International Economics

Prepared and Teaching by:

Lecturer : Duy Chandina Master in management DBA candidate Course: International Economics

Up-date, Academic year 2009-2010

International Economics
Copyright @ 2003 by Paul R. Krugman and Maurice Obstfeld Princeton University and University of California, Berkeley Sixth edition. Additional reading: Microeconomics
(Concepts, Analysis, and applications)

The economics of the international economy

International economics, study of

International trade

International money

Focuses on the real transactions that involve:

A physical movement of goods or a tangible commitment of economics resources

Focuses on the monetary side, that is on financial transactions such as foreign purchase of US dollars.
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Topic we have to studied

Topic I: How countries gain from international trade
Topic II: Government intervention in trade Topic III: Exchange rates Topic IV: Money, Interest rates, and Exchange rates Topic V: The political economy of trade policy

*The gains from trade

We know that some IT is beneficial when countries sell goods and services to each other. But there is a common misconception that trade is harmful if there are large disparities between countries in productivity or wages. 1- productivity and competitiveness low productivity, low wages, low quality, Not strong enough to stand up to foreign competition. low wages labor can not compete with high wages labor

Countries engage in IT for 2 basic reasons

Countries trade because they are different from each other: -labor with different skill -technological progress -resources -environment -climate -law, culture

Countries to achieve economies of scale in production. That is If each country produced only a limited range of goods, it can produce each of these goods at a large scale and hence more efficiently than if it tried to produce everything.

The essential concept in this analysis is that of comparative advantage

6

What is specialization?
Jobs that have very narrow scope.

Is the ability to concentrate ones efforts and there by become proficient at that type of work. The advantage of the high specialize job is that they yield high productivity, low unit cost, and they are largely responsible for high standard of living.

Topic I

How Countries Gain From International Trade

Topic Focus
This lecture explain how economists think about international trade. Key points to take away from this lecture are: -The economic purpose of IT -Why all countries should gain from IT? -Where does a countrys comparative advantage come from? -Why different groups in the community are effected differently by IT

I- Introduction

Since world war 2 the advanced democracies, led by the United State have persuaded abroad policy

To remove the Trade barriers

This policy reflected -Prosperity -World peace

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The patterns of International Economics

IT is the exchange of goods across the national boundaries. The terms used for goods and services that are traded across the national boundaries are:

Exports: are domestically produced goods purchased by other countries.

And Imports: are goods purchased from other countries.

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Net Exports are also called the balance of trade

The balance of trade is the relationship between a countrys exports and imports.

The balance of trade surplus is when a country exports more goods and services than it imports, and net exports are positive.

The balance of trade deficit is when a country imports more goods and service than it exports and net exports are negative.
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The Gain from Trade

IT is beneficial, when Countries sell goods and services to each others.
Common misconception

India often worry their economies to IT will led to disaster because their industry wont be able to compete.

Advanced nations where workers earn high wages often fear that trading with less advanced will drag their standard of living down
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II- Two ways of meeting demand in the home economy

Direct: Local Production

Use nations resources to produce the goods and services required within the home economy. *Indirect: IT Use nations resources to produce goods and services which can be exported to pay for imports of goods and services actually required within the home economy.

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Direct: local production

Use local resources: Labor Technological equipment Resources. To produce goods and services required within the home economy

15

Indirect: international trade

Use local resources Labor Technological equipment Resources To produce goods and services which can be exported

16

Nations Resources

-Labor

Natural resources

Technology

How to use them

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Objective:
Obtain the required goods and services at the lowest possible resource costs

Farming

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A- A correct perspective on IT

-Imports make countries better off by allowing some goods and services to be obtain from overseas at a lower resource cost than producing them in home country

-Exports represent the resource cost of obtaining the benefit of imports.

19

B- An incorrect perspective on IT
(Mercantilism)

Exports are good

Imports are bad

Discussing how to export goods and services

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III- Can countries gain from IT?

Absolute advantage versus comparative advantage

Absolute advantage:

Based on the comparing the efficiency of two countries in producing the same goods. Example: assume for the time being that labor is the only resource input. (See the table in the next slide)

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Alternative outputs from one year of labor input

Japan Cars 5

Indonesia 1

Coffee

100kg

400kg

22

Conclusion:

-Japan has absolute advantage in cars production

-Indonesia has absolute advantage in coffee production

23

*Comparative advantage
Based on comparisons between countries of relative efficiency in producing different goods. Example: *How many cars must Japan and Indonesia give up to produce 100kg of coffee? *How many kgs of coffee must Japan and Indonesia give up to produce one car?

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-Opportunity cost of producing one car or 100kgs of coffee

Japan

Indonesia

1 car

----kgs coffee?

----kgs coffee?

100kgs coffee

----- Cars?

----- Cars?

25

Conclusion
*------------------Has comparative advantage in production of cars? * ------------------Has comparative advantage in production of coffee?

Japan

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IV-A basic proposition about comparative advantage

Even if one country has absolute advantage (has higher

productivity) in the production of every goods and services but: The other countries must have comparative advantage (be relatively more efficient) in the production of some goods and services Each country will benefit by exporting those goods and services in which it has comparative advantage And by importing those goods and services in which it has comparative disadvantage

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Example
Alternative outputs from one year of labor input

Japan Cars 4

India 1

cloth

1000m

500m

(Japan has absolute advantage in production of both cars and cloth)

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**Opportunity cost of producing 1car or 1000m of cloth

Japan 1car 1000m cloth 250m cloth 4 cars

India 500m cloth 2 cars

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Conclusion
Japan has comparative advantage in production of cars

India has comparative advantage in production of cloth

If Japan specialized in production of cars, India should be willing to pay up to 500m of cloth per car, compared to opportunity cost of 250m of cloth per car in Japan Or if India specialized in production of cloth, Japan should be willing to pay up to 4 cars per 1000m of cloth, compared to opportunity cost of 2 cars per 1000m of cloth in India.

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***Illustration of how price is determined, e.g. For cars

India wishes to buy cars from Japan (Indias import demand curve for cars) Japan wishes to sell cars to India (Japans supply curve of cars)

Without trade -Indian buyers pay 500m of cloth per car -Japanese sellers receive 250m of cloth per car

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V-Limitation of comparative advantage

*Competitive markets (Prices reflect opportunity costs)

*All resources are fully employed

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Discussion 1
Winners and losers from International Trade in the

domestic economy

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VI-Key points about factors of production

1-Payments to factors of production related to productivity

-High Labor productivity -Low labor productivity

high wages low wages

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Cont.
2-Productivity of any one factor depend on quantity and quality of other factors available to work with it. E.g. Labor productivity will be higher with more capital and more or better natural resources

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Discussion 2

How does an economy change from being a low wage economy to become a high wage economy?

36

Comparative advantage with many products (CA) A model in which only two goods are produced and consumed. To move closer to reality, it is necessary to understand how CA functions in a model with a large number of goods.

37

1- setting up the model Again, a world of two countries, India and Japan. Each country has only one factor of production is labor. These countries consume and to be able to produce a large number of goods let say: Cloth, Shoes, Rice, TVs, Cars. The technology of each country can be described by its Unit Labor Requirement (ULR) for each goods, that is the number of hours of labor it take to produce one unit of each. We label alc als alr altv alcar

India ULR to produce one unit of each

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a*lc

a*ls

a*lr

a*ltv

a*lcar

Japans ULR to produce one unit of each. We choose one trick to calculate the ratio of Indias ULR to Japan

alc
<

als
<

alr
<

altv
<

alcar a*lcar

a*lc

a*ls

a*lr

a*ltv

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2- Relative wages and specialization

Now, we are prepared to look at the pattern of trade. This pattern depends on only one thing W/W* the ratio of India to Japan wages we know this ratio, we can determine who produces what. let: W be the wage rate per hour labor in India W* be the wage rate per hour labor in Japan We think that goods will always be produced where it is cheapest to make them. The cost of making good, (Ex. Cloth) = W * alc

W * alc < W* * a*lc Or W / W* < a*lc / alc

Cloth will be produce in India

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W * alcar > W* * a*lcar Or W / W* > a*lcar / alcar

Car will be produce in Japan

See the table 1-1 Offers a numerical example in which India and Japan both consume and are able to produce five goods. The third column is the ratio of the Japan ULR to the India ULR for each good-or stated differently, the relative India productivity advantage in each good. We have labeled the goods in order of India productivity advantage, with the India advantage greatest for cloth and least of cars.

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Table 1-1: India and Japan ULR

Good India ULR (ali) Japan ULR (a*li) Relative India productivity advantage (a*li /ali)

Cloth Shoes Rice TVs Cars

1 5 3 6 12

10 40 12 12 9

10 8 4 2 0.75

Which country produces which goods depends on the ratio of India and Japan wage rates. India will have a cost advantage in any good for which its relative productivity is higher than its relative wage, and Japan will have the advantage in the others.
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Ex. W = 5W* lead to W / W* = 5 If the India wage rates is five times that of Japan ( a ratio of India wage to Japan wage of five to one. We can be rearranged to yield

-Cloth: -Shoes:

5 < 10 5< 8

Cloth and shoes will be produced in India

Rice: TVs: Car :

5>4 5>2 5> 0.75

These goods will be produced in Japan

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If the India wage rates is only three times that Japan W = 3W* lead to W / W* = 3

India will produce: cloth, shoes, and rice Japan will produce only TVs and cars

44

One-factor economy
Home: has only one factor of production produce two goods:

-wine
-cheese

45

Cont.
The technology of Homes economy is labor productivity in each industry

Is Unit Labor Requirement (ULR) The number of hours of labor required to produce a pound of cheese or a gallon of wine.
46

Cont.
aLw : ULR in wine production

We define
aLc : ULR in cheese production
The economys total resources L the total labor supply

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Production possibilities
Because any economy has limited resources, there are

limits on what it can produce, and there are always trade-off to produce more of one good the economy must sacrifice some production of another good. These trade-off are illustrated graphical by a production possibility frontier (PPF)

48

Homes PPF
Home wine production in gallons (Qw) L / aLw P
(Figure 2-1)
Absolute value of slope equals opportunity cost of cheese in term of wine = aLc/aLw

L / aL c

Home cheese production in pounds (Qc)

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Cont.
The line PF show the maximum amount of cheese Home can produce given any production of wine, and vice versa. Note: when there is only one factor of production the PPF of an economy is simply a straight line.

