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There are a number of factors that can determine exchange rates in a system with a flexible exchange rate. In general, these factors have to do with the relative levels of demand for the various currencies. Let us look at some of the most important of these factors.
First, there is demand for exports from a given country. The higher the demand for these exports, the greater the demand for that country’s currency. This is because exports must be paid for in the currency of the country that produces them. The higher the demand for a country’s currency, all other things being equal, the stronger its currency will be.
Second, there is the expected rate of return for investments in a given country. If foreign investors think that a country will, for example, pay high interest rates relative to its rate of inflation, they will want to invest in that country. They will do so because the real rate of return that they enjoy will be high. This will lead to an increased demand for that country’s currency and, thereby, will strengthen its currency.
Finally, there is the degree to which foreigners trust the country’s economy and government. Investors want to invest in stable countries. They do not want to risk investing in countries where wars or coups might devalue their investments. Therefore, all other things being equal, there will be more demand for the currency of stable countries.
These are some of the major determinants of exchange rates in a system in which such rates are flexible.
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