Exchange Rate Relationship

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The relationship between the interest rate and exchange rate has long been a key focus of international economics. This also explains the theoretical and empirical literature proves that there exist a relationship between interest rate and exchange rate. Some studies found out that in the short run, there exit a negative relationship and positive relationship in the long run. Moreover, most papers and articles in countries deliberate on the impact of these economic variables (exchange rate and interest rate) in equally determining a country’s economic growth, inflation, levels of international trade and other economic determinants. In terms of dealing with the global markets (international trade), the link between these are realistic and…show more content…
A high inflation will depreciate the domestic currency and an increase in inflation will increase the demand for foreign goods. It also decrease export, leading to balance of payment deficit. Hence, exchange rate on the foreign base countries currency will rise which appreciate the home base currency, (Madura, 2008). He also explained the relationship using the purchasing power parity. The theory of PPP states that a basket of a good in one country should have the same cost in another country, taking into account exchange…show more content…
A data of study is recorded from the period from 1970-2010 to indicate the relationship. They stated that for the government to stabilize its currency, it should not focus on inflation targeting. So, inflation in a home country is one very important factor that may lead to currency depreciation. According to Bleaney (1996), there exist a strong positive correlation between exchange rate and inflation. In a study of a sample of 41 developing countries from 1980 until 1990, he found a negative link between exchange rate and growth and a direct relationship between exchange rate and inflation.
2. Expectations on future exchange rate.
This effect is based on the speculation about the future exchange rate which are driven by changes in interest rates. From Carlson and Osler (1998), individuals in the market speculation on exchange rate comes as a results of the type of shock. Speculations can lessen exchange rate impact on the shocks that is a downward pressure on the currency. Contrary, changes interest rate or risk do affect speculators directly on portfolio positions. They specified that for a huge number of speculators in the market, the adherence to the shocks will increase so exchange rate responses to these changes are high.
3. Changes in the relative income level between
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