Macroeconomic Effects of Exchange Rates

A central bank will be concerned about the exchange rate for multiple reasons:

(1) Movements in the exchange rate will affect the quantity of aggregate demand in an economy;
(2) frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation’s banking system–this may contribute to an unsustainable balance of trade and large inflows of international financial capital, which can set the economy up for a deep recession if international investors decide to move their money to another country.

Let’s discuss these scenarios in turn.