Model Answer
0 min readIntroduction
In an increasingly globalized world, understanding the relationship between a country’s international purchasing power and its trade performance is paramount. The Real Exchange Rate (RER) and Terms of Trade (TOT) are two key indicators used to assess this relationship. The RER measures the relative price of goods and services between two countries after accounting for exchange rates, while the TOT represents the ratio of a country’s export prices to its import prices. While distinct, under certain conditions, these two measures can become synonymous, providing valuable insights into a nation’s economic competitiveness.
Defining Real Exchange Rate and Terms of Trade
Real Exchange Rate (RER) is the exchange rate between currencies adjusted for the relative prices of goods and services in each country. It indicates how much of a foreign country’s goods and services can be obtained for one unit of a domestic country’s goods and services. The formula is:
RER = Nominal Exchange Rate * (Domestic Price Level / Foreign Price Level)
Terms of Trade (TOT) is the ratio of a country’s export prices to its import prices. It indicates the relative amount of imports a country can obtain for a given amount of exports. The formula is:
TOT = (Index of Export Prices / Index of Import Prices)
Conditions for RER to be synonymous with Terms of Trade
The RER and TOT are synonymous when the following conditions hold:
- Unit Elasticity of Demand: If the demand for exports and imports is unit elastic, the changes in quantities traded will exactly offset the changes in prices. This means that a percentage change in export prices will be matched by an equal percentage change in the quantity of exports, and vice versa for imports.
- Balanced Trade: When a country’s exports are equal to its imports (trade balance is zero), the impact of price changes on the overall trade value is neutralized.
- Single Good Economy: If both countries specialize in and trade only one good, the RER simplifies to the relative price of that single good. In this scenario, the TOT also reflects the relative price of that single good.
- Homogeneous Goods: The goods traded must be homogeneous, meaning they are identical across countries. This eliminates any quality differences that could affect price comparisons.
Mathematical Explanation
Let's consider a simplified two-country model with only one export good (X) and one import good (Y). Assume quantities are Qx and Qy respectively, and prices are Px and Py.
RER = e * (Px / Py), where 'e' is the nominal exchange rate (domestic currency per foreign currency).
TOT = Px / Py
If 'e' = 1 (exchange rate is unity), then RER = Px / Py. Therefore, under this condition, RER = TOT.
Real-World Implications and Limitations
In reality, the conditions for equivalence rarely hold perfectly. Most economies trade a diverse range of goods, and demand elasticities are rarely unitary. However, the concept is useful for understanding the underlying forces driving changes in a country’s trade balance. For example, a depreciation of a country’s currency (increase in 'e') will worsen the RER, but if export demand is inelastic, the TOT might improve due to increased export volumes.
Example: Consider India and the USA. If the nominal exchange rate is INR 80 per USD, the price of Indian rice is INR 30/kg, and the price of US wheat is USD 0.5/kg, the RER is 80 * (30/0.5) = 4800. If India’s rice export price increases to INR 35/kg while the US wheat price remains constant, the TOT improves for India. However, the RER will only equal the TOT if the exchange rate remains constant and the quantities traded don't significantly change.
Conclusion
In conclusion, while the Real Exchange Rate and Terms of Trade are distinct concepts, they become synonymous under specific, often idealized, conditions such as unit elasticity of demand, a balanced trade, and a single-good economy. Understanding these conditions provides a valuable framework for analyzing a country’s international competitiveness and trade performance. However, it’s crucial to acknowledge the limitations of this equivalence in the complex reality of global trade.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.