Question

Explain what determines exchange rates in the short and long run.

Answer 1

The exchange rate of an economy , which may be considered as two countries suppose A and B is defined by a variety of factors with the difference being the - Long run and Short run exchange rate .

Long Run -

In the long run PPP (Purchasing Power Parity) is a determinant which is an application of law of one price to entire economies .

It is an approach that compares two goods through basket of goods approach , according to this two currencies are in equilibrium i.e the currencies being at 'par' when the basket of goods is economically having a price at the same level with accounting for the rate of exchange .

Mathematically it is given by :

Ratios of exchange rates in two currencies = Ratio of price of good X in two currencies

(Exchange rate of currency 1) / (Exchange rate of currency 2) = (Price of Good X in currency 1) / (Price of Good X in currency 2)

PPP also puts an assertion that in the long run the exchange rates tend to balance at 1 i.e they arrive at equilibrium to restore the PPP. The PPP model explains the nominal exchange rate of the economies or countries.

Real long term exchange rate is also depended on the other parameters that evaluate the relative demand-supply of a countries production or output , the parameters being :

-Countries relative total factor productivity;

-Preferences of consumer's;

-Government spending and revenue(includes taxes);

-Structure of the economic marketplace;

Short run:

Short run exchange rates are influenced by the demand and supply of currencies in each of these countries , this can be better explained by the below example :

India(INR) and USA($) have had a long history of fluctuating exchange rate in the short run ; suppose the exchange rate is 70 INR =1 $

1. One day the demand for goods sold in $ increases thus increasing the exchange rate of $ as compared to INR , thus now the exchange rate becomes 74 INR = 1 $ i.e the value of dollar increases as compared to INR.
2. Speculations also lead to the fluctuations in the exchange rate in an economy , suppose the word about increase in the price of dollar spreads in the FOREX market thus increasing the price of dollar $ again as compare to INR , now the exchange rate becomes 76 INR = 1 $.
3. Central Banks and Government sometimes buy up foreign exchange to affect exchange rate's in the short run.