Question

Give an example of how a change in the exchange rate alters the relative price of domestic goods in terms of foreign goods.

Short answer

An increase in exchange rate will decrease the relative price of domestic goods in terms of foreign goods making foreign goods cheaper. A decrease in exchange rate will increase the relative price of domestic goods, making foreign goods more expensive.

Step-by-step solution

Understanding Exchange Rates

Exchange rate refers to the price of one country's currency in relation to another's. It informs the number of units of foreign currency that can be bought with a unit of the domestic currency.

Effects of Increase in Exchange Rate

Suppose the exchange rate increases, meaning that one unit of domestic currency can now purchase more units of the foreign currency. This would effectively make foreign goods cheaper in relation to domestic goods. Hence, an increase in the exchange rate lowers the relative price of domestic goods in terms of foreign goods.

Effects of Decrease in Exchange Rate

Let's now consider a decrease in the exchange rate, meaning that one unit of domestic currency can now purchase fewer units of the foreign currency. This, in turn, makes foreign goods more expensive compared to domestic goods. Consequently, a decrease in the exchange rate increases the relative price of domestic goods in terms of foreign goods.