Answer to Question #76799 in Macroeconomics for Kevina

Question

Explain the impact of the following situations on the value of the exchange rate of a country under a floating exchange rate system :
An increase in local demand for imported goods
An increase in international demand for the country's local product

Answer 1

Let there be two countries say A with currency AC and country B with currency BC.
a) As there is floating or flexible exchange rate system, the value of currency of each country, in terms of the other depends upon the demand for and supply of their currencies. An increase in local demand for imported goods from B causes increase in imports from B by A and price will have to be paid in BC causing the demand for BC to increase which will push up the price of BC with respect of AC. There is flow of money from A to B. This will cause valuation of AC to depreciate and the exchange rate for country A with respect to B (i.e. BC/AC) will fall.

b) An increase in international demand for the country's local product will cause increase in export from country A to country B, say. This will increase the supply of BC to buy A’s goods in the foreign exchange market and this increase in the supply of BC in foreign exchange market will lower the price of BC in terms of AC. Then exchange rate for country A with respect to B (i.e. AC/BC) will rise.