Question

A2. Imagine that the following events occurred in the period between 2004 and 2008.  EU adopted new trade restrictions (such as higher tariffs) on Chinese products and reduced the annual rate of growth of their money supply from 5% to 3%.

 Over the same period of time, Chinese trade policies and the Chinese monetary supply remained stable.

Consider these changes in a long run framework with flexible prices (i.e. PPP based theories with the real exchange rate extension apply). How do you expect the real & nominal exchange rates between the EU and China to be affected by these events, i.e. how would they change over this period? Explain using the relevant model, graphically (e.g. time paths of relevant variables) and verbally.

Answer 1

• Nominal Exchange rate is the rate at which two currencies are exchanged at each other. Real Exchange rate is the rate at which commodities in two countries can be exchanged with each other, it accomodates nominal exchange rate & domestic price levels also.
• Forex markets are at equilibrium, where foreign exchange demand = foreign exchange supply. Foreign Exchange Demand curve & foreign exchange supply curve intersect.
• PPP theory states that each currency has same purchasing power in the countries, or goods price in terms of a currency is same in the countries. Exchange rate is defined as per price level ratio in two countries, as per the theory.

If EU adopts trade restriction tariff on chinese products : then chinese imports will become expensive for Europe & it will reduce their demand of chinese currency in forex market. Decrease in EU's demand of chinese forex currency, depreciates chinese currency & appreciates EU's currency.

If EU reduces the money supply growh rate in their economy from 5% to 3% : then price levels will rise in EU. Relatively higher inflation than chinese economy implies that EU's currency will depreciate & chinese currency will appreciate. Such because; relative version of PPP theory suggests that - foreign exchange rate change is determined as per price levels change, inflated countries exchange rate depreciates & deflated countries exchange rate appreciates.

So, the net change in real & nominal exchange rate is determined based on comparison on the above explained opposite mechanisms. If 1st case (tariffs) impact is more than 2nd case (price level) impact, EU currency appreciates & chinese currecny depreciates. If vice versa, latter is more than former, EU currency depreciates & chinese currency appreciates.