Question

Question 3: In the light of Purchasing-Power Parity theory explain how inflation rate a county affects its nominal exchange rate?

Question 4: Explain why and how net exports and net capital flow are related to each other. Does trade deficit necessarily create trouble for a county’s economic growth? Discuss.

Answer 1

QUESTION 3 :

• Purchasing Parity Theory put forwards that exchange rate between currencies are in equilbrium when their purchasing power is the same in each of the two countries.
• This theory states that inflation will reduce the purchasing power of a nation which will inturn affects its exchange rate.
• According to this theory, if a country has relatively high inflation rate then the value of its currency will decline.
• Anticipating the higher inflation of a country than abroad can lower the exchange rate of the country below the purchasing power differences.
• For example, if inflation causes an increase in the average price for goods by 4% in country A and the at the same time the price of goods increased by 8% in country B, then we can say that country B has more inflation than country A. According to the purchasing power parity theory, this 4 point difference will bring a 4 point change in the exchange rate between the country A and country B.

QUESTION 4 :

PART A :

• Net exports are the value of a nation's exports minus the value of its imports, also known as trade balance.
• Net capital flow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
• Net exports are equal to Net capital outflows because, exports from country A to country B equals to payment of some asset from the country B to country A.

PART B :

• Trade deficits takes place when a country's imports exceeds its exports in a given period of time.
• Trade deficits affects economic growth by creating substantial problems in the long run.
• Trade deficits can create trade colonization and are dangerous with fixed exchange rate.
• It affects the employment level the home country which contributes to the economic growth.