Question

According to the simple monetary model of exchange rates, on what do exchange rates depend? What is the effect of a monetary contraction on exchange rates? How does this change if goods market prices are slow to adjust?

Answer 1

FIRST OF ALL I WOULD START ANSWERING THE QUESTION WITH THE BASIC DEFINITION OF " EXCHANGE RATE" -

EXCHANGE RATE IS THE PRICE OF A NATIONS CURRENCY IN TERMS OF ANOTHER CURRENCY.

EXCHANGE RATE DEPENDS ON VARIOUS FACTORS SOME OF WHICH ARE LISTED BELOW:-

( # ) INFLATION RATE OF THE COUNTRIES FOR WHICH YOU ARE EXCHANGIN.

FOR EXAMPLE ; A COUNTRY WITH LOWER INFLATION RATE THAN ANOTHER'S WILL SEE AN APPRECIATION IN THE VALUE OF ITS CURRENCY.

( # ) INTEREST RATES : INCREASE IN INTEREST RATE CAUSE A COUNTRY'S CURRENCY TO APPRECIATE BECAUSE HIGHER INTEREST RATES PROVIDE HIGHER RATES TO LENDERS,THEREBY ATTRACTING MORE FORIEGN CAPITAL,WHICH CAUSES A RISE IN ECHANGE RATES.

( # ) GOVERNMENT DEBT: THE COUNTRY WITH HIGH GOVERNMENT DEBT WILL HAVE DEPRECIATION IN ITS CURRENCY VALUE.

( # ) BALANCE OF PAYMENTS : A DEBT ON THE CURRENT ACCOUNT MEANS THAT THE VALUE OF IMPORTS OF GOODS IS GREATER THAN THE VALUE OF EXPORTS. IF THIS IS FINANCED BY A SURPLUS ON THE CAPITAL ACCOUNT ,THEN THIS IS OK,BUT A COUNTRY WHICH STRUGGLES TO ATTRACT ENOUGH CAPITAL INFLOWS TO FINANCE CURRENT ACCOUNT DEFICIT WILLS EE A DEPRECIATION IN THE CURRENCY.

( # ) ECONOMIC RECESSION : A RECESSION MAY CAUSE A DEPRECIATION IN THE EXCHANGE RATE BECAUSE DURING THE RECESSION INTEREST RATES USUALLY FALL.