Question

How are exchange rates determined? Among the economic factors that influence exchange rates between two countries are relative interest rates, relative inflation rates, and relative growth in real GDP. How do each of these factors influence the exchange rate? For example if the United States is growing faster than Canada, what happens to the exchange rate between US and Canadian dollars? If the rate of inflation is higher in the United States than in Canada? Or if Canada increases interest rates relative to US interest rates?

Answer 1

Exchange rates, for a free floating currency is determined by the market forces of Demand and supply.

Relative interest rates - higher interst rates in one country increases the value of their currency than the country having lower interest rates. Hence, affecting the exchange rates and making in the difference between the value of two larger.

A country with lower inflation rate has a rising currency value as its purchasing power increases relative to other countries.

Increase in real GDP in one nation, will increase the supply of its currency in foreign countries, causing the currency of that country to depreciate.