International Trade Q8 - Estate Agent's Examination Part 1&2

Q.
In the context of international trade, explain the followings:-

c) Exchange rate. (5 marks)

(20 marks, 2014 Q8)

A.
c) Exchange rate

[There is 'context of international trade', so the lower exchange rate would favour a country's export and a higher exchange rate would increase revenue generation of the country exporting its products. The interaction of exchange rate in international trading is key to partnership in export and import of goods between two countries. Due to such exchange rate pressure, China for example, would benefit more with exports with the lower Renminbi (Yuan), to western countries. Thus, making its goods cheap compared to local products of these countries. Winter clothings is one example that has impacted the trade balance with European Union, and trade blocks were initiated to protect the local manufacturers of these countries.]

The exchange rate plays an important role in a country’s trade performance. Whether determined by exogenous shocks or by policy, the relative valuations of currencies and their volatility often have important repercussions on international trade, the balance of payments and overall economic performance.

The first aspect of the relationship between exchange rates and trade relates to exchange rate volatility. The basic argument for which an increase in exchange rate volatility would result in lower international trade is that there are risks and transaction costs associated with variability in the exchange rate, and these reduce the incentives to trade.

The findings of the economic literature on this issue have evolved in the last few decades. While early studies found adverse effects of exchange rate volatility on trade (Ethier, 1973; Clark 1973; Baron, 1976; Cushman, 1983; Peree and Steinherr, 1989) subsequent studies report very small impacts (Franke, 1991; Sercu and Vanhulle, 1992).

More recently, the use of refined quantitative methods resulted in more scepticism about causality of short-term exchange rate volatility on international trade (Clark, Tamirisa and Wei, 2004; Teneyro, 2006). In summary, the relationship between the two variables is most likely driven by underlining long-term policy credibility rather than the short-term causality (Klein and Shambaugh, 2006; Qureshi and Tsangarides, 2010).

In addition, any relation between volatility and international trade could be driven by reverse causality, in which trade flows help stabilize real exchange rate fluctuations, thus reducing exchange rate volatility (Broda and Romalis, 2010). In any case, there are several reasons why volatility is often not a critical issue for international trade. One particularly compelling argument is that the risks associated with volatile exchange rates are softened by the increasing number of financial instruments available (e.g. forward contract and currency options) that allow firms to hedge against these risks (Ethier, 1973).

Another critique is related to the presence of sunk cost in exporting (Krugman, 1989; Franke 1991). The higher the fixed costs of exports are, the less responsive firms (and therefore international trade) are to exchange rate volatility. All this makes exchange rate volatility less of a critical issue for international trade. In modern cross-border transactions firms often decide to hedge against the risk in the exchange rate or to bear the cost associated with possible exchange rate fluctuations as part of their export strategy.

The second aspect of the relationship between exchange rates and international trade pertains to currency mis-alignments. The influence of currency misalignment on international trade is largely driven by its impact on relative import prices (Mussa, 1984; Dornbusch, 1996). An undervalued currency, whether determined by exogenous shocks or by policy, increases the competitiveness of the export- and import-competing sectors at the expense of consumers and the non-tradable sector (Frieden and Broz, 2006).

In this regard, the effects of misaligned currency on prices are similar to those of an export subsidy and import tax. The literature on the topic provides a great amount of evidence on how responsive trade flows are to changes in relative prices consequent to movements in exchange rates (Hooper and Marquez, 1995; Bernard and Jensen, 2004). Still, as in the case of volatility, there are a number of issues that greatly complicate the relationship between exchange rate misalignment and international trade (Staiger and Skyes, 2010). Of particular importance is the issue that part of the undervaluation or overvaluation of the exchange rate is often absorbed by firms which do not fully adjust their price in the destination country (Goldberg and Knetter, 1997). Related to this is the presence of irreversible sunken costs of entry which act as powerful incentives for firms to stay in the market even when there is substantial undervaluation of the importer currency (Baldwin, 1988; Froot and Kemperer, 1989).

Finally, vertical integration and the role of production networks (the presence of a large share of imported inputs) make currency misalignment less important (Zhao and Xing, 2006).3 The final issue on the relationship between exchange rates and trade explored here regards the effect of exchange rate misalignments on trade policy. The rationale is that the stance of the exchange rate may indirectly affect governments’ decisions regarding other policies, especially those affecting international trade.4 The recent literature on this topic is more limited and largely focused on contingency measures. Most of the studies find that long periods of overvalued exchange rates are often associated with an increase in the use of protectionist trade policies, especially anti-dumping (Frieden, 1997; Knetter and Prusa, 2003; Irwin, 2005; Oatley, 2010).5

Trade policy may be used to compensate for some of the effects of an overvalued currency. Domestic firms that lose competitiveness as a result of a real exchange rate appreciation may lobby for restrictive trade policies. In practice, disputes over exchange rate policies among trading partners could foster an increase in domestic political pressures and unilateral action on trade (Copelovitch and Pevehouse, 2010). In more general terms, countries may also be using trade policy as a substitute for exchange rate overvaluation, so as to deal with persistent disequilibria in the trade balance.

The main findings of this paper can be summarized as follows.

First, exchange rate volatility does not affect international trade except in the occurrence of currency unions and pegged exchange rates. That is, any relationship between the volatility and trade variables is most likely driven by the underlining long-term policy credibility provided by currency unions and pegged exchange rates rather than short-term volatility itself.

The second finding is that exchange rate misalignments do affect international trade flows in a substantial manner. Currency undervaluation is found to promote exports and restrict imports and conversely in the case of overvaluation. In magnitudes, misalignments across currencies result in trade diversion quantifiable in about one per cent of world trade.

Finally, this paper finds some evidence supporting the argument that trade policy is used to compensate for some of the repercussions of an overvalued currency. However, the policy response seems to be largely restricted to anti-dumping interventions. The evidence of a response in terms of slower overall tariff liberalization in periods of currency overvaluation is small.

(Above was added 09Apr2015 due to inadequate answer of relevance below - comment to Vicky).

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.[1]

For example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday.
The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country . There are different kind of measurement for RER. [10]

Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1.

The rate of change of this real exchange rate over time equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.

Ref:
Wikipedia search: Exchange rate at
http://en.wikipedia.org/wiki/Exchange_rate
Alessandro Nicita. 2013. UNCTAD, Geneva, Exchange Rates, International Trade And Trade Policies. Policy Issues in International Trade and Commodities Study Series No. 56. United Nations Conference on Trade And Development. Available at

http://unctad.org/en/PublicationsLibrary/itcdtab57_en.pdf