Question

You are a purchasing manager for General Electric and need to decide whether you should buy stainless steel from a supplier in China or source it from a foundry in Pittsburgh. If you buy it from the Pittsburgh foundry, you’ll pay $3,000 per metric ton. If you buy from China, you’ll pay 14,000 yuan per metric ton. Both prices include transportation costs. The nominal exchange rate is US$1 for 7 yuan.

A.Calculate the real exchange rate—the price of domestic steel in dollars, relative to the price of imported steel converted into dollars—and use this to decide whether you should buy the domestic or imported steel.

B. A rise in the cost of Chinese labor leads to a rise in the price of Chinese steel to 28,000 yuan per metric ton. The nominal exchange rate is still US$1 for 7 yuan. What has happened to the real exchange rate? Does this make it more or less likely that General Electric purchases steel from the foundry in Pittsburgh?

Answer 1

Here, given that:

Domestic price = $3000

Foreign price = 14000 yuan

Nominal exchange rate = $1 = 7 yuan

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a) Real exchange rate =

Since this is greater than 1, it implies that the foreign price is lower than the domestic price.

In yuan terms, foreign price is 14000 yuan, while domestic price is 21000 yuan.

In dollar terms, foreign price is $2000, while domestic price is $3000 yuan.

The firm should buy imported steel, as it is cheaper.

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b) If foreign price is 28000 yuan:

Real exchange rate =

Since this is less than 1, it implies that the foreign price is higher than the domestic price.

In yuan terms, foreign price is 28000 yuan, while domestic price is 21000 yuan.

In dollar terms, foreign price is $4000, while domestic price is $3000 yuan.

The real exchange rate of USA has appreciated. This is because inflation is greater in the foreign country.

The firm should buy domestic steel, as it is cheaper.