International Money and Capital Markets Research Paper

International Money and Capital Markets - Research Paper Example A developed economy is defined by high level of economic activities including foreign trade resulting to high demand of foreign currency, especially hard currencies such as US dollar. A higher demand of foreign currency induces increase in exchange rate and the other way round (Taylor, 2001). Exchange rate shares an important relationship to relative price level because; price level establishes a link between foreign price and domestic price. Relative price difference or purchasing power parity is an important determinant of exchange rate as it recognizes various adjustments that need to be made in the exchange rate for maintaining equilibrium in the international currency rates (Auboin and Ruta, 2013). Trade flow can be categorized as trade inflow (import) and trade outflow (export). When the cost of foreign currency is relatively high, countries focus on greater export and less import while low exchange rate result in increasing level of import. However, frequent fluctuation in the exchange rate has negative impact on trade flow because of fluctuation in transaction and conversion costs (Auboin and Ruta, 2013). Interest rate is an influential factor with respect to fluctuation in exchange rate. Studies suggest that higher interest rate result in appreciation in the currency value of a country with respect to that of other because, high interest rate attracts greater investment in the appreciating currency for earning better future returns (Taylor, 2001). Impact of economic factors on exchange rate equilibrium Assessment of exchange rate behavior is a perennial subject of international monetary economics where various macroeconomic factors are examined to understand their role in maintaining equilibrium in exchange rate.