Question

Answer the following on real exchange rate.

A) Why are price levels generally higher in more developed economies? Why do more rapidly developing economies generally experience higher domestic inflation than those growing more slowly? What do these observations imply about the equilibrium real exchange rate?

Answer 1

Developing countries generally have more circulation of money in their economies which means people there have cash in their hands to spend on goods and services which raise their willingness to pay for goods and induce producers to extract more from you which raise the general price level and make it more than deveoping country. This becomes the reasons of rising inflation at a fast pace in developing countries more than countries growing slowly.

Real exchange rate is calculated as: Nominal Exchange rate * (Domestic Price Level / Foreign Price Level)

As there is rise in price level in developed countries and make it more than under developing countries, real exchange rate of developed countries will be higher than developing countries.