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International Economics at Shippensburg University EXCHANGE RATE DETERMINATION Introduction What are the factors that cause supply and demand for exchange to change There are several theories on this topic Some theories attempt to explain short run movements in exchange rates while others study long run movements The determinants of equilibrium exchange rates in the short run and in the long run tend to be different 1 Balance of Payments Approach to Exchange Rate Determination This approach emphasizes the flows of goods services and investment capital that respond gradually to real economic factors such as GDP It predicts that exchange rate depreciation for countries with deficits in their current accounts and appreciation for countries with surplus Recall D for FX involves all debit transactions in the BPs S involves all credit transactions D is downward sloping and S is upward sloping S and D for FX reflect changes in the domestic D for foreign goods and services and in the foreign D for domestic goods and services These in turn are determined by macroeconomic conditions at home and abroad relative prices of domestic and foreign goods eg If US inflation rate is higher than UK D for British goods goes up D for American goods down D for FX up S down depreciation Figure 1 the level of real income within countries eg If US income grows faster than UK
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