Determination of exchange rates, Microeconomics

Assignment Help:

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: 

P× e = Pf

where Pis price level in the domestic economy, Pis price level in a foreign country and e is the exchange rate.


Related Discussions:- Determination of exchange rates

Explain how the price system eliminates a shortage, Explain how the price s...

Explain how the price system eliminates a shortage. A deficiency means that quantity demanded is greater as compared to quantity supplied. This will lead to upward pressure on pr

Production possibility curve, draw a production possibility frontier task u...

draw a production possibility frontier task using the graph and value and identity the pareto efficent and inefficient point and the marginal oppotunity cost of x for each point of

Elasticities of demand:, price of laptop increases by 20% and there is a 40...

price of laptop increases by 20% and there is a 40% drop in the quantity demanded?

Transport infrastructure, Transport Infrastructure: The development of...

Transport Infrastructure: The development of transport infrastructure plays an important role in the growth process through increasing mobility of resources and increasing fac

Demand-pull inflation, The average price level has increased at a relativel...

The average price level has increased at a relatively rapid rate since 2008 even though the deep recession that UK experienced in 2008/09. The growth in the price level has been dr

Standard indifference curve analysis, Use standard indifference curve analy...

Use standard indifference curve analysis to demonstrate whether the following statement is true or false. If the objective of government welfare programs is to provide lower inc

Narrowness definition of commodity, Why narrowness of definition of a commo...

Why narrowness of definition of a commodity may influence price elasticity of demand

What is return on investment, What is return on investment?   Return on ...

What is return on investment?   Return on investment is the profit earned by investing in some business or some project, for instance investment in stock exchange. Profit earned

Need answer as a assignment right now please, Consider what would happen if...

Consider what would happen if a taxes of 10000$ was imposed on imported automobiles on dealers.Using a demand and supply diagram, show its impact of price and quantity. Suppose the

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd