Introduction to Finance


FIGURE 6.1 Exchange Rate Determination in the Currency Exchange Market



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R.Miltcher - Introduction to Finance

FIGURE 6.1
Exchange Rate Determination in the Currency Exchange Market


140
C H A PT E R 6 International Finance and Trade
Inflation, Interest Rates, and Other Factors 
In addition to changes in supply 
and demand relationships, currency exchange rates are also aff ected by changes in relative 
infl ation rates, relative interest rates, and political and economic risks. Let’s fi rst turn our 
attention to what happens if diff erences occur in expected infl ation rates between two coun-
tries. A nation with a relatively lower expected infl ation rate will have a relatively stronger 
currency. For example, if infl ation becomes lower in the United States relative to eurozone 
member countries, eurozone member products of comparable quality will become increas-
ingly more expensive. Americans will fi nd it less expensive to buy American products and so 
will eurozone members. The result will be fewer eurozone member imports into the United 
States and greater U.S. exports to eurozone member countries, causing an appreciation of the 
dollar relative to the euro. 
Purchasing power parity (PPP)
theory states that a country with a relatively lower 
expected infl ation rate will have its currency appreciate relative to a country (or group of 
countries using a single currency) with a relatively higher expected infl ation rate. A simplifi ed 
PPP relationship can expressed as the percentage change in a foreign currency (% FC Change) 
being approximately equal to the diff erence in infl ation rates expected for the two involved 
countries. This can be expressed as,
Expected % FC Change ≈ InfR
hc
– InfR
fc
InfR
hc
is the expected infl ation rate for the home country and the InfR
fc
is the expected infl a-
tion rate for the foreign country. For example, if the U.S. (home country) infl ation rate is 
expected to be 3 percent next year and the eurozone member (foreign country) infl ation rate 
is expected to be 2 percent, we would expect the euro to appreciate (and the U.S. dollar to 
depreciate) over the next year. Using the above relationship, 
Expected % FC Change = 3% – 2% = 1%
Thus, the euro would be expected to appreciate relative to the U.S. dollar by 1 percent over 
the next year.
It is more technically accurate to express the expected percentage change in the FC using 
the relative infl ation rates between the two countries, as follows:
Expected % FC Change =
1 + InfR
hc
1 + InfR
fc
−1 (6.3)
The value “1” is subtracted from the relative infl ation ratio to show the expected FC change 
as a percentage. 
Returning to our example of an expected infl ation rate over the next year of 3 percent for 
the $US and 2 percent for the euro, the expected percentage change in the foreign currency 
(euro) is,
Expected % FC Change =
1.03
1.02
−1
Expected % FC Change = 1.0098 − 1 = .0098, or .98%
Thus, based on relative expected infl ation rates, PPP theory suggests that the euro will appre-
ciate by .98 percent over the next year.
Some economists use relative interest rates, instead of relative infl ation rates, between 
countries to estimate expected changes in currency exchange rates. Irving Fisher contended 
that the nominal (quoted) interest rate and the infl ation rate are related, and that the nominal 
interest rate consisted of a real rate of interest and an expected infl ation premium or rate.
3
The 

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