If the real exchange rate appreciates, what is the likely effect on net exports and why?

• A. Net exports increase
• B. Net exports decrease
• C. Net exports unaffected
• D. Net exports increase only with inflation

Answer: (B)

When the real exchange rate appreciates, domestic goods become more expensive relative to foreign goods. That makes our exports less affordable to buyers abroad and makes foreign goods cheaper for us to buy. As a result, demand for exports falls while import demand rises, so net exports decline. Think of net exports as exports minus imports; with prices changing in favor of foreign goods, exports drop and imports climb, pushing this net figure downward. The effect depends on how sensitive buyers are to price changes, but the direction is clear: net exports are likely to decrease when the real exchange rate strengthens.