The nominal exchange rate (rupees per dollar) stays fixed, while prices in India rise faster than prices in the USA. Taking the real exchange rate as the relative price of foreign goods in terms of domestic goods, which of the following is likely?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → The real exchange rate falls; India’s imports rise and its exports fall.
The real exchange rate is the price of foreign goods in terms of Indian goods. If Indian prices rise faster while the nominal rate is fixed, foreign goods become relatively cheaper, so the real exchange rate falls.
A lower real exchange rate makes foreign goods cheaper for Indians, so imports rise. Indian goods become dearer for foreigners, so exports fall.
NCERT (2026-27): “Determination of Equilibrium Income in Open Economy … The demand for imports depends on domestic income (Y) and the real exchange rate (R ). Higher income leads to higher imports. Recall that the real exchange rate is defined as the relative price of foreign goods in terms of domestic goods. A higher R makes foreign goods relatively more expensive, thereby leading to a decrease in the quantity of imports. Thus, imports depend positively on Y and negatively on R. The export of one country is, by definition, the import of another. Thus, our exports would constitute of foreign imports. It would depend on foreign income, Yf , and on R. A rise in Yf will increase foreign demand for our goods, thus leading to higher exports. An increase in R, which makes domestic goods cheaper, will increase our exports. Exports depend positively on foreign income and the real exchange rate. …” |