Explain the main determinants of exchange rate behavior in the long Essay

Explain the main determinants of exchange rate behavior in the long run and in the short run. In the context of your analysis di - Essay Example The speculation concept in this market has made it hard for achievement of stability. Gains and losses can be made in the same breath in this market. This presents a challenge in both the macro and micro economics world. The factors that influence this behaviour in the foreign exchange market has been a topic of concern to many scholars and economists the world over. The aim of this paper is to evaluate the main determinants of exchange rate behaviour both in the short-run and long-run by illuminating a number of theories and explain why exchange rates tend to be volatile and notoriously hard to predict. To better understand the exchange rates, the paper will first discuss the foreign exchange market and then it will look at the exchange rate regimes. The The Purchasing Power Parity (PPP) and the asset market approach through the Uncovered Interest Rate Parity (UIRP) will also be analyzed here.   Overview of the Foreign Exchange Market As the name suggests, a foreign exchange marke t is a market where currencies are traded. Foreign exchange market is also known as forex market. In this market, money is traded for other money. This is the basic definition of the foreign exchange market but in broader terms, the foreign exchange market is not restricted to the exchange of currencies. ... Gains are made in the same breath as losses in this market. This is so because the price of the currency in the market is determined by forces of demand and supply (Carbaugh, 2011). The financial market like goods market obeys the laws of demand and supply; the demand for currency varies inversely with price (Williamson, 2009). If demand for a currency increases its price increases (appreciates) making it unattractive in the market. Buyers thus switch to buying products where value of currency is low leading to depreciation of the currency until equilibrium is reached. For example, in a market involving dollars and pounds whereby the dollar is the domestic currency and the pound is the foreign currency, an increase in demand for foreign currency (pound) results in depreciation of the domestic currency (dollar) while an increase in supply of foreign currency leads to appreciation of the dollar until equilibrium is reached (Sercu and Uppal, 1995). The demand and supply concept As shown in figure 1, Do represents the demand curve for pounds while So represents the supply curve. Equilibrium exchange rate is obtained at the point where demand curve intersects with supply curve (point E). At this point, the exchange rate of dollars per pound is stable hence the market is efficient (Carbaugh, 2011 p. 399). The demand curve in this case represents the desire of the Americans to purchase British goods, services and assets and by observing the law of demand; the US demand for pound varies inversely with price. If price increases, the demand for pounds decreases and if price decreases the demand for pound increases. This means that if the dollar price of pound increases, exports from