Chapter 6, Problem 1PA

Subpart (a):

To determine

Changes in the trade balance, real exchange rate, and nominal exchange rate.

Explanation of Solution

The fall in consumer confidence about the future induces the following effect on the trade balance, real exchange rate, and the nominal exchange rate which is depicted in figure 1.

In figure 1, the horizontal axis measures the net exports (trade balance) and the vertical axis measures the real exchange rate.

When the consumer spends less and save more, the $\left(\text{S}-\text{I}\right)$ schedule shifts to the right from $\left({\text{S}}_1-\text{I}\right)$ to $\left({\text{S}}_2-\text{I}\right)$ when the saving increases from S₁ to S₂. This causes the real exchange rate to depreciate from ${\text{ε}}_1$ to ${\text{ε}}_2$ and the trade balance increases to NX₁ to NX₂. The nominal exchange rate also depreciates as there is no change in the relative price level.

Economics Concept Introduction

Nominal exchange rate: Nominal exchange rate can be defined as the relative price of currencies of two countries that is the rate at which one currency can be exchanged for another currency.

Real exchange rate: Real exchange rate can be defined as the relative price of goods or services of two countries, which is the rate at which one can exchange the goods and services of one country for the goods and services of another.

Inflation: Inflation is the situation of abnormal price hike in the economy which leads to the situation of too much money chasing less number of goods.

Depreciation of currency: The depreciation of currency implies decrease in the value of currency of respective country.

Appreciation of currency: The appreciation of currency implies increase in the value of currency of that country.

Subpart (b):

To determine

The changes in the trade balance, real exchange rate and nominal exchange rate.

Explanation of Solution

The tax reform induces the following effect on trade balance, real exchange rate, and the nominal exchange rate which is depicted in figure 2.

In figure 2, the horizontal axis measures the net exports (trade balance) and the vertical axis measures the real exchange rate.

The tax reform induces business to build factories and this increase the investment, which shifts the $\left(\text{S}-\text{I}\right)$ schedule to the left from $\left(\text{S}-{\text{I}}_1\right)$ to $\left(\text{S}-{\text{I}}_2\right)$, as the investment increases from I₁ to I₂. This causes the real exchange rate to appreciate from ${\text{ε}}_2$ to ${\text{ε}}_1$ and the trade balance decrease from NX₂ to NX_1. The nominal exchange rate also appreciates as there is no change in the relative price level.

Economics Concept Introduction

Nominal exchange rate: Nominal exchange rate can be defined as the relative price of currencies of two countries that is the rate at which one currency can be exchanged for another currency.

Real exchange rate: Real exchange rate can be defined as the relative price of goods or services of two countries, which is the rate at which one can exchange the goods and services of one country for the goods and services of another.

Inflation: Inflation is the situation of abnormal price hike in the economy which leads to the situation of too much money chasing les number of goods.

Depreciation of currency: The depreciation of currency implies decrease in the value of currency of respective country.

Appreciation of currency: The appreciation of currency implies increase in the value of currency of that country.

Subpart (c):

To determine

The changes in the trade balance, real exchange rate, and nominal exchange rate.

Explanation of Solution

The consumer prefers foreign cars over domestic cars induces the following effect on the trade balance, real exchange rate, and the nominal exchange rate which is depicted in figure 3.

In figure 3, the horizontal axis measures the net exports (trade balance) and the vertical axis measures the real exchange rate.

The consumers’ preference for foreign cars over the domestic cars would have no effect on the savings and investment and therefore, there is no shift in $\left(\text{S}-\text{I}\right)$. However, it will shift the net exports or trade balance inward from NX₁ to NX₂. This causes the real exchange rate to depreciate from ${\text{ε}}_1$ to ${\text{ε}}_2$, whereas the trade balance remains the same. The nominal exchange rate also depreciates as there is no change in the relative price level.

Economics Concept Introduction

Nominal exchange rate: Nominal exchange rate can be defined as the relative price of currencies of two countries that is the rate at which one currency can be exchanged for another currency.

Real exchange rate: Real exchange rate can be defined as the relative price of goods or services of two countries, which is the rate at which one can exchange the goods and services of one country for the goods and services of another.

Inflation: Inflation is the situation of abnormal price hike in the economy which leads to the situation of too much money chasing less number of goods.

Depreciation of currency: The depreciation of currency implies decrease in the value of currency of respective country.

Appreciation of currency: The appreciation of currency implies increase in the value of currency of that country.

Subpart (d):

To determine

The changes in the trade balance, real exchange rate, and nominal exchange rate.

Explanation of Solution

Doubling the money supply induces the following effect on trade balance, real exchange rate, and the nominal exchange rate which is depicted in figure 4.

