Question

1. Currency X is traded freely in currency markets. Fluctuations in the exchange rate over the course of a few months is mostly due to interest rate differentials. Is it true of false? And all being equal, if it isnt because the difference in interest rate, then is it due to the inflation ?

Answer 1

Answer - If the currency X is freely traded in the currency market , the exchange rate will be determined by the demand and the supply of the currency . It will be determined at the equilibrium point of the demand and the supply of the Currency X. If the interest rate rises , the currency will become expensive and the demand will fall. On the other hand rhe supply will rise and vice a versa. Thus the equilibrium will change as the demand and the supply respond and so will the exchange rates. The inflation does not play a role here.