Purchasing Power Parity is most reliable as a predictor of exchange rates over:

The long run, acting as an anchor rather than a short-run predictor

Only under a fixed exchange-rate regime

Covered interest parity holds the interest-rate/exchange-rate relationship using:

A fixed exchange rate set by law

Triangular arbitrage in the foreign exchange market ensures that:

Exchange rates between any two currencies stay consistent with their rates against a third currency

Only one currency can exist at a time

The Prebisch-Singer hypothesis argues that primary-commodity exporting countries face:

A permanent rise in their terms of trade

No relationship at all between exports and terms of trade

The transition from GATT to the WTO in 1995 chiefly added:

A permanent institutional structure, a binding dispute-settlement mechanism, and coverage of services and intellectual property

The complete abolition of all tariffs worldwide

The end of regional trade blocks

Which of the following are true of gains from trade in standard trade theory?

Gains from exchange arise on the consumption side even without any change in production

Gains from specialisation arise from reallocating resources toward the comparative-advantage good

Trade always expands a country's consumption possibilities beyond its production possibility frontier

Gains from exchange arise on the consumption side even without any change in production

Gains from specialisation arise from reallocating resources toward the comparative-advantage good

Trade always expands a country's consumption possibilities beyond its production possibility frontier

Only large countries can gain from trade

Exchange Rates, Gains from Trade and the Terms of Trade, and Trade Policy and Institutions

This chapter closes Unit 5 with exchange-rate theory and the foreign exchange market, the measurement of gains from trade and the trade multiplier, and the instruments and institutions of trade policy.

1. Exchange Rate: Concepts and Theories

The Purchasing Power Parity (PPP) theory says the equilibrium exchange rate between two currencies should equal the ratio of their price levels, so that a representative basket of goods costs the same everywhere once converted to a common currency (absolute PPP), or that exchange-rate changes should track the DIFFERENCE in the two countries' inflation rates over time (relative PPP). The Interest Rate Parity condition links exchange rates to interest-rate differentials: uncovered interest parity says the expected depreciation of a currency should equal the interest-rate differential in favour of the other currency (arbitrage equalises expected returns across currencies), while covered interest parity holds this relationship using the FORWARD exchange rate, eliminating exchange-rate risk through a forward contract.

⚠️ PPP explains long-run trends, not short-run exchange-rate movements

PPP notoriously fails as a short-run predictor because it ignores capital flows, non-traded goods and services, transport costs and trade barriers, all of which drive short-run exchange-rate movements far more than relative price levels do; it works best as a LONG-RUN anchor around which the actual (nominal) exchange rate fluctuates. A question describing PPP as failing empirically in the short run is not describing a flawed theory but a correctly scoped one.

2. Foreign Exchange Market and Arbitrage

Arbitrage in the foreign exchange market is the riskless simultaneous purchase and sale of a currency (or a chain of currencies) to profit from a price discrepancy, and its very availability is what keeps exchange rates consistent across markets. TRIANGULAR ARBITRAGE checks that the exchange rate between any two currencies is consistent with their rates against a third currency — if converting currency A to B to C and back to A yields more A than one started with, an arbitrage opportunity exists, and the very act of exploiting it (buying where cheap, selling where dear) pushes the three rates back into consistency, closing the opportunity almost immediately in a liquid market.

3. Gains from Trade, Terms of Trade and the Trade Multiplier

The Terms of Trade (ToT) index measures the ratio of a country's export prices to its import prices (× 100); a RISING ToT means a country earns more imports per unit of exports (favourable), while a FALLING ToT means it must export more to buy the same imports (unfavourable) — the Prebisch-Singer hypothesis famously argued that primary-commodity exporters (typically developing countries) face a long-run SECULAR DECLINE in their terms of trade relative to manufactured-goods exporters. The trade (foreign-trade) multiplier extends the closed-economy multiplier to an open economy: because part of each round of induced spending now leaks abroad through imports (the marginal propensity to import, MPM), the open-economy multiplier 1/(MPS + MPM) is SMALLER than the closed-economy multiplier 1/MPS — an additional leakage that dampens the domestic expansionary effect of any autonomous spending increase.

