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Real Exchange Rate Definitions Economics Essay

The difference between a countrys imports and its exports. Balance of trade is the largest component of a countrys balance of payments. Debit items comprise imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy. A country has a trade deficit if it imports more than it exports; the opposite scenario is a trade surplus.

Also referred to as "trade balance" or "international trade balance.”

'Balance Of Trade - BOT'

The balance of trade is one of the most misunderstood statistic of the U.S. economy. For example, it is believe that a trade deficit is a bad thing. However, whether a trade deficit is bad thing is relative to the business cycle and economy. In a recession, countries like to export more, creating jobs and demand. In a strong development, countries like to import more, providing price competition, which restrict inflation and, without increasing prices, provides goods outside the economy's ability to meet supply. Thus, a trade deficit is not a good thing during a recession but may help during an development.

Definition of 'Gross Domestic Product - GDP' The economic value of all the finished goods and services produced within a country's borders in a particular time period, though GDP is usually calculated on an annual basis. It comprise all of private and public consumption, government spends, investments and exports less imports that occur within a defined region.

GDP = C + G + I + NX

where:

"C" is equal to all private consumption, or consumer expenditure, in a nation's economy

"G" is the sum of government payments

"I" is the sum of all the country's businesses spending on capital

"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports – Imports explains 'Gross Domestic Product - GDP'

GDP is usually used as an indicator of the economic health of a country, as well as to determine a country's standard of living. Critics of using GDP as an economic measure say the statistic does not take into account the secretive economy - transactions that, for whatever reason, are not account to the government. Some people say that GDP is not proposed to gauge material well-being, but serves as a measure of a nation's productivity, which is unrelated.

Gross Domestic Product (GDP): GDP equals the value of all the goods and services created for money in an economy, assess at their market prices. GDP eliminate the value of unpaid work (such as caring reproductive labour performed in the home). GDP is measured by adding up the value-added at each stage of production (deducting the cost of produced inputs and materials purchased from an industry’s suppliers). Nominal GDP: This is the simplest, most direct statistic of GDP, expressed in dollar terms. Real GDP: It is stated that the value of GDP, adjusted for changes in the overall level of prices in an economy. Real GDP must be expressed in terms of a “base year.” The average level of prices is calculated starting at that base year (example: U.S. statistics on real GDP are currently expressed in 2000 dollar terms – that is, in reference to the average level of prices that prevailed in the U.S. economy in 2000). Then, successive growth in GDP is adjusted to eliminate the effect of inflation in average prices since the base year. That adjusted statistic of changes in real GDP is planned to be an precise indicator of changes in the true quantity of total output. The base year for real GDP data is usually rationalized every few years. And modern GDP accounts use a “chain price”, methodology in which the underlying price index is adjusted to some extent each year to account for technological changes in the nature and quality of production.

Gross Domestic Product, Deflator: A price index which indicate the prices of all domestic production. It is stated that the GDP deflator equals the ratio of nominal GDP to average increase real GDP. The GDP deflator is an another measure of inflation (although changes in the consumer price index are considered a more accurate indicator of “true” inflation than changes in the GDP deflator). GDP deflators can be measured for each type of expenditure in total GDP (including consumption, investment, exports, and imports).

Gross Domestic Product, Per Capita: This is the level of GDP divided by the population of a country or region. Changes in real GDP per capita over time are often take as a measure of changes in the average standard of living of a country, although this is confusing (because it doesn’t account for differences in the distribution of income across factors of production and individuals, and it doesn’t consider the value of unpaid labor or leisure time).

Definition of exchange rate

“Rate at which one currency may be converted into another. The exchange rate is used when simply converting one currency to another (such as for the purposes of travel to another country), or for engaging in speculation or trading in the foreign exchange market. There are a wide variety of factors which influence the exchange rate, such as interest rates, inflation, and the state of politics and the economy in each country also called rate of exchange or foreign exchange rate or currency exchange rate.”

