential surge in US inflation may cause currency traders to sell dollars

Many institutional investors take currency positions based on anticipated interest rate movements in various countries

Factors Influence Exchange Rates

Expectations Economic signal that affect exchange rate can change quickly such that speculators may overreact initially and then find that they have to make a correction Speculation on the currencies of emerging markets can have a substantial impact of their exchange rates

Factors Influence Exchange Rates

Factors Influence Exchange Rates

Interaction of Factors The sensitivity of an exchange rate to the factors is dependent on the volume of international transactions between the two countries. Large volume of international trade relative inflation rates may be more influential Large volume of capital flows interest rate fluctuations may be more influential

Factors Influence Exchange Rates

Interaction of Factors An understanding of exchange rate equilibrium does not guarantee accurate forecasts of future exchange rates because that will depend in part on how the factors that affect exchange rates will change in the future.

Speculating on Anticipated Exchange Rates

Exchange rates are very volatile, and a poor forecast can result in a large loss One well-known bank failure, Franklin National Bank in 1947, was primarily attributed to massive speculative losses from foreign currency positions