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Cont.
The PPF is determined by the limits on the economys resources in this case, labor
The limits on production are defined by the inequality,

(aLC * QC) + (aLW *QW) < L

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Cont.
The opportunity cost of cheese in term of wine is:

aLC / aLW

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Cont.
Ex. If it take one person hour to make a pound of cheese and two hours to produce a gallon of wine, the opportunity cost of cheese in terms of wine is one-half = aLC / aLW = *this opportunity cost is equal to the absolute value of the slope of the PPF
(see figure 2-1)
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The opportunity cost of cheese in terms of wine

Wine Wine Cheese 1 pound gallon gallon

1 hour

Time

1 pound Cheese

1 hour

Time

Note: Lw = Qw * aLw = 1 gallon * 2h = 2 labor Lc = Qc * aLc = 1 pound * 1h = 1 labor

54

Cont.
PPF:

illustrates the different mixes of goods the economy can produce

And to determine what the economy will actually produce, we need to look at the price
55

Cont.
It mean that the economist need to know the Relative price

The price of one good in terms of the other.

56

Cont.
**We know, Labor is the only one of production, so the supply of cheese and wine will be determine by the movement of labor to whichever sector pays the higher wage.

57

Cont.
**Let say, Pc be the price of cheese and Pw be the price of wine
**It takes aLC person-hours to produce a pound of cheese. **if no profit the hourly wage in cheese sector will equal the value of what a worker can produce in an hour Wc = Pc / aLC.
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Cont.
And aLw also do the same thing Ww = Pw / aLw

Wages in the cheese sector will be higher if: Pc / aLc > Pw / aLw

PC / Pw > aLC / aLw

Or the economy will specialize in the production of cheese

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Cont.
Or wages in wine sector will be higher if: Pc / aLc < Pw / aLw

PC / Pw < aLC / aLw

Or the economy will specialize in production of wine.

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Cont.
If: PC / Pw = aLC / aLW

In the absent of international trade Home would have to produce both goods for itself. But it will produce both goods only if the relative price of cheese just equal to its opportunity cost (aLC / aLw)

61

Trade in a one-factor world

Trade between two countries, each country has only one factor of production this trade models can offer a real world issues such as: - what constitutes fair international competition. - and fair international exchange.
62

Cont.
Before we get to these issues, let us get the model stated:
these are two countries

Home
Has one factor of production (Labor)

and

Foreign
Has one factor of

production (Labor)

Can produce two goods, wine and cheese

63

Cont.
We denote:
Homes labor force by (L) Homes ULR in wine

We denote: Foreign labor force by (L*)

Foreigns ULR in wine

aLw Homes ULR in cheese aLC

a*Lw Foreigns ULR in cheese a*LC

64

Cont.
We have in Home
aLc/aLw = Pc/Pw

We do the same thing in Foreign, we get

a*Lc/a*Lw = P*c/P*w

We can see the example in the next slide

65

Cont.
Ex. Home could be less productive than Foreign in wine but more productive in cheese, or vice versa. **We make only one assumption that:

If:aLC / aLw < a*LC / a*Lw

Or

Pc/Pw<P*c/P*w
Or

aLC / a*LC < aLw / a*Lw

Pc/P*c <Pw/P*w
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Cont.
++ We are assuming that, Homes relative productivity in cheese is higher it is in wine. But: Remember that the ratio of ULRs is equal to the opportunity cost of cheese in terms of wine.

67

Cont.
We defined comparative advantage precisely in terms

of such opportunity costs:

aLC /aLW < a*LC /a*LW aLC/a*LC < aLW/a*LW

If

Home has a comparative advantage in cheese

Home labor is more efficient than foreign in producing cheese. So Home has an absolute advantage in producing cheese.
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aLC < a*LC

Cont.
** Given the labor forces and ULRs in the two countries, we can draw the PPF for each country. For Home we already done.
Foreign wine production (Q*w) in gallon Foreigns PPF figure 2-2

L*/a*Lw

F*

P*

L*/a*LC

Foreign cheese production Q*c in pound

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Cont.
Since the slope of PPF equals the opportunity cost of

cheese in terms of wine Foreigns frontier is steeper than Homes

70

In the absence of trade

The relative price of cheese and wine (RPCW) in each

country would be determine by the relative ULRs

In Home the (RPCW) would be: In foreign the (RPCW) would be:

aLC/aLW = Pc /Pw a*LC/a*LW = P*c/P*w

71

With trade
If the relative price of cheese is higher in foreign than

in Home: aLC/aLW < a*LC/a*LW

it will be profitable to ship cheese from Home to Foreign and to ship wine from Foreign to Home.

72

Cont.
So, Home will export enough cheese and Foreign will

export enough wine to equalize the relative price. But what determines the level at which that price settles?

73

Determining the relative price (RP) after trade

Prices are determined by supply and demand.
In discussing comparative advantage we must apply

supply and demand analysis carefully.

Some of the trade policy analysis it is acceptable to

focus only on:

Supply
Demand

in a single market, example the sugar market.

74

Cont.
** For two markets
- cheese market - wine market

It is to focus not just on the quantities of cheese and wine supplied and demanded but also on the relative supply and demand, that is, on the # of pound of cheese supplied and demanded divided by the # of gallons of wine supplied and demanded.
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Cont.
Let see if:

-Pc/Pw <aLC/aLW

:Home

will specialize

in the production of wine

-Pc/Pw

<a*LC/a*LW :Foreign will specialize

in wine production

-aLC/aLW<a*LC/a*LW :so, at relative prices of cheese below aLC/aLW there will be no world cheese production.
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Cont.
**When relative prices of cheese

Pc/Pw = aLC/aLW, we know that workers in

Home can earn exactly the same amount making either cheese or wine.

77

Cont.
When Home specializes in cheese production, it produces L/aLC pounds.
Ex. Total labor L=120 people, they need aLC = 2 hours to

produce 60 pounds of cheese, so, 120 people take only 1 hour, it can produce 30 pounds of cheese (120 people/2 * 2 hours = 30 pounds). Calculated with the formula: Labor productivity = 60 / (120 * 2) = pound per labor / hour So, 120 people per hour = 120 /4 = 30 pounds
78

Cont.
Similarly, when foreign specializes in wine production it produces L*/a*LW gallons
So, for any relative price of cheese between aLC/aLW and

a*LC/a*LW

the relative supply of cheese is:

(L/aLC)/(L*/a*LW)

79

RP of cheese (Pc / Pw) Pc/Pw=a*Lc/a*Lw

Graph
RS 1 RD

..

Pc/Pw=aLc/aLw

2 : : : : (L /aLc)/(L*/a*Lw) RD

Relative quantity of cheese (Qc+Q*c)/(Qw+Q*w)

80

Cont.
- First: Pc / Pw< aLc / aLw < a*Lc / a*Lw , no supply of cheese. Because Pc / Pw < aLc / aLw , Home specialize in wine and Pc / Pw < a*Lc / a*Lw , Foreign specialize in wine -Second: Pc / Pw = aLc / aLw it producing a flat section to the supply curve. - Third: aLc/aLw < Pc/Pw < a*Lc/a*Lw Home will export cheese to Foreign and Foreign will export wine to Home.

81

Cont.
+ If Pc / Pw > aLc / aLw , Home specialize in cheese production, it produce L / aLc = Qc pounds + Pc / Pw < a*Lc / a*Lw , Foreign specialize in wine production, it produce L* / a*Lw = Q*w gallons So, aLc / aLw <Pc / Pw < a*Lc / a*Lw , relative supply curve of cheese is (L /aLc)/(L*/a*Lw) = Qc/Q*w
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Example: home work problem 3

Suppose that Home and Foreign have the ULR illustrated in table: Cheese Wine Home aLc=1 hour /pound aLw=2 hours / gallon Foreign a*Lc=6 hours/pound a*Lw=3 hours/gallon
If the world relative price (PR) Pc/Pw =1 Which product Home trade to Foreign? And how much he gain from trade? And which product Foreign trade to Home? How much he gain?
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Ex. Home work problem 4

Home has 1200 people. It can produce two goods, apples and bananas. The ULR in apple production is 3, while in banana production it is 2. a- graph Home PPF. b- what is the opportunity cost of apples in terms of bananas? c- with no trade, what would the price of apples in terms of bananas be? And why? There is now also another country, Foreign, with a labor force of 800. Foreign ULR in apple production is 5, while in banana production it is 1. d- graph Foreign PPF e- construct the world relative supply curve. f- what determines the level at which that price settles?
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Solution problem 4
Home Qa

b-The opportunity cost of apples in terms of bananas is aLa/aLb = 3/2

400

c- the price of apples in terms of bananas is Pa/Pb = aLa/aLb = 3/2

600

Home Qb

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Cont.
Q*a

d- Graph Foreign PPF 800/5=160 units to 800/1=800 units

160

800

Q*b

86

Solution:
Pa/Pb If Pa/Pb=a*La/a*Lb = 5 ... 1 2 : : : : (L/aLa)/(L*/a*Lb) =400/800=1/2 RS

RD

If Pa/Pb=aLa/aLb = 3/2

RD Relative quantity of apple (Qa+Q*a)/(Qb+Q*b)

87

Cont.
1- If Pa / Pb < 3/2 there will be no world apple production. Because: Pa / Pb < aLa / aLb=3/2 Home specialize in bananas production. Similarly Pa / Pb < a*La / a*Lb=5 Foreign specialize in bananas production. But, 3/2 < 5, Pa / Pb < aLa / aLb < a*La / a*Lb, no supply of apple.

