Question

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

a. The world interest rate rises (r*)

b. expansionary fiscal policy at home i.e. domestic output rises

c. Foreign demand for domestic goods falls as result of contraction fiscal policy at abroad

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

e. The domestic prices rise more than foreign prices

f. nominal exchange rate e falls

Answer 1

a. When the world interest rate rises, the investment abroad becomes more lucrative because of higher return. There will be outflow of funds from the home country. The value of the domestic currency would depreciate and the real exchange rate would fall. This will make home produced goods and services more competitive than the world and the exports rises. The net export in turn increases.

b. With a fiscal expnasion, the AD curve shifts out to the right, both the output and the price increases. With an increase in the domestic price level, the real exchange rate will increase. With higher domestic prices and real exchange rate, the home products will be less competitive than the foreign products. Thus net exports would decrease.

c. The fall in demand for home products by the foreigners imply that they will demand lesser domestic currency now to pay for the goods and services. So the domestic currency's value decreases and so does the real exchange rate. the net exports also decreases.

d. With restrictions the foreign good would become expensive for the domestic consumers and the real exchange rate will decrease. This will promote home consumption due to limit on foreign produced goods. Net exports will rise.