Two fictitious countries, Bigsea and Tadloch, produce only two products: Boats, which are traded...

Question:

Two fictitious countries, Bigsea and Tadloch, produce only two products: Boats, which are traded internationally, and seafood restaurant meals, which are not. The countries have equal populations. Bigsea's currency is called 'Big' and Tadlock's currency is called 'Tad.' (Note: k = 1,000.)

Boats Restaurant Meals
Bigsea 50 @ 30k Bigs/boat 4k @ 15 Bigs/meal
Tadloch 30 @ 400 Tads/boat 3k @ 2 Tads/meal

A) If the exchange rate does a perfectly good job equating prices of traded goods (i.e. so that the law of one price holds for traded goods), what is the exchange rate, in 'Bigs per Tads?'

B) Under the exchange rate in Part A, what is the ratio of Bigsea's GDP to Tadlockhs?

C) Using the PP method, calculate the ratio of GDPs first using Bigsea's prices, then Tadloch's prices. Why are the ratios so different?

D) What happens in this example to the ratio between GDPs when the PPP method is employed instead of the exchange rate method?

GDP:

It is the total value of goods and services produced in a country over specific time frames such as a quarter or year and it is used worldwide to show the economic health of a country.

Answer and Explanation:

A. Exchange rate here, bigs per tads means , (15 bigs / meal ) / (2 tads / meal) = 7.5 bigs per tads.

This means that 1 tads are given to the Bigsea people for 7.5 bigs.

B. Bigsea's GDP = (50 boat x 30k big/boat ) + (4k meals x 15 bigs/meal)

= (50 boat x 30,000 big/boat ) + (4,000 meals x 15 bigs/meal) (Since , k = 1000)

= 15,00,000 bigs + 60,000 bigs

= 15,60,000 bigs

Tadloch's GDP = (30 boats X 400 tads/boat) + ( 3,000 meals X 2 tads/meal )

= 12000 tads + 6000 tads

= 18,000 tads

Thus the ratio of Bigsea's GDP to Tadloch's under the exchange rate of 7.5 bigs / tads

we have R= Ratio of Bigsea's GDP to Tadloch's and then finding out the Tadloch's GDP by multiplying with the exchange rate to find the GDP in terms of Bigsea's.

R = {eq}\frac{ 15,60,000 bigs }{18,000 tads} = \frac{15,60,000 bigs }{135000 bigs} = 11.556 {/eq}

C. Purchasing power parity is derived when we compare the same basket of goods across two different nations. Let one

Hence using the PPP method, we may derive the exchange rate = (30000 + 15 ) / (400 +2 ) = 74.66 bigs / tads

Hence using the PPP method, we may derive the exchange rate = (400 +2 ) / (30000 + 15 ) = 0.0133 tads / bigs

The ratios are different since we are comparing one country's purchasing power with another country. Hence In 1 tad, we can have 74.66 bigs. This means we can purchase products up to the value exact to 74.66 bigs if we pay 1 tad to the foreign exchange reserve bank in Bigseas. Similarly, if a Bigsea people visit Tadloch then for 1 big he can only buy products up to the value of 0.013 tad in Tadlock.

D. The ratio of Bigsea's GDP to Tadloch's under the PPP method changes as the exchange rate in PPP is 74.66 bigs /tads

Thus,

The ratio becomes

{eq}\frac{ 15,60,000 bigs }{18,000 tads} = \frac{15,60,000 bigs }{1343880 bigs} = 1.16 {/eq}

Because we previously were comparing only the GDP values in terms of the exchange rate but not according to their actual purchasing power. Hence, their purchasing power being compared we find out that Bigsea's GDP is 1.16 times only. But previously Bigsea's GDP was 11.5 times to that of Tadlochs.


Learn more about this topic:

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Gross Domestic Product: Definition and Components

from Economics 102: Macroeconomics

Chapter 4 / Lesson 3
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