APT/Multi-Factor Models

 You will recall that a representative domestic expenditure basket includes some imported products but places a relatively heavier weight on goods and services produced domestically. At the same time, the representative foreign basket is skewed toward goods and services produced in the foreign country. Thus, a rise in the price of the foreign basket in terms of domestic baskets, say, will be associated with a rise in the relative price of foreign output in general relative to domestic output. 3 To determine how such a change in the relative price of national outputs affects the current account, other things equal, we must ask how it affects both EX and IM . When EP * > P rises, for example, foreign products have become more expensive relative to domestic products: Each unit of domestic output now purchases fewer units of foreign output. Foreign consumers will respond to this price shift (a real domestic currency depreciation) by demanding more of our exports. This response by foreigners will therefore raise EX and improve the domestic country’s current account. The effect of the same real exchange rate increase on IM is more complicated. Domestic consumers respond to the price shift by purchasing fewer units of the more expensive foreign products. Their response does not imply, however, that IM must fall, because IM denotes the value of imports measured in terms of domestic output, not the volume of foreign products imported. Since a rise in EP * > P (a real depreciation of the domestic currency) tends to raise the value of each unit of imports in terms of domestic output units, imports measured in domestic output units may rise as a result of a rise in EP * > P even if imports decline when measured in foreign output units. IM can therefore rise or fall when EP * > P rises, so the effect of a real exchange rate change