Equilibrium in the foreign exchange market is determined from the condition of interest parity. This states that at equilibrium all currencies deposit should offer same rate of expected return (Engel 2014). The equilibrium condition in the foreign exchange market is given as
R$: Expected rate of return = interest rate on dollar deposit
R€: Interest rate on Euro deposit
Ee$/€ : Expected exchange rate
E$/€ : Current exchange rate
: Expected rate of return on Euro deposit.
Given that interest rate on dollar deposit (R$) =1.75% = 0.0175
The interest rate on Euro deposit (R€) = 3.25% = 0.0325
The expected exchange rate is (Ee$/€ ) = 1.1
Therefore, following equilibrium condition the exchange rate that determine the market in equilibrium is obtained as
Figure 1: Equilibrium in foreign exchange market
(Source: as created by Author)
A decrease in Euro interest rate to 3% will make investment in euro deposit less attractive. The agents is now more interested in investing in terms of dollar deposit. The fall in euro interest rate lead to an appreciation of dollar. The new equilibrium exchange rate is
Figure 2: Effect of a decline in Euro interest rate
(Source: ac created by Author)
Multinational companies have carried on operation in different countries. This enables the companies to shift production from an expensive location to a relatively cheaper one. This phenomenon called however depends on relative strength off currency. A number of American companies now engage in outsourcing. In the global economy, currencies float against one another. A relatively strong US dollar implies dollar can now purchase a higher amount of imported goods. This is beneficial consumer and people in US traveling around the world as they find goods cheaper in other countries. However, this put US producers at a disadvantageous position in the global market as their exported goods now become expensive in the international market. This encourages US companies to relocate their plants in countries with a weak currency. Opposite is the situation when dollar deprecates. Depreciation of dollar indicates a situation of weak currency. A weak dollar makes US factor of production like labor cheaper (Cavusgil et al. 2014). In this situation, it is more preferable for companies to purchase US originated things. As foreign currencies become expensive, moving to other countries no longer seems to be profitable. This in turn discourages outsourcing and it is more profitable for American companies to operate in their domestic country.
Tornik LLC is a leading manufacturing company in US. It offers electronic manufacturing service. The customers of Tornik LLC mostly outsource non core functions. Tornik by outsourcing its manufacturing has now hold an important position in global market (tornik.com, 2018). Outsourcing of the company gets afftected from fluction in dollar value.
Figure 3: Production possibility curve for France
(Source: as created by Author)
Figure 4: Production Possibility Curve for UK
(Source: as created by Author)
From the table, it is observed that France can produce 30m of milk if it produces only milk and can produce 6m of wool if it produces only Wool. UK on the other hand can produce 36m of milk or 24m of wool in a year. UK is better both in producing milk (36m>30m) and Wool (24m >6m) than France. Therefore, UK enjoys an absolute advantage in both milk and Wool.
Opportunity cost in France
Milk
In order to produce 30m of milk France needs to sacrifice 6m of wool.
Therefore, for 1 unit of milk France Sacrifices (6/30) = 1/5 units of wool. This is the opportunity cost of milk in France
Wool
In order to produce 6m of Wool France needs to sacrifice 30m of milk.
Therefore, for 1 unit of wool France Sacrifices (30/6) = 5 units of milk. This is the opportunity cost of wool in France.
Opportunity cost in UK
Milk
In order to produce 36m of milk France needs to sacrifice 24m of wool.
Therefore, for 1 unit of milk France Sacrifices (24/36) = 2/3 units of wool. This is the opportunity cost of milk in France
Wool
In order to produce 24m of Wool France needs to sacrifice 36m of milk.
Therefore, for 1 unit of wool France Sacrifices (36/24) = 3/2 units of milk. This is the opportunity cost of wool in France.
Opportunity cost table
|
Milk |
Wool |
|
|
France |
1/5 |
5 |
|
UK |
2/3 |
3/2 |
France has a lower opportunity cost in milk (1/5<2/3) while UK has a lower opportunity cost in wool (3/2 < 5). Therefore, France enjoys a comparative advantage in milk and UK has a comparative advantage in wool (Caselli et al. 2015). According to question 2, UK has absolute advantage in both milk and wool. However, when compared in terms of opportunity cost then UK has comparative advantage in milk and UK has an advantage in wool.
Following the theory of comparative advantage France should export milk as it is has a lower opportunity cost in producing milk and import wool. UK on the other hand has a lower opportunity cost in wool and hence should export wool and import milk. With trade as countries specialized in line with their comparative advantage both countries are better off and total output increases (Hanson, Lind and Muendler 2015).
