# ECON 3403 Problem Set 4 answers 1 Consider the following data situation for country A before and aft

### Pages to are hidden for

"ECON 3403 Problem Set 4 answers 1 Consider the following data situation for country A before and aft"

```					                                                ECON 3403

1.   Consider the following data situation for country A before and after it forms an FTA with B:
Pre-FTA
Imports from C              100 mil. units
Imports from B              0 units

Post-FTA
Imports from C              0 units
Imports from B              270 mil. units

How much trade was diverted by this agreement? Since 100 million units are no longer exported
from country C, they have been diverted. How much trade was created? There are now 270
million units coming from B, so the difference (270-100) = 170 mil units make up the trade
created. Suppose C charges \$5 for this product and B charges \$6. Suppose that A’s original tariff was
\$2 per unit. Calculate the welfare gain or loss to A from forming this FTA. It is useful to draw a
graph to do the welfare calculations. The net loss is \$15 million.

2.   Describe two ways in which a representative trying to please the majority of her constituents (i.e. the
median voter model) may fail to vote for the efficient outcome (i.e. that which raises net welfare).
There are a many ways (e.g. intensity of preferences, free-riding).

3.   Explain how voter apathy and rational ignorance (which lead to free-rider problems among voting
groups) can result in the existence of sub-optimal trade policies such as tariffs and quotas.
You could briefly discuss the basics of rational ignorance and voter apathy and then show the
result in #10.

4.   Given below are two groups’ (consumers, c, and a special interest group, i) true demands concerning a
tariff on snack foods.
Demand against (consumers): wtp(\$)  100  2t
Demand for (special interest): wtp(\$)  60  t
Where t is the tariff rate.

a.   Graph the demand curves and explain how much tariff there will be if there were no free
riding and all preferences were fully revealed. Shown below.

b.   Now assume that free riding plagues the consumer group so that their revealed willingness to
pay is given by: wtp(\$)  40  t . Now what will be the equilibrium tariff rate? Graph this
scenario in the same graph.
\$                                                                     Dagainst

100

DagainstR
60

50

40                                                                  Dfor

10                                                           t%

a.   t* = 0 when demands are fully revealed
b.   t* = 10% when there is free riding in the consumer group

5.       Create an example of automobile prices in London and New York where PPP holds. Assume initially
that the exchange rate is \$2 per pound, and a particular car sells for \$20,000 in New York and 10,000
pounds in London. Create new prices and a new exchange rate that will yield PPP.
If the exchange rate is \$2/pound and the car sells for \$20,000 in NY and 10,000 pounds in
London, then PPP holds to begin with. A change where PPP still holds would be \$1.50/pound,
the price drops in NY to \$15,000 and stays 10,000 pounds in London.

6.       A U.S. resident can earn 6% interest on a one-year bank deposit of \$100,000 at home. Alternatively,
she can convert her dollars into Bulgarian Lev and earn 4% on a one-year deposit in Bulgaria. If the
exchange rate is initially, 1.5 lev per dollar and then changes to 1.45 lev per dollar in one year, which
deposit would have given her a higher return?

The US deposit would leave \$106,000 at the end of a year. To invest in Bulgaria, the \$100,000
must be converted to 150,000lev, which would then earn 4% or 6,000lev, leaving 156,000lev at
the end of the year. After the exchange rate change the 156,000lev would be worth
156,000/(1.45lev/\$) = \$107,586. So the Bulgarian investment is better.
7.    Suppose one pound = \$1.626 in New York, \$1 = 6.828 Chinese Yuan in Paris, and 1 Yuan = 0.10
pounds in London.
a. If you begin by holding 1 pound, then how could you profit from these exchange rates? By first
buying dollars, then Yuan, then pounds again.
b. Ignoring transaction costs, what is your arbitrage profit per pound initially traded? You will make
0.11 pound profit per pound initially traded.

8.  Suppose the spot exchange rate changes from 0.68 \$/£ to 0.63 \$/£. Which currency has appreciated?
Answer the same question for the following: 135 yen/\$ change to 143 yen/\$.
The dollar appreciates in both examples.

9.    In the following examples, is the dollar selling at a premium or a discount?
Spot                       90-day
a. \$/pound = 1.77               \$/pound = 1.78 discount
b. \$/yen = .004                 \$/yen = .005       discount
c. \$/DM = .40                   DM/\$ = 2.50        neither
d. CNY/\$ = 6.60                 \$/CNY = .15        premium
e. \$/SF = .51                   SF/\$ = 1.94        discount

10. Depicted below is a foreign exchange market between dollars and Swedish Kroner (Kr). The price of
which currency is on the vertical axis? The kroner. How many Kr and how many dollars are traded
in equilibrium at point A? 10 bil. kroner and 6 bil. dollars.

\$/Kr                                S0

S1

A             C
.60

.50                       B

10b    12b    14b              Kr

11. In the same diagram is drawn a rise in the supply of Kroner. What would happen to the exchange rate?
It falls to \$0.50. If the Swedish central bank chose to prevent this and to fix the exchange rate at the
old level, how many Kroner would it have to buy or sell? Buy 4 billion kroner. How many dollars?
Sell 2.4 billion dollars.

12. For what type of goods should the law of one price hold well (this is absolute PPP)? Homogeneous
goods that are freely traded internationally.
13. List four reasons why deviations from PPP might occur; then explain briefly why each reason causes
such deviations. e.g.:
Transportation costs
Relative price changes
Exchange rates adjusting faster than the price level
Non-traded goods are factored into prices indexes

14. Suppose at the beginning of the year, a CD sells for BRL60 in Brazil and AWG20 in Aruba, and PPP
holds. Over the year, there is an inflation rate of 33% in Brazil and no inflation in Aruba. What
exchange rate would maintain PPP at the end of the year?

Initially the exchange rate must be BRL3/AWG. After 33% inflation the CD will sell for BRL80
so the new exchange rate must be BRL4/AWG (or AWG.25/BRL).

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 130 posted: 12/7/2010 language: English pages: 4
Description: Car Sells Agreement document sample