Long-run Determinants of Exchange Rates Essay Example | Topics and Well Written Essays - 3000 words

Long-run Determinants of Exchange Rates - Essay Example There are several factors that are responsible in determining exchange rate in any country. Exchange rates show the value of a country's currency through which it can buy other country's currencies. Every country needs stable foreign exchange rate to trade freely. Exchange rate may get affected through various things. There are two regimes with respect to exchange rate which can either be fixed or flexible. In fixed exchange rate regimes, the currency rates do not move freely. However, in flexible exchange rate system, the currency rates are affected by a number of variables prevailing in an economy. The macroeconomic factors that affect exchange rates are variable by nature and thus play a great role in determining exchange rates. Governments and Central Banks especially utilize these macroeconomic factors to maintain a desired level of exchange rate in the economy. These macroeconomic factors may lead to great fluctuations in exchange rates both in short and long run. The factors t hat determine exchange rate in the long run include imports/exports, monetary shocks, inflation, demand/supply pressures, foreign reserves, economic productivity and government spending etc. The study of factors determining exchange rate in the long run is important so as to understand the reasons for which the currency rates appreciate or depreciate. This paper shed light on the factors determining exchange rates in the long run and evaluates these exchange rate determinants. It elaborates and gives comprehensive understanding of factors that can cause the value of a currency to fluctuate. DETERMINANTS OF EXCHANGE RATE IN LONG RUN Exchange rates greatly signify a country's overall economic position and trading prospects. These rates depict a country's position in terms of its currency's price with respect to that of the other. These are mainly the rates at which currencies could be bought and sold. Exchanges rates have a great impact on other economic variables of a country such as money supply, trade growth, imports, exports and interest rates etc. In the same vein, there are several factors that cause fluctuations in a currency's exchange rates. These determinants of foreign exchange rates may be external or internal and tend to play a great role in causing changes to currency rates. Some of these factors either take place in the short run while several cause exchange rate fluctuations in the long run. The rest of the paper elaborates and evaluates the various determinants of currency exchange rate in the long run. Exports and Imports Countries having fewer imports and more exports usually have high exchange rates. In the same fashion, countries having a lower tendency to export and have imports tend to have trade deficits. Current account surplus and deficit play a significant role in determining exchange rate of a particular country. The elements form crucial elements of a country's GDP. Balance of payment in the receipt side shows the trade surplus and thus puts the positive impacts on exchange rate while the balance of payment in the payment side reflects the trade deficit or loss which puts the negative impact on exchange