Question

What are the main determinants of exchange rate behaviour in the long and short term. In the context of your analysis discuss why foreign exchange rates tend to be volatile and notoriously hard to predict

Answer 1

In the short run, the main determinants are the inflation rate in the economy, trade deficit, interest rate and supply v/s demand of the currency in the forex market. These determinants have quick impact upon the exchange rate value of the any currency in the forex market. In the long run, it is the productivity of the country, position of PPP, the trade deficit in the economy and long run monetary policy of the country that determine the exchange rate of the currency. It makes impact at the structural level and shows the status of one  economy w.r.t. the other economy. It is shown in the long run.

Forex rates tend to be volatile and unpredictable, because it is not bound to one country or one market, rather it absorbs the global impact and it is very difficult to balance the macroeconomic condition in each economy. There will always be some of the economies growing, but at the same time, some economies suffer. It creates change in the corresponding monetary policy and subsequent change demand and supply conditions. It brings change either as per the expectations or against the expectations that makes forex rates to be unpredictable.