Question

10) Consider that in the UK inflation and interest rates are expected to decline due to Brexit while in the US it both will rise due to full employment and Fed policy. Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant).

Answer 1

International trade flows are the exchange of goods and services for money between different countries. It is referred to as sales which cross juridical borders. Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price levels rises, each unit of currency buys fewer goods and services.

1. Flow of International Trade in response to the changes in inflation. (Holding exchange rates constant)

The U.S. balance-of-trade deficit should increase in response to the changes in inflation, Since there wil be full employment and execution of Fed policy , Purchasing power for buying commodities in US will increase & if U.S. inflation rises, causing a decline in the UK (British) demand for U.S. exports. In addition, the U.S. demand for British exports should increase if U.S. prices increase.

2. Flow of International capital flows in response to the changes in interest rates.(Holding exchange rates constant)

The capital flows from the U.S. to the U.K. should decrease in response to lower British interest rates,

while the capital flows from the U.K. to the U.S. should increase (assuming exchange rates are held constant).