Question

4. Suppose the real exchange rate falls (perhaps from a neutral level) for the domestic currency of a country.

(a) Are domestic residents traveling abroad helped or hurt?

(b) Are domestic businesses that use foreign parts helped or hurt?

(We’ll say these businesses don’t face foreign competition for their products.)

(c) Are domestic producers that face foreign competition helped or hurt?

(We’ll say these producers don’t import parts.)

(d) What happens to domestic inflation?

Answer 1

Answer : 4) a) Fall in real exchange rate for domestic currency means that the domestic currency depreciates in compared to other currencies. Due to depreciation of domestic currency the travel in other countries by domestic residents become more expensive. Therefore, the fall in real exchange rate for domestic currency hurt domestic residents if they travel abroad.

b) Due to fall in real exchange rate for domestic currency the import of foreign goods become more expensive. So, in this situation the use of foreign parts in domestic business increase the business cost which increase the domestic price level. Because of higher price level the demand decrease although there exists no foreign competition. As a result, the sale decrease for domestic business. Therefore, the fall in real exchange rate for domestic currency hurt the domestic business who use domestic parts for their production.

c) If domestic producers do not use foreign parts in production and also face foreign competition, then the fall in real exchange rate for domestic currency help the domestic producers. Because of falling real exchange rate for domestic currency the price level decrease for domestic products in compared foreign products. Due to falling price of domestic products the demand increase for domestic products. As a result, the domestic producers sell more and become more profitable.

d) When the real exchange rate fall for domestic currency then the domestic inflation level increase. Because of more expensive imports and due to increase in domestic demand which increase the domestic price level.