The Market for Foreign-Currency Exchange
The real exchange rate is determined by the supply and demand for foreign-currency exchange. The supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net capital out flow does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping. At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.
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