Macroeconomics lesson – how do the exchange rates fluctuate

Recently I took a course in macroeconomics which proved extremely useful for my economics know-how. Among other things, I (and doitinvest.com) found out about how the exchange rate interacts with a national economy. This is very interesting stuff for all the forex traders, so just have alook and let me know how it looks for you

One critical driver of external demand of goods and services from a national economy is the exchange rate. The exchange rate sets the price of one currency in terms of another: for example, if the £/$ rate is 1.50 it tells us the US dollars needed to buy £1 – that is, $1.50. The exchange rate is fixed daily in foreign exchange rates across the world. Changes in the exchange rate have a big effect on cross-border spending, that is, on exports.

Exchange rates also impact on imports, that is, on leakages from the circular flow of income so they also impact on the endogenous demand arising from the circular flow of income.

When the exchange rate falls the price paid in the home market goes up benefiting the domestic producer who sells more at the expense of the now dearer imported product so leakages from the circular flow of income fall. As a result GDP also goes up.

If the exchange rate goes up (appreciates) exactly the opposite happens.

 

Prices in export markets rise when the £ is stronger. This rise will reduce export volume and hence exogenous demand. Note also the fall in import prices which increases both import volume and the level of leakages from the circular flow of income.

There are many examples of the effect of exchange rates on exogenous demand and GDP. An increase in the exchange rate, like that which occurred in the UK 1996–2000, reduced trade competitiveness and exports. It also increased import leakages from the circular flow of income. This reduced the demand for domestically produced goods and output growth fell as a result.

If the exchange rate falls the opposite happens. The strong growth of the Euro area economies in 2000 was a direct result of the fall in the Euro after its introduction in 1999. The depreciation of the Korean won and other Asian currencies in 1997/98 had the same effect on those economies in 1999/2000.

Why does the exchange rate change? The exchange rate is determined in the foreign exchange market and reflects the forces of both supply 

and demand in that market. The drivers of supply and demand in the  foreign exchange (FOREX) market are set out every day by the supply and the demand of that currency traded.

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