Question

Explain why when the real exchange rate rises, the quantity of net exports decreases.

Answer 1

Solution-

When the domestic real exchange rate appreciates, domestic goods become more expensive relative to foreign goods. This induces domestic residents to buy more goods overseas, which increases imports. The appreciation also induces foreign citizens to buy fewer domestic goods, so exports fall. The decline in exports and increase in imports decrease net exports, and so the demand for domestic currency declines. The inverse relation between the exchange rate and the quantity of domestic currency demanded in the market for foreign-currency exchange is represented by the downward-sloping demand curve.