A country imposes a tariff on imports from abroad. How does...

Name: Problem 9, Chapter 16: International Economics: Theory and Policy
Uploaded: 2022-04-11T04:16:11-08:00
Duration: 1 min 13 s
Channel: Jennifer Stoner
Description: A country imposes a tariff on imports from abroad. How does this action change the long-run real exchange rate between the home and foreign currencies? How is the long-run nominal exchange rate affected?

A country imposes a tariff on imports from abroad. How does this action change the long-run real exchange rate between the home and foreign currencies? How is the long-run nominal exchange rate affected?

Key Concepts

Purchasing Power Parity (PPP)

Purchasing Power Parity is an economic theory stating that the exchange rate between two countries should adjust to reflect changes in the relative price levels of their baskets of goods and services. Tariffs can disrupt this equilibrium in the short run by altering domestic prices, but under PPP, the nominal exchange rate should eventually adjust to eliminate long?run price differentials. This concept explains why, despite changes in the real exchange rate due to tariffs, the long-run nominal exchange rate may remain largely unaffected.

Nominal Exchange Rate

The nominal exchange rate is the rate at which one currency can be exchanged for another without adjusting for price level differences. In the long run, the nominal exchange rate is largely determined by fundamental factors such as monetary policy, inflation expectations, and overall economic fundamentals, rather than by temporary protective measures like tariffs. Therefore, while tariffs may influence domestic price levels, they often have little or no lasting effect on the nominal exchange rate.

Tariff

A tariff is a tax imposed on imported goods that raises the cost of foreign products in the domestic market. It is an example of a trade policy instrument used by governments to protect domestic industries or generate revenue. Tariffs can lead to changes in domestic price levels as the cost of imports rises, which in turn may affect relative prices in the economy.

Real Exchange Rate

The real exchange rate measures the relative price of domestic goods in terms of foreign goods by adjusting the nominal exchange rate for differences in price levels between countries. Tariffs can alter domestic price indices by increasing the cost of imported goods, leading to a change in the real exchange rate. In the long run, if tariffs cause persistent price distortions, the real exchange rate may adjust to reflect the new relative purchasing power between domestic and foreign currencies.

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