Households often hold some of their wealth in the form of savings accounts or cash. As the price level rises, the purchasing power of this wealth falls because the money will purchase less of the (now higher-priced) goods. According to the wealth effect, increases in the price level decrease the quantity of output demanded.

When an economy's price level rises, consumers require more money to purchase a given basket of goods and services, so that money demand rises, causing the domestic interest rate to rise. Foreign investors respond to higher domestic interest rates by seeking higher returns in the domestic economy. As foreign investors attempt to convert foreign currency into dollars to buy domestic assets, the demand for dollars increases in the market for foreign-currency exchange, and the real value of the dollar increases.

When each dollar buys more units of foreign currencies, foreign goods become less expensive than domestic goods. Because of dollar appreciation, foreigners find domestic goods to be relatively more expensive. Exports of domestic goods to foreigners therefore fall, while domestic imports of foreign goods rise. Net exports (exports minus imports) therefore fall, leading to a fall in the quantity of domestic output demanded.

The tendency for a rise in the price level to increase the real exchange rate and decrease net exports is known as the exchange rate effect.