The Real Exchange Rate Definitions

The different definitions of the real exchange rate can mainly be classifying under two main groups. The first group of definitions is made in line with the purchasing power parity. The second group of definitions, on the other hand, is based on the division between the tradable and the non-tradable goods. Although they can match in some very special cases, these definitions usually give different results.

Purchasing Power Paritys

According to this definition, “the real exchange rate can be defined in the long run as

the nominal exchange rate (e) that is adjusted by the ratio of the foreign price level (Pf) to the

domestic price level”.

Ahmet N. Kıpıcı(1997), On the whole, the real exchange rate can be expressed as the nominal exchange rate that takes the inflation discrepancy among the countries into account. Its importance check from the fact that it can be used as an indicator of competitiveness in the foreign trade of a country. The importance of the real exchange rate for a Central Bank is associated with the effects of the real exchange rates on the Central Bank balance sheet and, in turn, with its ability to conduct a sensible monetary policy. And any changes in the real exchange rates would lead to fluctuations in short term capital flows. These fluctuations would then have an affect on the Central Bank’s net foreign possessions The changes in the volume of net foreign possessions would lead to changes in the volume of currency in circulation on the liability side of the balance sheet. So, the changes in the volume currency in circulation would require the management of the liquidity fluctuations in the economy through the utilization of the monetary policy tools by the Central Bank, whose final objective is price stability. Because of the important role it plays in an economy as mentioned above, the real exchange rate has been one of the most debated matter both in theory and practice.

Trade is indeed a powerful engine for economic growth, poverty reduction, and development. Though, harnessing the power of trade is often difficult for developing countries, particularly the least developed countries, because of supply-side domestic constraints (lack of trade-related infrastructure and capacity). The Aid for Trade Proposal was launched to address these constraints. The report “Binding Constraints to Trade Expansion: Aid for Trade Objectives and Diagnostics Tools” [COM/DCD/TAD(2009)5/FINAL] showed that the four most and more important objectives of aid-for-trade projects and programmes (increasing trade, diversifying exports, maximizing the linkages with the domestic economy, and increasing adjustment capacity) have the capacity to boost up growth and reduce poverty in developing countries. However, the growth capacity of trade may not always be realized. While most trade reforms have been successful, in some cases trade reforms proved unsustainable and in other they did not have a significant impact on economic growth. Here,we discusse the various reasons for these outcomes (they range from targeting the wrong problems to lack of credibility and policy incoherence) in order to draw the lessons for the design of aid-for-trade projects and programmes and enhance their effectiveness. The scope of activity of aid-for-trade project and programmes is broad enough to support the compatible policies that will make the improvement sustainable and the complementary policies that will enhance its growth impact.

• Compatible policies: Aid for Trade can diminish the risk of macroeconomic problems which are the main reason of policy reverse. We have experienced that fiscal and balance of payments problems and an ineffective exchange rate policy often made trade reforms unsustainable. Aid for trade can help solve these problems. In particular, aid for trade can help diminish the fiscal revenue effect of a trade reform by provided that technical assistance in the design of the trade reform, by helping rebalance the tax system outside trade taxes to domestic taxes but also by providing financial assistance to face the regulation. Aid for trade has also a major role to play in promotion an early export reaction to the reform. An early export response decreases the balance of payments, employment, and fiscal problems appear from the fact that a trade reform tends to have an instant impacts on imports and on the activity of the import competing sector as its impact on exports and activity of the export sector emerge with a lag. For the same reason, a quick export response helps achieve another objective of aid for trade, like, smoothing the adjustment cost of a trade improvement. Finally, we come to know an early export response is a political advantage. As people see early the benefit of the reform, support to the reform process increases.

