Deck 17: Output and the Exchange Rate in the Short Run

Question 1

Carefully describe how changes in foreign income tend to affect a country's exports.

Answer 1

In the short run, a country's exports are a function of two major determinants. The first determinant is the level of income in foreign countries, (Y^f). A country's exports depend on foreigners' ability to pay for the goods and services. As foreign incomes change, the level of a country's exports will also change. The size of this foreign income effect depends on two factors. The first and most obvious factor is the size of the change in foreign income. If the change in foreign income is relatively small, the effect on a country's exports is likely to be small. The second factor is the income elasticity of demand for the country's exports. The second determinant is the real exchange rate. Changes in the real exchange rate affect exports through both the size of the change and the price elasticity of the demand for exports.

Question 2

Suppose that GDP rose by ten percent and that imports only rose by one percent. Explain what this would imply about the income elasticity of the demand for imports.

Answer 2

This would imply that the income elasticity of the demand for imports is equal to 0.1. The income change induces only a one-tenth of one percent change in imports.

Question 3

Country X has an income elasticity of demand for exports and imports of one and three, respectively. If foreign income and domestic income both rose by the same amount, what would tend to happen to the trade balance?

Answer 3

The trade balance would decline over time as income increases. If exports and imports were initially equal then the trade balance would decline by 2% as incomes increased by 1%.

Question 4

If CNBC reported today that the U.S. dollar depreciated one percent against the Euro, describe what this would mean for U.S. trade with the EU by referring to the concept of the price elasticity of demand for imports and exports.

Question 5

Demonstrate the effects of an appreciating currency on the price level in a country.

Question 6

Show how the depreciation of currency could lead to a higher price level.

Question 7

An appreciating currency would tend to lower the price level and reduce the level of output. Is this statement true or false? Explain your answer.

Question 8

What is an exchange rate shock? Show the effects of this type of event on real GDP and the price level in the short run.

Question 9

An appreciation of the currency would tend to increase the percentage of GDP allocated to nontradable goods. Explain why this statement is true.