241 Assignment Solution: Exchange Rates and International Finance

Solution to Microeconomic Question

Trading internationally gives the domestic producer a wider market, which increases demand for their product. This allows them to reach customers who otherwise wouldn’t have access to their products, and who would potentially have to pay more for something similar. Additionally, the wider market can allow the domestic producer to take advantage of (or additional advantage of) economies of scale in production, lowering costs and increasing profits. This advantage accrues to domestic sales as well as exports.

If foreign exchange decreases in value, export revenues may be worth less than expected. This is the downside of exchange rate risk. But if the foreign exchange increases in value, export revenues are worth more than the exporter expected. This is another benefit.

Solution to Macroeconomic Question

Exports and imports are a smaller proportion of a large nation’s GDP since they have a large enough market domestically to support a sizeable amount of domestic trade. Smaller nation’s have a greater need to trade internationally since they don’t have large enough markets domestically to produce at scale, and since they don’t produce enough products domestically to satisfy diverse demands. What this means is that exchange rate fluctuations have less of a macroeconomic impact on large countries than on small countries. Thus, large countries are more likely to adopt flexible exchange rates and small countries are more likely to adopt fixed exchange rates with their trading partners.