What Happens When Real Exchange Rate Increases?

When the real exchange rate increases, it means that a country’s goods and services have become more expensive relative to those of other countries. This has several far-reaching effects on the economy, international trade, and domestic markets.

To understand this, we need to first break down what the real exchange rate is. The real exchange rate adjusts the nominal exchange rate (the rate at which one currency can be exchanged for another) by the relative price levels between countries. In other words, it reflects the purchasing power of one currency in terms of another, taking into account inflation differences.

Effect on Exports and Imports

One of the most direct impacts of an increase in the real exchange rate is on trade balance. When the real exchange rate rises, domestic goods and services become more expensive for foreign buyers. As a result, exports tend to decrease because foreign consumers find them less attractive due to higher prices. Conversely, imports become relatively cheaper for domestic consumers. This means that domestic consumers might start purchasing more foreign goods and services, leading to an increase in imports.

Impact on Trade Balance and Current Account

The change in exports and imports directly affects the trade balance and, consequently, the current account of the balance of payments. An increase in the real exchange rate usually leads to a trade deficit because the value of imports exceeds that of exports. This can put pressure on the country’s current account balance, which might require adjustment through various means such as borrowing from abroad or using foreign exchange reserves.

Domestic Economic Effects

For domestic producers, a higher real exchange rate can be a double-edged sword. On one hand, it can lead to reduced competitiveness in international markets due to higher prices for their products. On the other hand, domestic consumers might spend more on imports, potentially leading to increased demand for domestically produced goods that are not substitutable by foreign products.

Inflationary Pressures

An increase in the real exchange rate can also have implications for inflation. If domestic demand remains strong despite the higher prices of domestic goods, the pressure on prices can increase, leading to inflation. Additionally, if the cost of imported goods decreases due to the higher real exchange rate, it might initially reduce inflationary pressures, but this effect can be temporary as domestic prices adjust.

Investment Flows

Capital flows and investment decisions are also influenced by changes in the real exchange rate. Higher real exchange rates can attract foreign investors seeking to benefit from the higher value of the domestic currency. Conversely, domestic investors might seek opportunities abroad where the cost of investment is lower due to a relatively lower real exchange rate.

Long-Term Economic Growth

In the long run, persistent increases in the real exchange rate can impact economic growth. A sustained trade deficit may lead to a build-up of foreign debt or a reduction in foreign reserves, potentially affecting the country’s economic stability. Additionally, reduced competitiveness in international markets can hinder the growth of export-oriented industries and limit overall economic growth.

Adjustment Mechanisms

Countries experiencing a significant increase in their real exchange rate may adopt various adjustment mechanisms to mitigate negative impacts. These can include monetary policy adjustments to influence inflation and interest rates, fiscal policies to address trade imbalances, and efforts to improve the competitiveness of domestic industries through innovation and efficiency gains.

In summary, an increase in the real exchange rate can have a complex array of effects on a country’s economy. It influences trade balances, domestic prices, investment flows, and overall economic growth. Understanding these dynamics is crucial for policymakers, businesses, and investors as they navigate the implications of exchange rate fluctuations.