Question

1. Write about comparative advantage in relation to international trade.
2. Give the formula for equation of exchange and also give the assumption of Quantity Theory of Money about the equation of exchange comment on the second part
3. Name two important tools of Fiscal Policy that the government uses to stabilize the market. Write about one of them and explain how it works (assume the economy is in recession and government wants to increase aggregate demand (GDP) and create more jobs
4. Last week we paid $1.25 for a euro. This week we pay $1.10, assuming that euro didn’t go through any devaluation or revaluation, Is the dollar appreciated or depreciated?

Answer 1

Solution

Last week for 1 Euro, 1.25 USD was paid . But now only 1.10 USD was paid.

This means the USD has appreciated in relation to the Euro because now less number of USD are required to get the equivalent value of USD (i.e., 1 Euro)

2 Important tools of fiscal policy are : Taxation and Public spending

Through taxation govt.can really control the economy.If the government increases the tax rates / taxation,less money will be left (discretionary income) in the hands of the people to spend.So,the aggregate demand in the economy reduces along with the drop in inflation.

On the other hand if the Govt.reduces the tax rates / taxation if the economy is suffering with recession.Recession occurs because the GDP is reducing / is showing a negative growth rate.So if the govt. reduces the tax rates /taxation,then more money is left in the hands of the people to spend which means it leads to increase in the aggregate demand(GDP)of the economy. More aggregate demand means more production will happen (in order to cater to increased demand) which means more jobs will be created.

Equation of exchange :

M * V = P * Y Where

M = the money supply in an economy (usually M1 is considered)

V = Velocity of money (It is defined as the number of times a unit of currency is used to purchase the final goods and services in a given year in the economy)

P = Price level in the economy

Y = Real GDP

Assumptions : 1.The Real GDP (Y) is fexed in the short-run

2.The velocity of money changes by a very small amount in the short-run so it is assumed as constant in the short-run

Comparative advantage : In international trade between different countries,the comparative advantage exists if one country can produce can produce a good (or) a service at a lower opportunity cost than another country.

So any country should try to produce more of a good / service in which it has a comparative advantage to the other countries.Due to this phenomena,the trade becomes beneficial for all the involved countries.This concept can be utilized to understand the direction of international trade.It was developed by David Ricardo.This theory is mutual and reciprocal.