FACTORS

AFFECTING
EXCHANGE
RATES
MEMBERS
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LESSON OUTLINE
1. Basic understanding of exchange rates

2. Factors affecting exchange rates

3. Real-world example demonstrates

exchange rate

4. Activity
1. BASIC UNDERSTANDING
OF EXCHANGE RATES

Exchange rate is the value at which one currency

may be converted into another.

In finance, an exchange rate is also known as a

foreign-exchange rate. It focuses on determining
exchange rates used for international trade,
investment, and currency conversions
 The foreign exchange market (Forex, FX,
or currency market) is a global
What is foreign exchange market decentralized or over-the-counter (OTC)
market for the trading of currencies.
Forex market determines foreign
exchange rates for every currency. This
market includes all aspects of buying,
selling, and exchanging currencies at
Why exchange rates important current or determined prices.

2 type of transaction:
+ Spot exchange rate
+ Forward exchange rate
How is foreign exchange traded
 Exchange rates are important because
they affect the relative prices of
domestic and foreign goods.

What are foreign exchange market When a country's currency appreciates,

the country's goods abroad become
more expensive, and foreign goods in
that country become cheaper.

Why exchange rates important When a country's currency depreciates,

its goods abroad become cheaper, and
foreign goods in that country become
more expensive

How is foreign exchange traded

 Most foreign exchange transactions do
not involve the direct exchange of
What are foreign exchange market
physical currency but rather the trading
of bank deposits denominated in
different currencies.

The foreign exchange market is

Why exchange rates important enormous, with daily trading volumes
exceeding $5 trillion, highlighting its
critical role in the global economy.

How is foreign exchange traded

2. FACTORS THAT AFFECT
EXCHANGE RATES
A) EXCHANGE RATES IN
LONG-RUN
More stable

Changes in economic
affects exchange
rates gradually

Refers exchange
rates over a period,
typically a year or
more
A) EXCHANGE RATES IN
LONG-RUN

Law of one price Theory of Purchasing

Power Parity
A) EXCHANGE RATES IN
LONG-RUN The Law of One Price states
that: Identical goods should
cost the same in different
markets when expressed in a
common currency, after
Law of one price considering transportation
costs and trade barriers. If a
product is priced differently in
two countries, the difference is
usually due to factors like
exchange rates or extra costs.
Theory of purchasing
power parity
A) EXCHANGE RATES IN
$1,000 £800
LONG-RUN

Law of one price

EXCHANGE RATE OF 1 USD = 0.75 GBP

--> the laptop should cost £750 in the
U.K
--> £800 price may result from taxes,
shipping costs, market demand, or
Theory of purchasing
power parity pricing strategies.
A) EXCHANGE RATES IN
LONG-RUN Theory of Purchasing Power Parity (PPP)
extends the Law of One Price to entire
baskets of goods. PPP suggests that
exchange rates should adjust so that the
same basket of goods costs the same in
Theory of purchasing different countries when expressed in a
power parity common currency.

Law of one price

A) EXCHANGE RATES IN
LONG-RUN
Doesn’t apply to products
where quality, design, and
brand matter

Why the Theory of

Purchasing Power
Parity cannot fully
explain exchange
rates ?
Price changes in these non-
Ignores goods and tradable goods can raise a
services that aren’t country's price level without
traded affecting exchange rates.
internationally
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
Relative price levels
Trade barriers
Factors Preferences for domestic versus foreign goods
Productivity

Factors that boost the demand for domestic goods strengthen

The key takeway the currency, while those favoring foreign goods weaken it.
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
Higher U.S. prices, foreign prices stay the same →
Weaker dollar (reduced demand for U.S. goods)
Higher Japanese prices → Stronger dollar (U.S.
goods become cheaper)
Relative Price Levels
( PPP Theory )

=> Over time, higher prices in a country

lead to a weaker currency, while lower
prices strengthen it.
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
tariffs: taxes on imports
quotas: limits on imports

The U.S. raises tariffs or reduces quotas on sesame

Trade Barriers
seeds from Japan -> more people buy American
sesame seeds -> stronger dollar.

=> Over time, higher trade barriers can

strengthen a country's currency by boosting
demand for local goods and reducing imports.
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
Japan increases its demand for American
goods → Stronger dollar
Preferences for
Americans prefer Japanese goods → demand
domestic versus
foreign goods
for imports rises -> Weaker dollar

=> In the long run, higher export demand

strengthens a country's currency, while higher
import demand weakens it.
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
Preferences for Example: In the 1980s, when Japanese cars became
domestic versus more popular in the U.S., the demand for Japanese
foreign goods
imports rose, contributing to a depreciation of the dollar
as more dollars were exchanged for yen to buy those
cars.
FACTORS AFFECTING EXCHANGE RATES IN
THE LONG RUN
Higher productivity → More goods produced with the
same resources → Products become cheaper and
more attractive to foreign buyers → Increased exports
→ Stronger currency.
Productivity eg: If the U.S. becomes more productive in manufacturing
cars, it can produce more cars at lower costs, increasing
exports leading to demand for the U.S. dollar rises
Lower productivity → Fewer goods produced →
Reduced exports → Weaker currency.

