Econ452 Learning Unit 05
- 1. Learning Unit 5 Exchange Rate and Issues on Comparative Advantage ECON452 International Economics
- 2. Objectives 1. Explain how an exchange rate of currencies is determined 2. Distinguish between real and nominal exchange rates and explain how two are related 3. Refute common fallacies about international trade
- 3. Trade with Money • In reality, each country has own currency and not directly exchange goods, but currencies to purchase goods produced in other countries. • Real Exchange Rate: How much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country – Relative price of exporting goods • Nominal Exchange Rate: How much foreign currency can be exchanged for a unit of domestic currency
- 4. Trade with Money – Example • Unit labor requirements and (nominal) wage rates determine (nominal) prices of goods in domestic currencies. • For example, Home’s currency is $, while Foreign’s currency is €. Home Foreign Cheese Wine Cheese Wine Unit labor requirement 1 2 6 3 Wage rate (per hour) $12 $12 €20 €20 Domestic price $12 $24 €120 €60 • In Home, unit labor requirement for producing wine is 2 labor hours. • At wage rate of $12/hour in Home, a price of wine should be $24 with no profits (2 x $12). • In Foreign, unit labor requirement for producing wine is 3 labor hours and a wage rate is €20, so a price of wine is €60 in Foreign (3 x €20).
- 5. Domestic Prices of Foreign Goods • Given an exchange rate of currencies, prices of goods produced in foreign currencies can be converted to prices in domestic currencies. Home Foreign Cheese Wine Cheese Wine Domestic price $12 $24 €120 €60 Dollar price $1=2 ($0.5=1) $60 $30 $1=2.5 ($0.4=1) $48 $24 $1=5 ($0.2=1) $24 $12 $1=10 ($0.1=1) $12 $6 $1=20 ($0.05=1) $6 $3 • When the exchange rate is at $1 = €2, One unit of Home currency is exchanged for two units of Foreign currency. • At the exchange rate of $1 = €2, a dollar price of cheese produced in Foreign is $60 (€120/2). It requires $60 to purchase €120 worth of good in Foreign.
- 6. Range of Exchange Rate • Given domestic prices of cheese ($12) and wine ($24), Home will purchase goods produced in Foreign if Foreign’s good price in domestic currency ($) is cheaper than domestic price in Home. Foreign Cheese Wine Domestic price €120 €60 Dollar price $1=2 ($0.5=1) $60 $30 $1=2.5 ($0.4=1) $48 $24 $1=5 ($0.2=1) $24 $12 $1=10 ($0.1=1) $12 $6 $1=20 ($0.05=1) $6 $3 • At the exchange rate of $1= €5, a dollar price of cheese is lower in Home ($12<$24) and a dollar price of wine is lower in Foreign ($24>$12), so Home imports wine from Foreign and Foreign imports cheese from Home. • The exchange rate of two currencies must be between $1= €10 (for cheese) and $1= €2.5 (for wine). • If the exchange rate is greater than $1= €10, then domestic prices of both goods will be lower in Foreign. If the exchange rate is less than $1= €2, then domestic prices of both goods will be lower in Home.
- 7. Wage Rates and Exchange Rate • Given wage rates in two countries ($12 in Home and €20 in Foreign), at the exchange rate of $1 = €5, a dollar wage rate in Foreign is $4 (€20/4). • Why does labor earn less in dollar in Foreign? – Lower the productivity of labor in Foreign, less wage labor receives once wages are adjusted for exchange rate between currencies. • When wage rate is high nominally (workers in Foreign are paid at €20), prices of goods produced are also high. – High wage rate contributes to high goods prices (Inflation). • Why (nominal) wage rate is high in Foreign? – Too much money in economy
- 8. Misconceptions about Comparative Advantage • Although the international trade almost always benefits an economy, the general public is skeptical about free trade because of misunderstanding and misuse of concept of comparative advantage. • Myth #1: Free trade is beneficial only if a country is more productive than foreign countries. • Myth #2: Free trade with countries that pay low wages hurts high wage countries. • Myth #3: Free trade exploits less productive countries whose workers make low wages.
- 9. Misconceptions about Comparative Advantage: Myth #1 1. Free trade is beneficial only if a country is more productive than foreign countries. – But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. – High costs derive from inefficient use of resources. – The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.
- 10. Misconceptions about Comparative Advantage: Myth #2 2. Free trade with countries that pay low wages hurts high wage countries. – While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. – Consumers benefit because they can purchase goods more cheaply. – Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages.
- 11. Misconceptions about Comparative Advantage: Myth #3 3. Free trade exploits less productive countries whose workers make low wages. – While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade. – Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation may result without export production. – Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. – Producers/workers benefit from having higher profits/wages—higher compared to the alternative.
- 12. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University