Question

4. Carefully explain why exchange rates will deviate from their long-run equilibrium position over the short- to medium-run.

Answer 1

In short, the exchange rate of a country's currency is determined by its supply and demand rate in the country for which currency is being exchanged.

In the medium run of a few months or a few years, exchange rate markets are influenced by inflation rates. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.