Currency vs price level

One of the reasons aggregate demand curve is downward sloping is because a lower price level means that the real exchange rate:

  1. depreciates, making domestic goods cheaper in other countries and imports less competitive, resulting in a higher level of net exports.
  2. appreciates, making domestic goods more expensive in other countries and imports more competitive, resulting in a higher level of net exports.
  3. appreciates, making the country’s exports and imports less competitive and leading to lower net exports.

The answer is A

Can someone please explain why currency depreciates at lower price level?

If you see the formula of real exchange rate, it is quite straightforward:


If Pd (domestic prices) goes lower, “er” (real exchange rate) goes lower or depreciates. It makes sense because, if domestic prices are lower, the people will buy more local goods instead of foreign ones, so people will import less products, a double effect that increases net exports.

The concept of real exchange rate is somewhat ethereal because nominal exchange rate (en) is an economic variable that results from the combined effects of 20+ variables, not only price levels between countries. But yeah, this formula still makes sense in some scenarios, mostly in non-crisis ones.

Thank you.