Real Exchange rate = eP f P P = Price levels in India P f = Price levels abroad (say US) e = nominal exchange rate. If a pen costs ₹ in India and it costs USD in the US, Real Exchange Rate = = . 75x5 Q - - International Economics . Differentials in Interest Rates There is a high degree of correlation between interest rates, inflation and exchange rates.
Central banks can influence over both inflation and exchange rates by manipulating interest rates. Higher interest rates attract foreign capital and cause the exchange rate to rise and vice versa. . Current Account Deficits A deficit in the current account implies excess of payments over receipts.
The country resorts to borrowing capital from foreign sources to make up the deficit. Excess demand for foreign currency lowers a country’s exchange rate. . Public Debt Large public debts are driving out foreign investors, because it leads to inflation.
As a result, exchange rate will be lower. . Terms of Trade A country’s terms of trade also determines the exchange rate. If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade will improve.
Favorable terms of trade imply greater demand for the country’s exports and thus BoP becomes favorable. . Political and Economic Stability If a nation’s political climate is stable and economic performance is good, its currency value will be appreciated by attracting more foreign capital. If real exchange rate is equal to , the currencies are at purchasing power parity.
It the price of the pen in US is . USD, then the real exchange rate = then it could be said that the USD and Indian rupee are at purchasing power parity. NEER and REER are not explained here. Interested students and teachers can search for them.
. . . Determinants of Exchange Rates Exchange rates are determined by numerous factors and they are related to the trading relationship between two countries.
. Differentials in Inflation Inflation and exchange rates are inversely related.