If a country experiences a depreciation of its currency, what is the likely effect on net exports and the price level in the short run?

• A. Net exports fall and price level rise
• B. Net exports rise and the price level may rise due to higher import prices
• C. Net exports rise and the price level falls
• D. Net exports fall and price level fall

Answer: (B)

A depreciation means the domestic currency loses value relative to others, so exports become cheaper for foreigners and imports become more expensive for residents. In the short run this tends to raise net exports because demand for domestically produced goods abroad increases while domestic demand for imports falls, boosting the trade balance.

As for prices, higher import prices from the weaker currency can push up the overall price level if these cost increases are passed through to domestic prices. The stronger demand from higher net exports can also push prices higher when resources are near full capacity. Because the extent of pass-through and price adjustments can vary, the price level may rise but isn’t guaranteed to do so.