Trade balance can be defined as the difference between the value of countries exports and its imports. A nation balance of trade can be said to be favorable when the value of its exports exceeds the value of its exports. Trade balance can contribute to the volatility of exchange rates between countries. This is because trade balance depends on market conditions in the determination of the exchange rates (Betts & Devereux, 2000). This implies that market forces, which are unpredictable in nature, will determine the prices of imports, exports and capital flows. Since market forces are unpredictable, it is likely that trade balance will contribute to the volatility of exchange rates.
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Capital flows and the international trade between countries influences trade balance. Since both capital flows and international trade depends on the exchange of foreign currency, changes in foreign exchange rates will determine the trade balance. The major risk of importing and exporting is associated with unpredictable changes in foreign exchange rates. Again investing in assets from foreign countries can be affected by the foreign exchange rate volatility (Chari et al, 2002). For example, when there is a change in foreign exchange rate between two countries, the balance of trade will be affected. The country that is favored by a change of the foreign exchange rate will gain whereas as the other country that is not favored by the change in the foreign exchange rate will experience a reduction in balance of trade.
Currency Substitution and the Volatility of Foreign Exchange Rate
Currency substitution involves the use of a currency from a foreign country as the medium of exchange in place of a local currency. It can also involve the use of a foreign currency together with local currency as a means of exchange. Currency substitution can contributes to the volatility of exchange rates between different countries in a number of ways. Since different countries have different monetary and fiscal policies, it will be difficulty for the countries to develop a standard fiscal and monetary policies that can help check the volatility of foreign exchange rates (Gali & Monacelli, 2005). This will contribute to the volatility of foreign exchange rate between the countries.
Stabilizing the international monetary currency is a difficult task that can not be achieved by a single state. Since foreign currency is subjected to different macroeconomic conditions from various countries, its stabilization can only be made possible through a combination of efforts between the countries using the foreign currency. This however cannot be achieved due various policies and interest from different countries. The stabilization policy can be made worse if the foreign currency is used by multiple states hence causing conflicts of interest between these countries.
Adjustment of Asset and Goods Markets and the Volatility of Foreign Exchange Rate
Differential speed of adjustment of asset markets versus goods markets can also contribute to the volatility of foreign exchange rates. Under normal economic circumstances goods and asset markets often clear at different speeds. Given that the speed of adjustment in various markets such as goods and asset markets is different, the main factor which will determine monetary expansion in the short run effects is the degree of capital mobility (Arize et al, 2000). In the circumstances that the capital mobility is high, the foreign exchange rates will overshoot its long term value. On the other hand, when the capital is relatively immobile then the foreign exchange rate will undershoots its long run value (Alvarez et al, 2000).
The difference in adjustments speed of asset markets and goods market can lead to speculation in the market. Speculation can affect the prices of goods in a country either positively or negatively. It can increase or reduce the prices of goods and assets in a country hence create imbalance in foreign exchange rates. When the rate of price adjustment in asset market is lower than that in the goods market, businesses can decide to sell the assets and maintain cash. This can reduce the liquidity in the market hence contribute to the volatility in foreign exchange rates.
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