Group Assignment- Open Economy

Topics: International trade, Macroeconomics, Inflation Pages: 7 (1526 words) Published: July 16, 2013
Assignment 2 – Question 4

An article published in Die Zeit on 25 March 2010 analyses the German policy that allows for only moderate increases in wages. According to this article, the unit labor costs in Germany increased by only 4% from 1998 to 2008, while they increased by 20% in France and 32% in Greece. Germany’s trade surplus grew significantly in the same period. France’s trade deficit with Germany, however, increased significantly. The French Minister for Economic Affairs, Lagarde, asked Germany to boost the do-mestic demand, which stagnated due to the slow growth of the unit labor costs and wages. The unit labor costs are an indicator for a country’s price level. Assume that the French (German) unit labor costs are an equivalent of the domestic (foreign) price level P (P*). a) Explain the term “unit labor costs” briefly in words and use the internet for your research.

b) How has the real exchange rate between France and Germany developed (France=Home Country)?

c) According to the article, France’s net exports with Germany have decreased. Is there a connection between the development of the real exchange rate and the net exports? Name an important condition that must be fulfilled if the connection exists.

d) Why did the French Minister for Economic Affairs ask Germany to boost the domestic demand? Describe the effects of an increase in the German do-mestic demand in words and draw a diagram of the French goods market (including DD, ZZ and NX-curve). How do the components of the demand and the net exports change in France?

a) Explain the term « unit labor costs » briefly in words and use the internet for your research.

« The Unit Labor Costs (ULC) measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output. Also, ULCs can be calculated as the ratio of labor compensation to real GDP.  Unit Labor Costs represent a direct link between productivity and the cost of labor used in generating output. In other words, a rise in an economy's unit labor costs represents an increased reward for labor’s contribution to output.»[1] Or put it more simply, unit labor costs represent the amount of money needed to produce one more unit of goods/service. This also means that they are functions of two variables: hourly wages of the workers and their productivity (in an hour). As the productivity is not an easy variable to change and it can not change significantly over a certain smaller period of time as wages can(in quarter, 6 months period etc), unit labor costs are a good indicators of wage inflation. As wage inflation is the starting point of all other changes in price level, (because it eventually induces higher consumer prices) we can deduce that the Unit Labor Costs change can be a good indicator of the price level P change.

b) How has the real exchange rate between France and Germany developed (France = Home country)? Knowing that the unit labor costs are an indicator for a country's price level and that we assume the French (German) unit labor are an equivalent of the domestic (foreign) price level P (P*). Moreover, according to the article, we know that the unit labor costs in Germany increased by 4 % and increased by 20% in France. Both the domestic price level (P) and the foreign price level (P*) have increased and the P increased more than P*. Therefore, the real exchange (Ɛ) rate (of France) has increased for (20:4=5%)

The real exchange rate is given by: Ɛ = EP / P*
Ɛ (↑) = EP(↑20%) / P*(↑4%) Ɛ 2 = EPx1.05 / P* which leads us to conclusion that Ɛ 2 = 1.05 Ɛ1

c) According to this article, France's net exports with Germany have decreased. Is there a connection between the development of the real exchange...
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