Question

DISCUSSION POST - PLEASE ANSWER BOTH QUESTIONS WITH 1 PARAGRAPH EACH

1. In a free market, what determines exchange rates in the long run and the short run?
2. What is the asset market approach to exchange rate determination?

Answer 1

Part 1:
Exchange rates are used to measure the price of foreign goods in both currency and price level adjusted terms.
In the short run, exchange rates movements are determined by the demand and supplies of assets that are denominated in various currencies. This is called as asset market approach to determine exchange rates. In the long run, exchange rates are determined by the difference in inflation rates of different companies. This is called as monetary approach to determine exchange rates.

Part 2:
Asset market method to exchange rate determination:
This approach holds that, when local residents buy more foreign assets and increase their ownership in the foreign assets, the demand for foreign currency increases. This leads to depreciation in the local currency with respect to the foreign currency.