Question

1. Explain how exchange rates are considered a self-correcting mechanism of international trade.

Answer 1

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Introduction

The exchange rate has an effect on the trade surplus or deficit, which in turn affects the exchange rate, and so on. In general, however, a weaker domestic currency stimulates exports and makes imports more expensive. Conversely, a strong domestic currency hampers exports and makes imports cheaper

In following ways exchange rates are considered a self-correcting mechanism of international trade

1) The importing and exporting activity of a country can influence a country's GDP, its exchange rate, and its level of inflation and interest rates.

2) A floating exchange rate is determined by the private market through supply and demand of goods in international trade

3) A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate and that can lead to growth and higher demand of international trade

4) The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment and ultimately it will boost the activities related to international trade

5) If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves

6) Exchange rate ensure an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) . The central bank can also adjust the official exchange rate when necessary.

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