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Explaining terms contributing to exchange rate volatility

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I have read and re-read the text in regards to flexible exchange rates. I still can not understand why the major complaint regarding flexible exchange rates is that the exchange rates are too volatile when they float.

Please explain each of the topics: the trade balance, currency substitution, differential speed of adjustment of asset markets versus goods markets, news, and market microstructure effects contributes to exchange rate volatility. Please be detailed.

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This solution explains terms that contribute to exchange rate volatility.

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Impact of trade balance on Exchange rate: As we know that the exchange rate fluctuated due to demand and supply of currency. Suppose the demand of USD increase as compared to the Euro then the USD will appreciate against dollar causing the exchange rate of USD/Euro to increase. Now if US have a trade with Euro countries and Japan and the trade balance of the US with these countries states deficit that means the US is importing more from these two countries and the import is less. If the import is more from Euro area than Japan that means the demand for euro is more as compared to Yen. So the exchange rate for USD/Euro will decline more as compared to the USD/Yen. As the demand ...

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  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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