What are the main determinants of exchange rates in the short-run?

What are the main determinants of exchange rates in the short-run? 

Ans. In the short run, an exchange rate is determined by following factors: 

(a) In the short-run the most important factor determining exchange rate is future expectations of exchange rate. Speculators buy and sell forex so fast that it can easily modify demand and supply curves to make profits. 

(b) Interest rate parity theory: Foreign banks deposits and domestic deposits are close substitutes of each other for banks and other investors. They keep an eye on interest rates in two markets and keep shifting their investments from one market to another. If Ee t+1 is an indicator of trader’s expectations of the future exchange rate, and et is the current exchange rate then we can find expected rate of return f holding foreign deposits by putting the formula given below:

Interest rate parity exists where

It is so because traders keep on comparing id with Rf , where i d is interest rate in domestic markets. Two things may happen: 

(a) If Rf is greater, traders will prefer foreign deposits to domestic. 

(b) If Rf is less than i d , then traders will prefer domestic deposits to foreign deposits. It will keep on happening until Rf and Id become equal. When interest rate parity holds, there is no tendency for movement of investments. They keep on updating themselves with latest information so that their expectations hold good.