Theories of Exchange rate determination

Jun 21st, 2015
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INTRODUCTION : By definition, the Foreign Exchange Market is a market1 in which different currencies can be exchanged at a specific rate called the foreign exchange rate. We can anticipate the huge importance of the foreign exchange rate if we can just consider the influence of it on the imports and exports of a country.

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Theories of Exchange rate determination INTRODUCTION By definition, the Foreign Exchange Market is a market1 in which different currencies can be exchanged at a specific rate called the foreign exchange rate. We can anticipate the huge importance of the foreign exchange rate if we can just consider the influence of it on the imports and exports of a country. For example, let's assume a currency appreciation2 - the euro against the US dollar. Firstly, the exports of the European Union (E.U) nations will become 'expensive' for the United States of America (USA), which among other things means that E.U product will lose in terms of competitiveness. Secondly, such a currency appreciation will be to the benefit of E.U imports, should those be payable in US dollars. Conversely, a depreciation3 of the euro against the US dollar will cause an opposite impact. On the other hand, the rapid growth of international trade (both the import penetration4 and the export ratio5) during the last decades, which was mainly due to the increase of the open economies, enhances the significance of the foreign exchange rates. VOLATILITY AND RISK Undoubtedly, dramatic movements in the value of currencies can occur where the forces of supply and demand freely determine the price. Consequently, such a system increases the exchange rate risk associated with but not limited to international transactions. The cross-border financial activity differs from the domestic activity in respect to related

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