What causes real exchange rate to increase?

Understanding the Factors Driving Real Exchange Rate Appreciation

The real exchange rate measures the value of a country’s currency in terms of its purchasing power relative to other currencies. An increase in the real exchange rate indicates that the currency has become more expensive relative to others, making imported goods cheaper and exported goods more expensive.

One significant factor that can contribute to an increase in the real exchange rate is technological advancements that boost productivity in internationally traded goods. When production costs are lowered due to these advancements, it becomes necessary to adjust the exchange rate to maintain market equilibrium.

The Role of Technological Advancements

Technological advancements can result in increased productivity, which leads to lower production costs for internationally traded goods. This, in turn, reduces the prices of these goods in the domestic market. As a result, demand for imported goods increases, while demand for exported goods decreases.

To counterbalance this shift in demand, the real exchange rate must appreciate. This means that the domestic currency becomes more expensive relative to foreign currencies, making imported goods cheaper and exported goods more expensive. This discourages further imports and encourages exports, restoring market equilibrium.

Implications for Economic Growth

The appreciation of the real exchange rate can have significant implications for economic growth. While it can make imported goods more affordable for consumers, it can also hinder export-oriented industries. Exported goods become more expensive in foreign markets, reducing their competitiveness and potentially leading to a decline in exports.

In contrast, an appreciating real exchange rate can benefit import-dependent industries. Access to cheaper imported goods and raw materials can lower production costs and enhance profitability.

Conclusion

Technological advancements that boost productivity in internationally traded goods can lead to an increase in the real exchange rate. This appreciation is driven by the need to maintain market equilibrium in the face of changing demand patterns. While it can have both positive and negative implications for economic growth, policymakers must carefully consider the potential impacts and implement appropriate measures to mitigate any adverse effects.