Extra Credit

1. Why do exchange rates rise and fall?

Exchange rates rise and fall due to a variety of factors, including changes in interest rates,
inflation rates, political stability, economic performance, and market speculation. When a
country's economy is doing well and has higher interest rates and lower inflation rates
compared to other countries, its currency tends to strengthen. Conversely, when a country's
economy is struggling or facing unstable political conditions, its currency may weaken.

2. What is purchasing power parity?

Purchasing power parity (PPP) is an economic theory that suggests that in the long run,
exchange rates should adjust to equalize the prices of a basket of identical goods and services
in different countries. It implies that the value of a currency should reflect its purchasing
power and therefore, the cost of living in different countries should be approximately the
same when measured in a common currency. However, in reality, due to various factors such
as trade barriers, transportation costs, and non-tradable goods, the actual exchange rates often
deviate from PPP.

3. What causes trade deficits?

Trade deficits occur when a country's imports exceed its exports. There are several factors
that can cause trade deficits:

- Differences in productivity: If a country has lower productivity levels compared to its

trading partners, it may not be able to produce goods or services as efficiently, leading to a
dependence on imports.

- Exchange rate fluctuations: If a country's currency depreciates, its imports become more
expensive and its exports become cheaper, which can lead to an increase in imports and a
decrease in exports, resulting in a trade deficit.

- Domestic demand and savings patterns: If a country has high domestic demand for goods
and services, it may import more to satisfy this demand, leading to a trade deficit.
Additionally, if a country has low domestic savings rates and relies on borrowing from
foreign countries to finance its consumption, it can contribute to a trade deficit.

- Protectionist policies: Trade deficits can also be caused by protectionist measures, such as
tariffs and quotas, imposed by a country. These barriers to trade can restrict imports and
promote domestic industries, leading to a trade deficit.