1. Why are exchange rates so volatile and change a lot (the question is general,
ID: 1164499 • Letter: 1
Question
1. Why are exchange rates so volatile and change a lot (the question is general, not specific to the recent events, in other words the question asks why the exchange rates change all the times, what are the reasons)? What are the general factors affecting the exchange rate and causing price of different currencies to change?
2. How would the inflation in U.S. affect the price of dollar (the exchange rate between dollar and other currencies)?
3. What factors did affect the price of British Pound last year?
Explanation / Answer
(1)
Exchange rates are the units of one currency required to buy one unit of another currency. In a fixed exchange rate regime, the exchange rate is fixed by the central bank and it does not change. But in floating or managed float regime, exchange rate changes on basis of demand and supply of domestic and foreign currency, therefore it is volatile. The following are some determinants of exchange rate:
(a) If interest rate in home country is higher (lower) than than in foreign country, more (less) foreign investment will come to home country, increasing (decreasing) the demand for home currency and increasing/appreciating (decreasing/depreciating) the exchange rate.
(b) If inflation rate in home country is lower (higher) than than in foreign country, exports will rise (fall) and imports will fall (rise), thereby increasing (decreasing) net exports and increasing (decreasing) the demand for home currency and increasing/appreciating (decreasing/depreciating) the exchange rate.
(c) If home country is politically stable (unstable) compared to foreign country, demand for domestic currency will be higher (lower) and exchange rate will increase (decrease).
(d) If foreign country experiences higher (lower) growth compared to home country, export demand for home country will rise (fall) and import demand will fall (rise), thereby increasing (decreasing) the demand for home currency and increasing/appreciating (decreasing/depreciating) the exchange rate.
NOTE: As per Chegg Answering Policy, first question has been answered.
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