Final answer:
In a floating exchange market, an increased demand for foreign currency raises its value, causing an appreciation against other currencies. Conversely, when demand falls, the currency depreciates. These changes are influenced by economic factors, speculative activity, and differences in interest rates.
Step-by-step explanation:
In a floating exchange market, a change in demand for foreign currency can significantly impact the exchange rate. For example, if there is an increased demand for Mexican pesos, perhaps due to an uptick in American consumers purchasing Mexican products, the value of the pesos will rise against the U.S. dollar. This is because more dollars are needed to buy the same amount of pesos. Conversely, if Mexicans become more interested in American products, demand for dollars would rise, leading to a depreciation of the peso relative to the dollar. Supply and demand in a floating exchange rate regime naturally dictate the value of currencies without direct government intervention.
Short-term currency fluctuations can be influenced by speculators or differences in interest rates, which affect the relative rates of return on investments in different countries. In the long term, shifts in exchange rates reflect the economic fundamentals of countries, such as productivity growth, inflation rates, and the flow of international financial capital. These adjustments in exchange rates have the potential to correct imbalances between countries, allowing for changes in purchasing power and the cost of imports and exports.