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Chapter 12: Problem 1

In a free market, what factors underlie currency exchange values? Which factors best apply to long and short-run exchange rates?

Short Answer

Expert verified
Currency exchange values in a free market are influenced by factors including inflation rates, interest rates, public debt, terms of trade, political stability and economic performance. In the short-run, exchange rates may be affected more by speculations, changing market sentiments, and sudden changes in policies, while in the long run, sustained economic growth, consistent government policies, and stability in inflation and interest rates are more important.

Step by step solution

01

Defining Key Terms

Start by outlining the definitions of key terms. A free market is an economic system in which prices are determined by unrestricted competition between businesses, without government intervention. Currency exchange refers to the act of changing one country's currency into another country's currency. Long-run and short-run exchange rates refer to variations in exchange rates over different periods of time.
02

Identifying Factors That Influence Currency Exchange Values

Next, identify the factors that influence exchange rates. These can include inflation rates, interest rates, public debt, terms of trade, political stability and economic performance. These factors can cause a currency to appreciate (increase in value) or depreciate (decrease in value).
03

Differentiating Factors for Short-run and Long-run

Finally, distinguish between the factors that affect short-run and long-run exchange rates. In the short-run, speculations, news events, sudden changes in policies, and market sentiments can cause existing exchange rates to fluctify significantly. In the long run, however, factors like sustained economic growth, consistent government policies, stability in inflation and interest rates are more important in setting exchange rates.

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Most popular questions from this chapter

Identify the factors that account for changes in a currency's value over the long run.

Suppose that the dollar/franc exchange rate equals \(\$ 0.50\) per franc. According to the purchasing- power-parity theory, what will happen to the dol- lar's exchange value under each of the following circumstances? a. The U.S. price level increases by 10 percent and the price level in Switzerland stays constant. b. The U.S. price level increases by 10 percent and the price level in Switzerland increases by 20 percent. c. The U.S. price level decreases by 10 percent and the price level in Switzerland increases by 5 percent. d. The U.S. price level decreases by 10 percent and the price level in Switzerland decreases by 15 percent.

What is meant by exchange rate overshooting? Why does it occur?

What predictions does the purchasing-powerparity theory make concerning the impact of domestic inflation on the home country's exchange rate? What are some limitations of the purchasingpower-parity theory?

Assuming market-determined exchange rates, use supply and demand schedules for pounds to analyze the effect on the exchange rate (dollars per pound) between the U.S. dollar and the U.K. pound under each of the following circumstances: a. Voter polls suggest that the U.K.'s conservative government will be replaced by radicals who pledge to nationalize all foreign-owned assets. b. Both the U.K. and U.S. economies slide into recession, but the U.K. recession is less severe than the U.S. recession. c. The Federal Reserve adopts a tight monetary policy that dramatically increases U.S. interest rates. d. Britain's oil production in the North Sea decreases, and exports to the United States fall. e. The United States unilaterally reduces tariffs on U.K. products. f. Britain encounters severe inflation, while price stability exists in the United States. g. Fears of terrorism reduce U.S. tourism in the United Kingdom. h. The British government invites U.S. firms to invest in British oil fields. i. The rate of productivity growth in Britain decreases sharply. j. An economic boom occurs in the United Kingdom that induces the U.K. consumers to purchase more U.S.-made autos, trucks, and computers. k. Ten percent inflation occurs in both the United Kingdom and the United States.
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