DETERMINATION OF EXCHANGE RATES:
When we study the determinants of exchange rates, we must distinguish between long run determinants and short run because the determinants in the two situations are different and exchange rates are more volatile.
In the long run, the exchange rates are determined by the movement of the important variables, called the fundamentals, like price and real incomes in different countries. The long run exchange rates between two currencies are determined by supply and demand. There are other factors that affect the exchange rates by shifting the demand and supply curves. An important such factor is real income in an economy, which reflects the productivity of the country's resources. Change in real income at home relative to that abroad will shift the demand and supply curves in the foreign exchange market. In the long run the equilibrium exchange rate is determined by the intersection of supply and demand curves. Shifts in the supply curve or demand curves are brought about by variables such as real income and price levels. Another important long-run determinant of exchange rates is the domestic price level compared to that abroad. A basic result is that all things remaining equal, an increase in a country's price level will lead to long-run depreciation of the country's currency. The third factor influencing exchange rates are tariffs, trade barriers and preferences. These
affect the ability of domestic residents to purchase foreign goods and hence affect demand for foreign currencies. This altered demand changes the exchange rate. Of course, the same kind of effect works for foreign consumers to buy domestic goods and services. Finally, it is suggested that interest rates prevailing in the domestic financial markets as well as in foreign markets influence long run exchange rates. However, if interest rate parity holds, interest rates affect exchange rates mainly in the short run. If interest rates in country A are higher relative to those in country B, holders of deposits in country B's currency in B's domestic economy find it
worthwhile to convert the currency of B into currency of A. this raises the demand for A's currency. Thus a rise in interest rate in A leads to a decrease in the currency of A in the domestic market.
We have put forward several determinants of exchange in the long run. There is a simpler theory, called purchasing power parity (PPP) that asserts that in the long run the exchange rate between two currencies is determined only by differences in the price level in the two countries. The idea of PPP derives from the law of one price, which states that two identical goods within a same market must sell at the same price. Violations of the law will be corrected by consumers buying only the cheaper one. Applied to international economics, the law of one price assets that an identical good must sell at the same price expressed in the same currency. The law of one price applies to identical goods, but has extended to purchasing power parity, which is a relationship not between prices of identical goods but between price
levels in different countries. Purchasing power parity states that the price level in the domestic economy times the exchange rate (expressed as foreign currency per unit of domestic currency) equals the price level in a foreign country:
Pd × e = Pf
where Pd is price level in the domestic economy, Pf is price level in a foreign country and e is the exchange rate.