Exchange Rate Determination Models Part One/Terms of Trade Parity Technic

Abstract

First, in order to proceed we must define the “Terms of Trade”. Terms of trade is a relationship between the prices of exports and the prices of imports, it’s mathematical expression is as follows: Px/Pm. Second, we assume there are two countries trading with each other, USA and China with US dollar and Chinese Yuan monies. Further, the terms of trade for both of these countries are as follows: USA’s Terms of Trade: PXus/PMus and China’s Terms of Trade: PXch/PMch. Now, lets investigate three different outcomes for exchange rate (in trade account framework) by this approach: A - Primary Equlibrium Status: In this case the terms of trade of the two countries are in equilibrium, here: we assume the two monies are equal in value for simplicity, so we could have the following equations: PXus/PMus = PXch/PMch ------------- Dus = Uch or DUSe = UCHe. As it is clear from the equation, there is an equilibrium and we have no change at all. B - Increasing of the US terms of trade: The increase in terms of trade for US causes the increase in price of US exports (the price for US imports is constant) which in turn decreases the demand for DUS and devalues the DUS, other things being held constant. So we could have: PXus/PMus UCH. The converse would happen to China’s terms. C - Decreasing of the US terms of trade: The decrease in terms of trade for US causes the decrease in price of US exports (the price for US imports is constant) which in turn increases the demand for DUS and upvalues the DUS, other things being held constant. So we could have: PXus/PMus > PXch/PMch ------------- DUS> UCH. The converse would happen to China’s terms.