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 domestic 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.
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, i.e. it shows how much output an economy receives relative to wages, or labor cost per unit of output, it serves as labor productivity indicator. An increase in unit labor costs will result in a reduction in profitability unless a firm can pass along higher labor costs to its customers. Economists view increases in unit labor costs as an important indicator of potential inflation.
b) How has the real exchange rate between France and Germany developed (France=Home Country)?
The real exchange rate is the price of France goods in terms of German goods. Because we assume that the unit labor costs are an equivalent of the price level that means that France price level was increasing faster than German price level. Because of faster increasing in the price level, France real exchange rate (to German) was increased 16 percentage points in period between 1998 and 2008. Also answer can be formulated: Real exchange rate (France=Home Country) has increase (0.04/0.20*100) 20% in period between 1998 and 2008. This means that French goods are 20% more expensive relative to German goods 2008 than they were in 1998. Real appreciation in that period was 20%.
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.
Yes, there is connection between France's real appreciation (development of the real exchange rate) and the net exports.
French real appreciation affects the net export through tree separate channels: Export, X, decrease; Import, IM, increase; the relative price of foreign goods in terms of domestic goods, I/e, decrease. The real appreciation has made French goods relatively more expensive abroad. This has led to a decrease in German demand for French goods - Decrease in France's export. Also real appreciation has made German goods relatively less expensive in the France. This has led to shift in domestic demand (France=Home Country) toward foreign goods and to increase in quantity of import. France real appreciation has caused that same quantity of import cost less to buy (in terms of domestic goods).
The appreciation had led to a shift in demand, both foreign and domestic, toward foreign goods. This shift in demand had led in tum to both a decrease in domestic output and deterioration in the trade balance (this is without looking at dynamics because real appreciation leads initially an improvement and then to a deterioration of the trade balance, The J-curve). End result is that France's net exports with Germany have decreased (trade deficit increased) in that period.
The condition under which a real depreciation (appreciation) leads to an increase (decrease) in net exports is known as the Marshall-Lerner condition. If it is satisfied, a real depreciation (appreciation) leads to an improvement (deterioration) in the trade balance.
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 domestic 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?
We think that French Minister asked Germany to boost the domestic demand, because this might affect the Germany to import more foreign goods (from France), (higher income leads to higher imports, = higher German income leads to higher French exports to Germany, and higher German import). Germany can boost domestic demand by increasing G (government spending).
Than the aggregate demand increases and the multiplier effect states that the increase in output is greater than the increase in government spending. This will cause Germany to import more, so French exports will increase.(Causing the French trade deficit to decline)
French exports will go up; this will lead to a higher French output and the higher domestic demand for goods through the multiplier effect as well. Consumption in France will probably increase. Government spending will not change. So, what will happen is: French exports will increase but also this will lead to higher imports demanddue to fact that French output went up. (Causing the foreign trade deficit to rise a bit)
The demand for imports rises because French output rises, but not as much as the increase in exports. So if the trade was balanced on beginning, this would lead to trade surplus. But we know the trade between France and Germany wasn't balanced, so most likely this situation will improve trade balance, but it will not go in surplus, we believe it will remain in deficit.