Discuss the determinants of a nation's exchange rate value for its currency in foreign exchange markets. What happens to a nation's balance of trade if the nation's currency appreciates? Why?
What will be an ideal response?
A nation's exchange rate value is determined through the interaction of the demand and supply for the nation's currency in foreign exchange rate markets. Changes in demand and supply effect the value of the currency. The demand for the currency reflects foreign demand for the countries exports. (For example, foreigners will want to buy dollars to use for the purchase of American products.) The supply of a currency reflects the domestic demand for imports (For example, dollars are supplied by Americans to buy foreign currency used to buy imports.) Shifts in the demand and supply of foreign currency result from changes in such factors as tastes, relative price levels, relative interest rates and relative income levels.?If a currency appreciates in foreign exchange markets then the nation will experience a balance of trade deficit. For example, if the U.S. dollar appreciates (it gets stronger) then it takes fewer dollars to buy a foreign currency. Therefore, the relative price of foreign products becomes less expensive to Americans and the U.S. imports more. At the same time, because the value of the dollar has risen, it takes more units of a foreign currency to buy a single dollar. This means that American products become more expensive to foreigners. America exports less. As imports rise and exports fall, the U.S. develops a balance of trade deficit.
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