Question

There are two questions related to Exchange Rate Determination

1. In a free market, what determines exchange rates in the long run and the short run?
2. What is the asset market approach to exchange rate determination?

Please type the response.

Answer 1

Ans-1- The exchange rate is determined basically due to demand and supply for each currency in the short run but there are some other reasons also which determine this exchange rate is mentioned below-

(a)-Demand for goods, services, and investment priced in that country.

(b)- Speculation on future demands of that currency.

(c)- The central bank occasionally by up foreign currency to affect the exchange rate.

In the long run, the exchange is determined on the Purchasing Power Parity(PPP) hypothesis. PPP says that products should have a similar price in all the countries when the price is measured in the same currency, at least in the long run when full market equilibrium is established. It works in the following manner-

(a)- First, PPP predicts well at the level of one heavily traded commodity like wheat or gold.

(b)- Second, PPP predicts only moderately well at the level of all traded product.

(c)- Third, PPP predicts least well at the level of all products in the economy.

Ans-2-The asset market approach to the exchange rate is explained below-

The increasing volume of trading of financial assets such as stock and bonds have also put an impact on exchange rate determination. Economy growth, inflation, and productivity are no longer the only cause of currency movements. Cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading of goods and services.

The asset market approach views currencies as assets price traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets

Like the stock exchange, money can be made on trading by investors and speculators in the foreign exchange market. currencies can be traded at spot and foreign exchange options market. The spot market represents currencies exchange rates, whereas an option is derivatives of the exchange rate.