Question

The exchange rate and the labor market

Suppose the domestic currency depreciates (i.e., E falls). Assume that P and P* remain constant.

Given foreign price level, P*, what is the price of foreign goods in terms of domestic currency? (hint: remember that domestic consumers buy foreign goods (imports) as well domestic goods.)

Answer 1

If the domestic currency depreciates while the foreign price level remains constant, the cost of foreign goods in domestic currency terms increases, leading to more expensive imports for domestic consumers.

Step-by-step explanation:

The domestic currency depreciates:

The price of foreign goods in terms of domestic currency increases when the domestic currency depreciates and the foreign price level remains constant. This is because each unit of the weaker domestic currency now exchanges for less of the foreign currency, making imports more expensive. Let's say the domestic currency depreciates (i.e., the exchange rate E falls), meaning the domestic currency becomes weaker relative to the foreign currency. If the price level abroad (P*) is constant, the cost of foreign goods for domestic consumers will increase.

In real terms, consider the exchange rate to be the amount of domestic currency needed to purchase one unit of foreign currency. If, for example, the original exchange rate was 1.5 domestic currency units per foreign currency unit (1.5:1), and the domestic currency depreciates such that the new exchange rate is 3.0 domestic currency units per foreign currency unit (3.0:1).