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If a dollar could buy more wheat abroad than

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Unformatted text preview: I) and NX, causing a trade deficit, and raises the exchange rate. Trade policies are policies designed to influence directly the amount of goods and services exported or imported. Most often, trade policies take the form of protecting domestic industries from foreign competitors: either by placing a tax on foreign imports (a tariff) or restricting the amount of goods and services that can be imported (a quota). Because a trade deficit is an excess of imports over exports, one might guess that protectionist policies would reduce a trade deficit. Yet your model shows that they only lead to an appreciation of the real exchange rate. The increase in the price of domestic goods relative to foreign goods tends to lower net exports by stimulating imports and depressing exports. Protectionist policies reduce both the quantity of imports and the quantity of exports. This fall in the total amount of trade is the reason economists almost always oppose protectionist policies. Determining the nominal exchange rate The real exchange rate (ϵ) = nominal exchange rate (e) x ratio of price levels (P/P*), therefore: Nominal exchange rate (e) = Real exchange rate (ϵ) x P*/P (flipped ratio of price levels) The exchange rate equation can be written as: % Change in e = % Change in ϵ + % Change in P* - % Change in P The percentage change in ϵ is the change in the real exchange rate. The percentage change in P is the domestic inflation rate π, and the percentage change in P* is the foreign country’s inflation rate π*. Thus, the percentage change in the nominal exchange rate is: Page 16 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 % change in e = % Change in ϵ + (π* - π). The percentage change in the nominal exchange rate = percentage change in real exchange rate + difference in inflation rates. The law of one price states that the same good cannot sell for different prices in different locations at the same time. The law of one price applies to the international marketplace is called purchasing- power parity. If a dollar could buy more wheat abroad than domestically, arbitrageurs would buy wheat abroad and sell it domestically, driving down the domestic price relati...
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