International Business - Essay Example

The demands and supply in the international market determines the exchange rate of world major currencies. The supply of a nation currency reflects demands for foreign goods services and securities by that country. The demand of a currency of a country reflects foreign demand for that country goods, services and securities from other countries. Ceteris Paribus, the quantity demanded reflects a negative function of the exchange rate. The market gravitates to equilibrium exchange rate where quantity demanded is equal to the quantity supplied.

For instance, Ceteris Paribus, from initial equilibrium, if U.S incomes, inflations or foreign interests’ rates rise, U.S demand for foreign goods, services and securities will increase and so will the supply of dollar. The market will gravitate to the new equilibrium at a lower exchange rate that corresponds to the depreciation of the dollar (Bigman and Teizo 2003, p. 88). Similarly, Ceteris Paribus, if foreign incomes, foreign inflations, or U.S interest rates rise, foreign demands for U.

S goods, services and securities will rise and so will be the demand for the dollar. The market will gravitate to a new equilibrium at a higher exchange rate that corresponds to an appreciation of the dollar. . However, it is worth to note that market forces are not the only factors that influence the exchange rate. In addition, Central Bank may intervene in the foreign exchange market selling or buying currencies to impact the exchange rates. Central bank intervenes when the currency becomes either over or under valued.

This system is distinctively different from the fixed exchange rate system under the Breton woods accord. Therefore, it is interesting to note that the present international monetary system can be characterized more correctly as a managed float exchange rate system. This is because the exchange rates changes according to demand and supply, however, central bank may intervene when deemed necessary to save the currency (Burton 2009, p.436). Opponent of Floating exchange rate system argues that’s the system leads to exchange rate volatility which consequently affects trade.

Analysis of the effect of exchange rate volatility on trade can be grouped into two. There are those who use time series evidence to look at the relationship between volatility and trade, and there are those who use cross- sectional comparison across countries. Results on different studies relating to effect of exchange rate volatility and trade using the time series evidence varies quite widely a few have found a significant effect but most finds little or no impact, for instances surveys done by IMF in 1984 and the Commission for European Communities in 1990.

This research indicates that higher volatility has a small negative impact on trade volumes (Burton 2009, p.438). Alternatively, comparisons can be made across countries rather than over time. A model of expected trade flows between countries calculates