88

Cont.
2- if Pa/Pb = aLa/aLb = 3/2 workers in Home can earn exactly amount making either apple or banana. So, Home will be willing to supply any relative amount of the two goods, producing a flat section to the supply curve. 3- Pa/Pb > aLa/aLb = 3/2, Home will specialize in apple production, it produce L / aLa = 1200/3=400 units, and Pa/Pb < a*La/a*Lb = 5, Foreign will specialize in banana, it produce L*/ a*Lb = 800/1 = 800 units.

89

Cont.
So, 3/2 < Pa / Pb < 5, the relative supply of apple is (L / aLa ) / (L*/ a*Lb )= (1200/3)/(800/1)= . If Pa/Pb = a*La/a*Lb = 5, foreign have a flat section of supply curve. Finally, Pa / Pb > a*La / a*Lb > aLa / aLb, both Home and Foreign will specialize in apple production, there will be no bananas production, so relative supply of apple will become infinite. f- the price will be determine between 3/2<Pa/Pb<5. so, both countries will trade.
90

Cont.
If RD move from 1 to 2, Pa/Pb = aLa/aLb = 3/2, the same as the opportunity cost of apples in terms of bananas in Home. Home will produce both some apples and some bananas.

91

A model of a two-factor economy ( Heckscher-Olin model)

The economy we are analyzing can produce two goods -cloth and food Production of these goods requires two inputs that are limited supply
-Labor -Land ** The reason for this change from the Recardian model is that in a two-factor economy there may be some choice in the use of inputs.

92

Ex. A farmer may be able to grow more food per acre if he is willing to use more labor input to prepare the soil, weed, and so on. Thus the farmer may be able to choose to use less land and more labor per unit of output. In each sector, producer will face not fixed input requirements but trade-offs.

93

Cont.
Question: What input choice will producers actually make?

It depends on the relative cost of land and labor. If land rents ( r ) are high ( the cost of acre of land ) the people will use less land. and wage rate (w) per hour of labor is low, the people will employed more labor and vice versa they will save on labor and use a lot of land.
94

So, the input choice depends on the ratio of these two factor price is W / r and the ratio of land to labor is T / L (land-labor ratio). -in food production will always use a higher T / L than production of cloth. We say that: Production of food is Land-intensive Production of cloth is Labor-intensive.

95

Cont.
**Note: the definition of intensive depends on the T/L use in production, not the ratio of land or labor to output (T/output Or L/output) Thus the good can not be both land and labor intensive.

96

Page 75 in international economic

** Comparative advantage and factors of production

( Effects of IT between two-factor economies )

We look at Japan and India They have the same tastes and have identical relative demands for food and cloth when faced with the same relative price of the two goods. They also have the same technology.

97

Cont.
-a given amount of land and labor yields the same output of either cloth or food in the two countries. The only difference between the countries is in their resources: India has a higher ratio of labor to land than Japan does.

98

** Relative prices and the pattern of trade India is labor-abundant Japan is land-abundant

Note: abundant is defined in term of ratio not in absolute quantities

99

Ex. America has 80 million workers and 200 million hecta ( so, labor to land ratio of one-to-two and a half ) mean that: one worker work in 2.5 hecta. Britain has 20 million workers and 20 million hecta of land ( a labor to land ratio of one to one).

American is land-abundant Britain is labor-abundant

100

** India tends to produce a higher ratio of cloth to food (cloth/food) India will have a larger relative supply curve of cloth ( RS ) ** Japan tends to produce a lower ratio of cloth to food (cloth/food) Japan will have a larger relative supply curve of food ( R*S) RD is the relative demand for both countries Figure 4-8 trade lead to a convergence of relative price
101

**If there were no trade The equilibrium for India would be at point 1, the equilibrium for Japan at point 3. the RP of cloth would be lower in India than in Japan.

Relative price of cloth ( Pc /Pf )

R*S RS

**with trade Their relative price converge -the relative price of cloth rises in India and declines in Japan. -the new world relative price (RP) of cloth is at a point 2.

3 3 2 1
Relative quantity of cloth ( Qc + Q*c) / (Qf + Q*f)

RD

102

In India the rise in RP of cloth leads to a rise in the production of cloth, India becomes an exporter of cloth and an importer of food. Conversely, the decline in the RP of cloth in Japan leads it to become an importer of cloth and an exporter of food.

103

Cont.
**India has a higher of L / T than in Japan Lead to India is abundant in labor So, cloth production uses a higher ratio of L / T in its production than food. Cloth is labor-intensive India export cloth Labor-intensive good and food is land-intensive Japan export food land-intensive good

104

Economic Growth and International Trade

As real income increases

It affects both

Producers

Consumers

They need to decide how to alter production. increase in resources or change in technology

They are faced with how to spend the additional real income

105

Cont.
Both of these decisions have implications for the countrys participation in

International trade

And determining whether countries become more or less open to trade as economic growth occurs.
106

Trade effects of production growth

electronics

Return to point A, point lying to the left of the vertical line reflect cases where the new production of wine is less than at point A and vs. when it move to the right.

Production effects of growth PPF graph Figure 1

wine

Production points lying on the straight line passing through the origin and point A reflect outputs of electronics and wine that are proportionally the same as at A; that is, the ratio of electronics to wine production is a constant.
107

Trade effects of consumption growth

electronics Figure 2, point lying to the left of the dashed vertical axis reflect less consumption of wine, while point to the right indicate greater consumption of wine, if real income increases reflect a relatively larger increase in the consumption of wine than in that of electronics. Because wine is 0 the export good, a change in consumption is suggested that the country will reduce the export of wine.
Consumption effects of growth
B

wine

108

The growth
Growth can result from changes in Technology

Technology change alters the manner in which inputs are used to generate output, and it results in a larger amount of output being generated from a fixed amount of inputs. capital Labor.

The accumulation of factors such as:

109

Mid-term
Questions
1- We have to compared two situations One in which countries do not trade at all, Another in which they have free trade. What are the results from these situations? 2- what are the factor prices and goods price depends

on?
It take only 45 minutes.

110

Solution 1
1- Countries with no trade:
- Real income have fallen, because of increasing the price of goods. - No economy of scale lead to higher average cost. - Increasing unemployment rate. - inefficient used of local resources. - People go to the poor

111

Cont.
2- Countries with free trade:
- They can mutual benefit from free trade. Ex. We have two goods cheese and wine. If Cambodia specialized in wine production, it should produce wine as much as they can and then trading the wine for cheese. - another way to see the mutual gain from trade is to examine how trade affects each countrys possibilities for consumption. In the absence of trade, consumption possibilities are the same as production possibilities. If trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces.

112

Solution
-well also see that trade provides benefits by allowing countries to export goods whose production makes relatively heavy use of resources that are locally abundant while importing goods whose production makes heavy use of resources that are scare. - International trade allows countries to specialize in producing narrower ranges of goods, giving them greater efficiencies of largescale production.

113

Solution 2
- Suppose that the economy of a country produces both cloth and food. Then competition among producers in each sector will ensure that the price of each good equals each cost of production. The cost of producing a good depends factor prices: if the rental rate on land is higher, then other things equal the price of any good whose production involves land input will also have to be higher.

114

Cont.
- The importance of particular factor price to the cost of producing a good depends, however, on how much of that factor the goods production involves. If cloth production makes use of very little land, then arise in the price of land will not have much effect on the price of cloth; whereas if food production uses a great deal of land, a rise in land prices will have a large effect on the price of food.
-Fertilizers also effect to factor price and the price of goods -insecticide

115

Final exam 1
Suppose we have two countries (A and B) willing to

engage in the exchange of good. The domestic demand and supply schedules are given the following equations. Da,b is the quantity demanded for each country and Sa,b is the quantity supplied at price Pa,b (Hint: Solve this problem by graphing the demand and supply curves.) see the table at the next slide.

116

Table
Country A
Pa = 100 5 Da Pa = 0 + 5 Sa

Country B
Pb = 200 5 Db Pb = 0 + 20 Sb

a. If there is no trade between the two countries, what is the equilibrium price and quantity in each? b. Which country will import the good and which will export? c. What is the equilibrium price and quantity imported/exported in the international market? (Hint: construct the excess demand and supply curves.)

117

Final exam 2
If a tariff is imposed on Japanese automobiles

imported into the Cambodia, who is helped and who is hurt? Why? How?

118

Answer 1
Pa 200 150 100 50 5 10 15 20 Qa Pb 200 150 100 50 5 10 15 20 25 30 35 40 Qb

a. In country A the equilibrium price is 50 and the equilibrium quantity is 10. in country B the equilibrium price is 160 and the equilibrium quantity is 8. b. Since country A has a lower price than country B, country B will imports the goods and country A will exports the good.
119

Answer 1 (cont.)
Price 200 150 100 50 0 5 10 15 20 25 30

Excess supply from A

Excess demand from B

35 40

Quantity

c. The equilibrium price is approximately 92 (92.3 to be exact) and the equilibrium quantity imported/exported is approximately 17 (16.92 to be exact). Sa = - 20 + 0.4 Pc, Da = 40 0.25Pc.

