Question : The foreign trade effect suggests that an increase in the price level:
Option 1: Increases imports and decreases exports
Option 2: Decreases imports and increases exports
Option 3: Increases both imports and exports
Option 4: Decreases both imports and exports
Correct Answer:
Increases imports and decreases exports
Solution : The correct answer is (a) Increases imports and decreases exports.
The foreign trade effect suggests that an increase in the price level leads to an increase in imports and a decrease in exports. This effect occurs because a higher price level makes domestic goods and services relatively more expensive compared to foreign goods and services.
When the price level rises, domestic goods become relatively more costly for consumers both domestically and abroad. As a result, consumers in the domestic market are more likely to shift their demand towards cheaper imported goods and decrease their demand for domestic goods. This leads to an increase in imports.
On the other hand, the increase in the price level makes domestic goods relatively more expensive for foreign consumers. This reduces their demand for domestic goods and leads to a decrease in exports.
