Final answer:
Reducing a tariff on an imported item under a flexible rate of exchange system usually increases the equilibrium quantity of imports and decreases the equilibrium price of those goods due to lower additional costs. The impact on the exchange rate depends on various factors and may lead to currency appreciation due to increased demand for foreign currencies.
Step-by-step explanation:
Under a flexible rate of exchange system, when a country reduces a tariff on a major imported item, several economic outcomes can be expected. Firstly, the reduction in tariffs causes the equilibrium quantity of imports to increase because the imported goods become cheaper for domestic consumers. As a result, domestic demand for these imports rises. Consequently, with increased demand, foreign producers are encouraged to export more, resulting in a higher volume of imports.
Simultaneously, the decrease in tariffs leads to a decrease in the equilibrium price of the imported goods. This occurs because the reduction or removal of the tariff eliminates the additional costs that were previously included in the final selling price of the imported goods, making them more affordable for consumers in the importing country.
In the context of exchange rates, a lowering of tariffs can potentially lead to an appreciation in the domestic currency's value if it increases demand for foreign currencies—a phenomenon necessary to purchase the now cheaper imports. However, the actual impact on the exchange rate would also depend on a multitude of factors, including the country's trade balance, foreign investment flows, and market speculation.
Therefore, while a tariff reduction is expected to boost imports and reduce their prices, the effects on the exchange rate can be more complex and would vary by situation. It's important to consider that trade policies and exchange rates are intertwined, and adjustments in one can have ripple effects on the other.