The Real Exchange Rate

Question 1

What happens when Real exchange rate appreciates?

Answer 1

• Price of domestic good increase relative to foreign
  goods
• Relative price decreases for imports, increases
  demand for imports
• Firms in domestic countries stop producing goods
  that substitute imports, thus increasing demand for
  imports
• Net exports decrease

Question 2

What happens when Real exchange rate depreciates?

Answer 2

• Price of domestic goods fall relative to foreign goods
• Price rises for imports, leading to decrease in
  demand for imports
• Firms in the domestic economy produce substitute
  goods for imports, decrease in demand for imports
• Net exports increase

Question 3

Define the real exchange rate, and note the difference between the internal terms of trade
and the external.

Answer 3

Real exchange rate compares the relative price of two countries consumption basket
Reflects the competitiveness of a country, as it implies the trading stance of an economy.
The lower the ReR the more competitive a country is as domestic goods are cheaper, exports are higher are higher than exports

ReR = real exchange rate
P=price of domestic goods using domestic currency
P*=price of foreign goods using foreign currency

ReR = P/(P/S) = SP/P

Question 4

Describe the following terms in the Balance of Payments: 
Current Account
Capital Account
Financial Account  
Errors & Omissions

Answer 4

Balance of payments is an instument that measures economic and financial relations, e.g. a country with the rest of the world

Current account: The sum of;

• balance on goods and services
• the income account balance

Capital account: commercial transactions that include intangible non produced assets like the right to use land or acquisition of goods through debt cancellation

Finacial account: All lending and borrowing activities of the countries public and private sector
e.g direct investments

Errors and omissions:
All four above components sum to 0

Question 5

Describe and explain the Balassa-Samuelson effect

Answer 5

The price level in a country depends both on its traded and non-traded goods

In richer countries, the price of non-traded goods tends to be higher since there is demand for them. this known as the Balassa-Samuelson effect

The B-S effect explains differences in prices and incomes across countries as a result of differences in productivity

Because of technology richer countries are more productive than poorer ones

The price of traded goods converges to the market clearing price in international markets(Law of One price). This does not happen to non-traded goods