Determinants of an Exchange Rate Essay Example | Topics and Well Written Essays - 2000 words

Determinants of an Exchange Rate - Essay Example The exchange rates between countries are also essential in determining the balance of payments. According to Levich (2001) there is no general theory of exchange rate determination. Various economists apply different theories to come up with the short-run and long-run determinants of exchange rates. However, most of them agree that exchange rates are determined by parity conditions such as inflation, interest rates, and purchasing power. They are also determined by terms of trade, government expenditure and political risks (Dwivedi, 2010). The aim of this paper is to evaluate the main determinants of exchange rate behaviour in the short-run and long-run and explain why exchange rates tend to be volatile and notoriously hard to predict. To better understand the exchange rates, the paper will first discuss the foreign exchange market and then it will look at the exchange rate regimes. It will then discuss the exchange rate determination in foreign exchange market using combination of b alance of payment and asset approach to determination of exchange rate. The IS-LM model developed by Hicks will be used to analyse the changes in the product and money market which have a bearing on exchange rates through balance of payments. This is a market where currencies are traded or domestic currency is exchanged for foreign currency. The market is assumed to be efficient in that the price of the currency in the market is determined by forces of demand and supply (Carbaugh, 2011). The financial market like goods.