Question

What happens to the real exchange rate and net exports in each of the following cases?

a. Import restrictions i.e. quota or tariffs on foreign goods

b. The domestic prices rise more than foreign prices

c. nominal exchange rate e falls

Answer 1

Net Exports = Exports - Imports

Real exchange rate is ratio of foreign price level and domestic price level.

a) When there are tariffs imposed on goods which would reduce the influx of import in the domestic economy while there might be no effect on exports. Thus Net Exports would rise as imports falls. As imports have reduced, foreign currency would depreciate. If it depreciates, exchange rate rises.

b) When domestic price rise more than foreign price, exports would fall as consumers in abroad would not be willing to pay more for the same good. Thus Net exports would fall. As exports fall, domestic currency would depreciate which would raise the real exchange rate.

c) When nominal exchange rate rises, more foreign currency can be exchanged for same unit of domestic currency which means that which means that foreign currency have depreciated which cause real exchange rate rises.