Question

(Essay question) Evaluate the extent to which empirical evidence supports the idea that price level changes imply off-setting exchange rate changes. (plz don't not give me a hand writing answer, I cant read)

Answer 1

PRICE LEVEL CHANGES IMPLY OFF-SETTING EXCHANGE RATE CHANGES:

Changes in the price level in the domestic countryor in the foriegn country equilibrium exchange set to change.

If there is inflation in the domestic country so that price level in the home country is more than in price level in foriegn country.

Domestic goods are relatively costlier and foreign goods are relatively cheeper.As a result demand for our imports would generally fall while our demand for imports would generally rise.

Implying a situation when demand for our currency by the non-residents declines whiles the supply of domestic currency tends to rise.

Consequently, supply curve of domestic currency shifts to the right and demand curve for the domestic currency shifts to the left.

It results in a lower exchange rate which means depreciation of domestic currency. Increase in price level in the domestic economy shifts the demand curve for domestic currency to the left from D to D1 and its shifts supply curve to the right from S to S1 .

The new equation is at e1.The new exchange rate is OR, which is less than initial exchange rate OR. It implies depreciation of domestic currency.