Question

Suppose there are only 2 goods produced in world: Traded (T) and Non Traded (NT) in 2ountries A and B. The following table shows the information on the production and price of T and NT in A and B.

COUNTRY	T produced per capita	NT produced per capita	Price of T in local currency	Price of NT in local currency
A	200	800	20	35
B	600	2400	30	60

1. Calculate the PPP exchange rate between the two currencies where you are expressing the exchange rate as one unit of currency A in terms of currency B.
2. What is the ratio of GDP per capita in A and B using the PPP exchange rate?
3. Now suppose the Non Traded item also gets traded between the countries. The trade pattern is such that 1 unit of T is sold by Country A to obtain 2 units of NT from country B. Calculate the Nominal exchange rate expressing 1 unit of Currency A in terms of currency B. (HINT: find the price of 1T in terms of Country A’s currency and price of 2 NT in terms of Country B’s currency. Given the suggested trade pattern find the nominal exchange rate).
4. Given your answer in part c, calculate the ratio of GDP per capita between country A and B. Comparing your answers obtained for parts b. and d. explain in 4-5 sentences what role does the existence of non traded sector play in comparing the GDP ratios.

Answer 1

QB) a)PPP is known as the Purchasing Power Parity and refers to the exchange rate of two seperate currencies which are going to be in equilibrium.

It can be calculated by the formula: Cost of a good in currency 1 / Cost of the same good in currency 2

PPP exchange rate = Cost of good T in currency A/Cost of good T in currency B

= 20/30 = 0.67 = 0.67 units of currency A/Currency B,

so, 0.67 units of currency A = one unit of currency B,

one unit of currency A = 1/0.67 = 1.49 units of currency B.

So, PPP exchange rate = 1.49.

b) The PPP tells us how much goods would cost if the country used the currency of the foreign country. The total of all these goods and services equal to the country's economic output.

So, if we calculate the GDP per capita of country A: we should multiply the units of Good T and NT by their respective domestic prices,

GDP per capita of country A = 200* 20 + 800 * 35 = 32,000 units of currency A

Now, if we convert it to currency B as per the PPP exchange rate we have determined, it will be

32,000 * 1.49 = 47,680 units of currency B, = GDP per capita of A.

So, similarly for country B: GDP per capital of B = 600 * 30 + 2400 * 60 = 162,000 units of currency B

So, Ratio = GDP per capita of A/GDP per capita of B= 32,000/ 162,000 = 16: 81 = 0.19 <1

c) Price of 1T in terms of Country A's currency = 20

Price of 2 NT in terms of country B's currency = 60* 2 = 120

So, the nominal exchange rate:

20 units of currency A = 120 units of currency B

I unit of currency A = 120/20 = 6 units of currency B

So, nominal exchange rate = Cost of good in currency B/Cost of good in currency A = 120/20 = 6 units of currency B per one unit of currency A = exchange rate = 6.

d) So, given this new exchange rate, if we calculate the GDP per capita ratio, we see:

GDP per capita of country A converted to currency B as per the exchange rate:

32,000 * 6 = 192,000

So, Ratio = GDP per capita of A/GDP per capita of B= 192,000/162,000 = 96: 81 = 1.18 >1

So, we see from the anwers in part b and d, the GDP per capita of country A has improved considerably, specifically by 6 times. So, this is because of the existence of the non-traded sector. So, trading the non-traded items has been a good decision for country A as it has helped to imptove the Per Capita GDP of country A considerably. So, the export of NT by country A has helped to bring in a lot of foreign capital/money and helped to boost the domestic economy.