Question

3. Briefly explain why a central bank will be concerned about the exchange rate.

Does an expectation of a stronger exchange rate in the future affect the exchange rate in the present? If so, how? (please respond yes or no then explanation)

Answer 1

The cenral bank is concerned about the echange rate. There are various reasons behind that. Some of them are:

1. Aggregate demand of a nation will be affected by the fluctuations in the exchange rate. International trade involves transactions in different currencies. The exchange of different currencies depends on the echange rate. If there is a change in the echange rate then it would affect the international trade of a nation, i.e. the imports and exports of that nation. As a result of this the aggregate demand of the nation will also be affected.

2. Fluctuations in exchange rates affects the banking system of a nation adversely. In international borrowing of money banks often borrow money in foreign currency but pay back in domestic currency. This process works well only till there is no flucuation in the exchange rates. If the foreign currency strenghtens and the domestic currency weakens then the borrowing bank suffers huge losses.

When a nation's banks will suffer huge losses like this a situation of recession might arise.

Yes, an expectation of a stronger exchange rate in the future affect the echange rate in the present. For example suppose the exchange rate of a currency X is expected to rise in the future. Then the demand for currency X will increase in the market because investors would like to make profits due to an increase in the rate of the currency X. Also the supply in the market of currency X would fall because the investors would like to hold it till the rate rises. This would cause the equilibrium exchange rate of currency X to rise. So the exchange rate of currency X would rise immediately. Hence an expectation of a stronger echange rate in the future appreciates the current exchange rate.