ABSTRACT
In the previous chapter, we described the long-run relationship between the price level or rate of inflation and the exchange rate. As we have shown, many of the nominal fluctuations in the exchange rate are related to differences in national rates of inflation. When this is the case, changes in nominal exchange rates do not have a very important impact on an open economy in the short run. However, when a country’s real exchange rate changes, this change has a noticeable impact on imports and exports. As we will see, when the currency depreciates in real terms, the current account balance tends to improve: Exports tend to increase and imports tend to fall. If the currency appreciates in real terms, the current account balance tends to worsen. Exports tend to decline as they become more expensive to foreign consumers, and imports tend to rise as they become cheaper to domestic consumers.
