How Is Exchange Rate Determined. How Important Is the Expected Future Exchange Rate for Exports and Imports?

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How is exchange rate determined.
How important is the expected future exchange rate for exports and imports?

1. Introduction

Exchange rate is the price of a currency expressed in another currency, it is one of the most important determinants of a country's relative level of economic health. Exchange rate directly affects the prices of goods in foreign trade and foreign assets prices in the internal market, and indirectly the price of goods for the domestic market. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

2. Determinants of Exchange Rate

There are many factors that directly or indirectly affect the trading of currencies. Each must be considered individually and in relation to the other.

• Inflation and Interest Rates

There exists a strong correlation between interest rates, inflation and exchange rates, so consequently differentials in both these factors will affect the exchange rate.

Generally, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

Central banks can exert influence over both inflation and exchange rates by manipulating interest rates. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is limited, but if the inflation rate in the country is much higher than in the others, or

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