Question

Imagine that there are only two countries in the world: America and China. Each country produces and consumes two goods – a tradable good (T) and a non-tradable good (NT). The production of these goods involves the use of labour, but no other resources are used in the production process. This is of course a ridiculous assumption, but it is one we will make for the purposes of this assignment. There are perfectly competitive markets for the non-tradable good (NT) in each country, but no trade in this good between the countries. There is a perfectly competitive global market in the traded good (T). Labour is homogeneous within America. An hour of labour produces 10 units of the traded good (T) or 5 units of the non-traded good (NT) in America. Labour costs are 10 dollars (USD) an hour in America. Labour is also homogenous within China. An hour of labour produces 5 units of the traded good (T) or 5 units of the non-traded good (NT) in China. Labour costs are 10 yuan (CNY) an hour in China.

Suppose that over time the productivity per hour of labour in China in the tradable good industry increases to 10 units of T, while the other three productivity figures do not change. What will happen to the real exchange rate? (1 mark)

Answer 1

The real exchange rate will increase (from US view point)
Explanation
	Since there is no change in production of non tradable goods,we will consider the figures of tradable goods only
	America produces 10 traded goods per hour (lab rate=$10 per hour),i.e $1 per goods($10/10)
	When china produces 5 goods per hour (lab rate=10 yuan per hour),i.e 2 yuan per goods(10yuan/5)
	Let us assume $1=10 yuan is the nominal exchange rate
	We sell 1 tradable good in US for $1.
	Now we exchange this $1 into 10 Yuan
	We are able to produce 5 tradable goods in china with 10 yuan
	therefore 1 tradable good in US=5 tradable goods in china
	the real exchange rate is 5 tradable goods in china per 1 tradable good in US
	When china produces 10 goods per hour (lab rate=10 yuan per hour),i.e 1 yuan per goods(10yuan/10)
	We sell 1 tradable good in US for $1.
	Now we exchange this $1 into 10 Yuan
	We are able to produce 10 tradable goods in china with 10 yuan
	therefore 1 tradable good in US=10 tradable goods in china
	the real exchange rate is 10 tradable goods in china per 1 tradable good in US
	The real exchnage rate has increased from 5 traded goods per 1 traded good in US to 10 traded goods in china per 1 traded goods in US.
	Hence the real exchange rate has increased when production of tradable goods in china has increased.
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