120

Way of creating the supply equation

P
P = b + aQ a = slope of the line a = P/Q = (1.5 1)/(20 0) a = 0.5/20 Intercept (Q=0), P=b=1 P = 1 + (0.5/20)Q 2 1.5 1

Other way
P = b + aQ 1.5 = a(20) +b 2 = a(40) +b - 0.5 = - 20a + 0

20

40

a = 0.5/20 b = 1.5 (0.5/20)/20 = 1 P = 1 + (0.5/20)Q

121

Cont.
P* = b* + a*Q* a* = slope of the line a* = (2 1.5)/(0 20) = - 0.5/20 b* = 2 (Q* = 0), P* = b* P* = 2 (0.5/20)Q* P* 2

1.5
1

0 20 40 Q*

122

Answer 2
A tariff on imported Japanese automobiles helps domestic automobiles producers because they can charge a higher price and sell more output. It also helps Japanese consumers because Japanese automobiles manufacturers are forced to sell more output at home at a lower price. However, this tariff hurts domestic consumers because they have to pay a higher price for a smaller quantity of the good. It also hurts Japanese automobiles manufacturers because they sell less output.

123

She work hard

Thank

124

Topic 2: Government intervention in trade

Prepared and Teaching by Lecturer Duy Chandina
(DBA candidate)

Course International Economic

125

Topic focus

This lecture explains how government interfere in trade, and how this interference affects the economy

126

Cont.
Key points to take away from this lecture *the different ways in which government can interfere in trade (tariffs, quotas etc..) *how tariffs and other types of protection affect the economy *how to analysis the effect of protection when domestic producers use imported input

127

I-Some common forms of trade intervention

1- Import restrictions

To help the domestic producers

Allow the price to rise in the domestic market

Domestic producers will increase their production

128

2- Tariffs
Definition: Tariff = Tax on imports Example: Import price of car: 20% tariff Domestic selling price $10,000 $2,000 $12,000

Note: Consumers must pay a higher price because of the tariff and if the higher the tariff, the consumers will buy less

129

-Imports will reduced because: *Domestic producers are producing

more
*Consumers are buying less import goods when the price is higher

-Tariffs also produce revenue for the government

130

Types of Tariff:

Ad Valorem (percentage of value)

Specific duty (per unit e.g. per litre)

Prohibitive tariff is a tariff which is set so high that imports are setout of the domestic market.

131

Basic tariff analysis

-The effect of the tariff is to raise the cost of shipping goods to a country.

-Tariffs have been used as a source of government income and to protect particular domestic sectors.

132

Cont.
Early 19 century, the UK used tariff to protect its agriculture from import competition. *In the late 19th century, both Germany and US protected their new industrial sectors by imposing tariffs on imports of manufactured goods. Later on The modern governments usually prefer to protect domestic industries through a varieties of non-tariff barriers such as Import quotas (limitations on the quantity of imports) Export restrictions (limitations on the quantity of exports)
133

The effects of a tariff

From the point view of SO shipping goods, a tariff is just like a cost of transportation.

* If Cambodia impose a tax of $2 on every bushel of wheat imported, shipper will be unwilling to move the wheat unless the price different between the two markets at least $2.

134

Figure 2-1
India market
excess demand in India, The price below equilibrium

World market

Japan market

xs

S*

PT
Pw D Q t

2
1 3
MD

P*T=PT - t D* Q Q

QT Qw

135

Cont.
Figure 2-1 illustrates the effect of a specific tariff of $t per unit of wheat. *In the absent of a tariff the Pw in both India and Japan at point 1 (world market). *With the tariff in place, shipper are not willing to move wheat from Japan to India unless India price exceeds the Japan price by at least t$. If no wheat is being shipped, however, there will be an excess demand in India and an excess supply in Japan. Thus the price in India will rise and that in Japan will fall until the price difference is t$.
136

Cont.
** introduce a tariff: the tariff raise the price in India to PT and lower the price in Japan to P*T=PT-t. In India producers supply more at the higher price, while customers demand less, so that fewer imports are demanded (as you can see in the move from point 1 to point 2 on the MD curve). In Japan the lower price, decrease supply and increase demand and thus a small export supply (as seen in the move from point 1 to 3 on the xs curve).

137

Cont.
Thus the volume of traded declines from Qw, the free trade volume, to QT, the volume with tariff. At a trade volume QT, India import demand equals Japan exports supply when PT P*T = t PT P*T> t (Japan happy to export) PT P*T< t (no import)

138

Cont.
The increase in price in India from Pw to PT is less than the amount of the tariff, because part of the tariff is reflected in a decline in Japans export price and thus is not passed on to India consumers.

139

Cont.
For small countries that impose a tariff has very little effect on the world price. In this case a tariff raise the price of the import goods in the country imposing the tariff by the full amount of the tariff from Pw to Pw+t

140

Non-tariff Barriers to free trade

Besides the use of tariffs to distort the free trade allocation of resources, government policy makers have become very adept at using other forms trade barriers. These are usually called non-tariff barriers to trade. * import Quotas * voluntary export restraints (VERs)

141

3- Import Quotas
-A Quota sometimes called a quantitative restriction
-The quota is usually controlled by an import licensing system -The quotas also cause the price to rise in the domestic market

142

Cont.
* The import quotas differs from an import tariff in that the interference with prices that can be charged on the domestic market for an import goods is indirect. It is indirect because the quotas itself operates directly on the quantity of the import instead of on the price.

143

4- Voluntary export restraints

The country may choose to negotiate an administrative agreement with a foreign supplier whereby that supplier agrees voluntarily to refrain from sending some exports to the importing country.

144

5-Anti-Dumping duties

-Anti-Dumping duties is that dumping it mean Unfair.

-It used to protect the domestic producer

145

II-Consumer surplus and Producer surplus

Consumer surplus P

Q CS= Amounts they are willing to pay - Amounts paid to the market price
146

Producer surplus
P S

Producer surplus

Q PS= The price the price that producer willing to accept

147

III- Price and quantity effects of a tariff

(Small country case) Sd P

Sw+t t Sw

Dd

148

IV-Who gains and who loses from the tariff

Small country case

Sd

f
Pt t Pf g b h k

j
d l

Sw+t

Sw

Dd

149

V-How tariffs affect the economy

Production and price of the protected goods increases. Producers income increase Consumers buy less at a higher price

The Government receives revenue from the tariff

150

Discussion: Does protection increase total production and employment in the economy?

How do you think

151

** Tariffs and Quotas may have similar effects

P Sd Sd+q

Pr Pf Sw

Dd

Q
152

Before quota
Price
Consumption Domestic production

Pf
OD OA

Imports

AD

153

With quota limiting imports to BC

At price of Pf and the quota may be added to domestic

supply, giving a total supply curve, Sd+q Price rises to Pr Consumption falls to OC Domestic productions rises to OB

154

VI-Who captures the quota rent?

**This depends on how the import licenses are allocated

1- If licenses are sold by open tender

-Quota rent is collected by government as revenue (i.e. same situation as tariff)

2- If licenses allocated on historical share basic

-Quota rent is captured by license holders -License holders import at Pf, sell at Pr

155

Vii- Effective rates of protection

1-Value added and nominal vs. effective rates of protection In many countries, the manufacturing sector relies heavily on imported inputs.
is The difference between the imported inputs and the finished The value added

156

** The value added

Price of shirt $1.00

Value added
=40 cents Price of cloth $0.60 Input (cloth)

e.g. Shirt (output) Cloth (input)

=60 cents

157

** Nominal rate of protection

Measures amount by which protection increases

domestic price above world price (e.g. a tariff of 20% raises domestic price 20% above world price) Important for evaluating impact of protection on consumers
Domestic price World price

N.R.P=

World price
158

**Effective rate of protection

Measures difference between value added in domestic

industry and value added at world prices This difference is caused by protective barriers in the importing country Extent of the difference is influenced by tariff on both imported inputs and finished goods Important for evaluating impact of protection on producers incomes and on efficiency of resource use in production.

159

Example A: Tariff on final good > Tariff on input e.g. tariff on shirt = 20% tariff on cloth= 10%
World prices $1.00 Value added Domestic prices $1.20 20% tariff 1.20 0.66 = $0.54

Value added
40 cents $0.60 $0.66

10% Tariff

Input (cloth) Input (cloth) 60 cents

60 cents

160

We can see Value added at world price = 40 cents Value added at domestic price = 54 cents
54 - 40 E.R.P = 40 120 - 100 N.R.P = 100 = 20% E.R.P > N.R.P = 35% Tariff on final good > Tariff on input Lead to value added increases

161

Example B

World price
TV set Imported Components 360 $400

Tariff
10%

162

World prices
$440

Domestic prices
10% tariff $400

VA = $40 $360 Components = $360

$360
Components = $360

163

Value added at domestic prices = $80 Value added at world prices

80 - 40

= $40

E.R.P =
40 440 - 400

= 100%

N.R.P =
400

= 10%

164

Conclusion:
If * tariff on final good exceeds tariff on input * import content is high

Then E.R.P can be very high even if N.R.P appears low

Interpretation of 100% effective rate of protection Resources use in domestic production Value of domestic production at world prices $2 $1
165

Thank

166

Topic 3 : Exchange Rates

(international Finance)

Course International Economic

Academic Year: 2011-2012

167

Exchange rates
Play a central role in international trade. Because They allow us to compare the prices of goods and services produced in different countries.

