Final: Exchange Rates

Question 1

Foreign exchange rates are important because

Answer 1

they affect the price of domestically produced goods sold abroad and the cost of foreign goods bought domestically.

Question 2

The theory of purchasing power parity suggests that long-run changes in the exchange rate between the currencies of two countries are determined by

Answer 2

changes in the relative price levels in the two countries. Other factors that affect exchange rates in the long run are tariffs and quotas, import demand, export demand, and productivity.

Question 3

In the short run, exchange rates are determined by

Answer 3

changes in the relative expected return on domestic assets, which cause the demand curve to shift. Any fac- tor that changes the relative expected return on domes- tic assets will lead to changes in the exchange rate. Such factors include changes in the interest rates on domestic and foreign assets, as well as changes in any of the fac- tors that affect the long-run exchange rate and hence the expected future exchange rate.