Chartered Financial Analyst (CFA) Practice Exam Level 2

What primarily determines the equilibrium exchange rate between two countries?

1. The balance of trade between the countries

2. The ratio of their national price levels

3. The interest rates set by their central banks

4. The level of their national debts

The correct answer is: The ratio of their national price levels

The equilibrium exchange rate between two countries is primarily determined by the ratio of their national price levels, which reflects the purchasing power parity (PPP) concept. This concept suggests that in the long run, exchange rates should adjust so that identical goods cost the same in both countries when prices are expressed in a common currency. When a country experiences inflation, its price levels rise relative to its trading partner. As a result, the value of its currency should decline in order to maintain equal purchasing power for goods between the two countries. Conversely, if a country’s price level is lower than that of another country, the demand for its currency may rise, leading to a stronger exchange rate. Other factors, such as interest rates, balance of trade, and national debts, can influence currency values in the short term but do not determine the long-term equilibrium exchange rate directly. While interest rates influence capital flows and can lead to currency appreciation or depreciation, and while balance of trade can affect demand for a currency, the fundamental driver for long-term currency valuation remains the relative price levels of the two economies involved.