The Structural Change and Economic Dynamics - MyAssignmenthelp.com

Question: Discuss aboutThe Structural Change and Economic Dynamics. Answer: Introduction This report gives an overview about the vital factors that affects the relative prices of products. Relative prices of goods refer to the ratio between price of a specific good and the weighted average of other products that are available in the marketplace. If the prices of those specific good increases by 2% while other products decreases, then relative prices of products increases without affecting the purchasing power parity (Melvin and Norrbin 2017). A vital part of the difference in price of goods between the nations is terms of trade, compression of wage, variation in exchange rate etc. The study also focuses on how this effect on relative price of goods induces variation in exchange rate and deviations in purchasing power parity (PPP). Volatility in relative price and exchange rate can be generated from the two sources that include- domestic price as well as dollar value and imported price or currency value. The correlation between the exchange rate and terms of trade (TOT) a re also analyzed in this study. Furthermore, the government intervention engaging in operations of foreign exchange market and its impact on TOT is also illustrated in this study. Discussion Main factors affecting relative prices of products Some of the vital factors that affects the relative prices of products are exchange rate, terms of trade, purchasing power parity etc. Movements in the exchange rate changes the relative prices if products and services. This means that if the exchange rate declines, the relative prices of local commodities and services also declines but relative prices of international products and services rises. However, this fluctuation in relative price leads to increase in the nations exports and decline in its imports. On the other hand, increase in exchange rate leads to increase in relative price of products as well as services while it leads to decline in relative price of international commodities and services (Reisman 2013). Moreover, this variation in relative price leads to decline in exports and rise in imports. In addition, the relative prices between the two countries can also be recapitulated by means of PPP. PPP defines that the exchange rate between the nations is equivalent to the ratio of currencies with respect to the purchasing power. The PPP for the particular industrys output is the total currency that is needed by one nation to purchase this amount of output that will equal to one currency value of the other country. Therefore, the PPP highlights the relative prices of products and services, which in turn makes up the sectors output of the two nations. In similarity with outputs, the PPP for inputs are mainly based on the relative prices of products and services and this in turn makes up inputs of the industries. In context to this, TOT relates to relative prices of the imported goods in account of its exported goods and hence is termed as ratio of prices of export to its imports. In addition, the policies imposed by the government of the respective countries that limits imports or subsidize exports usually leads to fluctuation in relative prices of products and services. This in turn makes its attractive to either exported goods or imported goods. Fur thermore, import quotas also increases relative price of the imported products, which in turn decreases demand. Effect that induce changes in exchange rate and deviations from purchasing power parity Exchange rates are mainly defined as the value in which one countrys currency could be converted to another nations currency. There are several factors that influence the exchange rate in the long run, which includes- relative levels of prices of goods, barriers in trade, total productivity and preferences of domestic versus international products. It has been stated by Reisman (2013) that , the variation in price level of goods also leads to variation in the foreign exchange rate. this means that adjustment in prices of the commodities also creates changes in the exchange rate. Furthermore, the exchange rate might also change owing to real economic events and also with average level of prices constant. As the PPP is illustrated with the prices indices, such changes in relative prices of commodities might cause deviations from PPP since the exchange rate varies even though prices index remains to be constant. Even the condition of PPP presumes that there is basically no cost of trans action. However, PPP might not hold exactly in the existence of the transaction cost (Taylor 2013). Instead this transaction cost might create band within which deviation from PPP might vary without setting into foreign arbitrage of products. The main reason behind this is that in presence of this transaction cost, any arbitrage activities might not occur for those commodities in which profit margin from arbitrage is less than cost of transaction. Jolliffe and Prydz (2015) founds out that as the non traded good price enters into price index and thereby into deviation of real exchange rate from PPP. However, this indicates that the divergence from PPP might not be constant. Correlation between exchange rate and terms of trade There is indirect correlation between the exchange rate and terms of trade. The TOT can be affected by exchange rate as increase in value of the nations currency decreases the domestic import prices but might not directly impact the prices of exported commodities. Moreover, direct as well as indirect impact of exchange rate might induce variation in TOT as well as trade volume. Depreciation of a countrys currency declines the TOT, which in turn increases trade volume. On the other hand, appreciation in the currency value of a specific nation increases TOT and declines the trade volume (Berman, Martin and Mayer 2012). The export prices from the nation can heavily impact by the currency value and this in turn might be affected by rate of interest in the nation. Furthermore, if the currency value of the specific nation is increased owing to rise in rate of interest, it might be predicted that the TOT will improve (OHYAMA 2013). Apart from this, the impact of variation in exchange rate o n the volume of trade is basically lower than the impact on TOT, which in turn implies that international price elasticity of demand for import is less than one. In fact, the elasticitys of domestic s well as international prices for the import demand are important to decide the exchange rate in influencing the TOT as well as trade volume. Melvin and Norrbin (2012) opines that weaker currency value increases exports and also makes the imports highly expensive. In addition, direct as well as indirect affect of variation in exchange rate also leads to fluctuation in trade deficit or trade surplus. In short run, the trade balance might worsen import value in the foreign currency. Based on the standard trade theory, it can be said that the balance of trade (BOT) can be expected to directly impact by depreciation. This also states that BOT in the country might rise after real exchange rate depreciation. For example, recent evidences reflect that depreciation in US dollar declines TOT. The indirect impact of variation in exchange rate on domestic Korean beef price becomes equivalent to direct impact of foreign Korean beef price. As a result, the TOT might be changed by US dollar depreciation. The direct impact of exchange rate variation on imported beef price is higher than that indirect impact of exchange rate on Korean beef price. Government intervention in foreign exchange (FX) market operations Government mainly intervenes in the foreign exchange market through implementation of the monetary policy where the policymakers take role for influencing transfer of the monetary fund rate of that particular currency (Noussair, Plott and Riezman 2013). The government intervention in the FX market can be divide into two parts, which includes The country which are mainly reliant on exports and hence is concerned with appreciating value of currency, the government of respective nation might intervene. This is because by weakening the currency value can make the export commodities competitive in the global marketplace. In certain circumstances, the government intervention can be reactionary for short time for specific event. Hence, these events can cause the countrys currency to move in specific direction in short span of time. The government usually intervenes in the FX market for inflecting the level of exchange rate. Certain methods implemented by the government for affecting exchange rate includes- Reserving If a particular countrys government wants to keep the original value or decline exchange rate, then it can utilize the foreign exchange reserves (Taylor 2013). Changing the rate of interest- increase in rate of interest leads to rise in money flow. In case, it does not have any effect in depressing demand , then the government can be unwilling to decrease interest rate in order to enhance currency value. Borrowing- In certain situation, the government also imposes tighter monetary as well as fiscal policy in order to reduce aggregate demand. This in turn might influence exchange rate level. The reasons behind government intervention in FX market are shown below- For correcting the market failure For improving the economys performance For reversing the countrys growth in trade shortage For example, in China, the government tries to keep their currency undervalued for making their exports highly competitive. They do this by purchasing US dollar assets and this in turn raises the US dollar value to Chinas currency (McKinnon and Schnabl 2012). Conclusion It concludes from the above report that variation in relative price is one of the vital factor that impacts on exchange rate and terms of trade. Some factors that influences FX rate are rate of inflation, political as well as economic stability, government debt etc. Furthermore, government intervention in this FX market also enhances economic performance of the country by making repayment I foreign loans and stabilizing exchange rate. References Berman, N., Martin, P. and Mayer, T., 2012. 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