• Complementary policies: Policies that increases the economic growth impact of a trade reform are supported by aid for trade. Complementary policies are a fact: trade reforms cannot take place in isolation but these are a broader reform package. There is potentially a wide range of complementary policies. Here we shows that aid-for-trade projects and programmes already support some of the most important complementary policies like, building infrastructure, supporting the financial and banking sector development, building public and private sector capacities or supporting some regulatory reforms. By using trade as development tool we can support compatible and complementary policies will help aid for trade to reach its objective. Aid for trade should not only focus on helping developing countries to trade opportunities into trade but also tackle the binding constraints that block the impact of trade on economic growth. Aid for trade, in supporting friendly and balancing policies, has the means to do so but there is need for proper sequencing and policy consistency. Here we argues that once a country has recognized the most compulsory constraints to its trade growth, it should apply the reform planned to tackle it making sure that the measure is sustainable and supported by complementary reforms that will increase its effect on economic growth. As much as possible, proper sequencing and policy consistency should be reflected in the design of aid-for-trade projects and programmes. This cannot be achieved without adequate donor management and alignment on country’s main concern. friendly and balancing policies will also ehance the efficiency of aid for trade. Efficiency has become a main issue for aid for trade. Aid for Trade proposal has been successful in activate resources and it is increasing awareness on the positive role trade can play in development. though, the purposal has reached a stage where it is also important to determine that the substantial amount of aid mobilized has been well spent and had an impact. assessment is really important role to play in this concern. It is stated that complements of OECD is working on assessment by focusing on good practices and it is hope that it will help to make aid for trade as efficient as possible.

“Exchange rate is an important macroeconomic variable and backbone of trade. The change in exchange rate plays an important role in the determination of trade balance”. unstable exchange rate slows down the process of trade, disabilities the capital activities, and break the investor’s confidence to invest in a country with high exchange rate volatility, which in turn slows down the process of growth. Instability in exchange rate can influence longer-term decisions by affecting the volume of exports and imports, the allotment of investment and government sales and procurement policies. It is stated that in medium term, it can affect the balance of payments and the level of economic activity, whereas in the short run local consumers and the local trader can be affected.

Exchange rate instability gives chances to investors to invest in foreign currency (dollars) to get higher returns and thus resulting in the strengthening the dollar against the home currency, which directly impacts the prices of exports and imports and their growth rates. The system where the variance of the difference between actual and expected value of exchange rate is minimized, is always prefer by risk averter traders and investors, on the other hand risk lover traders and investors prefer unstable exchange rate because, there is chances of high risk premium so they can maximize their profit. Therefore, exchange rate instability and fluctuation can have positive impact on exports and negative for imports for risk lover traders and vice versa for risk averter traders.

MAGDA KANDIL (June, 2004) There has been a current debate on the suitable exchange rate policy in developing countries. The debate focuses on the degree of changing in the exchange rate in the face of internal and external shocks. Exchange rate fluctuations are expected in order to determine economic performance. To judge the desirability of exchange rate fluctuations, it becomes, then necessary to evaluate their effects on output growth and price inflation. As we come to know that demand and supply channels determine these sound effects. A depreciation (or devaluation) of the domestic currency may encourage economic activity through the primary increase in the price of foreign goods relative to domestic goods. By enhancing the international competitiveness of home industries, exchange rate reduction switch expenditure from foreign goods to domestic goods. As demonstrate in Guitian (1976) and Dornbusch (1988), the success of currency depreciation in encouraging trade balance largely depends on switching demand in proper direction and amount, with the capacity of the home economy to meet up the additional demand by provide more goods. Although the conventional view point out that currency depreciation is expansionary, other academic developments have harassed some contractionary effects. This possibility is also talked about theoretically in a model by Meade (1951). If the Marshall-Lerner condition is not fulfilled currency depreciation could produce contraction. Hirschman (1949) discuss that currency depreciation from an primary trade deficit reduces real national income and may lead to a fall in total demand. Currency depreciation gives with one hand, by reducing export prices, at the same time as taking away with the other hand, by increasing import prices. If trade is in balance and terms of trade are not changed these price changes balance each other. But if imports are more than exports, the net result is a reduction in real income the country. Cooper (1971) verify this point in a general equilibrium model. Diaz-Alejandro (1963) present another argument for contraction following devaluation. Depreciation may raise the premium profits in export and import-competing industries. It is mentioned that if money wages lag the price increase and if the marginal propensity to save from profits is higher than from wages, national savings will increases and real output will decrease. Krugman and Taylor (1978) and Barbone and Rivera-Batiz (1987) have formalized the same views. Supply-side channels further confuse the effects of currency depreciation on economic performance. Bruno (1979) and van Wijnbergen (1989) postulate that in a typical semi-industrialized country where inputs for mechanized are largely imported and cannot be easily made domestically, firms’ input cost will increase following a depreciation consequently, the negative impact from the higher cost of imported inputs may control the production stimulus from lower relative prices for domestically traded goods. Gylfason and Schmid (1983) provide evidence that the final effect depends on the level by which demand and supply curves shift because of depression To conclude, currency depreciation increases net exports and increases the cost of production. in the same way, currency appreciation decreases net exports and the cost of production. So that the combined effects of demand and supply channels decide the net results of exchange rate fluctuations on real production and prices.

