"ECON 3403 Problem Set 4 answers 1 Consider the following data situation for country A before and aft"
ECON 3403 Problem Set 4 answers 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 Barriers to trade 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).