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If inflation in country A is higher than in country B, and the exchange rate between the two countries is fixed, which of the following is likely to happen to the trade balance between the two countries assuming the initial prices of the basket is same in both the countries?
- a)It is favourable for country A to export more goods than country B.
- b)Exports of country B to country A will increase.
- c)Country A would experience surplus trade balance.
- d)Both (a) and (c).
Correct answer is option 'B'. Can you explain this answer?
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If inflation in country A is higher than in country B, and the exchan...
Explanation:
Impact of Inflation on Trade Balance:
Inflation can have a significant effect on a country's trade balance. When the inflation rate in one country is higher than in another country, the prices of goods and services in the first country will be higher than in the second country. This means that the first country's exports will be less competitive in the international market, and its imports will be more competitive. This will lead to a decline in exports and an increase in imports, which will result in a trade deficit.
Impact of Fixed Exchange Rate on Trade Balance:
When the exchange rate between two countries is fixed, it means that the central bank of one country has committed to buying or selling its currency at a fixed rate in exchange for the currency of the other country. This means that the exchange rate will not fluctuate in response to changes in supply and demand in the foreign exchange market.
Impact of Inflation and Fixed Exchange Rate on Trade Balance:
If inflation in country A is higher than in country B, and the exchange rate between the two countries is fixed, the following is likely to happen to the trade balance between the two countries assuming the initial prices of the basket is the same in both countries:
- It is not favourable for country A to export more goods than country B because the higher inflation rate in country A will make its exports less competitive.
- Exports of country B to country A will increase because the lower inflation rate in country B will make its exports more competitive.
- Country A would not experience a surplus trade balance because its exports will decline due to the higher inflation rate.
Therefore, option B is the correct answer.
Impact of Inflation on Trade Balance:
Inflation can have a significant effect on a country's trade balance. When the inflation rate in one country is higher than in another country, the prices of goods and services in the first country will be higher than in the second country. This means that the first country's exports will be less competitive in the international market, and its imports will be more competitive. This will lead to a decline in exports and an increase in imports, which will result in a trade deficit.
Impact of Fixed Exchange Rate on Trade Balance:
When the exchange rate between two countries is fixed, it means that the central bank of one country has committed to buying or selling its currency at a fixed rate in exchange for the currency of the other country. This means that the exchange rate will not fluctuate in response to changes in supply and demand in the foreign exchange market.
Impact of Inflation and Fixed Exchange Rate on Trade Balance:
If inflation in country A is higher than in country B, and the exchange rate between the two countries is fixed, the following is likely to happen to the trade balance between the two countries assuming the initial prices of the basket is the same in both countries:
- It is not favourable for country A to export more goods than country B because the higher inflation rate in country A will make its exports less competitive.
- Exports of country B to country A will increase because the lower inflation rate in country B will make its exports more competitive.
- Country A would not experience a surplus trade balance because its exports will decline due to the higher inflation rate.
Therefore, option B is the correct answer.
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If inflation in country A is higher than in country B, and the exchan...
- Inflation is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Thus it indicates a decrease in the purchasing power of a nation’s currency.
- As inflation in country A is greater than country B, the purchasing power of the currency of country A is less than that of country B.
- Initially we assumed that the prices of basket is same in both the countries. But as inflation in country A is greater than country B, the price of basket in country A would become greater than country B. Therefore, prices of goods and services of country A tends to be higher than that of country B.
- In this situation, the exports from country B to country A will go up resulting in improvement or surplus trade balance for B. But due to higher price in country A, its imports will increase from country B and it will lead to a deficit in the trade balance for country A.
Hence, option (b) is correct.
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If inflation in country A is higher than in country B, and the exchange rate between the two countries is fixed, which of the following is likely to happen to the trade balance between the two countries assuming the initial prices of the basket is same in both the countries?a)It is favourable for country A to export more goods than country B.b)Exports of country B to country A will increase.c)Country A would experience surplus trade balance.d)Both (a) and (c).Correct answer is option 'B'. Can you explain this answer?
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