Question

1) Explain the factors that are relevant in trying to explain how to determine exchange rates. Why do you feel it is so difficult to forecast interest rate?

Answer 1

Ans : The factor that are relevant in determining the interest exchange rate are

• Economic growth rate vs underlying trend rate: If the underlying trend rate is lower, economic growth above this target is likely to cause inflationary pressure in turn increasing the interest rate.
• Savings Vs Consumption : Interest rate is also determined by the savings of money in the economy vs consumption as savings helps in increasing the production and consumption helps in increasing the return on the savings in the form of interest rate.
• Spare capacity : A key test is the amount of spare capacity in the economy, though this can be difficult to calculate. For example, in a recession how much potential capacity is lost causing the production and consumption to fall in turn having a impact on the interest rate.
• Wage inflation: Rising wages lead to higher costs for firms and higher spending. This is a very important factor as it can be self-reinforcing leading to a wage price spiral increasing the cost of production for a firm and for the economy as a whole increasing the need of money and causing a change in the interest rate.
• Unemployment : High unemployment tends to depress wage inflation and therefore keep interest pressure low because of low consumption and production.
• Commodity prices :Rising commodities will tend to increase interest. However, some commodities have a tendency to be volatile meaning it is more unreliable as a guide to underlying interest.
• Exchange Rate :A depreciation in the exchange rate will cause demand and supply of the money flow in the market and causing a pressure on the interest rate as per the same . This is because imports become more expensive, and there will be greater demand for exports to settle the exchange requirement of money.
• Mortgage or Home prices: House prices don't directly influence the CPI. However, rising house prices causes a positive wealth effect and therefore higher consumer spending
• Consumer confidence. Higher confidence leads to higher spending reducing the rate of interest.
• Government Fiscal and Economic Policy: Government fiscal and economic policy impact on the rate of interest .

As there are Uncertainty in international market causing a lot of fluctuation in the investment and international trade causing increase or decrease in the flow of money and in turn it impact on the interest vice versa. Change in domestic market conditions like availability of loans loans, consumption and production. Employment rate and Inflation rate Financial Frauds of large scale may wipe the savings from economy and change in the interest rate in the exchange because of this it is difficult to predict the interest rate.