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Econ 457
April 4, 2016
1. Assume your country is Mexico. If all of your imports are priced in dollars and exports in pesos,
what is the impact on the real exchange rate of a 10% rise in peso/dollar exchange rate? If 100%
of your imports but about 80% of your exports are priced in dollars, what is the impact on the
real exchange rate of a 10% rise in peso/dollar exchange rate? Assume that all prices remain
fixed in the short run.
Answer:
Real exchange rate = E P*/P where P* is in dollars and P is in pesos. If both remain fixed, then
the percentage change in the real exchange rate is the same as the percentage change in E. If
export prices are partly in pesos and partly in dollars then we are facing two sets of goods. Call
the first set that has dollar prices as 1 and the other as 2, let P1 be the dollar price of the first set
of goods, and P2 be the peso price of the second set.
Then for the first set, the real exchange rate is = EP*/(EP1) = P*/P1, while for the second set it is
EP*/p2. The first one is not affected by the exchange rate changes, it is only the second set. As
far as the aggregate real exchange rate is concerned, it is
q = 0.8 P*/P1 + 0.2 EP*/p2
Notice that the first term on the RHS is not affected by changes in E, it is only the second term.
Thus a 10% increase in E changes q only by 0.2* 10 = 2%.
2. Suppose every quarter US exports 10 million units of widgets at a unit price of $100, and
imports 10 million of another kind from Europe at a unit price of 100 euros. If the exchange rate
is 1.3$/euro, what is the US trade balance?
Trade balance in dollars = 1billion – 1.3*1billion = -300 million$
3. Suppose the exports and import contracts in the short run are fixed. Some of them will be up for
renewal in 3 months, some of them in six months, some of them in 9 months, and by the end of
the next year all contracts will be new. Now, suppose dollar depreciates to 1.4$/euro, but the
prices in both countries remain the same. What will be the trade balance for the next quarter?
Trade balance in dollars = 1billion – 1.4*1billion = -400 million$
4. By the end of the next year, after new export and import contracts come into effect, quarterly
exports increase to 12 million and imports decrease to 8 million. Suppose exchange rate remains
at 1.4$/euro, and the prices in both countries remain the same. What will be the quarterly trade
balance after one year?
Trade balance in dollars = 1.2billion – 1.4*0.8billion = + 0.08 billion$