Answer to Question #316257 in Macroeconomics for Jay

Question

Question 1 (15 marks) the questions that follow:

Commodity prices have been increasing on the world market. South Africa is a major exporter of commodities such as gold and platinum.

1.1 Use a foreign exchange diagram to illustrate and explain the effect of the increase in commodity prices on the rand–dollar exchange rate, ceteris paribus. (10 marks)

1.2 Define the terms of trade, and explain how the terms of trade will be affected in South Africa by the increase in commodity prices. (5 marks)

Answer 1

1.1The exchange rate is decided by demand and supply of currency in foreign exchange market. Demand and supply is widely affected by foreign capital inflow and outflow. When foreign capital inflow increase currency get appreciate and vice-versa. The inflow and outflow are widely affected by net export and interest rate. When net export increase and/or then then demand for domestic currency increase and domestic currency get appreciated and vice-versa.

If gold prices rises in South Africa and all other things being unchanged or constant, it will appreciate the South African rand against the USD. Here due to increasing price of gold investors will pay more for gold that will increase demand for South African rand and demand for South African rand will shift D1 to D2 that will appreciate South African rand against the USD.

1.2Terms of trade (TOT) represent the ratio between a country's export prices and its import prices. How many units of exports are required to purchase a single unit of imports? The ratio is calculated by dividing the price of the exports by the price of the imports and multiplying the result by 100.

1. Reciprocal Demand

The terms of trade of a country depend upon reciprocal demand, i.e. “the strength and elasticity of each country’s demand for the other country’s product”. Suppose there are two countries, Germany and England, which produce linen and cloth respectively.

2. Changes in Factor Endowments

Changes in factor endowments of a country affect its terms of trade. Changes in factor endowments may increase exports or reduce them. With tastes remaining unchanged, they may lead to changes in the terms of trade.

3. Changes in Technology

Technological changes also affect the terms of trade of a country. The effect of technological change on terms of trade

4. Changes in Tastes

Changes in tastes of the people of a country also influence its terms of trade with another country. Suppose England’s tastes shift from Germany’s linen to its own cloth. In this situation, England would export less cloth to Germany and its demand for Germany’s linen would also fall. Thus England’s terms of trade would improve. On the contrary, a change in England’s taste for Germany’s linen would increase its demand and hence the terms of trade would deteriorate for England.

5. Economic Growth

Economic growth is another important factor which affects the terms of trade. The raising of a country’s national product or income over time is called economic growth. Given the tastes and technology in a country, an increase in its productive capacity may affect favorably or adversely its terms of trade.

6. Tariff

An import tariff improves the terms of trade of the imposing country.

7. Devaluation

Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing its currency in relation to the currency of another country.

The effects of devaluation on the terms of trade have been much debated among economists. According to Prof. Machlup, “Devaluation is supposed to improve the balance of trade. A reduction in the physical volume of imports in relation to the physical volume of exports constitutes an adverse change in the gross barter terms of trade.”