2. Determining long-term exchange rates
Consider two countries, the United States and India, that trade with each other. Suppose that the productivity growth in the United States accelerates, but it remains the same in India. The following graph shows the supply and demand for the Indian rupee in the United States before the change in productivity. The vertical axis is the exchange rate of the rupee in terms of the dollar, and the horizontal axis is the quantity of rupees.
Show how the change in productivity affects the equilibrium exchange rate by shifting one or both of the curves on the graph.
Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.
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As a result of the change in productivity, the U.S. dollarappreciates .
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Generally, if a country becomes more productive and can produce goods more cheaply than its foreign competitors can, its productivity gains can be passed forward to domestic and foreign buyers in the form of lower prices, increased exports, and decreased imports. Thus, in the long term, depending on whether a country becomes more or less productive relative to other countries, its currency either appreciates or depreciates.
Specifically, if the productivity growth in the United States accelerates, but it remains the same in India, U.S. goods would become relatively less expensive, and the U.S. demand for Indian goods would decrease. This causes the demand for rupees to shift left to D1D1 . Regarding the supply of rupees, India’s demand for U.S. goods would increase, so the supply of rupees shifts right to S1S1. These two effects cause the dollar to appreciate, so it takes fewer dollars to buy the same amount of rupees.