Growth economists have discovered a very profound impact of terms of trade changes on economic growth. Income terms of trade instability have long run relationships with output; both are negatively related with each other [Ghirmay, Sharma, and Grabowski (1999)]. An improvement in terms of trade leads to higher levels of investment and thereby rapid economic growth [Mendoza (1997); Bleaney and Greenaway (2001); Blattman (2003)]. Here we need to explain and identify that is what are the factors which are believed to determine the terms of trade. These above all involve the cost of production of the two countries involved, in with their productivity and efficiency. Another important variable is high inconsistency in terms of trade. If there is a quick change in a country’s terms of trade (e.g., a drastic fall in the price of a primary product that is a country’s main export) it can be reason serious balance-of payments problems if the country depends on the foreign exchange receive by its exports to pay for the import of its man-made goods and capital equipment. High inconsistency can also negatively influence the economy’s growth through reallocation of both inputs (production processes) and outputs, with a loss in output though reallocation takes place. Existing investment may no longer be gainful to continue operating and may have to be give up that definitely reduces capital stock. It is stated that is Ex-ante uncertainty related with high relative price instability of both inputs and outputs may decrease investment considerably where hedge markets are incomplete. Exchange rate fluctuations also have close relation with terms of trade. A large reduction in the value of the exchange rate would lead to a decrease in export prices and a increase in the cost of imports. This deteriorate the terms of trade index in contrast, we come to know that the lower exchange rate re-establish competitiveness for a country since, demand for exports will go up and import demand from home consumers will slows down. In Pakistan’s scenario, in sspite of of having a considerable openness to international trade, the country come across low diversification in production and exports. It can be makes it vulnerable to unfavorable fluctuations and shocks in international market, as is evident, for instance, in the terms of trade fluctuations and the instability in its economic performance. Before studying Pakistan’s long run terms of trade pattern and examining the loss in terms of GDP the country had to bear owing to deterioration in its terms of trade in detail, it is necessary to conceptualise certain related terminologies and realized the relationship that exists between them.

Philip R.Lane (2002 certainly, the size of the trade surplus that a nonpayer country has to run to service its external liabilities will depend on the rate of return it has to pay on these liabilities, in addition to its production growth rate. Such as, going back to the US example, a debtor country that develop rapidly and manages to earn profits on its foreign assets that are higher than the payouts on its foreign liabilities needs a much smaller trade surplus to become stable its net foreign asset position than a country with deprived growth performance and adverse net investment income Flows. By expansion the scale of any real exchange rate depreciation will be less in the former state of affairs. In the experiential analysis, we present direct evidence on how the connection between the trade balance and net foreign assets depends on investment gains, output development and exchange rate activities. Here we also underline that the relationship between trade balance and real exchange rate depends on other factors, such as comparative output per capita, comparative productivity levels, and the terms of trade, and we give evidence on the economic and statistical importance of long-run co-movements between these variables. The practical analysis focuses on a sample of OECD economies for the period 1970–1998. By selecting this group of countries for which superior quality data are available, we are able to improve our practical analysis – such as, by directly calculating for productivity variables in estimation the long-run relation between the trade balance and the relative price of non tradable. Additionally, to the trade balance, in our empirical findings it is find and confirm that the importance of relative output as a key determinant of the relative price of non traded goods and the real exchange rate.

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