Country 1 produces good X, and country 2 produces good Y. People in both countries begin to demand more of good X and less of good Y.
Country 1 produces good X, and country 2 produces good Y. People in both countries begin to demand more of good X and less of good Y. Assume that there is no labor mobility between the two countries and that a flexible exchange rate system exists. What will happen to the unemployment rate in country 2? Explain.
The flexible exchange rate is the rate set by the forces of demand and supply of the currencies in the foreign exchange market.
Any change in the value of Country 1A's currency depends on the currency of Country 2B under a flexible exchange rate. If the good X produced by Country 1A is demanded by both the countries, 1A and 2B, Country 2B will exchange the currency with Country 1A to buy good X. As the demand for currency increases when the demand for goods increases, Country 2B will supply more currency to Country 1A. This will cause the currency of Country 1A to appreciate and that of Country 2B to depreciate.
As Country 1A's currency appreciates, its domestic goods will become relatively more expensive for Country 2B, which will reduce the demand for good X. Since Country 2B's goods become relatively cheaper for Country 1A, they will demand more of good Y. This increased demand for good Y of Country 2B will increase the employment rate as they will hire more workers to sell more goods. The bad economic times in Country 2B due to the initial rise in the unemployment rate because of the fall in demand for good Y will fade away.
If the labor is immobile, there will be changes in relative demand under a flexible exchange rate due to which there be an initial rise in unemployment and decline in the long run.