ASSIGNMENT

ON
INTERNATIONAL ECONOMICS

SUBMITTED BY
PHIDARISHISHA SYNJRI
ROLL NO: 23MAECO39
PAPER NAME : ECO-CC-602(INTERNATIONAL ECONOMICS)
DEPARTMENT OF ECONOMICS
NORTH EASTERN HILL UNIVERSITY
PROF: R. SUTRADHAR
DATED: 10/12/2024

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Q.1. what are the effect of exchange rate appreciation on export and import?
Conversely, what will happen to export and import performance if exchange rate
depreciates. Discuss
Exchange rates, the price of one currency relative to another, are a fundamental aspect of international
trade and economic policy. A change in the exchange rate of a country's currency can significantly impact
the volume and structure of its exports and imports, influencing its trade balance, economic growth, and
inflation. The impact of an exchange rate appreciation (when a country's currency strengthens) on export
and import performance is complex, involving numerous factors, both immediate and long-term. In this
essay, we will examine these effects in greater depth, explore the theoretical frameworks that explain
them, and provide real-world examples to better illustrate the dynamics at play.

Exchange rate appreciation refers to the increase in the value of a country’s currency in relation to foreign
currencies. This change can occur due to various factors such as a country's economic performance,
monetary policy decisions, or speculative trading in foreign exchange markets. An appreciating currency
means that it takes fewer units of the domestic currency to purchase a unit of foreign currency. For
example, if the exchange rate between the U.S. dollar (USD) and the euro (EUR) changes from 1 USD =
0.85 EUR to 1 USD = 0.95 EUR, the U.S. dollar has appreciated relative to the euro.

The impact of exchange rate appreciation can vary depending on the broader economic and the specific
countries involved. However, in general, currency appreciation tends to have significant effects on export
and import performance, which are central components of a country’s trade balance.

Figure 1: Appreciation and depreciation on export and import.

1. Impact of Exchange Rate Appreciation on Exports

When a country’s currency appreciates, the cost of its exports in foreign currencies rises. This is because,
with a stronger domestic currency, foreign buyers need to spend more of their own currency to purchase
goods and services from the appreciating country. As a result, the price of exports becomes higher in the
international market, potentially reducing demand.

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In figure 1, The EMU demand curve for U.S. exports (Dx) and the U.S. supply curve (Sx) establish the
equilibrium price and quantity. At R = $1/€1 the dollar price of exports (Px) is $2, and the quantity exported
(Qx) is 4 billion units annually (point B).

A stronger dollar ( R= $ 0.80/€1)makes U.S. goods more expensive in euro terms. This reduces demand for
U.S. exports in the EMU, shifting the demand curve downward from Dx to D’x . The U.S. supply curve (Sx)
remains unaffected, as it depends on domestic production costs in dollars.

The new equilibrium (point E) reflects a lower dollar price for exports (e.g., $1.80) and a reduced quantity
exported (e.g., 3 billion units). Higher costs for foreign buyers make U.S. goods less competitive
internationally, reducing export revenues.

Dollar appreciation reduces export volumes and makes U.S. goods less competitive abroad, potentially
worsening the trade balance.

The effect of currency appreciation on export competitiveness is one of the key issues for export-driven
economies. Countries like Germany, China, and South Korea, which have large export sectors, may
experience a decline in export growth when their currencies appreciate, as their products become less
competitive in global markets. This can lead to a reduction in market share and potential revenue losses
for exporters. However, the effects of currency appreciation on exports are not always straightforward. In
some cases, exporters may absorb the cost of currency appreciation by lowering their profit margins to
maintain competitive pricing. In other cases, they may innovate or improve the quality of their goods to
justify higher prices in foreign markets. Nevertheless, in many cases, an appreciating currency will reduce
export demand and negatively affect a country’s trade balance

2. Impact of Exchange Rate Appreciation on Imports

On the other side, a stronger domestic currency makes foreign goods cheaper for domestic consumers.
When the domestic currency appreciates, the cost of imports decreases, as fewer units of the domestic
currency are needed to purchase foreign goods. This encourages domestic consumers and businesses to
demand more imported goods and services, leading to an increase in import volume.

The U.S. demand curve for imports (Dm) and the EMU supply curve (Sm) determine the equilibrium price
and quantity of imports. At the initial exchange rate (R= $1/ €1), the dollar price of imports (Pm) is $1, and
the quantity imported (Qm) is 12 billion units annually (point B).

When the dollar appreciates (e .g R= $o.80/ €1), the EMU exporters receive more euros for each dollar.
This reduces the dollar price of imports, shifting the supply curve downward from Sm to S’m. The U.S.
demand curve (Dm) remains unchanged, as the preferences of U.S. consumers in dollar terms are not
directly affected.

