Question

Distinguish between the nominal exchange rate and the real exchange rate . Explain the various short-run and long-run factors that affect the exchange rate of a country . Why exchange rate is volatile.

Answer 1

Nominal exchange is basically the rate at which one can exchange domestic currency for foreign currency or vice versa through financial institution that deal with international currencies. Real exchange rate, on the other hand, indicates the ratio of commodities that are purchased domestically to the commodities purchased in the foreign market. It determines the ratio of price in the domestic market to the foreign market.

Some of the short and long run factors that affect the exchange rates of a country are given below-

a. Inflation Rates- With a rate of inflation that is comparatively lower, the exchange rates tend to appreciate and when the rate of inflation that is comparatively higher, the exchange will witness depreciation with respect to domestic currency.  

b. Interest Rates- When interest rates are higher the value of the domestic currency increases because of higher capital inflow into the country and the exchange rate appreciate. On the other hand, when the interest rates are comparatively lower, capital flows out of the country and the exchange rate depreciates.

c. Current Account Balance- A deficit in current account balance, that is when the imports of the country exceed its export, the exchange rate falls.

d. Political Stability- A stable political scenario in a country will attracts more foreign investment and this will lead to appreciation of the exchange rate. Countries facing unstable political situations will have a depreciation in their exchange rates.

e. Public Debt- Countries having more government debt will have a depreciation of their exchange rates in comparison to countries having lower government debt.

The transactions in the financial markets are cleared and adjusted way quicker than the transactions in the commodity markets. As a result, exchange rates are more sensitive and volatile.