Factors Affecting the Exchange Rate Flashcards
What is a floating exchange rate?
A floating exchange rate is determined by the demand and supply of a currency in the FOREX market, with no government intervention. The value of other currencies fluctuates according to market forces of supply and demand for the currency on the foreign exchange market.
What factors affect the demand for a currency in a floating exchange rate system?
The demand for a currency refers to the desire to change other currencies into that currency in order to spend on domestic goods and services, save in domestic banks, or make speculative purchases of the currency in the hope that it will increase in value in the future. Examples of factors that increase demand for a currency include:
- Increased exports
- Higher interest rates
- Long-term investment
- Speculation that the value of the currency will increase in the future
What factors affect the supply of a currency in a floating exchange rate system?
The supply of a currency refers to the desire to change that currency into another currency in order to buy overseas goods and services, save in overseas financial institutions, or make speculative sales of the currency. Examples of factors that increase supply for a currency include:
- Increased imports
- lower interest rates
- investment prospects in foreign countries
- speculation that the value of the currency will drop
What are some examples of factors that can cause an appreciation of a currency in a floating exchange rate system?
Examples of factors that can cause an appreciation of a currency in a floating exchange rate system include:
- an increase in demand for domestic exports
- a higher domestic interest rate relative to abroad
- long-term investment into the country
- speculation that the value of the currency will increase in the future
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What are some examples of factors that can cause a depreciation of a currency in a floating exchange rate system?
Examples of factors that can cause a depreciation of a currency in a floating exchange rate system include:
- an increase in demand for imports
- higher interest rates in other countries
- investment prospects in foreign countries
- speculation that the value of the currency will drop
How do short-term capital flows affect exchange rates?
Short-term capital flows can have a significant impact on exchange rates. When capital flows into a country, it increases the demand for the country’s currency and drives up the exchange rate. Conversely, when capital flows out of a country, it reduces the demand for the country’s currency, causing the exchange rate to fall.
How do longer-term factors affect exchange rates?
In the longer term, the exchange rate is determined by other factors, such as Purchasing Power Parity Theory, which states that the exchange rate will adjust to equalize the purchasing power of different currencies over time. Other factors that affect exchange rates in the longer term include trade flows, relative productivity, and relative inflation rates.
How does economic growth affect exchange rates?
- Economic growth can affect exchange rates in different ways depending on whether it is domestic or foreign growth.
- Generally, if a country’s economy is growing faster than other countries, its currency will appreciate as demand for its goods and services increases.
- On the other hand, if a country’s economy is growing slower than other countries, its currency will depreciate as demand for its goods and services decreases.
How does inflation affect exchange rates?
Inflation can affect exchange rates by altering the relative purchasing power of different currencies. If a country has higher inflation than other countries, its currency will depreciate as the relative cost of goods and services in that country increases. Conversely, if a country has lower inflation than other countries, its currency will appreciate as the relative cost of goods and services in that country decreases.
How does interest rates affect exchange rates?
Interest rates can affect exchange rates by altering the relative return on investments in different countries. If a country’s interest rates are higher than other countries, its currency will appreciate as investors seek higher returns in that country. Conversely, if a country’s interest rates are lower than other countries, its currency will depreciate as investors seek higher returns elsewhere.
How does government policies affect exchange rates?
Government policies can affect exchange rates by influencing economic factors such as economic growth, inflation, and interest rates. For example, if a government increases spending to stimulate economic growth, it may lead to an appreciation of the currency due to increased demand. On the other hand, if a government raises taxes to decrease inflation, it may lead to a depreciation of the currency due to decreased demand.
How does political stability affect exchange rates?
Political stability can affect exchange rates by influencing investor confidence and economic policies. If a country is politically stable and has a predictable economic policy, investors will have more confidence in the country’s economy, leading to an appreciation of the currency. Conversely, if a country is politically unstable and has unpredictable economic policies, investors will have less confidence in the country’s economy, leading to a depreciation of the currency.
How does natural disasters affect exchange rates?
Natural disasters can have a significant impact on exchange rates by disrupting economic activity and damaging infrastructure. This can lead to decreased demand for a country’s goods and services, leading to a depreciation of the currency. Additionally, natural disasters can also increase government spending and lead to inflation, further exacerbating the depreciation of the currency.
How does technology affect exchange rates?
Technology can affect exchange rates by influencing economic growth, inflation, and investment. For example, if a country’s technology sector is growing rapidly, it can lead to an increase in economic growth and demand for its goods and services, resulting in an appreciation of the currency. Additionally, advancements in technology can also lead to increased productivity and decreased inflation, further supporting the appreciation of the currency. On the other hand, if a country lags behind in technology advancements, it can lead to a decrease in economic growth and demand for its goods and services, resulting in a depreciation of the currency.
