Question

1. This question concerns our short run model of exchange rate determination.

1. Why do we need a different model of exchange rates in the short run and the long run? Your answer should include some reference to empirical evidence.

2. Assume we are in the short run, and assume that the Federal Reserve keeps the supply of dollars fixed. The U.S. has an excellent corn harvest this year, so real output Y goes up. Explain what you expect to happen to the dollar-euro exchange rate E$/€ and why.

Answer 1

In the short term the exchange rate is determined by the demand and supply of a currency in the foreign exchange market. In the short term the exchange rate is influenced by inflation rates, interests rates, public debts, political stability and economic performance, terms of trade, current account position. When the inflation rates are low the currency will appreciate. Interest rates and exchange rates are correlated when the interest rises the currency appreciates as it will attract foreign capital to the country. The country 's current account which reflects the value of foreign trade and foreign transactions influences the exchange rate. When there is surplus in the account it results in the appreciation of the currency. Government debt influences exchange rate, when the government has a high fiscal deficit it results inn the depreciation of the currency. Terms of trade is the ratio of export prices to import prices, If the export prises at a greater rate than the import prices it results in the appreciation of the currency. A country 's political state and economic performance will influence the exchange rate, when there is political stability and economic growth it results in attracting foreign capital leading to appreciation of currency. Economic cycle of recession and boom also influences exchange rate, when a country experiences recession its interest rates fall discouraging inflow foreign capital resulting in depreciation of currency. Speculation regarding the value of currency also influences the exchange rate, if a currency is expected to appreciate its demand will increase resulting in appreciation of the currency.The supply of a currency in a foreign exchange market is determined by demand for goods, services, and investments priced in that currency, speculations on future demands of that currency. In the short term the exchange rate is determined by the demand and supply of currency in the foreign exchange market and the demand and the supply of a currency is in turn influenced by several economic factors.

In the long term the exchange rate needs to be the level which a basket of goods costs the same in two currencies. In the long term exchange rate is determined by purchasing power parity. Additionally there are other factors which affect the exchange rate in the long run : relative trade barriers, differential preferences for domestic and foreign goods, and differences in productivity. Factors such as government debt, inflation, trade balance, economic cycle, interest rate, poitical and economic stability and performance which influences the exchange rate in the short term are transient in nature and fluctuate and do not remain consistent and constant in the long term to influence the exchange rate in the long term. In the long term only the purchasing power of a country determines its exchnages rate.

When the output of a country increases it results in increase in the demand for the domestic currency as more goods are now available in the country to make purchases. When the demand for a currency increases while the corresponding supply remains constant the the currency will appreciate as those who want to purchase the currency will quote higher price for the currency to obtain the currency. Hence the exchange rate will become  favorable for the U.S. dollars when its Real GDP increases and now as the purchasing power of Dollar increases relatively fewer Dollars have to be exchanged to obtain the Euro.