Question

Explain what is meant by a strong currency?

explain how the currency markets work?

identify what causes fluctuations in the exchange rate?

discuss the advantages and disadvantages of a weak dollar

Answer 1

A system of money in general use in a particular country is called currency. A currency is strong or weak depends upon the market forces by the levels of supply and demand on the international market. A strong currency is that which has worth more relative to other currencies.

Note -

• A High interest rates help promote a strong currency because foreign investors can get a higher return by investing in that country.
• Monetary policies and fiscal policies help promote a strong currency.
• A strong government with a well established rule of law and history of constructive economic policies are the type of things that promote a strong currency.

As we know, Money is a medium of exchange .It facilitates exchange through a common medium i.e. Currency. With money as a medium, the two components of a transaction namely, sale and purchase can be easily separated. In other words, money eliminates the need for double coincidence of wants for an exchange to take place and can be performed independently of each other. Moreover, money has widened the domain and scope of market. Today, market is no more limited to a specific geographical location. This can be verified by the increasing popularity of online transactions.

The following factors causes fluctuation in Exchange Rate -

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports.

ADVANTAGES OF WEAK DOLLAR -

1. It  increases the competitiveness of US goods, benifitting the sales of US corporations and manufacturing activity.
2. It  boosts foreign demand while keeping US consumer demand domestic.

DISADVANTAGES OF WEAK DOLLAR -

1. It raises profit margins of the exports and likely to make them complacent which may result in higher cost and cost push inflation.
2. It raises the cost of foreign goods and international travel.