Ex. American car cost $39,000 and Japanese car cost 3,000,000 yen. To make this comparison, we must know the relative price of dollars and yen.

168

Cont. ex.
Ex. How many dollars would it cost to buy sweater

costing 50? We know an exchange rate of $1.50 per pound. A change in the $/ exchange rate would alter the sweaters dollar price. At an exchange rate of $1.25 per pound, how many dollar would it cost? Or at an exchange rate of $1.75 per pound. The sweaters dollar price would be higher, how much it cost?

169

I- What is an exchange rate?

An exchange rate is the price at which a foreign currency is converted to domestic currency. e.g. US$1=4000 Riels

170

**Devalue or depreciate

The domestic currency is said to devalue or depreciate when its value falls. e.g. US$1=4500 Riels

Note that in this case the price of foreign currency is rising

171

** Appreciate or Revalue

The domestic currency is said to appreciate or revalue when its value rises. e.g. US$1=3500 Riels

Note that in this case the price of the foreign currency is falling

172

**Analysis in term of Goods and Assets 1-When the domestic currency depreciates, goods and assets whose prices are expressed in domestic currency become cheaper in foreign currency. Conversely, goods and assets whose prices are expressed in foreign currency become more expensive in domestic currency.

173

2-When the domestic currency appreciate, goods and assets whose prices are expressed in domestic currency become more expensive in foreign currency.

Conversely, goods and assets whose prices are expressed in foreign currency become more cheaper in domestic currency.

174

Flexible exchange rates

Suppose that, US exports goods to French for future delivery in 30 days and that the exporter requires a price of $1,000 per unit to be willing to make the sale. If French buyer is willing to pay 5,000 francs per unit. 1-What is an exchange rate between US$ and Francs? 2- and when exchange rate changes to 5.25 francs = $1 by the end of 30 days. How much $ the US will be received?
175

Fixed & flexible exchange rates

The flexible rates are less conducive to the expansion

of world trade and FDI than are fixed rates. With a flexible rates instead of a fixed rates, the exporting firm will require some insurance against the exchange rate change. This insurance can take the form of holding out for slightly higher expected price than $1,000. A smaller volume of trade will occur under flexible rates than under fixed rates. Would fixed or flexible exchange rates provide for greater
growth in international trade and investement? 176

Would Fixed or Flexible exchange rates provide for greater efficiency in resource allocation?
Forward for fixed exchange rates is that the wasteful resource movements associated with flexible exchange rates are avoided. If the exchange rates can vary substantially, there can be constantly changing incentives for the trade-able goods sectors.

177

Cont.
If the countrys currency depreciates in the exchange

markets.
The factors of production will be induce to move into

the trade-able goods sectors and out of the non-tradeable goods sectors. Because the production of exports and import substitutes is now more profitable.

If the countrys currency appreciates. The incentive reverse themselves and resource move out of trade-able goods sectors and move into non-tradeable goods sectors
178

Effect of dollar depreciation on exports and imports

R=y/$
US exports computers US imports Japanese cars

Domestic price
$10,000 Y 2,000,000

Feb 02 R=134
Y 1,340,000 =$ 14,900

May 02 R=124
Y 1,240,000 $ 16,100

Effects
X increases M decreases

179

Effect of dollar appreciation on exports and imports

R =y /$
Us .export computers US. Imports Japanese cars

Domestic price
$ 10,000 Y 2,000,000

Jan 01 R=116
Y 1,160,000 $ 17,200

Jan 02 R=132
Y 1,320,000 $ 15,200

Effect
X decreases M increases

180

Exchange rates and relative prices

Import and export demands, like the demand for all

goods and services, are influenced by relative prices, such as the price of sweaters in terms of designer jeans. We compute the relative prices of goods and services whose money prices are quoted in different currencies.
An exchange rate $1.50 per pound. If a sweater priced at

50 in Britain. How much an American trying to decide to spend on British sweater?

181

Cont.
If the price of a pair of American jeans is $45. how

much an English trying to decide to spend on a pair of American jean? (other things equal). answer
An American pays $75 for a British sweater.
A Briton pays 30 for a pair of American jean. The relative price of ($75 per sweater)/($45 per pair of

jeans) = 1.67 pairs of jeans per sweater. The relative price of (50 per sweater)/(30 per pair of jeans) = 1.67 pairs of jean per sweater.
182

Cont. compute $/ exchange rates and relative price

of American jeans and British sweaters
Exchange rate ($/) 1.25 1.75

Relative price (pairs of jeans /sweater)

1.39

1.94

Note: the price of a pair of jeans is $45 and the price of a sweater is 50

183

The foreign exchange market

Just as other prices in the economy are determine by

the interaction of buyers and sellers. Exchange rates are determined by the interaction of the households, firms, and financial institutions that buy and sell foreign currencies to make international payments. The market in which international currencies trades take place is called the foreign exchange market.

184

The actors
The major participants in the foreign exchange market

are:
Commercial banks Corporations that engage in international trade Nonbank financial institutions such as:

Assets management firms Insurance companies

Individuals like tourist who buys foreign currency at a

hotel front desk. (insignificant)

185

Commercial banks
Are the center of foreign exchange market because: Every international transaction involves

The debiting and The crediting of accounts at commercial banks.

186

Cont.
Example: Exxon corporation wishes to pay 160,000 to a German supplier. First: Exxon gets an exchange rate quotation from its own commercial bank by the Third National Bank. Then it instructs to debits Exxons dollar account and pay 160,000 into the suppliers account at a German bank. If the exchange rate $1.2 per euro, how much $ is debited from Exxons account?
***Note: foreign currency trading among banks-called interbank trading. The rates banks charge to each other called interbank rates. The rates available to corporate customers, called retail rates are usually less than interbank rates. The difference between the retail and interbank rates is the bank compensation for doing the business.

187

Corporations
Corporations with corporations in several countries

frequently make and receive payments in currencies.

To pay workers in a plant in Cambodia, for ex. The

company may need the Cambodia Riels. If company has only dollar earned by selling his products in the United States, it can acquire the Riels it needs by buying them with its dollars in the foreign exchange market.

188

Exchange rates and Asset returns

to see which deposit, euro or dollar, offers a higher

expected rate of return, you must ask the question: if I use dollars to buy a euro deposit, how many dollars will I get back after a year? To answer this question let see the ex. Todays exchange rate is $1.10 per euro, but that you expect the rate to be $1.165 per euro in a year (Perhaps because you expect unfavorable developments in the US. Economy).

189

Cont.
Suppose also that the dollar interest rate is 10% per

year while the euro interest rate is 5% per year. This means :
A deposit of $1.00 pays $1.10 after a year.

A deposit of 1.00 pays 1.05 after a year.

Question: which of these deposits offers the higher

rate of return?

190

The answer can be found 3 steps

Step 1: If the exchange rate today is $1.10 per euro, the

dollar price of a euro is just $1.10. Step 2: since you expected the dollar to depreciate against the euro over the coming year so that the exchange rate 12 months from today is $1.165 per euro, then you expect the dollar value of your euro deposit after a year to be $1.165 per euro 1.05 = $1.223

191

Cont.
Step 3: now that you know the dollar price of a 1.00

deposit today ($1.10) and can forecast its value in a year ($1.223), you can calculate the expected dollar rate of return on a euro deposit as (1.223 1.10)/1.10 = 0.11 or 11% per year. Conclusion: the dollar interest rate exceeds the euro interest rate by 5% per year, the euros expected appreciation against dollar gives euro holders a prospective capital gain that is large enough to make euro deposits the higher-yield asset.
192

A simple rule
First, define the rate of depreciation. In example:

dollars expected depreciation rate is (1.165 1.10)/1.10= 0.059, or roughly 6% per year. So, the expected dollar rate of return on a euro deposit is the euro interest rate plus the rate of depreciation of dollar against the euro.

193

Cont. some notation:

R = todays interest rate on one-year euro deposits,
E$ = todays dollar/euro exchange rate E$= dollar/euro exchange rate expected to prevail a

year from today (or the expected future dollar/euro exchange rate)
Expected rate of return on a euro deposit, measured in

terms of dollars =R + (E$ - E$)/E$

194

Cont.
The expected rate of return difference between dollar

and euro deposits = R$ - [R + (E$ - E$)/E$] Or = R$ - R - (E$ - E$)/E$ Note:

When the difference above is positive, dollar deposits

yield the higher expected rate of return. When it is negative, euro deposits yield the higher expected rate of return.

195

Cont.
The expected rates of return on a dollar deposit,

measured in terms of euro = R$ - (E$ - E$)/E$

Example: todays exchange rate (Riels/$) is 1$=4,000 riels

but that you expect rate to be 1$= 4,500 riels in a year. Suppose also: The riels interest rate is 10% per year While the $ interest rate is 5% per year.

196

Cont.
A deposit of 2,000,000 riels A deposit of $500

Question: Define the expected rate of return on dollar deposits,

measure in term of riels?

197

Cont.
In the case you expect rate to be $1 = 3,500 riels
Question: What is the expected rate of return on dollar deposits, measure in term of riels? And What is the expected rate of return on riels deposits, measure in term of dollar? In each case, which of these deposits give a higher rate of return? Work in class!

