Question #2318

A nation will become more competitive in international trade if:

(a) Its nominal exchange rate is unchanged, but its inflation rate falls relative to other nations.

(b) Its nominal exchange rate is unchanged, but its inflation rate rises relative to other nations.

(c) Its nominal exchange rate appreciates, but its inflation rate is unchanged relative to other nations.

(d) Its nominal exchange rate depreciates, but its inflation rate is unchanged relative to other nations.

(a)
(b)
(c)
(d)
(a) and (b)
(b) and (c)
(a) and (c)
(a) and (d)

Answer #11603

Answer: (a) and (d)

Explanation

Answer: Options (a) and (d)

We often want to know whether local goods and services are becoming more or less competitive with respect to goods and services produced overseas.

Another concept - the real exchange rate - helps us in that respect.

It depends on two factors:

1. Movements in the nominal exchange rate; and

2. Relative inflation rates (domestic and foreign).

The following conclusions can be drawn:

1. If foreign and local prices are unchanged, then a depreciating (appreciating) nominal exchange rate, results in local goods becoming relatively cheaper (dearer) than foreign goods.

2. If the nominal exchange rate is constant, and foreign prices are rising faster (slower) than local prices, then local goods are becoming relatively cheaper (dearer) than foreign goods.

The real exchange rate measures the combined impact of these two influences.

A rise in the real exchange rate, which signals that a nation has increased its international trade competitiveness, can occur if:

1. The nominal exchange rate depreciates; and/or

2. Foreign prices rise more than local prices, other things unchanged.

A fall in the real exchange rate, which signals that a nation has decreased its international trade competitiveness, an occur if:

1. The nominal exchange rate appreciates; and/or

2. Foreign prices rises less than local prices, other things unchanged.

Nations often attempt to improve their international competitiveness by slashing wages, thinking this will reduce production costs and domestic prices relative to rest of world prices.

But this strategy not only undermines total spending but may also damage productivity through a decline in workplace morale. In that case, unit production costs rise, and the strategy becomes self-defeating.

Robust research evidence supports the notion that, by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity which yields improvements in a country's international competitiveness.

So the correct answer is both (a) and (d).

That is enough for today!