In figure 4, the horizontal axis measures the net exports (trade balance) and the vertical axis measures the real exchange rate.

Output Y is determined by the amount of capital and labor, whereas the investment I(r^*) is determined by the world interest rate (r^*). The net export (NX), on the other hand, is determined by the difference in domestic saving and domestic investment $\left(\text{S}-\text{I}\right)$. In figure 4, the intersection of the $\left(\text{S}-\text{I}\right)$ schedule and the net export (NX) determines the real exchange rate ($\text{ε}$).

Doubling the money supply has no effect on any real variables by the money neutrality. However, it affects the nominal exchange rate through its effect on the domestic price level P.

Price level P adjusts to equilibrate the demand for supply of real balances which is given as follows:

$\frac{\text{M}}{\text{P}}={\left(\frac{\text{M}}{\text{P}}\right)}^{\text{d}}$

The level of output and the interest rate determines the real money demand ${\left(\frac{\text{M}}{\text{P}}\right)}^{\text{d}}$  and thus, the real money demand does not change by doubling the money supply M. Thus, price level P must double in order to restore the equilibrium in the money market.

The nominal exchange rate is given as follows:

$\text{Nominal Exchange rate}=\left(\text{Real Exchange rate}\right)\times \left(\begin{array}{l}\text{Ratio of price levels }\\ \text{of the two countries}\end{array}\right)$

It can be expressed as follows:

$\text{e}=\text{ε}\times \left(\frac{{\text{P}}^{*}}{\text{P}}\right)$,

Where e is the nominal exchange rate, $\text{ε}$ is the real exchange rate, P^* is the foreign price level and P is the domestic price level. As P^* remains unaffected, the increase in P cause the nominal exchange rate e to depreciate.

Economics Concept Introduction

Nominal exchange rate: Nominal exchange rate can be defined as the relative price of currencies of two countries that is the rate at which one currency can be exchanged for another currency.

Real exchange rate: Real exchange rate can be defined as the relative price of goods or services of two countries, which is the rate at which one can exchange the goods and services of one country for the goods and services of another.

Depreciation of currency: The depreciation of currency implies decrease in the value of currency of respective country.

Appreciation of currency: The appreciation of currency implies increase in the value of currency of that country.

Subpart (e):

To determine

The changes in the trade balance, real exchange rate and nominal exchange rate.

Explanation of Solution

Increase in the demand for money induces the following effect on trade balance, real exchange rate, and the nominal exchange rate.

Output Y is determined by the amount of capital and labor, whereas investment I(r^*) is determined by the world interest rate (r^*). The net export (NX), on the other hand, is determined by difference in domestic saving and domestic investment $\left(\text{S}-\text{I}\right)$. In figure 4, in subpart (d), the intersection of the $\left(\text{S}-\text{I}\right)$ schedule and the net export (NX) determines the real exchange rate ($\text{ε}$).

The increase in demand for money has no effect on any real variables by the money neutrality. However, it affects the nominal exchange rate through its effect on the domestic price level P.

Price level P adjusts to equilibrate the demand for supply of real balances which is given as follows:

$\frac{\text{M}}{\text{P}}={\left(\frac{\text{M}}{\text{P}}\right)}^{\text{d}}$

The level of output and the interest rate determines the real money demand ${\left(\frac{\text{M}}{\text{P}}\right)}^{\text{d}}$  and thus, the real money demand does not change by increase in the demand for money. Thus, price level P must fall in order to restore the equilibrium in the money market.

The nominal exchange rate is given as follows:

$\text{Nominal Exchange rate}=\left(\text{Real Exchange rate}\right)\times \left(\begin{array}{l}\text{Ratio of price levels }\\ \text{of the two countries}\end{array}\right)$

It can be expressed as follows:

$\text{e}=\text{ε}\times \left(\frac{{\text{P}}^{*}}{\text{P}}\right)$,

Here, e is the nominal exchange rate, $\text{ε}$ is the real exchange rate, P^* is the foreign price level, and P is the domestic price level. As P^* remains unaffected, the fall in P causes the nominal exchange rate (e) to appreciate.

Economics Concept Introduction

Nominal exchange rate: Nominal exchange rate can be defined as the relative price of currencies of two countries that is the rate at which one currency can be exchanged for another currency.

Real exchange rate: Real exchange rate can be defined as the relative price of goods or services of two countries, which is the rate at which one can exchange the goods and services of one country for the goods and services of another.

Depreciation of currency: The depreciation of currency implies decrease in the value of currency of respective country.

Appreciation of currency: The appreciation of currency implies increase in the value of currency of that country.