Question

There was a change in the rate of exchange, which £1 is now worth $1, where it is used to worth $2.

a) Please discuss the effects of this change in the relative prices on consumers. Please also included graphs for income and substitution effects implied by the change.

Answer 1

On viewing with US as home country,

we can see that US Dollar is appreciated with respect to pound. As first we can use $1 to 0.5 pound but afterwards we can use $1 to buy 1 pound.

For US consumers there currency is now more worth than before. This also means that US consumers have more relative income than before to UK. So demand for import quantities of UK by US shift outwards ( demand shift outward in first graph from D_m to D_m^/ ) in terms of euro. so relative price of commodity imported to US rises in terms of euro. similarly as by appreciation import quantity that are produced in US has been reduce as real income increases with appreciation of USD( consumer will buy imported products more as they are more cheaper now for US) So in second graph suppy curve shifts downwards showing decline in domestically produced import goods, so relative price of commodity decrease in term of dollars.

By substitution effect US consumer which substitute domestically produce goods to imported good as they are cheaper to them now as relative price of good decrease in term of dollar whereas relative price of commodity increases in term of euro so UK consumers will buy Uk domestically produce good more than US imported goods to US as their currency is depreciated with respect to US dollar.