Milk and wool production in France
Given that countries produce 15 units of milk and then spend the remaining time on wool, before trade milk production would be = 15 units
For 15 units of milk France requires a time of (12/30) *15 = 6 months
Therefore, the remain time that is (12 – 6) = 6 months would be spend on Wool production.
In 12 months, France produce 6 units of wool
Therefore, in 6 month France is able to produce = (6/12) *6 = 3 units of wool.
Milk and wool production in wool
Given that countries produce 15 units of milk and then spend the remaining time on wool, before trade milk production would be = 15 units
For 15 units of milk France requires a time of (12/36) *15 = 5 months
Therefore, the remain time that is (12 – 5) = 7 months would be spend on Wool production.
In 12 months, France produce 24 units of wool
Therefore, in 6 month France is able to produce = (24/12) *7 = 14 units of wool.
Hence, before trade total milk production (15 +15) = 30 unit
And total wool production (14 +3) = 17 units
After trade
After trade, country produces only the product in which it has a comparative advantage. In France produces only milk then total 30 units of milk will be produced in a year. Similarly, if UK produces only wool then total 24 units of wool will be produced.
Therefore, as shown above after trade the milk production remain same but wool production increases. This shows how countries and world as a whole better off from specialization and trade.
United States despite being one of the leading economy in global world uses different protectionism policy against free trade. The government intervention in trade has become more prevalent during nineteenth century. Various protectionism policy that US has adapted include protection of import competing industries through tariff and import quota. US government also provides export subsidies to stimulate export.
Recently US has decided to introduce a tariff on the imported steel from countries like Canada, South Korea, Mexico, Russia, China and others. Following dumping of steel by China in United States, price in US has lowered and many jobs have been lost. US has imposed a 24% tariff on imported steel from different countries (cnn.com, 2017). Higher tariff on steel import encourages US firms to purchase more steels from US producers rather than using imported one. US consumers now face a higher steel price leading to lower surplus. The tariff benefits domestic steel industry in US and creates jobs.
Imposition of import quota is another policy used by US government to intervene in trade. US holds an important position in both consumption and production of sugar. In order to protect sugar industry US uses Tariff Rate Quotas. In 2012, US has imposed an import quota of 155,634 tons of raw sugar cane from Brazil (sugarcane.org, 2016). The quota restricts quantity of sugar imported from countries. The quota restriction by limiting imported sugar increases domestic sugar demand and encourage production.
US government provides an export subsidy to its cotton industry. The Farm bill introduced in 2014 has made some changes in its subsidy policy. The policy of countercyclical payments now replaced with a subsidized insurance program (aei.org, 2017). The subsidy policy of US encourages domestic cotton producers. However, the policy has an adverse effect on world price and foreign producers.
a)
Unemployment is a situation where some members of the labor force are unable to find jobs. Unemployment is more related with issues in labor market. Business cycle fluctuation is one important determinant of unemployment. Tariff is the tax imposed on imported goods. It is a kind of protection given to import competing industries. With tariff, price of imported goods increases. This reduces demand for imported goods (Beshkar, Bond and Rho 2015). With expansion of import competing industries, there are new opportunities for jobs and hence, unemployment reduces. However, this is not an efficient way of reducing unemployment. In response to tariff in one country, other countries may follow the same. When these countries impose tariff on export of concerned country then this hurts the export competing industry. Consequently, unemployment increases in these industries.
The tariff imposed by either a small country or a large country has the effect of raising price of imported goods. This encourages domestic producers to increase supply while the domestic consumer reduces their demand. As a result, imports falls for both the nation. However, the extent of this effect differ between large and small countries. Small countries because of small size of their economy cannot influence world price. Small countries constitute only a small part of global demand. A large country on the other hand can influence world price. When a large country imposes tariff then domestic price of the country increases. In addition to domestic price, tariff in a large country reduces world price (Arvis et al. 2016). The amount of tariff in the large country equals the difference between domestic and world price. This allows large countries to bypass some portion of burden entailed from tariff on exporting countries in global market.
The loss is welfare from tariff imposition is the deadweight loss arises from reduction in consumer and producer surplus and inefficient resource allocation. The gain in welfare in the resulted tariff revenue obtained from goods imported after imposition of tariff. The large country has an additional gain realized from terms of trade gain (Viner 2016). This falsify the given statement which states tariffs have a more negative effect on welfare in large countries than in small countries.
