The determinants of exchange rate fluctuations are different in the short run, medium run, and long run.
Which of the following influence short-run exchange rates? Check all that apply.
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In the short run (a few weeks or even days), foreign exchange transactions are governed by transfers of assets (bank accounts, government securities) that are sensitive to differences in real interest rates and to the changing expectations of future exchange rates.
Long-term fluctuations in exchange rates stem from volatility in such market fundamentals as relative price levels (purchasing power parity), relative productivity levels, preferences for domestic or foreign goods, and trade barriers. However, such factors fail to explain sudden fluctuations in exchange rates. For example, exchange rates can change by two percentage points or more in a single day. But variations in the determinants usually do not occur frequently or significantly enough to fully account for such exchange rate volatility. To understand short-term exchange rate behavior, it is important to recognize that foreign exchange market activity is dominated by investors in assets such as Treasury securities, corporate bonds, bank accounts, stocks, and real property.
The following graph presents exchange rates as simultaneously determined by long-term structural, interim cyclical, and short-term speculative forces.
Complete the following table by indicating the exchange rate path for each graph element listed.
Exchange Rate Path
|Green curve||Medium-run cyclical path|
|Blue line||Long-run equilibrium path|
|Green curve||Short-run overshooting path|
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The graph represents a view that exchange rates are simultaneously determined by long-term structural, interim cyclical, and short-term speculative forces. The graph illustrates the idea that there exists some equilibrium level or path to which a currency will eventually gravitate. This path serves as a long-term magnet or anchor; it ensures that exchange rates will not fluctuate aimlessly without limit but, rather, will tend to gravitate over time toward the long-term equilibrium path.
The following list explains the exchange rate paths for each curve:
|•||Fundamental Equilibrium Path: The grey area depicts the fundamentally driven long-run equilibrium path and illustrates that longer-term structural forces and interim cyclical forces interact to establish a currency’s equilibrium path.|
|•||Long-Run Equilibrium Path: The blue line depicts the long-run fundamental equilibrium path, whereas the green curve depicts the fundamentally driven medium-run cyclical path. These graph elements illustrate that, although interim cyclical forces can induce fluctuations—sometimes, rather large ones—of a currency above and below its long-term equilibrium path, fundamental forces push a currency toward its long-term equilibrium path.|
|•||Medium-Run Cyclical Path: The green curve depicts the fundamentally drive medium-run cyclical path. As mentioned, the medium-run cyclical path can induce fluctuations of a currency above and below its long-run equilibrium path.|
|•||Short-Run Overshooting Path: The green curve depicts the technically driven short-run overshooting path and demonstrates that, on a daily basis, foreign exchange rates can move in the opposite direction from that indicated by longer-term fundamentals. However, it does not imply that it is necessarily inconsistent with short-term determinants, such as interest-rate differentials or changing expectations. Although such overshooting behavior can persist for significant periods, fundamental forces generally push the currency back into its long-term equilibrium path.|