ECONOMICS

Economics

Economics

Section 1

Introduction

The exchange rate of a country has a lot of macro as well as micro economic considerations. These considerations have been studied in detail by many economists and business people as well as financial experts to understand the financial and economic condition and position of a country in relation to other countries. Most importantly, the US dollar has been followed and the position of the US dollar has been given the most importance when it comes to understanding the economic condition of a nation in contrast with the US Dollar. In simple words, the gap between the rate of the dollar and the local currency determines the appreciation, depreciation and value of the currency. The last two decades have witnessed growing numbers of economic integrations between countries with different degrees of economic convergence.

One of the main objectives behind the increase in the number of some form of economic union is to increase trade and economic activities among member countries to attain better welfare. The increase in economic integration between countries has encountered plenty of obstacles, including the aspiration from each member to have power over the economic decisions (e.g., monetary policies and the maintenance of control over the tax revenues). However, the last two decades have witnessed growing numbers of economic integrations between countries with different degrees of economic convergence. Many countries have reached a very advanced level of integration, such as the European Monetary Union with 27 member states where 17 share one currency (the Euro) (McClean, 2008).

Primary Focus of the paper

“The movements of exchange rate overtime can be determined by certain factors and these factors remain significant as they are associated with macroeconomic variables used to explain and determine the rate of change or movements of exchange rate”

The determinants of exchange rate volatility in literature

There exist multiple theories on what determines the value of currencies and exchange rates. First, the concept of purchasing power parity, often abbreviated as PPP. Say the same commodities are traded within two different countries. Both countries may decide to export some of these commodities and will demand a price in their respective currencies. If the value of the same commodities is the same regardless of what country they came from, then the exchange rate that is established between the two countries' currencies is simply the ratio of prices demanded by each country. Then, Purchasing power parity arises from the notion that the same amount of money should have the same amount of purchasing power in different countries, barring arbitrage. Therefore, there should be some equilibrium of exchange rate that appropriately equates the prices of these commodities in the two currencies. Moreover, changes in exchange rates result from one country's change in inflation or deflation relative to another's (McClean, 2008).

In reality taxes, transportation costs, trade barriers, differences in local demand and the fact that two countries will rarely produce commodities that are exactly the same make it difficult to determine the exact relative prices between two countries' ...