Question

How do changes in exchange rates influence domestic prices?

Answer 1

Changes in exchange rates directly impact domestic prices, especially in an open economy that depends on imports and exports.

1. Depreciation of Currency (fall in exchange rate):
   • Makes imports more expensive, as more domestic currency is needed to buy foreign goods.
   • This leads to imported inflation, raising domestic prices.
   • For example, a weaker rupee increases the cost of imported goods like oil, electronics, and machinery, leading to higher overall prices.
2. Appreciation of Currency (rise in exchange rate):
   • Makes imports cheaper, reducing the prices of imported goods and services.
   • This can lower domestic inflation and stabilise prices.

Thus, exchange rate fluctuations influence the cost of imports, production, and inflation, affecting the overall price level in the economy.