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Review Questions Table: Demand and Supply for Gloves
Use the supplied table, which gives U.S. supply and demand for gloves, to answer the following
question(s).
The United States can also import gloves from China at $4 per pair and from Mexico at $5 per
pair. Currently, the United States imposes a specific tariff of $2 on its glove imports. How much
trade in gloves is diverted in the U.S.-Mexican free-trade area? four pairs of gloves
The United States can also import gloves from China at $4 per pair and from Mexico at $5 per
pair. Currently, the United States imposes a specific tariff of $2 on its glove imports. Is the
United States better off or worse off in its trade in gloves following the free-trade agreement with
Mexico? It is worse off because trade diversion losses exceed trade creation gains.
The United States can also import gloves from China at $4 per pair and from Mexico at $5 per
pair. Currently, the United States imposes a specific tariff of $2 on its glove imports. Suppose
instead that the United States negotiated a free-trade agreement with China. Will the United
States be better off or worse off as a result of its trade in gloves in the free-trade area with China?
It is better off because there are no trade diversion losses.
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Last Time
Exchange Rate: the price of some foreign currency expressed in terms of the home currency.
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How are exchange rates determined? PPP
Scenario: Denmark produces 10 million Legos in 1999, France produces 100 million apples in 1999.
Assumption: Trading price: 1 Danish Lego = 1 French Apple
Law of One Price (LoOP): If the price of an apple is 1 orange in Denmark, the price of an apple is 1 orange is France
Purchasing Power Parity (PPP) for a basket of goods.
Why might LoOP/PPP not hold?
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The role of money
Scenario: Denmark produces 10 million Legos in 1999, France produces 100 million apples in 1999.
MD = L * PY
MS = Whatever the central bank prints out.
Assume L = 1
Danish Money Supply = 100 million kroner, French Money Supply = 200 mill Francs
Price of a Lego in Denmark?
Price of an Apple in France?
Exchange rate?
What if E = 6?
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Inflation
Scenario: Denmark produces 10 million Legos in 1999, France produces 100 million apples in 1999.
Danish Money Supply = 100 million kroner, France Money Supply = 200 mill D‐marks
PD1999= 10 kr /apple PF1999 = 2 Fr /apple
E1999 = 5 kr /Fr The Danish economy grows 10% between 1999 and 2000.
Denmark increases the money supply by 20%.
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Money and interest rates: Why do people demand money?
i
MD
M
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The Uncovered Interest Parity
Suppose you had 10 kroner, and you could put it in a Danish bank to get for 1 year to get back IDK>1, or exchange it at a rate of E1999 and invest it in France to get back IFR>1, then exchange it back to kroner at an expected exchange rate of E2000expected.
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Free capital mobility (free FDI possible)
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Nominal Anchors
Goal of Central Bank: small and constant Inflationary rate.
3 Anchors:
By definition:
 D  D  gD
PPP:  D  e2000  e1999   F
Free capital mobility:  D  i D  rw
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How does Denmark fix it's exchange rate?
Uncovered Interest Parity:
expected
i D  i F  e2000
 e1999
How to do it:
i
MD
M
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The trilemma
expected
i D  i F  e2000
 e1999
A country can not do all three of these things:
1. free cross‐border capital flows
2. fixed exchange rate
3. an independent monetary policy.
Real Life Questions
Which parts of the impossible trinity does Denmark give up?
Which parts of the impossible trinity does UK give up?
Which parts of the impossible trinity does Spain give up?
What is the difference between Spain and Denmark's set‐up?
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"A currency union increases bilateral trade by 30‐90%" ‐Rose and Stanley 2008
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Review Questions
Suppose that the United Kingdom pegs the pound to the euro. If all countries who use the euro
decided to adopt expansionary fiscal policies, what would you expect to happen to European
interest rates ? What would happen to European GDP?
Suppose that the United Kingdom pegs the pound to the euro and the European Central Bank
decides to use monetary policy to offset the possible inflationary effects of European
expansionary fiscal policy. Would it expand, contract, or not change the European money
supply? How would the European Central Bank's monetary policy affect European interest
rates?
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