What causes the real exchange rate to increase?

Drivers of Real Exchange Rate Appreciation

The real exchange rate measures the purchasing power of a currency in relation to other currencies, adjusting for inflation. When the real exchange rate increases, it means that the domestic currency has become more expensive relative to foreign currencies, making imported goods more expensive and domestic goods cheaper for foreign buyers.

One key driver of real exchange rate appreciation is technological advancements that boost productivity in traded goods. When domestic firms become more efficient in producing goods that are traded internationally, they can reduce their production costs. This leads to an increase in the supply of traded goods in the domestic market, which in turn exerts downward pressure on domestic prices.

As domestic prices fall relative to foreign prices, the demand for imported goods decreases, and the demand for domestic goods from abroad increases. This shifts the supply and demand curves for the domestic currency, causing it to appreciate in real terms. The real exchange rate rises to maintain economic equilibrium, where the value of imports and exports is balanced.

For example, if a country experiences a significant technological breakthrough in manufacturing, leading to a substantial reduction in production costs, domestic firms can produce more goods at a lower cost. This would lead to an increase in the supply of traded goods, causing domestic prices to fall and the real exchange rate to appreciate.

In conclusion, technological advancements that boost productivity in traded goods can lead to an increase in the real exchange rate. The reduction in production costs necessitates a higher real exchange rate to maintain economic equilibrium, as it reflects the increased value of domestic goods in relation to foreign goods.