International Trade

Problems Problems Exchange Rates Nominal Exchange Rates versus Real Exchange Rates As we begin discussing exchange rates, we must make the same distinction that we made when discussing GDP. Namely, how do nominal exchange rates and real exchange rates differ?

The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of domestic currency. The real exchange rate is a bit more complicated than the nominal exchange rate. While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation: real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Let's say that we want to determine the real exchange rate for wine between the US and Italy. We know that the nominal exchange rate between these countries is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember that we are attempting to compare equivalent types of wine in this example. In this case, we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine. By using both the nominal exchange rate and the real exchange rate, we can deduce important information about the relative cost of living in two countries. While a high nominal exchange rate may create the false impression that a unit of domestic currency will be able to purchase many foreign goods, in reality, only a high real exchange rate justifies this assumption. Net Exports and the Real Exchange Rate An important relationship exists between net exports and the real exchange rate within a

country. When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise. This relationship helps to show the effects of changes in the real exchange rate.

Problem : How do we calculate the nominal exchange rate? To calculate the nominal exchange rate, determine the amount of foreign currency that can be calculated for one unit of domestic currency. Problem : How do we calculate the real exchange rate? Solution for Problem 2 >> The equation follows: real exchange rate = (nominal exchange rate X domestic price) / (foreign price) Problem : How do the nominal exchange rate and the real exchange rate differ? Solution for Problem 3 >> The nominal exchange rate tells how much foreign currency can be purchased with a unit of domestic currency. The real exchange rate tells how many foreign goods can be purchased with domestic goods. Problem : How do net exports relate to the real exchange rate? Solution for Problem 4 >> As the real exchange rate increases, net exports fall as imports increase and exports fall. Problem : If a country has a high real exchange rate, what does this tell you about the nominal exchange rate? Solution for Problem 5 >> The real exchange rate tells nothing conclusive about the nominal exchange rate since both the nominal exchange rate and the price level affect the real exchange rate. Barriers to Trade It may seem odd, but governments often step in to restrict trade. Why might a government want to restrict trade? If domestic industries cannot compete against foreign industries, the government will restrict trade to help the domestic industries develop. Governments may also restrict trade to foster business at home rather than encouraging business to move out of the country. These protectionist policies encourage prices to stay high and help domestic industries to develop. Trade Interferences

Governments three primary means to restrict trade: quota systems; tariffs; and subsidies. A quota system imposes restrictions on the specific number of goods imported into a country. Quota systems allow governments to control the quantity of imports to help protect domestic industries. Tariffs are fees paid on imported goods. Tariffs increase the price that consumers pay for the good, thus reducing the quantity of the good demanded and making the price more in line with the price charged by domestic producers. Tariff profits may go to the government or to developing industries. Subsidies are grants given to domestic industries to help them develop and compete with foreign producers. Through subsidies, domestic producers can charge less for their goods without losing money due to outside grants. Through judicious use of quotas, tariffs, and subsidies, governments are able to improve the domestic economy. This may increase the price that domestic consumers pay for goods, though this small annoyance is usually outweighed by significantly bolstered overall economic levels and long-term economic growth. Trade Deficit

In the section on net exports we learned that net exports equal exports minus imports. The difference between exports and imports is referred to as the trade deficit or the trade surplus. When exports exceed imports, a trade surplus exists. When imports exceed exports, a trade deficit exists. There often talk about the effects of the trade deficit on the economy. What is the actual effect of the trade deficit though? Remember that when there is a trade deficit, net foreign investment fills the gap between exports and imports, as NX = NFI. Thus, if a large trade deficit exists, foreign investment must be high. This is slightly problematic as domestic companies often enjoy domestic ownership--a large trade deficit threatens this condition. A trade deficit is often matched with a large governmental budget deficit. Though the specific effects of a trade deficit are nebulous, in general a large trade deficit is thought to stunt long-term economic growth slightly. How can the trade deficit be resolved? First, exports can be increased to make annual net exports positive. When employed, this method will cause a trade deficit decrease over time. Second, funds can be used to pay off foreign investors, reducing balance due from trade and causing a lower trade deficit.