Figure 5: Effect of tariff in a large country
(Source: as created by Author)
Loss in consumer surplus: (A+B+C+D)
Gain in Producer Surplus: A
Tariff revenue: (C+G)
National Welfare: G – (B+D)
Figure 6: Effect of tariff on a small country
(Source: as created by Author)
Loss in consumer surplus: (A+B+C+D)
Gain in producer surplus: A
Tariff Revenue: C
Reduced national welfare: (B+D)
Thus, positive welfare effect of G lowers the loss from tariff in case of large country.
The imposition of tariff on Automobile increases price of Automobile in United States imported from Mexico. This leads to a decrease in Automobile production in Mexico. If the tariff were set equivalent to the wage differential in Mexico and United States, then Automobile companies would no longer realize benefit from lower wage in Mexico. However, tariff itself has a distortionary effect of reducing net social welfare. After imposition of tariff consumer surplus enjoyed by US consumer reduces while the producer surplus increases. However, the lost consumer surplus would not transfer to producers. US government enjoys a tariff revenue. The net social welfare reduces and there will be a resulted deadweight loss.
Trade creation and trade diversion are economic terms where there is a redirection of trade flows following formation of a custom union or free trade areas. Trade creation refers to a situation where the cost of a concerned good decreases resulting in an increased efficiency due to greater economic integration. Trade diversion on the other hand is a situation where there is a diversion of trade flow from a cost efficient trade partner to a less efficient member (Dai, Yotov and Zylkin 2014).
With tariff, the price of cars imported from Japan is
1800 + (1800 * 50/100) = 1800 + 900 = €2700
The cost of Japanese cars inclusive of tariff exceeds the production cost of cars in Poland. Therefore, it is cheaper to buy cars from Poland. However, the real cost of production of cars is lower in Japan than that in Poland. As the trade flow does not flow the theory of comparative advantage, it is an instance of trade diversion.
The cost of Japanese cars with tariff is
1800 + 1800 = €3600
The cost of Japanese car after including the tariff rate exceeds the cost of cars in Poland. Therefore, again despite having a lower real cost production is Japan, Cars will be imported from Poland. Thus, inclusion of Poland in EU creates trade diversion.
In this case, the cost of Japanese cars is
1200 + 1200 = € 24,000
Like two previous situation, imported cars from Japan now costs greater than that from Poland. However, in terms of real cost Japan has a comparative advantage in car production. Thus, import from because of a lower price is trade divers
Reference list
aei.org. (2017). www.aei.org. [online] Available at: https://www.aei.org/publication/unraveling-reforms-cotton-in-the-2018-farm-bill/ [Accessed 24 Feb. 2018].
Arvis, J.F., Duval, Y., Shepherd, B., Utoktham, C. and Raj, A., 2016. Trade costs in the developing world: 1996–2010. World Trade Review, 15(3), pp.451-474.
Beshkar, M., Bond, E.W. and Rho, Y., 2015. Tariff binding and overhang: theory and evidence. Journal of International Economics, 97(1), pp.1-13.
Caselli, F., Koren, M., Lisicky, M. and Tenreyro, S., 2015. Diversification through trade (No. w21498). National Bureau of Economic Research.
Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.
Dai, M., Yotov, Y.V. and Zylkin, T., 2014. On the trade-diversion effects of free trade agreements. Economics Letters, 122(2), pp.321-325.
Engel, C., 2014. Exchange rates and interest parity. In Handbook of international economics (Vol. 4, pp. 453-522). Elsevier.
Hanson, G.H., Lind, N. and Muendler, M.A., 2015. The dynamics of comparative advantage (No. w21753). National bureau of economic research.
Horowitz, J. (2017). Trump tariffs on steel would hit China — and the entire global trading system. [online] CNNMoney. Available at: https://money.cnn.com/2018/02/18/news/economy/us-imports-steel-tariff-effect/index.html [Accessed 24 Feb. 2018].
Sugarcane.org. (2016). U.S. Sugar Policy — SugarCane.org. [online] Available at: https://sugarcane.org/global-policies/policies-in-the-united-states/sugar-in-the-united-states [Accessed 24 Feb. 2018].
Tornik.com. (2018). How Does The Strength Of The U.S. Dollar Affect Outsourcing? | Tornik. [online] Available at: https://www.tornik.com/how-does-the-strength-of-the-u-s–dollar-affect-outsourcing-pricing [Accessed 24 Feb. 2018].
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