ECONOMICS
FINANCIAL MARKETS
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Question
[CLICK ON ANY CHOICE TO KNOW THE RIGHT ANSWER]
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If the two countries engage in a large volume of international trade but only a small volume of international capital flows, then the relative inflation rates will likely have a stronger influence on the exchange rate.
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A significant portion of capital flows are due to large institutional investors, which commonly make large investments in securities denominated in specific currencies that may last only a day or two.
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If the two countries engage in a large volume of capital flows, however, then interest rate fluctuations may be not influential.
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The size of these capital flows can easily overwhelm trade flows, the relationship between the factors (such as inflation and income) that affect trade and exchange rates is sometimes weaker than expected.
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Detailed explanation-1: -Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values.
Detailed explanation-2: -Whereas the traditional view is that the exchange rate gets adjusted to equilibrate international trade in goods, the asset approach suggests that the exchange rate gets adjusted to equilibrate international transactions (flows) in financial assets.
Detailed explanation-3: -In floating exchange rate system, exchange rate are determined by market demand and supply forces for the currencies.
Detailed explanation-4: -One way that firms can limit their exposure to changes in the exchange rate is to implement a hedging strategy. By purchasing currency swaps or hedging through futures contracts, a company is able to lock in a rate of currency exchange for a set period of time and minimize translation risk.