At the new equilibrium point (say, point E), the dollar price of imports decreases (e.g., to $0.90), and the
quantity of imports rises (e.g., to 14 billion units). This makes foreign goods cheaper and encourages higher
import volumes, reducing demand for domestic substitutes.

Dollar appreciation lowers the cost of imports in dollar terms, increases their quantity, and can negatively
impact domestic industries producing import substitutes.

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In economies where imports form a significant portion of the overall consumption, an appreciating
currency can lead to a worsening of the trade balance. A rising demand for foreign goods, coupled with a
stagnation or decline in export performance, can lead to an increase in the trade deficit. This, in turn, may
negatively impact the overall economy by weakening the domestic manufacturing sector, leading to job
losses in industries that face stiffer competition from cheaper imported goods.

The Marshall-Lerner condition is a key economic theory that helps explain the effects of exchange rate
changes on a country's trade balance. According to this condition, a currency depreciation (or
appreciation) will improve (or worsen) the trade balance only if the sum of the price elasticities of demand
for exports and imports is greater than one. In simpler terms, this means that the responsiveness of foreign
demand for exports and domestic demand for imports to price changes must be large enough to offset
the negative effects of higher export prices and lower import prices.

If the sum of the price elasticities is greater than one: A depreciation of the currency will lead to an
improvement in the trade balance because the increase in export demand will outweigh the rise in import
demand.

If the sum is less than one: A depreciation could worsen the trade balance, as the increase in exports may
not fully offset the increase in imports.

This framework can also be applied to exchange rate appreciation. If the demand for exports and imports
is relatively inelastic, the impact of currency appreciation on the trade balance will be more significant, as
higher export prices will reduce demand, and cheaper imports will increase demand for foreign goods.

What Happens to Export and Import Performance if Exchange Rate Depreciates?

When the domestic currency depreciates (i.e., weakens), the situation reverses:

1. Exports: A depreciation of the domestic currency lowers the price of exports in foreign markets (since
the foreign currency now buys more of the domestic currency), which increases demand for exports. The
demand curve for exports shifts to the right, indicating a rise in the quantity of exports.

2. Imports: On the other hand, as the domestic currency depreciates, foreign goods become more
expensive for domestic consumers. The demand for imports decreases, leading to a leftward shift in the
demand curve for imports, indicating a reduction in the volume of imports.

The J-Curve Effect and Long-Term Adjustment

One important concept that comes into play when a currency depreciates is the J-Curve Effect. This term
describes the tendency of a country's trade balance to worsen initially after a depreciation before it starts
to improve over time.

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Figure 2: the J -curve

The J-Curve illustrates the effect of a currency devaluation or depreciation on a country's trade balance
over time. Initially, after the currency depreciates, the trade balance worsens. This happens because the
price of imports rises immediately, while the increase in demand for exports takes time to materialize. In
the short run, exporters may not yet see a significant boost in demand, and importers face higher costs,
leading to a deterioration in the trade balance.

However, after some time (point A), the trade balance improves. This is because, as the effects of the
depreciation continue, the demand for the country's exports rises due to their lower prices, and the
demand for imports decreases due to their higher prices. Eventually, the trade balance improves and
follows the upward curve of the "J" shape, reflecting the long-term benefits of the devaluation.

Short-Term: In the immediate aftermath of a depreciation, import prices rise, leading to higher costs for
domestic consumers and a deterioration of the trade balance. However, exports may not respond
immediately because it takes time for foreign markets to adjust to the lower prices.

Long-Term: Over time, the quantity of exports increases as foreign demand for cheaper goods rises, and
the quantity of imports decreases due to higher prices. As a result, the trade balance improves and follows
the shape of a "J," initially dipping before recovering.

Q.2 Explain the Rybczynski theorem with proof using Edgeworth box diagram
.why do we used Edgeworth box to explain the theorem .why do we see a
reduction in the production of good intensive in factor whose quantity remain the
same.
The Rybczynski theorem explains that, at constant commodity prices, an increase in the endowment of
one factor of production will lead to a more-than-proportional increase in the output of the commodity

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that uses that factor intensively, while the output of the other commodity will decrease. For example, if
only labor (L) increases in Nation 1, the output of the labor-intensive commodity (X) will rise more than
proportionally, while the output of the capital-intensive commodity (Y) will decline, as the economy uses
more labor for X but maintains the same level of capital for Y. This happens without any change in the
prices of the goods (PX and PY).