198

Comparing dollar rates of return on dollar and euro deposits (table 13.3)
Dollar interest rate Euro interest rate Expected rate of dollar depreciation against euro Rate of return difference between dollar and euro deposits
R$-R- (E$E$)/E$ 0.04 0.00 -0.04 0.02

case 1 2 3 4

R$ 0.10 0.10 0.10 0.10

R 0.06 0.06 0.06 0.12

(E$ - E$) E$ 0.00 0.04 0.08 - 0.04

199

Cont.
Case 1: the interest difference in favor of dollar deposits

is (R$ - R = 0.10 0.06 = 0.04) and no change in the exchange rate is expected (E$ - E$) = 0.00 E$
This means that the expected annual real rate of return

on dollar deposits is 4% higher than that on euro, so that, other things equal, you would prefer to hold your wealth as dollar rather than euro deposits.

200

Cont.
Case 2: the interest difference is the same (4%), but it

is just offset by an expected depreciation rate of the dollar of 4%. The two assets therefore have the same expected rate of return. Case 3: is similar to the one discussed earlier: a 4% interest difference in favor for dollar deposits is more than offset by an 8% expected depreciation rate of the dollar, so euro deposits are preferred by market participants.

201

Cont.
Case 4: there is a 2% interest difference in favor of euro

deposits, but the dollar is expected to appreciate against the euro by 4% over the year. The expected rate of return on dollar deposits is therefore 2% per year higher than that on euro.

202

Practice
Suppose that todays exchange rate is $1.20 per euro,

but that you expect the rate to be $1.30 per euro in a year. Suppose also that the dollar interest rate is 10% per year while the euro interest rate is 5% per year Questions:
1- Use todays dollar/euro exchange rate to find out the

dollar price of a euro deposit, (answer $1.20) 2- Use the euro interest rate to find the amount of euro you will have a year from now if you purchase 1 deposit today. (Ans. At the end of a year, your 1 deposit will be worth 1.05)
203

Cont.
3- use the exchange rate you expect to prevail a year from

today to calculate the expected dollar value of the euro amount determined in question 2? (answer: you expect the dollar value of your euro deposit after a year to be $1.30 per euro 1.05 = $1.365) 4- calculate the expected dollar rate of return on a euro deposit? (answer: 0.10 + (1.365 1.32)/1.32 = 13.340%). 1.32=1.20 + 1.20 * 0.10, (answer: R + (E$ - E$)/E$ = 0.05 + (1.30 1.20)/1.20 = 13.333%) (the same answer)

204

Cont.
5- calculate the expected rate of return difference

between dollar and euro deposits? (answer: R$ - [R + (E$ -E$)/E$] = 0.10 13.33% = -3.33%. Which of these deposits offers higher rate of return? Answer is euro deposits yield the higher expected rate of return.

Note: when the difference above is positive, dollar

deposits yield the higher expected rate return, when it is negative, euro deposits yield the higher expected rate of return.

205

The equilibrium in the foreign exchange market

We have learned about the demand for and supplies of

foreign currency assets to determine the

Equilibrium in the foreign exchange market The foreign exchange market is in equilibrium when

deposits of all currencies offer the same expected rate of return

206

Interest parity: the basic equilibrium condition

The condition that the expected returns on deposits of

any two currencies are equal when measured in the same currency is called the interest parity condition Lets see why the foreign exchange market is in equilibrium only when the interest parity condition holds?

207

Cont.
Ex. Suppose the dollar interest rate is 10% and the euro

interest rate is 6%, but that the dollar is expected to depreciate against the euro at an 8% rate over the year. (this is case 3 in table 13.3, slide 183). This means that
The expected return on euro deposit is 4% greater than

that on dollar deposits: the results - no one will be willing to continue holding dollar deposits. - the holders of dollar deposits will be trying to sell them for euro deposits.
208

Cont.
- so, there will be an excess supply of dollar deposits and an excess demand for euro deposits in the foreign

exchange market.

209

Cont.
As a contrasting example,
Suppose dollar deposits again offer a 10% interest rate

but euro deposits offer 12% rate. The dollar is expected to appreciate against euro by 4% over the coming year.(this is case 4 in table 13.3) Now the return on dollar deposits is 2% higher. Results
No one would demand euro deposits

So, they would be an excess supply and $ deposits would

be in excess demand.
210

Cont.
When $ interest rate is 10%
Euro interest rate is 6% $ expected depreciation rate against the euro is 4% $ and deposits offer the same rate of return and

participants in the foreign exchange market are willing to holder either. (this is case 2 in table 13.3, side 183). In this point: the foreign exchange market is in equilibrium when no type of deposits is in excess demand and excess supply. Or when the interest parity condition holds.
211

Cont.
The expected of return measured in dollar equal

R$ = R + [(E$/ - E$/)/E$/]

212

Cont.
Like all markets, the market for foreign exchange can be analyses in term of:

1- Demand for foreign exchange

2- Supply of foreign exchange

213

1- Demand for foreign exchange

Foreign exchange is needed for the following purpose

*To pay for imports As the price of foreign exchange falls(domestic currency appreciation) , the price of imports in domestic currency become cheaper, the demand for them will rise, and so will increase demand for foreign exchange to pay for them

**To pay for overseas investments being made by local investors, and to satisfy the needs of overseas investors withdrawing their capital or repatriating dividends from the local economy. As the price of foreign exchange falls, the price of foreign assets becomes cheaper relative to the price of assets in the domestic economy, and so there will be a flow of investment funds out of the domestic economy, creating an increased demand for foreign exchange.

214

2- Supply of foreign exchange

1- receiving payment from exports
- As the price of foreign exchange rises.

2- foreign investors wishing to invest in domestic economy

-as the price of foreign exchange rises

Mean that Riel depreciation The foreign currency price of exports becomes lower

The price of assets in the domestic economy became cheaper relative to the price of foreign assets and so there will be a flow of investment into domestic economy, bringing with an increased supply of foreign exchange. -Export sale will increase -Receipts of foreign exchange will rise, lead to an increased supply of foreign exchange.

215

III- The equilibrium exchange rate

P (Riel per $) S We have two reason: 1-Under a freely floating exchange rate system P* 2- Under a fixed exchange Rate system D

216

The equilibrium exchange rate

Under a freely floating
Under a fixed exchange

exchange rate system

The exchange rate

rate system

The Gov. or the central

moves continuously to balance supply and demand in the foreign exchange market.

bank aims to keep the exchange rate at a fixed level. If the exchange rate is not fixed at the equilibrium level, there will be excess demand or supply of foreign exchange. The Gov. then have to intervene in the foreign exchange market to prevent the exchange rate from rising or falling.
217

We can prevent the exchange rate by controlling at.

Domestic currency depreciation or
Domestic currency appreciation Ex. If it is appreciation lead to demand for import increased then demand for foreign exchange also increased. Mean that an excess demand for foreign exchange, $ flow out. So the Gov. should consider about this problem in order to keep the exchange rate at a fixed level.

218

** Changes in the equilibrium exchange rate

The shifts in the demand and supply curves for foreign exchange may be cause by the following:
P S

1- Changes in import demand

P** P* D**

D*
Q

219

Change in import demand

If the demand for imports rises, import payment will

increase. This means the demand curve for foreign exchange will shift outwards and the equilibrium exchange rate will rise. Similarly, if the demand for imports falls, the demand curve for foreign exchange shift inwards and the equilibrium exchange rate falls.

220

Increases in import payments may be caused by

A sudden rise in the price of essential imports, such as

oil Faster growth in the domestic economy

Imports technologies Imports resources And other goods relative to production

Higher inflation in the domestic economy, making domestic production less competitive with imports.

221

S** S*

2- Changes in exports

P**
P*

222

Change In exports
If exports fall, the supply of foreign exchange is

reduced, the supply curve for foreign exchange shifts inward, and the equilibrium exchange rate rises. If exports rise, the supply of for foreign exchange increases, the supply curve for foreign exchange shifts outward, and the equilibrium exchange rate falls.

223

A fall in exports may be caused by

-A fall in export prices -slower growth in overseas export markets -higher inflation in the domestic economy, making exports less competitive.

224

3- Interest rate differentials R

Q -domestic interest rate > over sea interest rate

Q -If domestic interest rates < over sea interest rate

225

Interest rate differentials

If capital is able to move in and out of the economy, the

supply and demand for foreign exchange will also be affected by changes in the difference between domestic and overseas interest rate.

226

Cont.
* If domestic interest rates rise relative to oversea rate, capital will be attracted into the domestic economy. The increased supply of foreign exchange shifts the supply curve outward and the equilibrium exchange rate falls.

227

Cont.
* If domestic interest rate fall relative to oversea rates, capital will be attracted away from the domestic economy, creating an increased demand for foreign exchange. The demand curve for foreign exchange shifts outward and the equilibrium exchange rate rises.

228

Interest Rates
To compare returns on different deposit, we need two

pieces of information
First: they need to know how the money values of the

deposits will change Second: they need to know how the exchange rates will change.

Interest rates play an important role in the foreign

exchange market because the large deposits traded pay interest. Ex. When the interest rate on dollars is 10% per year, a $100,000 deposit is worth $110,000 after a year.
229

IV- The effects of changing in the exchange rate

1- Devaluation or Depreciation of the domestic currency
* When the domestic currency is depreciated -Goods priced in foreign currency become more expensive in domestic currency (the price of Imports goods become more expensive in the domestic market and local goods therefore become more competitive with import, so imports fall).

