S products causes the value price of us goods

An increase in relative demand of U.S. products causes the
value (price) of U.S. goods relative to the value (price) of
foreign goods to rise.
¡
A real appreciation of the value of U.S. goods: P
US
rises relative
to
$ / € EU
E P ´
¡
The real appreciation of the value of U.S. goods makes U.S.
exports more expensive and imports into the U.S. less expensive
(thereby reducing the relative quantity demanded of U.S.
products).
¡
A decrease in relative demand of U.S. products causes a real
depreciation of the value of U.S. goods.
45

The Real Exchange Rate Approach to Exchange
Rates
(cont.)
A change in relative supply of U.S. products
¡
An increase in relative supply of U.S. products (caused by an
increase in U.S. productivity for example) causes the price/cost
of U.S. goods relative to the price/cost of foreign goods to fall.
¡
A real depreciation of the value of U.S. goods: P
US
falls relative
to
$ / € EU
E P ´
¡
The real depreciation of the value of U.S. goods makes U.S.
exports less expensive and imports into the U.S. more expensive
(thereby increasing relative quantity demanded to match
increased relative quantity supplied).
¡
A decrease in relative supply of U.S. products causes a real
appreciation of the value of U.S. goods.
46

Determination of the Long-Run Real Exchange Rate
47
• Suppose the supply of long run
output in the US economy is
equal to Y1
US
and the supply of
long run output in the EU is
equal to Y1
EU
.

Determination of the Long-Run Real Exchange Rate
48
• The equilibrium long-
run RER is at point 1
• Suppose gasoline
prices fall making US
cars more attractive
• Shift in RD to the right
• Causing the RER to fall

The Real Exchange Rate Approach to Exchange
Rates
(cont.)
The real exchange rate is a more general approach to
explain exchange rates. Both monetary factors and
real factors influence nominal exchange rates:
1a. Increases in monetary levels lead to temporary inflation
and changes in expectations about inflation.
1b. Increases in monetary growth rates lead to persistent
inflation and changes in expectations about inflation.
2a. Increases in relative demand of domestic products lead
to a real appreciation.
2b. Increases in relative supply of domestic products lead
to a real depreciation.
49

The Real Exchange Rate Approach to Exchange
Rates
(cont.)
What are the effects on the nominal exchange rate?
US
$ / € US
EU
EU
P
E q
P
= ´
When only monetary factors change and PPP holds, we have
the same predictions as before.
¡
No changes in the real exchange rate occurs.
When factors influencing real output change, the real
exchange rate changes.
¡
With an increase in relative demand of domestic products,
the real exchange rate adjusts leading to corresponding
change in nominal exchange rates.