Question

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

Short answer

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

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.

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).

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.

Key concepts

Free Market

In a free market, currency exchange values are determined without government intervention. This means that the forces of supply and demand regulate the value of a currency. When more people want a particular currency, its value goes up. Conversely, if there’s less demand, its value falls. This natural flow allows currencies to adjust to a true market value. A free market fosters open competition, where businesses and buyers interact to set prices. This generally leads to a dynamic environment where exchange rates can change daily based on global events and sentiments.

One major advantage of the free market is efficiency. Because there’s no outside control, prices reflect current economic realities. However, this can also lead to volatility, especially in times of economic uncertainty. For example, political instability in a country can cause its currency to depreciate rapidly as investors pull out.

• Supply and Demand Dynamics: Determines the value based on current market needs.
• Volatility: Can be affected by political and economic changes swiftly.
• Efficiency: Prices reflect real-time economic conditions without intervention.

Exchange Rate Determinants

Several key factors drive how exchange rates are determined in the currency exchange market. Understanding these can help predict trends or make informed trading decisions.

Firstly, **inflation rates** are crucial. If a country has low inflation rates consistently, its currency tends to increase in value because its purchasing power improves relative to other currencies.

Secondly, **interest rates** also matter. Higher interest rates offer lenders in that economy a higher return relative to other countries. Consequently, higher interest rates attract foreign capital and cause the exchange rate to rise.

Another factor is **public debt**. Countries with large amounts of debt are less attractive to foreign investors due to the risk of inflation and default. This tends to depreciate the value of the currency.

Moreover, **terms of trade** represent the ratio between export prices and import prices. A better ratio typically strengthens a currency. Lastly, **political stability and economic performance** play a critical role. Investors naturally seek regions with fewer political risks and strong economic performance, increasing currency demand.

• Inflation Rates: Low inflation can lead to currency appreciation.
• Interest Rates: Higher rates attract investments.
• Public Debt: Large debt may result in depreciation.
• Terms of Trade: Enhanced terms can boost currency value.
• Political Stability: Attracts investment, raising currency demand.

Long-run vs Short-run Exchange Rates

Exchange rates can behave differently depending on whether we look at the short-run or long-run. This distinction is important for anyone participating in currency markets or international trade.

In the **short-run**, exchange rates are often subject to rapid changes due to news events, market speculation, and sudden policy shifts. For instance, an unexpected political election result or a natural disaster can lead to a sharp currency fluctuation as markets react immediately to the new information.

On the other hand, the **long-run** is governed by more stable factors like sustained economic health and consistent monetary policies. Economic fundamentals such as growth rates, inflation, and interest rates tend to have more lasting impacts on currency value over time. As these factors take time to evolve, they do not cause sudden shifts, but rather a gradual movement in exchange rates.

Overall, understanding the difference between short-run and long-run exchange rates helps in setting realistic expectations for currency valuation.

• Short-run Factors: Speculation, news events, sudden policy changes.
• Long-run Factors: Economic fundamentals, sustained growth, consistent policies.
• Market Reaction: Immediate in the short-run, gradual in the long-run.