How do foreign exchange rates affect trade and investment?

• A. They affect the cost of imports and exports, and influence outcomes of international investment and inflation.
• B. They have no effect on trade.
• C. They only affect domestic interest rates.
• D. They determine the weather.

Answer: (D)

Foreign exchange rates determine how much a country can buy from or sell to other countries by shifting the relative prices of goods and returns on cross-border investments. When the home currency weakens, exports become cheaper for buyers abroad and imports become more expensive for domestic buyers. This tends to boost demand for domestically produced goods and can push inflation higher if import costs rise, affecting the trade balance and the cost of living. Conversely, a stronger home currency makes imports cheaper and exports more expensive, influencing trade flows and domestic prices in the opposite direction.

For investment, currency movements change the value of foreign profits and the riskiness of overseas projects. Investors consider currency risk when deciding where and when to invest, since gains or losses from converting foreign earnings back to the home currency can change project returns. That means exchange rates help shape not just what trades happen, but also where firms choose to locate production and capital.

The other options don’t fit because exchange rates do affect trade and inflation through price competitiveness and import costs, they are not solely about domestic interest rates (though rates and currency move together via capital flows), and they have nothing to do with weather.