The exchange-rate effect implies that when the price level increases:

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Examining the prompt, we are asked about the exchange-rate effect and what happens to net exports when the price level rises.
Option 1: 'net exports decrease' — This aligns with the standard negotiation of the exchange-rate effect. A higher domestic price level tends to reduce imports and/or increase imports? Actually, higher domestic prices make domestic goods more expensive relative to foreign goods, reducing the quantity of exports demanded and increasing imports, which lowers net exports. In the exchange-rate framework, a higher price level can crowd out foreign investment and appreciate the currency, making net exports fall. So this option reflects the typical outcome described in macroeconomic texts, where a rise in the domestic price level leads to a deterioration in net exports.
Option 2: 'net exports increase' — This would occur if domestic prices fell relative to foreign prices or if the exchange rate mechanism caused the currency to depreciate, boosting exports and reducing imports. However, the exchange-rate effect, as commonly taught, predicts that a higher domestic price level tends to appreciate the real exchange rate and reduce net exports, not increase them. Thus this option contradicts the standard implication.
Option 3: 'net exports do not change' — If a rise in the price level left net exports unchanged, it would imply either offsets by monetary policy, foreign price changes, or countervailing forces that exactly cancel each other. The classical exchange-rate effect, in a simple model, would not typically yield zero change when the price level rises; some adjustment in trade balances is expected.
Option 4: 'any of the options is possible' — This would imply great ambiguity or dependence on other assumptions (e.g., price elasticities, policy responses, capital mobility). While real-world outcomes can vary with model specifics, the standard short-run exchange-rate effect under plausible assumptions does not assert that any of the listed outcomes could occur with equal likelihood. It typically points toward a specific directional change in net exports following a price-level rise.
In summary, option 1 most closely matches the conventional short-run prediction of the exchange-rate effect: a rise in the domestic price level tends to reduce net exports due to adjustments in relative prices and currency values, while the other options rely on scenarios that either reverse that direction, imply no change, or rely on atypical conditions.

23115 Economics for Business - Autumn 2025 Assessed Quiz 6 - AD-AS Model

The exchange-rate effect implies that when the price level increases:

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