Exchange Rate Determination

An exchange rate measures the value of one currency in units of another currency. It is determined by demand of that currency relative to the supply of that currency.

Decline in value is called depreciation while increase in value is called apprecitation.
The percentage change in value is determined as

S(t) – S(t-1)/S(t-1)

where St is the spot rate

Spot Rate is the price quoted for immediate settlement on a commodity, security or currency. It is based on the value of the asset on at the moment of the quote. It depends on how much the buyers are willing to pay and how much the sellers are willing to accept.

Factors that affect Exchange Rate(comparison done between usa and britain)

1)Relative Inflation Rate

Let US inflation rate increases. Cost of commodities increases. Now they US citizens would shift their interest from US goods to British goods (sort of a substitution effect) because their prices have remained as it is. So, demand for Pounds increases. Similarly, British change their preference to their own produce so they now require lesser cash as they do not have to exchange Pound for Dollars. So  

supply of pound decreases. This leads to increase in exchange rate .

2)Relative Interest Rate

Let US interest rate increases. Now US people will borrow less dollars so that they do not to pay large interest. However, saving more will be a good decision at this time. Saving in what? US dollars. So , supply of Pounds increases so that it can be exchanged in return of dollars. Also, the US demand less of pounds now. This leads to decrease in exchange rate.

3)Relative Income Level

Let the US income level increase. The have more money so would like to buy more of British goods as well. So demand of Pound increases. The British have no such income change, so the supply of Pound remains the same. Therefore exchange rate increases.

How does higher interest reflect expectations of relatively high inflation.?