Question

Consider world consisting of two trading entities: the US and the EU. The EU is the exporter of cheese to the US and the importer of oil from the US. Assume the world price of both cheese and oil are set in terms of dollars ($). Also assume that there is no barriers or restrictions on trade for either good. Also assume that the entire exchange between the US and EU is made of trade account transactions and that there are NO capital/financial account transactions between them.

 

The following table represents the information about the EU’s import of oil. Note that the price of oil is denominated in the US dollar ($) and is equal to $30 per barrel.

 

1	2	3	4
Exchange rates ($/€)	The euro price of oil (€)	The EU quantity of oil imports	The number of euro supplied (€)
1.2	?	50	?
1.5	?	75	?
1.8	?	100	?

 

(a) Using the information above derive the supply of Euro by filling in the blanks.

(a)   The following table represents the information about the EU’s exports of cheese. Note that the price of cheese is also denominated in the US dollar ($) and is equal to $100 per ton.

 

1	2	3	4
Exchange rates ($/€)	The euro price of cheese (€)	The EU quantity of cheese exports	The number of euro demanded (€)
1.2	?	15.5	?
1.5	?	22.5	?
1.8	?	25	?

 

(b)  Draw a diagram to depict the supply and demand curve for euro as found above. What is the equilibrium value of the exchange rate?

(c)   Is this foreign exchange market stable? Why? Does your answer to part (c) have anything to do with the Marshall- Lerner condition? Explain.

Would your answer to (d) change if the EU quantity of oil imports (column 3) in the first table changed to 50, 60 and 70 (instead of 50, 75, 100)? Explain. 

Answer 1

(a) The Price of oil Denominated in dollar and is equal to $30 per barrel.

So , exchange rate of euro per oil is =

Exchange rate = Price in dollar / Price in euro

so price of barrel required in Euro = $30/1.2

                                                      = 25 euro

The number of supplied of Euro is as follows :

Number of Euro = The euro price of oil x Quantity of oil imports

1	2	3	4
Exchange Rates ($/euro)	The euro price of oil	The Eu quantity of oil imports	The number of Euro Supplied
1.2	25	50	1250
1.5	20	75	1500
1.8	16.67	100	1667

(b)

The Price of oil Denominated in dollar and is equal to $100 per ton.

So , exchange rate of euro per cheese is =

Exchange rate = Price in dollar / Price in euro

so price of barrel required in Euro = $100/1.2

                                                      = 83.33 euro

The number of supplied of Euro is as follows :

Number of Euro demanded = The euro price of oil x Quantity of cheese exports

Exchange Rates	The Euro price of Cheese	The Eu quantity of cheese exports	Quantity demanded of Euro
1.2	83.33	15.5	1292
1.5	66.67	22.5	1500
1.8	55.55	25	1388

(C)    Equilibrium Value of exchange rate is 1.5

Because at this point of exchange rate Quantity supplied is equal to quantity Demanded.

Supply point e Equilibrium Price of Exchon Rate Demand 91500 Quantity of Euro & - Quantitys of Euro

(d)

• No, foreign Exchange market is not stable .

Because , Foreign exchange kept on changing due to change in demand and change in supply of Currency in which trade is done ( i.e Euro) . So , it is fluctuating rather than being Stable.

• Marshall Lerner Condition means a condition where devaluation of currency lead to increase in the balance of payment when elasticity of demand and supply is greater than one.

So, in part (c) answer, Marshall Lerner Condition has no effect because at that part , exchange rate is at equilibrium where demand for the currency is equal to supply of currency.