Question

3) Consider the supply-demand framework for the British pound relative to the U.S. dollar shown in the chart. The equilibrium exchange rate based on both the supply (S) and the demand (D) is $1.90/£. Please ignore the demand curve D’. However, if the current market exchange rate is $1.80/£, does the U.S experience the trade deficit or surplus with the U.K. Moreover, explain your answer based on both the demand and the supply for the pound. (30points

Answer 1

We know that as a common rule whenever demand for a product raises the price of the product raised and when the demand reduces the price of the product reduces . That means that supply and demand are directly related

Accordingly, Given that the equilibrium exchange rate is $1.9/£.

That means if the exchange rate is at equilibrium there is no trade deficit in both the countries and the exports and imports were at an equivalent level.

But the current exchange rate is  $1.80/£ that means price of pound has reduced as compared to equilibrium.

That means demand for pound has reduced .

We can say that demand for pound has reduced because imports has reduced .

Simply speaking when we import from UK we have to pay pounds that means we have to buy pounds and sell dollars. When sale of dollar increases the price of dollar reduces and when the purchasing pounds increases the price of pound increases and vice versa

So we understood that when the price of pound has reduced compared to dollars . Hence imports reduced from UK and we can say the this is trade surplus.