ℹ️ Note

Gains from trade are conventionally decomposed into the GAINS FROM EXCHANGE (the pure consumption-side benefit of trading at world relative prices even with no change in production, moving to a preferred point on the existing production-possibility frontier's price line) and the GAINS FROM SPECIALISATION (the additional production-side benefit of reallocating resources toward the comparative-advantage good once trade is possible) — the two together are what standard trade-theory diagrams decompose when showing a country's consumption possibility frontier expanding beyond its production possibility frontier.

4. Tariffs, Non-Tariff Barriers and Trade Institutions

A tariff (import duty) raises the domestic price of the imported good above the world price, protecting domestic producers, raising government revenue, but creating a DEADWEIGHT LOSS — a net loss to national welfare from both a production-side inefficiency (resources drawn into now-artificially-competitive domestic production) and a consumption-side inefficiency (consumers priced out of units they valued above the true world cost). Non-tariff barriers — quotas, technical/sanitary standards, licensing requirements, local-content rules — achieve similar protective effects without directly raising government revenue, and a quota is generally considered MORE distortionary than an equivalent tariff because it caps quantity rigidly regardless of how demand or supply conditions later change. DUMPING is selling a good in a foreign market below its price at home (or below cost), and anti-dumping duties are the standard WTO-sanctioned response once dumping and resulting injury are established.

GATT to WTO — the General Agreement on Tariffs and Trade (1947) governed multilateral trade rules through successive negotiating 'rounds'; the World Trade Organization (1995, the Uruguay Round's outcome) succeeded it with a permanent institutional structure, a binding dispute-settlement mechanism, and expanded coverage to services (GATS) and intellectual property (TRIPS), not just goods.
Regional trade blocks — free trade areas, customs unions and common markets are progressively deeper forms of regional integration (removing tariffs among members; a customs union additionally imposes a common external tariff; a common market additionally allows free factor mobility), each raising the classic trade-creation-versus-trade-diversion question about whether regional integration is a stepping stone to, or a substitute for, global free trade.

