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Exchange RateDetermination



Equilibrium in Exchange Rate

Depreciation/ Appreciation

Devaluation/RevaluationSupply Demand model to analyzeexchange rate changes



Demand and Supply

Suppose direct quote in Indonesia:Rp9.000/$ ->

Which one is foreign currency?

If we buy one dollar, we pay Rp9,000.

If we sell one dollar, we receive

Where do demand and supply for dollar come from?



Demand and Supply for

Dollar Suppose we have two countries: US andIndonesia

Demand for $ derived from demand for USgoods and US securities denominated in $

Supply for $ derived from demand for Indonesian goods and Indonesian securitiesdenominated in Rp

The $ brought to convert into Rp (to buyIndonesian goods) becomes supply for $



EQUILIBRIUM

EXCHANGE RATE

$ Quantitiy

Rp/$

9.000



Suppose prices in Indonesiaincrease at faster rate than

that in US, what will happento Demand and Supplycurves?



Changes in Equilibrium

Demand for $ will increase, because moreIndonesian people want to buy relativelycheaper US goods. Demand curve shifts tothe right

Suppy for $ will decreae, because fewer USpeople want to buy Indonesian goods. $ toconvert into Rp is getting less. Supply curveshifts to the left

New equlibrium rate: Rp10,000/$



New Equilibrium

$ Quantity

Rp/$

9,000

10,000

D

D¶

S

S¶



How Much Rp/$

deppreciate / appreciate?

Dollar appreciation/dep against Rp

= (S1 ± S0) / S0

= Rp/US$ new ± Rp/US$ oldRp/US$ old

= (10,000 ± 9,000)/9,000 = +11.11 %

Since the sign is positive, we say:$ appreciates against Rp by 11.11%



How much Rp appreciates or

depreciates against $?

The formula: (S0 ± S1)/ S1

(9,000 ± 10,000) / 10,000 = -0.1 or

-10%

Since the sign is negative(depreciation), we can say:

Rp depreciates against $ by 10%



Calculation of Exchange

Rates

Suppose US$ appreciates against Rp

by 20%, how much Rp appreciates or depreciates against $?

Suppose euro depreciates against yenby 15%, how much yen appreciates or depreciates against euro?



Some Variables affecting Exchange

Rates

Variables Impact

Inflation Negative

Economic Growth PositiveReal interest rate Positive

Nominal interest rate Negative

Central Bank Independence Positive

Country¶s competitiveness Positive

Loose monetary Policy Negative

Expectation Positive/Negative



We really say the effect of one variableon exchange rate, ceteris paribus

In reality, all variables worksimultaneously to impact exchange rate

Difficult to disentangle the effect of one

variable on the exchange rate



Central Bank Independence

Central Bank functions:

1. Maintain price stability

2. Maintain fair or low interest rate

3. Maintain exchange rate in the ideal zone

Monetary policy versus governmentpopular policy



INTERVENTION BY CENTRAL BANK

$ Quantitiy

Rp/$

9,000

Suppose initial exchange rate is Rp8,000/$. Exchange

rate moves quickly to Rp9,000/$. Central bank wants tomove back to Rp8,000/$. How they intervene?

8,000

S$

D$



INTERVENTION BY CENTRAL BANK

$ Quantity

Rp/$

9,000

Suppose initial exchange rate is Rp9,000/$. Exchange

rate moves quickly to Rp10,000/$. Central bank wantsto move back to Rp9,000/$. How they intervene?

10,000S$

D$



Central Bank Intervantion

The impact tends to be short term

Long term impcat could be achievedby changes in macro economicfundamentals

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