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3. Use the information in the table to answer parts a, b, and c.
______________________________________________
____________Car Production________Wine Production
Country________per Day_______________per Day____
United States______6____________________2________
France___________1____________________1________
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a. Which country has the absolute advantage in cars? In wine?
b. Which country has the comparative advantage in cars? In wine?
c. Is there a basis for trade between the two countries? Explain in detail why or
why not.
a. The United States has the absolute advantage in the production of both cars and wine. It can produce more of both goods.
b. In the United States, 1/3 unit of wine must be given up to produce an additional car. In France, 1 unit of wine must be given up in order to produce an additional car. This means that the Unites States has a comparative advantage in the production of cars.
In the United States, 3 cars must be given up to produce a unit of wine. In France, 1 car must be given up to produce a unit of wine. This means that France has a comparative advantage in the production of wine.
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c. There is a basis for trade between these countries. The United States would be willing to trade for wine if it could get more than 1/3 unit of wine for each car. France would be willing to trade for cars if it could get more than l car for each unit of wine. Suppose the countries agree to trade at the rate of 2 cars for 1 unit of wine. In this case, the United States will get 1/2 unit of wine for each car it trades to France. It is better off than if it tried to produce wine. For each unit of wine it gives to the United States, France gets 2 cars. It is also better off as a result of trade. Thus, so long as the opportunity costs of production differ between the countries, trade can improve their welfare.
11. Explain how each of the following domestic factors can affect the exchange rate.
a. An increase in real GDP.
b. A decrease in the inflation rate.
c. An increase in the interest rate.
a. With an increase in real GDP, U.S. citizens will purchase more goods, including imports. As a result the supply of dollars to foreign countries increases. As the supply of dollars increases, the dollar depreciates.
b. If the inflation rate decreases, a nation's exports will become more competitive. As other nations buy these now cheaper goods, the demand for dollars increases, thereby driving up the exchange rate. At the same time, the decrease in inflation will make foreign goods look less attractive to domestic citizens. As a result the supply of dollars will decline. This will tend to drive up the exchange rate. Thus, the overall effect of a decrease in inflation is to cause the dollar to appreciate.
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c. If the interest rate increases, other countries will wish to invest in the United States. This will drive up the demand for dollars and increase the rate of interest. At the same time, it becomes less attractive for domestic citizens to invest abroad. This will decrease the supply of dollars and lead to increase in the exchange rate. The overall effect of the increased interest rate is to cause the dollar to appreciate.
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