THE DETERMINATION

OF EXCHANGE RATE
BY

ANNISA RAMADHANI
BERTHA MUHAMMAD
KARINA FITRI
ZAHIRA SALSABELLA
 Learning Objectives
༝ To explain the concept of an equilibrium exchange rate
༝ To identify the basic factors affecting exchange rates in a floating
exchange rate system
༝ To calculate the amount of currency appreciation or depreciation
associated with a given exchange rate change
༝ To describe motives and different forms and consequences of central
bank intervention in foreign exchange market
༝ To explain how and why expectations afffect exchange rates
EXCHANGE RATE

༝ Appreciation
Currency’s ༝ Positive Percentage Change
Value

༝ Depreciation
Currency’s
༝ Negative Percentage Change
Value
 2.1 Exchange Rate Equilibrium

 The exchange rate represents the price of

one nation’s currency in terms of another
currency, often termed the reference
currency.
 Exchange rate can be for spot or forward
delivery.
 Exchange Rate Equilibrium

༝ Spot rate is the price at which currencies are

traded for immediate delivery; actual delivery
takes place two days later.

༝ Forward rate is the price at which foreign

exchange is quoted for delivery at a specified
future date.
 Exchange Rate Equilibrium

༝ Demand for a currency increases when

the value of the currency decreases,
leading to a downward sloping demand
schedule.

༝ Supply of a currency increases when the

value of the currency increases, leading
to an upward sloping supply schedule.
Demand Schedule for Euro
Supply Schedule of British Pounds for Sale
 Exchange Rate Equilibrium

Equilibrium equates the quantity of

pounds demanded with the supply
of pounds for sale.
Equilibrium Exchange Rate Determination
 Factors That Affect the Equilibrium Exchange
Rate
༝ Relative Inflation: Increase in U.S. inflation leads to
increase in U.S. demand for foreign goods, an increase in
U.S. demand for foreign currency, and an increase in the
exchange rate for the foreign currency. Changes in
relative inflation rates can affect international trade
activity, which influences the demand and supply of
currencies and therefore influences exchange rates.
༝ Relative Interest Rates: Increase in U.S. rates leads to increase in demand
for U.S. deposits and a decrease in demand for foreign deposits, leading to
a increase in demand for dollars and an increased exchange rate for the
dollar.

༝ Real Interest Rates; Although a relatively high interest rate may attract
foreign inflows (to invest in securities offering high yields), the relatively
high interest rate may reflect expectations of relatively high inflation.

Real interest rate = Nominal interest rate − Inflation rate

This relationship is sometimes called the Fisher effect.

༝ Relative Economic Growth Sales
༝ Similarly, a nation with strong economic growth will attract
investment capital seeking to acquire domestic assets. The
demand for domestic assets, in turn, results in an increased
demand for the domestic currency and a stronger currency,
other things being equal. Empirical evidence supports the
hypothesis that economic growth should lead to a stronger
currency. Conversely, nations with poor growth prospects
will see an exodus of capital and weaker currencies.

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༝ Political and Economic Risk
༝ Other factors that can influence exchange rates include
political and economic risks. Investors prefer to hold lesser
amounts of riskier assets; thus, lowrisk currencies—those
associated with more politically and economically stable
nations—are
more highly valued than high-risk currencies

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Calculating Exchange Rate Changes
2.2 Expectations and The Asset Market Model of Exchange Rates

༝ The Nature of Money and Currency Values

the economic factors that affect a
currency’s foreign exchange value include its usefulness as a store
of value, determined by its
expected rate of inflation; the demand for liquidity, determined by
the volume of transactions
in that currency; and the demand for assets denominated in that
currency, determined by the
risk-return pattern on investment in that nation’s economy and by
the wealth of its residents
• Central Bank Reputations and Currency Values
A central bank is the nation’s official monetary authority; its
job is to use the
instruments of monetary policy, including the sole power to
create money, to achieve one or
more of the following objectives: price stability, low interest
rates, or a target currency value

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2.2 Expectations and The Asset Market Model of Exchange Rates

༝ Price Stability and Central Bank Independence

A central bank whose
responsibilities are limited to price stability is more likely to achieve
this goal
༝ Currency Boards
a currency board system, there is no central
bank. Instead, the currency board issues notes and coins that are
convertible on demand and at
a fixed rate into a foreign reserve currency
2.2 Expectations and The Asset Market Model of
Exchange Rates

༝ Dollarization
The ultimate commitment to monetary credibility and a
currency good as
the dollar
2.3. The Fundamentals of Central Bank Intervention

a) How Real Exchange

Rates Affect Relative
Competitiveness

For example, the rise in the value

of the U.S. dollar
from 1980 to 1985 translated
directly into a reduction in the
dollar prices of imported goods
and raw materials. As a result,
the prices of imports and of
products that compete with
imports
began to ease
b) Foreign Exchange Market Intervention
Depending on their economic goals, some governments will prefer
an overvalued domestic currency, whereas others will prefer an
undervalued currency

c) The Effects of Foreign Exchange Market Intervention

2.4. The Equilibrium Approach to Exchange Rates
a) Disequilibrium Theory and Exchange Rate Overshooting
The correlation between nominal and real exchange rate changes
is supplied by the disequilibrium theory of exchange rates. The
sequence of events associated with overshooting is as follows:
1) The central bank expands the domestic money supply
2) This monetary expansion depresses domestic interest rates
3) Capital begins flowing out of the country because of the lower
domestic interest rates, causing an instantaneous and
excessive depreciation of the domestic currency
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b) The Equilibrium Theory of Exchange Rates and Its
Implications
The equilibrium approach has three important implications for
exchange rates:
1) exchange rates do not cause changes in relative prices but
are part of the process through
2) attempts by government to affect the real exchange rate via
foreign exchange market intervention will fail
3) there is no simple relation between changes in the exchange
rate and changes in international competitiveness,
employment, or the trade balance
2.5. Summary and Conclusions
The healthier the economy is, the stronger the currency is
likely to be. Exchange rates also are crucially affected by
expectations of future currency changes, which depend on
forecasts of future economic and political conditions.
In order to achieve certain economic or political objectives,
governments often intervene in the currency markets to
affect the exchange rate. Although the mechanics of such
interventions vary, the general purpose of each variant is
basically the same: to increase the market demand for one
currency by increasing the market supply of another.
Alternatively, the government can control the exchange rate
directly by setting a price for its currency and then
restricting access to the foreign exchange market.