Problems

Problem : Why would a government impede free trade? Solution for Problem 1 >> A government might interfere with free trade to help developing domestic industries. Problem : How do quotas work? Solution for Problem 2 >> A quota system limits the specific number of goods that may be imported into a country. Problem : How do tariffs work? Solution for Problem 3 >> Tariffs are fees paid on imported goods. Tariffs increase the price that consumers pay for the good, which reduces the quantity of the good demanded and makes the price more in line with the price charged by domestic producers. Problem : How do subsidies work? Solution for Problem 4 >> Subsidies are grants given to domestic industries to help them develop and compete with foreign producers. Problem : What are two harmful effects of a large trade deficit? Solution for Problem 5 >> Harmful effects of a large trade deficit include foreign ownership of domestic industry and a tandem budget deficit. Test Why should countries trade? (A) To help them thrive (B) To increase output (C) To decrease output (D) To keep them busy Which of the following is a situation in which trade is advantageous? (A) Two countries produce the same goods for the same costs (B) Two countries produce different goods for different costs (C) Two countries are isolated (D) Two countries have the same markets When one producer can create a given amount of output with fewer inputs, what exists?

(A) Comparative advantage (B) Comparative disadvantage (C) Absolute advantage (D) Absolute disadvantage When one producer has a lower opportunity cost of production than another producer for a given item, what exists? (A) Absolute disadvantage (B) Absolute advantage (C) Comparative disadvantage (D) Comparative advantage Farmer John has a pistachio farm. It takes him 5 hours worth of work to harvest 1 pound of nuts. Farmer Rick also has a pistachio farm. It takes him 10 hours worth of work to harvest 1 pound of nuts. Finally, Farmer Erica owns a third pistachio farm. She can harvest 1 pound of nuts in 2 hours. Who has the absolute advantage in this example? (A) Farmer Erica (B) Farmer Rick (C) Farmer John (D) Unclear There are three producers. Producer A spends $10 to make a widget. Producer B spends $50 to make a widget. Producer C spends $4. Who has the absolute advantage? (A) Producer B (B) Producer C (C) Producer A (D) Unclear Mechanic A can change a tire in 1 hour and change a sparkplug in 2 hours. Mechanic B can change a tire in 0.5 hours and change a sparkplug in 0.25 hours. Who has the comparative advantage in changing sparkplugs? (A) Need more information (B) Both mechanics (C) Mechanic B (D) Mechanic A Rancher Tom can raise 10 goats and 20 pigs in a year. Rancher Joe can raise 20 goats and 100 pigs in a year. Who has the comparative advantage for raising pigs? (A) Need more information (B) Both ranchers (C) Rancher Tom (D) Rancher Joe What term applies when one option is chosen from among several possibilities? (A) Opportunity cost

(B) Absolute advantage (C) Comparative advantage (D) Lost possibilities If there are two producers and two products, which of the following cannot happen? (A) A producer has an absolute advantage on one product (B) A producer has the comparative advantage on both products (C) A producer has the comparative advantage on one product (D) A producer has an absolute advantage on both products When a comparative advantage exists, what should the producer with the comparative advantage do? (A) Produce the item for which he does not have the comparative advantage (B) Produce both items (C) Produce the item for which he does have the comparative advantage (D) Produce neither item When an absolute advantage exists, what should the producer with the absolute advantage do? (A) Produce the item for which he does not have the absolute advantage (B) Produce both items (C) Produce the item for which he does have the absolute advantage (D) Produce neither item Is it possible for a producer to have both an absolute advantage and a comparative advantage? (A) Yes (B) No (C) Only if the market is small (D) Only if there are two producers What equation describes output? (A) Y = C + I + G + X (B) Y = C + I + G + NX (C) Y = C + I + G + I (D) Y = C + I + G What else does the equation Y = C + I + G + NX describe? (A) Interest rate (B) Exchange rate (C) Income (D) Growth rate In the equation Y = C + I + G + NX, what does Y stand for? (A) Real output

(B) Real wages (C) Nominal wages (D) Nominal output What is the equation that describes net exports? (A) Net exports = exports - imports (B) Net exports = output - exports (C) Net exports = exports - output (D) Net exports = imports - exports When a country exports and imports the same amount of goods, what is its net exports? (A) Need more information (B) Zero (C) Exports plus imports (D) Output plus exports When a country exports more than it imports, what is the value of net exports? (A) Negative (B) Zero (C) Positive (D) Need more information When a country imports more than it exports, what is the value of the net exports? (A) Need more information (B) Zero (C) Positive (D) Negative When net exports are negative, what accounts for the difference? (A) Net foreign investment (B) Imports (C) Exports (D) Net exports What is the equation that relates net exports to net foreign investment? (A) NX = NFI + C (B) NX = NFI (C) NX = NFI - C (D) NX = 1 - NFI If a country always imports more than it exports, what will its net foreign investment look like? (A) Low (B) Medium (C) High

