Order ready-to-submit essays. No Plagiarism Guarantee!
Note: Our papers are 100% human-written, not AI-generated.
We Write Essays for Students
Tell us about your assignment and we will find the best writer for your paper
Get Help Now!
What determines exchange rates? The answer, like every economic
issue in a free market, is supply and demand. We can look at exchange rate
variations through three lenses: the short run, medium run, and long run.
• Short run: transfers of bank deposits in response to interest
rate differentials
• Medium run: cyclical economic fluctuations
• Long run: flows of goods and services based on inflation,
productivity, tastes, and trade policy
The normal functioning of the market can be impeded by trade
barriers. Imagine that the U.S. government imposes trade barriers on products
from the UK. UK goods become more expensive. U.S. consumers purchase fewer
pounds to buy UK goods. The decrease in demand for pounds increases the value
of the dollar, and the result is that trade barriers lead to appreciation of
the dollar.
There is a theory known as the law of one price, which states
that identical goods should cost the same in all nations. One whimsical tool to
prove such relationships is the Big Mac Index, named for the famous hamburger
sold across the globe. It is used to determine the extent to which market
exchange rate differs from equilibrium exchange rate.
The purchasing power parity theory is an application of the law
of one price, applied to national price levels. It implies that currency prices
adjust to make goods and services cost the same everywhere and that changes in
relative national price levels determine changes in exchange rates over the
long run.
Let’s look at the historical value of the dollar since the
1980s.
• The increase in value of the dollar began in 1979. This was
caused by tighter monetary policy and higher interest rates in response to high
inflation. Larger deficits also increased interest rates.
• The late 80s saw depreciation of the dollar because of
speculation that the dollar could not continue to appreciate, as well as an
expansionary monetary policy.
• The 1990s began with decrease in value of the dollar
associated with a weak economy, expansionary monetary policy, and low interest
rates.
• The mid-1990s saw economic growth and budget surplus, and
Japanese and
• European economies were sluggish. These factors caused
appreciation of the dollar.
• The dollar depreciated in 2002–04 because of decreased demand
for U.S. investments and recession. The stock market decline, accounting
practices, and low interest rates were also factors.
• By 2005, the dollar began to appreciate again due to economic
improvement and higher interest rates associated with restrictive monetary
policy.
Forecasting exchange rates can be cumbersome but is an important
effort for global organizations. There are multiple methods for forecasting
exchange rates. These include:
• Judgmental
forecasts
o “subjective” or “common sense” models
o wide array of political and economic data
• Technical
forecasts
o extrapolation from past trends
o ignores economical and political determinants
o analysis of short-term movements
• Fundamental
analysis
o statistical estimation based on economic variables related to
currency supply and demand
o best suited to long-term forecasting
Balance of payment adjustments are necessary due to the
complicated nature of the underlying factors. Balance of payment moves towards
equilibrium automatically as national price levels adjust.
In the gold standard:
• each nation’s money supply consisted of gold or paper money
backed by gold
• each nation set price of gold in terms of its currency
• free import and export of gold
• balance of payments surplus causes nation to acquire gold and
increase its money supply
The quantity theory of money is an important element in this.
The equation of exchange is:
MV = PQ
• M = nation’s money supply
• V = velocity of money
• P = average price level
• Q = volume of final goods
o classical economists assumed V and Q were constant
§
implication is that balance of payments is linked to money supply, which is
linked to domestic price level
Assuming balance of payments deficit
• gold outflow (under classical gold standard)
• decrease money supply
• reduce domestic price level
• increase international competitiveness
• increase exports and decrease imports
• return to balance of payment equilibrium
Assuming balance of payments surplus
• opposite movements in each variable would lead to fewer
exports
• again returns to equilibrium
Counterarguments are:
o nation’s money supply no longer linked to its gold supply
o central banks can offset a gold outflow through expansionary
monetary policy or a
o gold inflow through restrictive monetary policy
o if full employment does not exist, prices may not rise in
response to an increase in money supply
o prices and wages may be inflexible in a downward direction
Interest Rate Adjustments
o nation with a balance of payments surplus has increase in
money supply leading to lower interest rates
o nation with deficit sees decrease in money supply leading to
higher interest rates o interest rate differential leads to flow of investment
capital from surplus nation to deficit nation
o facilitates balance of payments equilibrium
o exception—if central bankers reinforced interest rate
adjustments
Income Adjustments:
o Keynesian assertion
o income determination
§ nation
with surplus will have increased income leading to increased imports
§ nation
with deficit will see income decline leading to fewer imports
§
assumption of fixed exchange rates
o foreign
repercussion effect—increase in income stimulates imports
causing an expansion abroad which in turn increases demand for home country’s
exports
Monetary Adjustments
o quantity of money demanded
§ directly
related to income and prices
§
inversely related to interest rates
o money supply as multiple of monetary base
§ domestic
component—credit created by monetary authority
§
international component—result of foreign balance of payments disequilibrium
Results:
• excess money supply => deficit
• excess money demand => surplus
References
Suranovic, S. (2011). International
economics: Theory and policy. Irvington, NY: Flat World Knowledge.
The post What determines exchange rates? The answer, like every economic issue in a free market, is supply and demand. We can look at exchange rate variations through three lenses: the short run, medium run, and long run. appeared first on essay-paper.
Welcome to originalessaywriters.com, our friendly and experienced essay writers are available 24/7 to complete all your assignments. We offer high-quality academic essays written from scratch to guarantee top grades to all students. All our papers are 100% plagiarism-free and come with a plagiarism report, upon request
Tell Us “Write My Essay for Me” and Relax! You will get an original essay well before your submission deadline.
