If nominal exchange rates do not change, an increase in the U.S. price level relative to the foreign price level represents a real appreciation of the dollar. However, if nominal exchange rates can change, is an increase in U.S. inflation relative to foreign inflation likely to cause appreciation of the dollar in the short run?
What will be an ideal response?
No. An increase in U.S. inflation relative to foreign inflation is likely to reduce the demand for dollars relative to other currencies. This will cause the nominal exchange rate to increase, a depreciation of the dollar relative to other currencies, and thus the effect on the real exchange rate is unclear.
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