27. (a) Explain three factors that influence the value of a country’s exchange rate (10 marks)
Firstly an exchange rate is the value of one currency expressed in terms of another. Meanwhile a floating exchange rate is an exchange rate regime where the value of the currency is allowed to be determined by the demand and supply for the currency in the foreign exchange market. There are several determinants that affect an exchange rate in a floating exchange rate system.
A primary determinant is consumer tastes. For example, when domestic consumers build a stronger preference for foreign produced goods, then the demand for foreign currencies increases. Relative incomes can also affect the value of a currency. An increase in the national income in the country will increase demand for all things including foreign goods, again increasing demand for foreign currencies. Similarly, lower inflation rates make goods and services relatively less expensive thus increasing demand for that country’s currency. (This is why the Fed or other central banks attempt to keep inflationary pressures low.) Lastly, there is speculation. As interest rates increase, assets become more attractive because of high returns. Hence speculation that interest rates of a country are going to increase relative to another will increase demand for that country’s assets and thus increase demand for its currency.
P.S. There are four factors in this answer, pick three that suit you best.