CHAPTER 2

The Determination of Exchange Rates

Part I. Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM
A. The exchange rate is the price of one unit of foreign currency expressed as a certain price in local currency. For example $.99/ means the euro in the U.S. is worth $.99.

Equilibrium Exchange Rates B. How Do Americans Purchase German Goods? 1. Foreign Currency Demand:
-derived from the demand for foreign countrys goods, services, and financial assets. e.g. Americans demand German goods such as Mercedes autos

The Demand for in the U.S.

$/

D
$1.20/ $1.10/ $1.00/

Qty
At higher exchange rates, Americans demand less euros and vice versa.

Equilibrium Exchange Rates

2. Foreign Currency Supply:
- derived from the foreign countrys demand for local goods. - Foreign buyers must convert their currency in order to purchase. e.g. German demand for US goods such as Dell computers means Germans must convert euros to US $ in order to buy.

The Supply of in the U.S.

$/
$1.20/

$1.10/
$1.00/

Qty
At higher exchange rates, Germans supply more euros and vice versa.

Equilibrium Exchange Rates

3. Equilibrium Exchange Rate
occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

The $/ Equilibrium Rate

$/
Equilibrium

D S
$1.10

Qty

Equilibrium Exchange Rates

C. How Exchange Rates Change
1. Increased demand as more foreign goods are demanded, more of the foreign currency is demand at each possible exchange rate 2. The price of the foreign currency in local currency increases.

Equilibrium Exchange Rates

3. Home Currency Depreciation a. Foreign currency more valuable than the home currency. b. Conversely, the foreign currencys value has appreciated against the home currency.

The US$ Depreciates When

$/

D D S

$1.20/

$1.10/
Q1 Q2

Qty

Equilibrium Exchange Rates

D. Computing a Currency Appreciation

= (e1 - e0)/ e0
where e0 = old currency value

e1 = new currency value

Equilibrium Exchange Rates

EXAMPLE: Appreciation
If the dollar value of the goes from $1.10 (e0) to $1.20 (e1), then the has appreciated by (1.20 - 1.10)/ 1.10 = 9.1%

Equilibrium Exchange Rates

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1
where e0 = old currency value e1 = new currency value

Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation
Use the formula
(e0 - e1)/ e1 substituting (1.10 1.20)/1.20 = - 8.3% is the US$ depreciation.

Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:
1. Inflation rates

2. 3.

Interest rates GNP growth rates

Sample Problem
Suppose the U.S. dollar appreciates against the Russian ruble by 500%. How much did the ruble depreciate against the dollar?

Sample Problem
Depreciation of the ruble:

(e0 e1 ) x e1

e1 e0 5 e0 e0

Sample Problem
e e0 1 e0 e0

e 1 1 1 5 1 e0 e 6e0 1

e0 6e0 x 6e0 5 x 6 x 83%

(e0 e1 ) x e1