Question

How each of the following changes will affect the real exchange rate (the number of US baskets per EU basket of goods/services):

a.The relative demand of U.S. products decreases.

b.The relative demand of U.S. products decrease

Answer 1

(a) The relative demand of U.S products decreases-

• Real exchange rate is the value of one currency in terms of another during the supply of goods and services.
• When U.S dollar is depreciated then the real exchange rate also falls. As a result the demand for products decreases sharply.
• It will increases the export business for U.S products and reduces the import services.
• Exchange rate will fall only when the quantity of dollar supply exceeds the amount of dollars demanded.

(b) The relative demand of U.S products increases-

• When the demand for U.S products increases then the value of dollar will get appreciated. Also import business will rise and export of goods will get reduce.
• Here the quantity of dollar demanded will be more than the value of supply.
• An increase in rate of interest will increase demand for dollar in foreign countries.

Note: both the options given in the question are same. So in the option (b) I am considering demand for U.S products increases.