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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. Lecture12Spring09 Page 1 Last Time Exchange Rate: the price of some foreign currency expressed in terms of the home currency. Lecture12Spring09 Page 2 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? Lecture12Spring09 Page 3 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? Lecture12Spring09 Page 4 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%. Lecture12Spring09 Page 5 Lecture12Spring09 Page 6 Money and interest rates: Why do people demand money? i MD M Lecture12Spring09 Page 7 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. Lecture12Spring09 Page 8 Free capital mobility (free FDI possible) Lecture12Spring09 Page 9 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 Lecture12Spring09 Page 10 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 Lecture12Spring09 Page 11 Lecture12Spring09 Page 12 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? Lecture12Spring09 Page 13 "A currency union increases bilateral trade by 30‐90%" ‐Rose and Stanley 2008 Lecture12Spring09 Page 14 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? Lecture12Spring09 Page 15