Determination of Exchange

Rates
 Learning Objectives
• Explain how exchange rate movements are measured.

• Explain how the equilibrium exchange rate is determined.

• Discuss the factors that determine exchange rates.

• Demonstrate how banks attempt to capitalize on anticipated exchange rate

movements.

• Propose strategies to deal with the persistent depreciation of the Ghana cedi.

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 Measuring Exchange Rate Movements (1)
• An exchange rate measures the value of one currency in units of another
currency.

• When a currency declines in value, it is said to depreciate.

• When it increases in value, it is said to appreciate.

• On the days when some currencies appreciate while others depreciate

against a particular currency, that currency is said to be “mixed in trading.”

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 Measuring Exchange Rate Movements (2)
• The percentage change (% D) in the value of a foreign currency is
computed as

Ending value – Beginning value

Beginning value

• Assume the spot rate of the dollar is GHS 8.0. The expected spot rate
one year from now is assumed to be GHS 9.5. What percentage
appreciation of the dollar does this reflect?
(9.5-8.0)/8.0 = 18.75%
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 Measuring Exchange Rate Movements (3)
• What percentage depreciation of the cedi does this reflect?

• The rate of depreciation of the cedi is reflected in the amount of dollars

a cedi can buy.

• Thus, using the indirect quotation, we get

Ending value – Beginning value
Beginning value
(0.1053-0.125)/0.125 = -15.76%
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 Annual Changes
in the Value of the Cedi
Source: Bank of Ghana

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 Exchange Rate Equilibrium
• Demand for a currency

• Supply for a currency GHS/

$
S0
• Equilibrium exchange rate
r0

D0

Quantity of $

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 What Factors Influence Exchange Rates? (1)

e  f INF , INT , INC , GC , EXP 

e = percentage change in the spot rate
 INF = change in the relative inflation
rate
 INT = change in the relative
interest rate
 INC = change in the relative
income level
2 Dec 2024
 GC = change in government controls 8
 What Factors Influence Exchange Rates? (2)
Relative Inflation Rates
$/£
S1
S0

r0
D1
D0

Quantity of £

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 What Factors Influence Exchange Rates? (3)

Relative
Interest Rates
$/£
S0
S1

r0

D0
D1

Quantity of £

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 What Factors Influence Exchange
Rates? (4)
Relative Interest Rates
• High interest rate may actually reflect expectations of relatively high
inflation, which may discourage foreign investment.

• It is thus useful to consider the real interest rate, which adjusts the
nominal interest rate for inflation.

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 What Factors Influence Exchange Rates? (5)
Relative Interest Rates

• This relationship is sometimes called the Fisher effect.

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 What Factors Influence Exchange Rates? (6)
• Relative Income Level
$/£

S0 ,S1
r1
r0
D1
D0

Quantity of £

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 What Factors Influence Exchange Rates? (7)
Government Controls
• Governments may influence the equilibrium exchange rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market, and
– affecting macro variables such as inflation, interest rates, and income
levels.

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 What Factors Influence Exchange Rates? (8)
Expectations
• Foreign exchange markets react to any news that may have a future
effect.
– News of a potential surge in inflation may cause currency traders to sell local
currency.

• Many institutional investors take currency positions based on

anticipated interest rate movements in various countries.

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 What Factors Influence Exchange Rates? (9)
Expectations
• Economic signals that affect exchange rates can
change quickly, such that
• speculators may overreact initially and then find that they
have to make a correction.

• Speculation on the currencies of emerging markets

can have a substantial impact on their exchange rates.

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 What Factors Influence Exchange Rates? (10)
Interaction of Factors
• The various factors sometimes interact and simultaneously affect exchange rate
movements.
• The sensitivity of an exchange rate to the factors is dependent on the volume of
international transactions between the two countries.
• Large volume of international trade 
– relative inflation rates may be more influential
• Large volume of capital flows  interest rate
– fluctuations may be more influential

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 Speculating on
Anticipated Exchange Rates (1)
• Banks attempt to capitalize on their forecasts of anticipated
exchange rate movements in the foreign exchange market.

• The potential returns from foreign currency speculation are high for
banks that have large borrowing capacity.

• The simple strategy is to get out of the currency about to depreciate

and into the currency that is going to appreciate against it.

• Then reverse the positions after the event to end up with more than
you started with.

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 Speculating on Anticipated Exchange
Rates (2)
London Bank expects the exchange rate of the New Zealand dollar to
appreciate against the £ from its present level of £0.35 to £0.38 in 30 days.

Borrows at 7.20% for 4. Holds £21,831,543

30 days
1. Borrows
£20 m
Repays £20,120,000
A profit of 21,831,543 – Exchange at £0.38/NZ$
Exchange at 20,120,000 = 1,711,543
£0.35/NZ$
Lends at 6.48%
2. Holds for 30 days
NZ$57,142,857 3. Receives
NZ$57,451,428

2 Dec 2024 19
 Speculating on
Anticipated Exchange Rates (3)
• London Bank expects the exchange rate of the New Zealand dollar to depreciate from its present
level of 0.50 euros to 0.48 euros in 30 days.

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 Review (1)
1) Assume the spot rate of the British pound is $1.73. The expected spot rate
one year from now is assumed to be $1.66. What percentage depreciation
does this reflect?
2) Why did the exchange rate of the dollar change recently?
3) Assume that the Ghana inflation rate becomes high relative to U.S inflation.
Other things being equal, how should this affect the (a) Ghanaian demand
for U.S dollars, (b) supply of U.S dollars for sale, and (c) equilibrium value of
the U.S dollar?

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 Review (2)
4. Assume U.S. interest rates fall relative to British interest rates. Other things being
equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of
pounds for sale, and (c) equilibrium value of the pound?
5. Explain why a public forecast by a respected economist about future interest rates
could affect the value of the dollar today. What factors affect the future
movements in the value of the dollar against the cedi?
6. How does the balance of payments affect the value of the cedi?
7. How does the value of the currency affect the economy?

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