Key takeaways

PPP predicts exchange rates from relative price levels but works only as a long-run anchor; uncovered and covered interest parity link exchange-rate expectations to interest-rate differentials.
Triangular arbitrage keeps cross-currency rates internally consistent; any inconsistency is a riskless profit opportunity that self-corrects almost instantly in a liquid market.
A rising terms-of-trade index favours a country; the Prebisch-Singer hypothesis argues primary-commodity exporters face secular ToT decline; the open-economy trade multiplier 1/(MPS+MPM) is smaller than the closed-economy multiplier due to import leakage.
Gains from trade decompose into gains from exchange (consumption-side) and gains from specialisation (production-side); tariffs create deadweight loss and quotas are generally more distortionary than an equivalent tariff.
GATT (1947, rounds-based) gave way to the WTO (1995, permanent institution, binding dispute settlement, covers goods/services/IP); regional trade blocks range from free trade areas to common markets, raising the trade-creation-versus-diversion question.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Purchasing Power Parity is most reliable as a predictor of exchange rates over:
1. The long run, acting as an anchor rather than a short-run predictor
2. The short run only
3. Never, under any horizon
4. Only under a fixed exchange-rate regime
Show answer
Answer: A — The long run, acting as an anchor rather than a short-run predictor
PPP ignores capital flows, non-traded goods, transport costs and trade barriers, all of which dominate short-run exchange-rate movements; it performs best as a long-run anchor rather than a short-run forecasting tool.
Covered interest parity holds the interest-rate/exchange-rate relationship using:
1. The forward exchange rate, eliminating exchange-rate risk through a forward contract
2. A fixed exchange rate set by law
3. No exchange rate at all
4. The gold standard only
Show answer
Answer: A — The forward exchange rate, eliminating exchange-rate risk through a forward contract
Covered interest parity uses the forward rate to hedge exchange-rate risk while uncovered interest parity relies on the EXPECTED future spot rate, carrying exchange-rate risk — the distinction between the two hinges exactly on this hedging feature.
Triangular arbitrage in the foreign exchange market ensures that:
1. Exchange rates between any two currencies stay consistent with their rates against a third currency
2. Only one currency can exist at a time
3. Interest rates are always zero
4. Trade barriers are eliminated
Show answer
Answer: A — Exchange rates between any two currencies stay consistent with their rates against a third currency
If converting currency A to B to C and back to A yielded a profit, arbitrageurs would exploit it until the three cross-rates realigned — this self-correcting mechanism is what keeps currency markets internally consistent.
The Prebisch-Singer hypothesis argues that primary-commodity exporting countries face:
1. A long-run secular decline in their terms of trade relative to manufactured-goods exporters
2. A permanent rise in their terms of trade
3. No relationship at all between exports and terms of trade
4. Automatic industrialisation
Show answer
Answer: A — A long-run secular decline in their terms of trade relative to manufactured-goods exporters
The Prebisch-Singer hypothesis is the standard structuralist argument used to justify import-substitution industrialisation policy in developing economies during the mid-20th century, based on this predicted secular decline.
The open-economy trade multiplier 1/(MPS+MPM) is smaller than the closed-economy multiplier 1/MPS because:
1. Part of each round of induced spending leaks abroad through imports (MPM), on top of the leakage into saving
2. Exports are always zero
3. The government always runs a surplus
4. Interest rates are fixed at zero
Show answer
Answer: A — Part of each round of induced spending leaks abroad through imports (MPM), on top of the leakage into saving
Adding an import leakage to the denominator (MPS+MPM instead of just MPS) shrinks the multiplier, since a larger fraction of each round of new income now escapes the domestic spending stream rather than being re-spent at home.
A quota is generally considered more distortionary than an equivalent tariff because:
1. It caps quantity rigidly regardless of later changes in demand or supply conditions
2. It always raises more government revenue than a tariff
3. It has no effect on domestic price
4. It is banned by every country
Show answer
Answer: A — It caps quantity rigidly regardless of later changes in demand or supply conditions
Because a quota fixes quantity directly, it cannot adjust as market conditions change the way a tariff (which lets quantity respond to price) can, and it also typically transfers the scarcity rent to quota-holders rather than to government revenue.
The transition from GATT to the WTO in 1995 chiefly added:
1. A permanent institutional structure, a binding dispute-settlement mechanism, and coverage of services and intellectual property
2. The complete abolition of all tariffs worldwide
3. A single global currency
4. The end of regional trade blocks
Show answer
Answer: A — A permanent institutional structure, a binding dispute-settlement mechanism, and coverage of services and intellectual property
GATT was a rounds-based agreement with no permanent institution behind it; the WTO, the Uruguay Round's outcome, added a standing institution, binding dispute settlement, and extended the rules beyond goods to services (GATS) and intellectual property (TRIPS).
Which of the following are true of gains from trade in standard trade theory?
1. Gains from exchange arise on the consumption side even without any change in production
2. Gains from specialisation arise from reallocating resources toward the comparative-advantage good
3. Trade always expands a country's consumption possibilities beyond its production possibility frontier
4. Only large countries can gain from trade
Show answer
Answer: A — Gains from exchange arise on the consumption side even without any change in production; B — Gains from specialisation arise from reallocating resources toward the comparative-advantage good; C — Trade always expands a country's consumption possibilities beyond its production possibility frontier
The first three correctly describe the standard decomposition and consequence of gains from trade; country size is irrelevant to whether gains from trade exist — even a small country gains, as comparative advantage requires no size assumption.
Name the practice — selling a good in a foreign market below its home-market price or below cost — that anti-dumping duties are designed to counter.
Numerical answer — type the value.
Show answer
Answer: dumping
Dumping is the standard name; anti-dumping duties are the WTO-sanctioned remedy once dumping and resulting material injury to the importing country's industry are established.