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International Finance

Determination of Exchange Rates,

Exchange Rate Dynamics and

Foreign Exchange Market


A network of markets and institutions that

handle foreign currency


Spot Market
Forward Market

Foreign Exchange Market


of Demand for Forex

Source of Supply for Forex

Factors Affecting Demand and Supply

(Shapiro & Sarin, 2009)

Inflation Rates
Relative Interest Rates
Relative Economic Growth
Political and Economic Risks

Participants in Forex Market

Bank and Non-Bank Forex Dealers
Individuals and Firms
Speculators and Arbitrageurs
Central Banks and Treasuries
Forex Brokers

Calculating Exchange Rate Changes

Percentage increase or decrease in value of

the domestic currency in terms of another


First Sample Problem


2002, the yen went from

$0.0074074 to $0.0084746.
By how much did the yen appreciate
against the dollar?
By how much did the dollar depreciate
against the yen?

Second Sample Problem

On April 1, 1998, the government of

Yugoslavia devalued the Yugoslav dinar,
setting its new rate at 10.92 dinar to the dollar,
from 6 dinar previously.

By how much has the dinar devalued against the

By how much has the dollar appreciated against
the dinar?

Exchange Rate Dynamics: Asset Market

Model (Appleyard & Field, 1998)
Exchange rates treated as the relative
prices of two financial assets traded in an
efficient market
Value of a currency determined largely by
expectations and how strongly people
would want to hold on to assets
denominated in the currency

Exchange Rate Dynamics: Asset Market

Model Important Assumptions

Integrated financial markets

Domestic residents can hold to both domestic
and foreign financial assets
Financial assets regarded as imperfect
Asset holders readily switch out of one type of
asset to another whenever events alter returns
Investors are forward looking (i.e. maximize
utility and try acquiring as much information
and knowledge about markets to form

Exchange Rate Dynamics: Asset Market

Model - Types of Financial Assets
Domestic Money
Domestic Bonds
Foreign Bonds


Exchange Rate Dynamics: Asset Market

Model Demand Factors of FAs

Return rate on domestic bond yield (rD)

Return rate on foreign bond yield (rF)
Expected change in the value of the local
currency (%e)
(+) expected appreciation
(-) expected depreciation
Domestic real income (YD)
Domestic price level (PD)
Domestic wealth (W D)


Exchange Rate Dynamics: Asset Market

Model Functional Forms
Domestic Money
(-) (-) (-) (+) (+) (+)
MD = f( rD , rF , %e , YD , PD , W D )
Domestic Bonds
(+) (-) (+) (+) (-,+) (+)
BD = f( rD , rF , %e , YD , PD , W D )
Foreign Bonds
(-) (+) (-) (+) (-,+) (+)
BF = f( rD , rF , %e , YD , PD , W D )


Exchange Rate Regimes

Pegged Exchange Rate Regime
Managed Float Exchange Rate Regime

Clean Float Exchange Rate Regime


Exchange Rate Intervention :

Money Defined

What is Money?
Bills and coins
Deposits in bank accounts
Access to credit
Store of value and liquidity


Exchange Rate Intervention:

Central Bank Defined

What is a Central Bank?

A central bank, or reserve bank, by
definition is the monetary authority
within a country or coalition of
countries that regulates money


Exchange Rate Intervention:

Responsibilities of a Central Bank
Printing and distribution of the
domestic currency
Implementation of monetary policy
Regulating the banking industry
Setting official interest rates
Lender of last resort


Exchange Rate Intervention:

Objectives of Central Bank
Price stability
Low interest rates
Stabilize currency value


Exchange Rate Intervention:

CB Reputation

Independence from executive branch of


Resists pressure to make short-term policy

decisions inconsistent with long term growth

Political influence over a CB leads to

perception of inflation risk

Exchange Rate Intervention:

Role of CB

Buy and sell forex to protect value of


Minimize opportunity cost of holding to

excess forex


Exchange Rate Intervention :

Govt Goals in an Open Economy

Internal Balance

External Balance


Exchange Rate Intervention:


Analysis begins with definition of money supply

MS = CP + DD

Where MS = money supply

CP = currency in circulation
DD = demand deposits


Exchange Rate Intervention:


CB affects domestic money supply by influencing the

monetary base (high powered money)

H = CP + RE
where H = monetary base
RE = reserves held by KBs


Exchange Rate Intervention:


Assets and liabilities side of high powered

money (H)
IR + CBC = CP + RE = H
H = IR + CBC
CB has no control over IR but can influence
To sterilize the effects any form of
intervention of CB in the market, it would get
to engage in open market operations