-Goods priced in domestic currency become cheaper in foreign currency (Exports become more competitive in overseas markets, so exports increase)
230

-The trade balance will improve -National production will increase (Since there will be increases in production by both Export industries and industries which compete with imports) -Because the price of tradable goods rises, inflation will increase (Since imports and exports make up only part of national production, inflation should rise by a smaller percentage than the exchange rate change, unless other costs, especially wages also rise as a result. In the latter case, the rise inflation could cancel out the effect of the exchange rate change on imports and exports.

231

2-Revaluation or appreciation of the domestic currency **When the domestic currency is appreciated

-Goods priced in foreign currency become cheaper in domestic currency (Imports become more cheaper in the domestic market and therefore become more competitive with local goods, so imports rise) -Goods priced in domestic currency become more expensive in foreign currency (Exports become less competitive in overseas market, so exports fall).
-The trade balance will deteriorate

232

-National production will slow down or fall (Since there will be falls in production by both exports industries and the industries which compete with imports). Because the price of tradable goods falls, inflation will decrease.

233

The effect of changing: expectations on the current exchange rate

Figure A, may also be used to study the effect on

todays exchange rate of a rise in the expected future dollar/euro exchange rate (E$.) Given todays exchange rate, a rise in the expected future price of euro in terms of dollars raised the dollar expected depreciation rate.

234

Example
If todays exchange rate is $1 per euro and the rate

expected to prevail in a year is $1.05 per euro the expected depreciation rate of the dollar against the euro is (1.05 1.00)/1.00 = 0.05; if the expected future exchange rate now rise to $1.06 per euro, the expected depreciation rate also rises, to 0.06. because A rise in the expected depreciation rate of the dollar raises the expected dollar return on euro deposits, the downward-sloping schedule shifts to the right, as in figure A.
235

Figure A: effect of a rise in the euro interest rate

A rise in the interest rate paid by euro deposits causes the $ to depreciate from E$ point 1 to 2. (this figure also E$ describes the effect of the rise in the expected future $ exchange rate) Exchange rate E$ Dollar return Rise in euro interest rate 2 1

Expected euro return

R$ Page 348

rates of return (in dollar terms)

236

Cont.
At the initial exchange rate E$/ there is now an excess

supply of dollar deposits: euro deposits offer a higher expected rate of return (measured in dollar terms) than do dollar deposits. The $ therefore depreciates against the euro until equilibrium is reached at point 2. We conclude that, all else equal, a rise in the expected future exchange rate cause a rise in the current exchange rate and vice versa.

237

Question for study and analysis 1

Suppose the exchange rate between $ U.S and Swedish

kronor is $1 in US currency can buy 8 kronor.

a. if the price of a U.S. computer is $2,000, according to the purchasing power parity, what should be the price, in kronor, of a Swedish computer? b. if the interest rate in the United States is 10% but it increases from 10 to 15% in Sweden, what is likely to happen to the exchange rate? c. if the growth rate of output is 5% in Sweden but the United Stated is in a recession and a growth rate is -2%, what is likely to happen to the exchange rate? d. if the exchange rate increases to 15 cents per kronor, which currency appreciates and which depreciates?
238

Problem 2
In terms of United States economics, as discuss in

topic 3, which is more likely to increase national output, depreciation or appreciation of domestic currency? Explain.

239

Answer 1
a. According to purchasing power parity a computer that has the price of $2,000 should has a price of 16,000 kronor in Sweden. If the price is less than 16,000 kronor, then someone in the United States can take $2,000, trade for16,000 kronor at a exchange rate of $1 = 8 kronor and have money left over. b. If the interest rate in Sweden increases from 10 to 15%, this is likely to attract investment dollars from United States. That the demand for Swedish kronor will increase, leading to an increase in the exchange rate between dollars and kronor. The price of a kronor will be greater than 0.40 Kronor, meaning the kronor appreciates relative to dollar.

240

Cont.
c. If Sweden economy grows relative faster than the US economy, $ depreciation. Kronor/$ exchange rate is 7.44 Kronor (8 8*7%)= $1 d. If the exchange rate between dollars and kronor increases to 15 cents per kronor, this mean $1 can buy fewer kronor (6.8 kronor per dollar) and 1 kronor can buy more dollars. As such the kronor appreciates relative to the dollars and the dollar depreciates relative to the kronor.

241

Answer 2
Since appreciation of US currency encourages imports and discourages exports, it will lead to a reduction in national output. However, depreciation of currency will have a opposite effect. It encourages exports because it makes the price of exported goods relatively cheaper and discourages imports because it makes the price of imports goods relatively higher. As such, depreciation of currency will lead to an increase in national output.

242

Mid-term
We have dollar and euro, you want to deposit them in a

bank, how do you think which on give you a higher rate of return, if exchange is fixed?

243

End of topic 3

Good Luck to you

244

Money, Interest Rates, and Exchange Rates

245

Introduction
To understand fully the determination of ERs, we have

to learn how interest rates (Rs) themselves are determined and how expectation of future ERs are formed.

246

I- Money defined
Money as a medium of exchange (is the most

importance function of money) Money as a unit of account (second importance role) Money as a store of value What is money How the money supply is determined

247

Money as a medium of exchange

Money accepted means of payment
People purchase goods and services Trade of goods or services for other goods or services

248

Money as a unit of account

A widely recognized measure of value. Ex. Prices of

goods, services, and assets are typically expressed in term of money Exchange rates (ERs) allow us to translate different countries money prices into comparable terms. The convention of quoting prices in money terms simplifies economic calculations by making it easy to compare the prices of different commodities. (Ex. The
international prices comparisons in chapter 3, which ERs to compare the prices of different countrys output)

249

Money as a store of value

Because money can be used to transfer purchasing

power from the present to future. Automatically makes it the most liquid of all assets (an asset is said to be liquid, when it can be transformed into goods or services rapidly and without high transaction costs, such as brokers fees.

250

What is money?
Currency and Checking may be written certainly

quality as money. Assets such as real estate do not qualify as money, because, unlike currency and checking deposits, they lack the essential property of liquidity.

251

How the money supply is determined

Money supply refer to the total amount of currency

and checking deposits held by household and firms. The large deposits traded by participants in the FE market are not considered part of the money supply, because they are not used to finance routine transactions.

252

Cont.
An economys money supply is controled by its central

bank The central bank directly regulates the amount of currency in existence and also has indirect control over the amount of checking deposits issued by privates banks.

253

II- the demand for money by individuals

The determinants of individual money demand can be

derived from the theory of asset demand in last chapter individuals base their demand for an asset on three characteristics
The expected return the asset offers compared with the

returns offers by other assets The riskiness of the assets expected return The assets liquidity

254

Expected return
When you hold money and you do not buy the

government bond, you will sacrifice the higher interest rate you could earn by holding your wealth in a government bond. The higher the interest rate, the more you sacrifice by holding wealth in form of money.

255

Cont.
Ex. Stocks pay return in the form of dividends and

capital gains The family spend their time at the beach pays a return in the form of pleasure of vacations at the beach. The money you lent pays a return in the form of interest

256

Cont.
Suppose, for example, that the interest rate you could

earn from a Cambodian Treasury bill is 10% per year. If you use $10,000 of your wealth to buy a treasury bill, you will be paid $11,000 at the end of the year. But you keep the $10,000 as cash in safe-deposit box, you give up the $1,000 interest you could have earn by buying the treasury bill.

257

Cont.
We conclude that, all else equal, a rise in the interest

rate causes the demand for money to fall. Risk is not important factor in money demand, but it is risky to hold money. Because an unexpected increase in the price of goods and services could reduce the value of your money in terms of the commodities you consume.
(note: interest-paying assets such as government bond)

258

Liquidity: being able to change assets into cash

The main benefit of holding money come from its

liquidity. Household, and firms hold money because it is easiest way of financing their everyday purchases.

259

III- aggregate money demand

Aggregate money demand (the total demand for money by households and firms in the economy)

Individual households demand for money

Firms demand for money

260

Three main factors determine aggregate money demand

Three main factors

The interest rate (Rs): a rise in the Rs causes each individual in the economy to reduce her demand for money. All else equal, lead to aggregate money demand falls

The price level: if the price level rises, individual households and firms must spend more money than before to purchase their usual weekly baskets of goods and services

Real National Income (GNP): when GNP rises, more goods and services are being sold in the economy, raises the demand for money

261

Cont.
If P is the price level

R is the interest rate Y is the real GNP or real income Md is the aggregate demand for money can be express as Md = P * L(R,Y) (1), (L= liquidity) Note: naturally L(R,Y) rises when R falls and falls when Y falls.

262

Cont.
From (1) we can write: Md/P = L(R,Y) (2)

The ratio Md/P that is, designed money holding measure in terms of a typical reference basket of commodities equal the amount of purchasing power people would like to hold in liquid form

Call aggregate real money demand

263

Cont. ex.
If people wish to hold $1,000 in cash at a price level of

$100 per commodity basket, their real money holding would be equivalent to $1,000/$100 per basket = 10 basket. If the price level double (to $200 per basket) the purchasing power of their $1,000 in cash would be halved, $1,000/$200 per basket = 5 basket

264

Figure 1.1: aggregate real money demand and the R

Interest rate (R)

The downwardsloping real money demand schedule show that for a given real income level ,Y, real money demand rises as the ,R, falls.

L(R,Y) Aggregate real money demand

265

Figure 1.2: effect on the aggregate real money demand schedule of a rise in real income
Interest rate (R) Increase in real income

An increase in real income from Y to Y raises the demand for real money balances at every level of the R and causes the whole demand schedule to shift upward.

