Question

What are the market fundamentals that influence the determination of exchange rates under a floating exchange rate system?

Answer 1

Floating excahange rate : It is determined by the market forces of supply and demand withing the foreign exchange market in comparison under a fixed excahange rate , the exchange rate is set at an official value by the central Bank.

Reasons that influence the determination of exchange rate in floating exchange rate

1. Inflation rate : As a general rule A country with a consisitently lower inflation rate exhibit a rising currency value as it's purchasing power increases realtive to other currencies.Those countries with higher inflation typically see depreciation in their currencies value.

2. Interest rate : By manipulating interest rate central bank exerts inflation over both inflation and exchange rate higher interest rate offer lenders a higher return relative to other countries .The impact of higher interest rate is mitigated.

3.Current account deficit : It is the balance of trade between in a country and its trading partners .Reflecting all payments between countries for goods and services etc.A defecit in current account shows a country is importing goods and services more than it is exporting. The country will typically borrow capital from foreign sources to make up the deficit causing its currency to depreciate.

4.Public debt : It will engage in large - scale deficit financing to pay for public sector projects using governmental funding.Nation with large public deficits and debts are less attractive to foreign investors because a large debt encourages more inflation and higher inflation tranlaste into lower currency value.

5.Terms of Trade : It is ration comparing export prices to import prices if the price of the country 's rises by a greater rate that of its imports its terms of trade have favourably improved which tends to show currency appreciation and vice versa.