Homework No 3 – Measures of Competitiveness and International Production

Networks
1) Study the figure below on India’s nominal and real effective exchange rates during
2000- 2012 and answer the following questions

a. Explain, giving reasons, what you can conclude from the above figure
about India’s overall competitiveness in international markets from
around 2006 onwards to May 2011 – has it improved or gone down?

Competitiveness is measured by the real exchange rate (REER). As a

result of the REER's appreciation during this time, which makes
domestic goods more expensive in comparison to commodities
produced abroad, overall competitiveness suffers.

b. What do you infer is the main reason for the change in

competitiveness: changes in the value of the Indian Rupee relative to
other currencies OR differences in inflation between India and its
trading partners?

Despite significant changes throughout this time, it is clear from NEER

that the overall nominal exchange rate has declined from levels in
2006. In other words, if India's costs do not rise, the actual effective
exchange rate will decline, which will boost competitiveness. Because
India's inflation rate must be significantly greater than that of its
trading competitors, the observed appreciation of REER must have
taken place because the difference in inflation is enough to
counterbalance the rise in competitiveness brought on by the
depreciation of NEER.
2) Consider a Japanese firm headquartered in japan that produces all its
garments in China. It imports 70% of its raw materials from Japan and
uses labour and some other inputs in China – adding the remaining
30% of its value - to produce the garments. Assume that inputs of all
inputs per unit of output are used in fixed proportions (i.e. do not
change with their prices).

a. Suppose it exports all the finished garments to Japan. If the Japanese

currency devalues by 10% but Japanese internal costs do not change,
will the profitability of the Japanese firm, reported in Yen, go up, down,
or remain the same, if profits are reported in Japanese currency? Explain
how you arrive at your answer.

We use indirect quotes, assuming Japan is the home country.

Suppose the exchange rate is E=ECHY/JPY (x unit of RMB is equal to 1 unit of
Japanese yen) = 0.2.

If the production cost is 100 yuan (30% of Chinese input equals 30 yuan, and
70% of Japanese material equals 70 yuan), then E decreases by 10%
after the yen depreciates by the same percentage.

The RMB price of imported Japanese materials is =70*(1-10%)=63RMB.

The input cost in China is 30 yuan; the total cost is 63 + 30 = 93. (Yuan)

Prices are in Japanese Yen and exported to Japan.

Cost=93RMB/0.18=516.67JPY (93/(1-10%)E=93/0.9E=103/E), which is
the total cost in Japanese yen.
When calculating 100RMB/0.2 = 500JPY (100/E) for the first time, the overall
production cost in yen increased by 3%. (Profit = Sales - Cost) will
decrease if the selling price is constant.

There is less incentive to invest in China and more incentive to produce in

Japan.

b. Suppose it exports all finished garments to the USA, and the US$/Rmb
rate does not change but Yen depreciated by 10% against both US$
and Rmb. will the profitability of the Japanese firm (in Yen) go up,
down, or remain the same? Explain how you arrive at your answer.

Even if sold for the same dollar price, when the money is sent back to
Japan, its value in yen increases by 10%. As a result, the cost in yen is
about 3% higher, but the return is 10% higher, so Japanese companies
are now more profitable than before. In fact, this is because 70% of
the inputs come from Japan, so the higher return on exports at a
lower exchange rate makes up for the higher cost of using some
Chinese inputs. If Japanese companies only use Chinese inputs and
sell in the United States, changes in the Japanese exchange rate will
have no effect. If the yen appreciates, the incentives are reversed:
firms will use more foreign inputs and move more production abroad.