Final answer:
The foreign purchases, interest rate, and real-balances effects are key reasons why the exchange rate fluctuates. They influence each other, with interest rate changes driving foreign capital flows, which in turn impact exchange rates and potentially the trade deficit.
Step-by-step explanation:
The foreign purchases, interest rate, and real-balances effects explain why the exchange rate fluctuates. These economic dynamics are interconnected. For instance, a budget deficit leads to increased demand in markets for domestic financial capital, in turn raising the domestic interest rate. A higher interest rate attracts an inflow of foreign financial capital, which appreciates the exchange rate due to increased demand for the domestic currency and decreased supply resulting from domestic investors finding local bonds more attractive. Conversely, a decrease in interest rates can lead to currency depreciation, which may result in an increasing trade deficit due to more attractive export prices, but can also negatively impact the economy if the inflows of capital reverse, potentially leading to a banking system collapse and a recession.