(D) Need more information If a country always exports more than it imports, what will the net foreign investment look like? (A) Need more information (B) High (C) Medium (D) Low Which of the following pairs go together? (A) Negative NX and high NFI (B) Negative NX and low NFI (C) Positive NX and high NFI (D) None of the above Which of the following pairs go together? (A) High imports and high net exports (B) Need more information (C) Low imports and high net exports (D) Low imports and low net exports What do you call the number that represents the nominal value of currency in two countries? (A) Interest rate (B) Output (C) Exchange rate (D) Price What do you call the number that compares the real cost of goods between two countries? (A) Nominal exchange rate (B) Real interest rate (C) Nominal interest rate (D) Real exchange rate Which is easier to calculate, the nominal exchange rate or the real exchange rate? (A) Nominal exchange rate (B) Real exchange rate (C) Need more information (D) None of the above Which of the following is not necessary to calculate the real exchange rate? (A) Domestic price (B) Domestic interest rate (C) Foreign price (D) Nominal exchange rate

What is the equation for the real exchange rate? (A) real exchange rate = (domestic price) / (foreign price) (B) real exchange rate = (nominal exchange rate X domestic price) (C) real exchange rate = (nominal exchange rate X domestic price) / (foreign price) (D) real exchange rate = (nominal exchange rate X foreign price) How are the nominal exchange rate and the real exchange rate related? (A) Inversely (B) Indirectly (C) Directly (D) Proportionally What is the real exchange rate if the domestic price is $5, the foreign price is 3 pounds, and the exchange rate is 1.5? (A) 2.5 (B) 3 (C) 8 (D) 4.5 What is the real exchange rate if the domestic price is $2, the foreign price is 2 pounds, and the exchange rate is 1.5? (A) 1 (B) 1.5 (C) 0 (D) 2 What is the real exchange rate if the domestic price is $10, the foreign price is 30 pounds, and the exchange rate is 2? (A) 0.5 (B) 0.55 (C) 0.67 (D) 0.70 What can be determined from the real exchange rate? (A) Standard of living (B) Interest rate (C) Output (D) Cost of living Which of the following situations is best if you wish to travel to a foreign country? (A) High nominal exchange rate and high real exchange rate (B) High nominal exchange rate and low real exchange rate (C) Low nominal exchange rate and high real exchange rate (D) Low nominal exchange rate and low real exchange rate

What is the effect on net exports of an increase in the real exchange rate? (A) They rise (B) They fall (C) No effect (D) Need more information When the real exchange rate falls, what is likely to increase? (A) Cost of living (B) Imports (C) Exports (D) Standard of living What is the general term for when a government interferes in free trade? (A) Policy (B) Intercession (C) Hindrance to trade (D) Barrier to trade Which of the following is not a reason that the government might impose a barrier to trade? (A) To hurt the economy (B) To help young domestic industries (C) To raise money (D) To make domestic producers competitive What do you call barriers to trade that help domestic producers? (A) Barriers to trade (B) Protectionist policies (C) Jingoist policies (D) Fiscal policies What is it called when the government places limits on the number of a given good that can be imported? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What is it called when the government places taxes on imported goods? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What is it called when the government gives domestic industries grants to keep them

running competitively? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What develops when exports exceed imports? (A) Trade deficit (B) Trade surplus (C) Barrier to trade (D) Tariff What develops when imports exceed exports? (A) Tariff (B) Quota (C) Trade deficit (D) Trade surplus Which of the following is not an effect of a trade deficit? (A) High net foreign investment (B) Decreased domestic ownership (C) Increased balances due (D) Increased output Which of the following is not a way to cure the trade deficit? (A) Increase imports (B) Decrease imports (C) Increase exports (D) Pay balances due Which of the following is thought to be related to a high trade deficit? (A) A low budget deficit (B) A high budget deficit (C) An even balance of trade (D) Protectionist policies