L(R, Y) L(R, Y)

Aggregate real money demand

266

Cont.
For a given level of real GNP, changes in R cause

movement along the L(R,Y) schedule. Changes in real GNP cause the schedule itself to shift. So, figure 1.2 show a rise in real GNP from Y to Y affects the position of the aggregate real money demand schedule. Because a rise in Y raises aggregate real money demand for a given R, L(R,Y) lies to the right of L(R,Y) when Y>Y.

267

IV- The equilibrium interest rate: the interaction of money supply and demand
The money market is in the equilibrium when
The money supply set by the central bank Equals aggregate money demand

In this section we see how the interest rate is determined by money market equilibrium
268

Equilibrium in the money market

If Ms is money supply
And Md aggregate So the condition for equilibrium is: Ms = Md (3)

269

Figure 1.3 determination of the equilibrium interest rate (R)

Interest rate (R)

real money supply

With p and Y given and a real money supply of Ms/p, money market equilibrium is at point 1. at this point aggregate real money demand and the real money supply are equal and the equilibrium R is R.

R R

1 3

Aggregate real money demand L(R,Y)

Ms/p=Q

real money holding

270

Cont.
We can express the money market equilibrium

condition in terms of aggregate money demand as

Ms/p = L(R,Y)

(4)

Given the price level, p, and output, Y, the equilibrium

interest rate is the one at which aggregate real money demand equal real money supply.

271

Cont.
Let see at its equilibrium level at point 2, with R, that is above R

At point 2 the demand for real money holding falls short of the supply by Q-Q, so there is an excess supply of money. Individuals will attempt to get rid of their excess money by lending it to the others.
272

Cont.
Similarly, if the R is at a level R below R, it will tend

to rise. There is an excess demand for money equal to Q-Q at point 3. individuals therefore attempt to sell interest bearing assets such as bonds to increase their money holdings (that is, they sell bonds for cash)

273

Cont.
At point 3 no every one can succeed in selling enough

interest bearing assets to satisfy his or her demand for money. People bid for money by offering to borrow at higher R and push R upward toward R and then R stop rising.

274

Interest rates (R) and the money supply

Initially the money market is in equilibrium at point 1,

with a money supply M and interest rate R. since we are holding p constant, a rise in the money supply to M increase the real money supply from M/p to M/p.

275

Cont.
With a M/p, point 2 is the new equilibrium and R is

the new, lower R that induce people to hold the increased available real money supply. Note
Ms is the money supply issue by the central bank.
M/p is the real money supply

With lower R people will hold more money. They use

their surplus funds to bid for assets they pay interest.

276

Cont.
We conclude that: An increase in the money supply, lowers the interest rate(R), while a fall in the money supply raises the R, given the price level and output (see figure 1.4)

277

Figure 1.4 effect of an increase in the money supply on the R

Interest rate (R)

Real money supply

For a given price level, p, and real income, Y, an increase in the money supply from M to M reduces the R from R (point 1) to R (point 2)

Real money supply increases

1 2

L(R,Y)

M/p

M/p

real money holding

278

Figure 1.5: output and the R

This show us the effect on the R of a rise in the level of

output from Y to Y , given Ms and p, an increase in Y causes the entire aggregate real money demand Q schedule to shift to the right, moving the equilibrium away from point 1. at the old equilibrium interest rate R, this is an excess demand for money equal to Q-Q (point 1).

279

Figure 1.5

Interest rate (R)

Real money supply

Increase in real income

1 L(R,Y) L(R,Y)

Ms/p=Q

real money holding

280

Cont.
We conclude that an increase in the real output Q

raises the R, while a fall in real output, Q, lower the R, given the price level and the money supply.

281

V- the money supply and the exchange rate in the short run
We will discover that an increase in a countrys money

supply causes its currency to depreciate in the Foreign exchange (FE) market, while a reduction in the money supply causes its currency to appreciate.

282

Linking money, R, and the ERs

Figure 1.6, we combine two diagrams. We are looking

at the $/ ER, that is, the price of euro in terms of dollars. The first diagram, shows the equilibrium in the FE market and how it is determined given Rs and expectation about future ERs.

283

Cont.
The, R$, which is determined in the money market.
At the intersection of the two schedules (point 1),

the expected rates of return on $ and deposits are equal, and therefore, interest parity holds.

284

Cont.
The second diagram we need to examine the relation

between money and ER was introduced as figure 1.3. this figure shows how a countrys equilibrium interest is determined in the money market. Both assets market are in the equilibrium at the R$ and the E$/, at these value money supply equals money demand ( point 1) and the interest parity condition holds (point 1)

285

Two diagrams, figure 1.6

$/ ER

E$/
Foreign exchange market

Return on $ deposits

E$/
0

Expected return on deposits Rates of return (in $ terms) L(R$, Yu.s)

R$
Ms(us)/Pus (increasing)

Money market

US real money holding

286

US money supply and the $/ ER.

We now use our model of asset market linkage (the

links between the money market and FE market) to ask how the $/ ER changes when the Federal reserve changes the US money supply =[Ms(us)].

287

Figure 1.7: effect on the $/ ER and R$ of an increase in the US money supply

Given Pus and Yus, when the money supply rise from

Mus to Mus, the R$ declines (as money market equilibrium is reestablished at point 2) and the $ depreciates against the (as FE market equilibrium is reestablished at point 2)

288

Figure 1.7
E$/ $ return

E$/
E$/

2 1 Expected return R$ R$ Rates of return (in $ terms) L(R$, Yus)

Mus/Pus Mus/ Pus

Increase in US real money supply

US real money holding

289

Cont.
At the initial money supply Mus, the money market

is in equilibrium at point 1 with an R$. Given the R and the expected future ER, a R$ implies that FE market equilibrium occurs at point 1with an ER equal to E$/.

290

Cont.
What happens when the Federal reserve raises the US

money supply from Mus to Mus? 1- at R$ there is an excess supply of money in the US money market, so the R$ falls to R$ as the money market reaches its new equilibrium (point 2) 2- given E$/ and the new, lower the R$, the expected return on deposits is greater than that on $ deposits. Holders of $ deposits try to sell them for deposits.

291

Cont.
3- the $ depreciates to E$/, as holders of $ deposits.

The FE market is once again in equilibrium at point 2 because the ERs move to E$/ causes a fall in dollars expected future depreciation rate sufficient to offset the fall in the R$. We conclude that an increase in a countrys money supply causes its currency to depreciate in the FE market and reverse.

292

Home work
$1.2 = 1 If $ 1200 buy 1800, question = E/$ ? R$ = 12%, question = E$/ ? In this case, if $1200 buy ? Answer: $1.2=1=1.8 lead to $1200/$1.2 = 1000=1800 1=$1.176=1.764 lead to $1200/1.176 =1020.4 1020.4 - 1000 = 20.4, 20.4 * 1.764 = 36 $1200 buy 1800 +36 =1836
R$ = 10%, E$/

293

Topic 5: page 218

The political Economy of Trade Policy
Lecturer: Duy Chandina DBA. Candidate

294

Introduction
In 1981 U.S. asked Japan to limit its exports of autos to the U.S.
Japan was willing to accommodate the U.S Gov. on this point. But a request that Japan eliminate import quotas on - beef, and citrus products. Quotas that forced Japanese consumers to buy incredibly expensive domestic products instead of cheap imports form the U.S.

- This raised the price of imported cars and forced U.S. consumers to buy domestic autos.

295

Cont.
This reason: Force the Gov. of both countries were thus determined to pursue policies

Is not base on economists cost-benefit calculations (consumer and producer surplus) Will discuss the characteristic trade policy issues facing developing and advanced countries, respectively.

296

The case for free trade

-free trade and efficiency. Efficiency case for free trade is simply to reverse of the cost-benefit analysis of a tariff. Using the concepts of consumer and producer surplus.
297

No tariff or import quotas

Cont.
P -Production distortion. World price + tariff -Consumption distortion

World price

Q **Tariff causes a net loss to the economy measured by the area of triangles; it does so by distorting the economic incentives of both: producers and consumers.
298

For free trade

Eliminates these Distortions And increases national welfare.

299

Additional gains from free trade

Economies of scale
Free trade offers more opportunities for learning and

innovation Increase real income

300

The domestic market failure argument against free trade

The domestic market failure because: Some markets in the country is not doing its job right. Labor market is not clearing

Unemployment Underemployment

The capital market is not allocating resources efficiently

301

If the tariff is small enough, the area must always exceed the area a + b, lead to level of social welfare higher than that free trade.

S *Shows the conventional costbenefit analysis of a tariff for a small country. D S S D D Q a, b =are the net loss of social welfare. s, s = increased production. Show the marginal benefit from production. c s s Marginal social benefit curve. Q
302

Pw+t

Pw

Dollars

How convincing is the market failure argument?

Who would want to argue that the real economies we

live in are free from market failures. In poorer nation

Market imperfection. Ex.

Unemployment Massive differences between rural and urban wage rates. Inability of innovative firms to reap the fall rewards of their innovations

303

How can we raise the national welfare? (two things solution)

The first argues that domestic market failures should

be corrected by domestic policies aimed directly at the problems sources The second argues that economists can not diagnose market failure well enough to prescribe policy.

304

End the course

305

Purchasing Power Parity (PPP)

To express the PPP, Pus be the dollar price of a

reference commodity basket sold in the United States and PE the euro price of the same basket in Europe. Then PPP predicts a E$/ of E$/ = Pus/PE Ex. The reference commodity basket cost $200 in United States and 160 in Europe, PPP predicts a E$/ of $1.25 per euro (=$200 per basket/160 per basket). If the US price level were to triple (to $600 per basket), so PPP would imply an E$/ = $3.75 per euro ($600 per basket/160 per basket)
306