The exchange rate effect illustrates how changes in a country's price level can influence international trade and, subsequently, aggregate demand. When a country's overall price level decreases, its goods and services become relatively more affordable compared to those of other nations.
- This relative price decline makes local goods more attractive to foreign buyers.
- As a result, exports increase, leading to a higher demand for domestically produced products.
Consider a scenario where the United States experiences a drop in its overall price level. U.S.-produced goods become cheaper for international buyers, like those in Europe or Asia. These buyers are more likely to purchase U.S. exports because they offer better value compared to products from their own or other countries. Increased exports result in more purchases of domestic goods, enhancing overall demand.
This rise in exports, driven by favorable exchange rates due to decreased price levels, strengthens the downward slope of the aggregate demand curve. This effect highlights the interconnectedness of global markets and how changes in one economy can ripple across borders, affecting demand worldwide.