=> Higher productivity tends to strengthen a country's

currency, while lower productivity can weaken it.
B) EXCHANGE RATE
IN THE SHORT RUN
 A SUPPLY AND
DEMAND ANALYSIS
Exchange rates change slowly in the long run, but
daily fluctuations are driven by short-term factors,
reflecting the relative prices of domestic and foreign
assets. The asset market approach, based on supply
and demand, explains these changes by focusing on
decisions to hold domestic or foreign assets.
 Supply Curve for Domestic Assets
A SUPPLY The supply of U.S. dollar-denominated assets, such as

AND DEMAND bank deposits, bonds, and stocks, is fixed and does not
change with the exchange rate. Therefore, the supply

ANALYSIS
curve is vertical, meaning the quantity of dollar assets
supplied remains the same at any exchange rate.

Demand Curve for Domestic Assets

The demand curve shows that when exchange rates fall,
domestic assets become more attractive, increasing
demand. When rates rise, demand decreases. Therefore,
the demand curve slopes downward.
A SUPPLY Equilibrium in the Foreign Exchange Market

AND DEMAND Equilibrium occurs when the quantity of dollar

ANALYSIS assets demanded equals the quantity supplied.

If the exchange rate is too high, excess supply

causes the dollar to fall.

If the rate is too low, excess demand drives

the dollar up.

The exchange rate adjusts to reach equilibrium.

EXPLAINING
CHANGES IN
EXCHANGE RATES
We assume the supply of dollar assets is fixed.
To explain exchange rate changes, we focus on factors
that shift the demand curve. The demand for dollar
assets depends on the expected return compared to
other assets, with shifts occurring when other factors
change, while the exchange rate remains constant.
 D
DOMESTIC INTEREST RATE I
When i Drises: When i Dfalls:
Dollar assets become more attractive. Dollar assets become less attractive.
Demand increases, shifting the demand curve right. Demand decreases, shifting the demand curve left.
Equilibrium exchange rate rises (E1 to E2). Domestic currency depreciates (E ↓).
 F
FOREIGN INTEREST RATE I
When i F rises: When i F falls:
Foreign assets become more attractive. Dollar assets become more appealing.
Demand for dollar assets decreases, shifting the Demand increases, shifting the curve right and
demand curve left. strengthening the dollar.
Dollar value falls, reaching a new equilibrium at a
lower exchange rate (D1 to D2).
 FOREIGN INTERCHANGE
IN EXPECTED FUTURE EXCHANGE RATE
If the future exchange rate (Eet+1) rises:
Investors expect the currency to appreciate.

They are more likely to invest in assets denominated in that currency, increasing demand.

This drives up the currency’s value and raises the current exchange rate (E ↑).
EXAMPLE IN VIETNAM
Vietnam's Economic Challenges (2024)

High Decreased Low

Inflation GDP growth
interest rates FDI inflows productivity

Limit capital Raises essential uncertainty Hinders the Projected at

access, slow goods prices, impacts large country’s 4.5%-5%, with
production, reduces projects and competitiveness potential for
increase purchasing foreign in the global recovery through
unemployment power investments market timely policy
measures
EXAMPLE IN VIETNAM
Exchange Rate Issues

Influenced by domestic and global factors, including inflation, capital flows,

external debt, and trade imbalances.

To address these challenges, Vietnam needs to focus on maintaining

economic stability, controlling inflation, managing external debt,
strengthening foreign reserves, and promoting export-driven growth to
improve the balance of trade.
REAL-WORLD EXAMPLE:
JAPAN IN 2022
The Japanese Yen is one of the most important
currencies in the world. It is the third most traded
currency. But the Japanese yen (JPY) can be one of the
more volatile currencies when it comes to exchange
rate fluctuations.
 JAPAN IN 2022
Japan has a strong reliance on
international factors, causing the value of
the yen to change rapidly based on both
domestic and foreign economic
decisions.
In 2022, the Japanese yen fall past 160
per Dollar for first time since 1990
 REASONS CAUSING THE VOLATILITY
Japan's interest rates have been
extremely low due to a sluggish

Japan's Low-Interest economy, rising debt, and an aging

population. These low rates aim to
Rate Policy
encourage inflation, boost bank lending,
and spur demand. This lead to:
Japan’s Heavy Reliance
A significant interest rate differential
on Trade
The yen is used in carry trades
The yen is a safe-haven asset
 REASONS CAUSING THE VOLATILITY
Japan is a major exporter of many products. When the yen strengthens,
Japanese goods become more expensive abroad, reducing export sales. A
weaker yen boosts exports but increases the cost of imports, driving up
domestic prices.
Japan's Low-Interest Changes in international demand or trade policies can lead to significant
Rate Policy fluctuations in the yen’s value

Japan’s Heavy Reliance

on Trade
RESULT
The depreciation of the Japanese Yen in 2022 had mixed effects.
Positive:
Boosted exports by making Japanese goods like cars and
electronics more competitive
Reduced public debt pressure by easing foreign currency
conversions.
Negative:
Increased import costs
Raising prices for essentials like oil and food, which led to higher
living expenses, reduced purchasing power.
Less attractive to foreign tourists and increased travel costs for
Japanese citizens abroad.