Question

In a free market ,what determines exchange rates in the long run?Give examples

Answer 1

Currency exchange rate is the most important determinant of a country's economic health.

There are a number of factors that determine the exchange rate in a free market economy, some of which are:

i) Differentials in inflation

A country with consistently low inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. On the other hand, countries with higher inflation see depreciation in their currency viz-a-viz the currencies of their trading partners

ii) Differences in interest rate

Interest rate, inflation and exchange rate are correlated. Higher interest rates offer lenders a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.

Similarly, lower interest rates lead to a fall in exchange rate.

iii) Terms of trade

If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade is said to have improved favourably. As a result, there is greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency.

Alternatively, if the price of exports rise less than that of imports, there is a fall in the currency's value in relation to its trading partners.

iv) Public debt

Large public debt results in large scale deficit financing by the government which results in inflation.  A high inflation might ultimately be paid off with cheaper real dollars in the future.