FIGURE 1: GRAPHICAL PROOF OF THE RYBCZYNSKI THOEREM

Figure 7.9 illustrates the graphical proof of the Rybczynski theorem. Initially, at point A on Nation 1's
production frontier (shown in the lower part of the figure), the economy is in equilibrium, with labor (L)
and capital (K) at certain levels. This point is derived from the Edgeworth box in the upper part of the
figure, before the labor endowment doubles, following the same logic as in Figure 3.9. When the amount
of labor doubles, the Edgeworth box also doubles in length, but the height remains unchanged since the
capital stock stays constant.

For the relative prices of the commodities to remain the same, the factor prices (wages and rental rates)
must remain unchanged. However, this is only possible if the capital-to-labor ratio (K/L) and the
productivity of labor and capital remain constant for both commodities. To ensure this, production must
shift from point A to point A* in the Edgeworth box, where the new allocation of labor and capital ensures
full employment of resources, and the ratio of capital to labor is unchanged.

At both points A and A*, the capital-to-labor ratio (K/L) in the production of both commodities is the same.
This means that the slopes of the isoquants at these points are identical, ensuring that wages and rental
rates (w/r) are the same at both points. Moving from point A to point A* means that commodity X, the
labor-intensive good, experiences a more-than-proportional increase in output, while the output of
commodity Y, the capital-intensive good, decreases. This aligns with the predictions of the Rybczynski
theorem.

After the labor increase, Nation 1's output of commodity X rises sharply, while the output of commodity Y
declines. At point A, before the labor increase, the economy produces 50 units of X and 60 units of Y. After
labor doubles, at point A*, the economy produces 200 units of X but only 50 units of Y, with the price ratio

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(PX/PY) now being 1/4. This demonstrates that the output of X more than doubles (in fact, it quadruples),
while the output of Y declines, which is consistent with the Rybczynski theorem.

However, to maintain constant commodity prices (PX/PY), commodity Y would need to be an inferior good.
If commodity Y were inferior, its production and consumption would fall as national income rises, even
without trade. If commodity Y is not inferior, the price ratio must change (PX/PY decreases, or PY/PX
increases) to allow for a reduction in Y's output, and more of commodity Y would be produced and
consumed. Alternatively, if Nation 1 is assumed to be too small to affect global prices and engages in free
trade, it could still consume more of both commodities after growth without the need for commodity Y to
be inferior, as relative prices might remain constant.

The Edgeworth box is used to explain the Rybczynski theorem because it provides a visual representation
of the allocation of two factors of production (labor and capital) across two goods. The Edgeworth box
helps to illustrate how changes in the endowment of one factor (such as labor) affect the distribution of
resources and the production of goods. It shows the feasible combinations of goods and factors that an
economy can produce given its resource constraints.

The Edgeworth box is particularly useful because it allows us to track how the relative amounts of labor
and capital change when one factor (in this case, labor) increases, while the other (capital) remains fixed.
The movement from point A to point A* in the Edgeworth box (as labor doubles) represents the shift in
the allocation of labor and capital that keeps the capital-to-labor ratio (K/L) constant, ensuring that the
economy remains in equilibrium.

When the quantity of one factor (labor) increases while the other factor (capital) remains constant, the
Rybczynski theorem predicts that the output of the labor-intensive good (X) will expand more than
proportionately, while the output of the capital-intensive good (Y) will decrease. Here's why:

1. Factor Reallocation: Since labor has increased, it is reallocated to the production of the labor-intensive
good (X), which relies more heavily on labor. However, there is no corresponding increase in capital, which
means that the capital-intensive good (Y), which relies more on capital, faces a constraint in its production.

2. No Increase in Capital: The lack of additional capital means that the capital-intensive good cannot
increase its output as much as the labor-intensive good. As labor is reallocated to X, the resources available
to produce Y become scarcer, leading to a reduction in the output of Y.

3. Maintaining Factor Price Ratios: The Edgeworth box also ensures that the capital-to-labor ratio (K/L)
remains constant in both goods. For this to happen, the economy must adjust the production in such a
way that both goods use labor and capital in a balanced manner. However, because labor increases more
significantly than capital, the economy shifts more resources into the labor-intensive good, while the
capital-intensive good contracts.

In essence, the reduction in the production of the capital-intensive good occurs because the economy is
constrained by its fixed capital and must allocate the increased labor in a way that maximizes the output
of the good that benefits more from additional labor (the labor-intensive good).

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REFERENCE:
• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics:
Theory and Policy (10th ed.). Pearson.
• Salvatore, D. (2013). International Economics (11th ed.). Wiley.