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Chapter 30: Problem 2

Briefly describe the four determinants of exchange rates in the long run.

Short Answer

Expert verified
The four determinants of exchange rates in the long run are 1) Relative price levels, 2) Net exports, 3) Productivity, and 4) Interest rates.

Step by step solution

01

Identify the Relative Price Levels

The first determinant is relative price levels. In the long run, a country with a lower price level compared to another country will see its currency appreciate, as goods become less expensive relative to the goods in the foreign country. This is known as the theory of Purchasing Power Parity.
02

Evaluate the Net Exports

The second determinant is net exports. A trade surplus, meaning that the value of exports is greater than the value of imports, will cause an appreciation of the domestic currency. Conversely, a trade deficit will cause a depreciation of the domestic currency.
03

Look at the Productivity

Thirdly, productivity influences exchange rates. A country that experiences faster productivity growth than another country will see its currency appreciate. This is because higher productivity can lead to higher income and thus higher demand for the currency.
04

Discuss Interest Rates

Lastly, interest rates play a role. Higher domestic interest rates attract foreign investors which increases the demand for the domestic currency and causes its value to rise, while lower interest rates cause the domestic currency to depreciate as investors seek higher returns elsewhere.

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Most popular questions from this chapter

On page 1074 , the text states that "the globalization of financial markets has helped increase growth and efficiency in the world economy." Briefly explain which aspects of globalization help to increase growth in the world economy.

In December \(2016,\) you needed 83 percent more pesos to buy one U.S. dollar than you had needed in December 2004\. Over the same time period, the consumer price index in Mexico increased 57.8 percent, and the consumer price index in the United States increased 26.7 percent. Are these data consistent with the theory of purchasing power parity? Briefly explain.

What is the theory of purchasing power parity? Does the theory give a complete explanation for movements in exchange rates in the long run? Briefly explain.

(Related to the Don't Let This Happen to You on page 1061 ) Briefly explain whether you agree with the following statement: "The Federal Reserve is limited in its ability to issue paper currency by the amount of gold the federal government has in Fort Knox. To issue more paper currency, the government first has to buy more gold."

What is an exchange rate system? What is the difference between a fixed exchange rate system and a managed float exchange rate system?
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