International Finance Chapter 4 (Exchange Rate Determinants)

How do expectations influence exchange rates?

- Markets react to news that will have a future effect - institutional investors take positions based on anticipated interest rate movements - Economic signals change quickly resulting in some corrections - Speculation of currencies in emerging markets can impact their exchange rates

How do government controls affect exchange rates?

- Restrict the supply of foreign currency - Impose foreign trade barriers - Intervene in foreign exchange market (Ex: quantitative easing) - Affect macroeconomic variables like inflation, interest rates and income levels

Interaction of factors

- Sensitivity of an exchange rate to factors depends on volume of transactions

SDR (Special Drawing Rights)

Created by the IMF in 1969 o support the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves that could be used to purchase the domestic currency in the foreign exchange market to maintain required exchange rate. Initial two key reserve assets were gold and the US dollar but those were inadequate so decided to create a new reserve asset.

What does the liquidity of a currency tell us?

How easily a particular currency can be bought or sold in the foreign exchange market. Note that illiquid currencies are quite volatile

How do interest rates affect exchange rate?

If US interest rates increase, US demand for British bank deposits decrease so lowers demand for pound. Increased British desire for U.S. bank deposits so the supply of the pound increases.

How does the relative income level affect exchange rates?

Increase in US income level increases US demand for British goods so demand for pound increases. No change in supply of pound.

Large volume of capital flows

Interest rate fluctuations may be more influential

What could a relatively high interest rate indicate?

May reflect expectations of relatively high inflation which would discourage foreign investment. Must consider the real interest rate, which adjusts for inflation

Fisher effect

Real interest rate = nominal interest rate - inflation rate

Large volume of international trade

Relative inflation rates may be more influential

Calculate the percentage change in the value of foreign currency

Spot - Previous spot / Previous spot (a positive percent change represents appreciation while negative represents depreciation)

What does the exchange rate represent?

The price of a currency (determined by the demand for that currency relative to the supply for that currency in the foreign exchange market)

How to value SDR

The value is determined by summing the values in USD based on market exchange rates of a basket of major currencies. Rate is calculated daily and valuation basked is adjusted every five years.

What does the exchange rate measure?

The value of one currency in units of another currency

How does inflation affect exchange rates?

US inflation increases the demand for British goods US inflation decreases British desire for US good so supply of pount decreases

What currencies make up SDR?

USD, euro, pound, yen, yuan

Confounding effects

Various factors often interact

List the factors that influence exchange rates

inflation, interest rates, income level, govt controls, future expectations