Question

How DO exchange rates adjust to changes in foreign and domestic income, prices and interest rates?

Answer 1

Ans. If there is no price rise, purchasing power of a country increases related to other currencies. A country that has high inflation faces depreciating effect on its currencies when they engage in trade with lower inflation countries. This happens in addition to higher interest rates. Adjustments in interest rates changes both inflation and exchange rate and brings about a change in currency value. Higher interest rates offers lender to earn higher return, as such this encourages investors and foreign capital to invest as this in turn prompts the exchange rate to rise.

Foreign and domestic income can be explained in terms of current account deficits. If a country spends more on its imports than exports current account deficit occurs. If current account deficit is more, it indicates that spending on foreign trade is more than the actual earning. Besides current account deficit occurs when a nation relies on foreign capital to invest and spend. Current account deficit can have both negative and positive impact. If current account deficit is done to promote growth then that is positive. It could be negative sign as it increases the credit risk of the country.