Question

The exchange rate between the U.S. dollar and other currencies has gone through wide fluctuations in recent years. Use an example of a foreign currency (e.g., Mexican peso, British pound, etc.) and discuss how it has changed in price relative to the U.S. dollar over the past two to three years. Analyze how exchange rates affect domestic economic activity, including the supply and demand factors that moved the relative prices.

Answer 1

The exchange rate affects domestic economic activity including the supply and demand factors that moved the relative price:

Diffrential in inflation:- Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increase relative to other currencies.

Diffrential in interest rate: Interest rates, inflation and exchange rates are all highly correlated.By manipulating interest rates bank exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.

current account deficits: the currrent account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. a deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit.

Public Debts: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

Recession:- When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.