Exchange Rate Problems

Exchange Rate Problems - University of North Carolina...

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Unformatted text preview: University of North Carolina Chapel Hill KenanFlagler Business School BA281 Microeconomics Practice Problem Set 4 Prof. Robert A. Connolly September 27, 2005 In this problem set, there are four separate opportunities for you to apply the reasoning discussed in the class meeting. They are arranged (approximately) in order from most conceptual to most computationally intense. Taken together, they give you some practice in the different ways to inject changing currency values into relatively standard microeconomics problems. Answers are available separately. Problem 1: Exchange Rates Affect Costs (or Do They?) HQP Inc.'s subsidiary in Germany conducts its business in Euros (). The subsidiary buys an input from the parent firm that is essential to the product, and constitutes 60 per cent of total costs. The other inputs are bought locally in markets where the supplying industries display long run increasing costs. The subsidiary has a number of local competitors who all produce essentially the same product with extremely similar costs and production methods. In your R&D/engineering group, you discover how to vary the production process to make vastly more efficient use of the input that your subsidiary buys from the parent firm. This improvement is a carefully and successfully guarded trade secret. a) In the shortrun, what happens to the ATC and MC of the subsidiary if the new process is implemented at a onetime cost of $600,000, an increase in fixed costs of about ten per cent? b) In the shortrun, what happens to the cost of the other inputs that the subsidiary buys locally? c) In the long run, the firm's planning group expects the Euro to depreciate from 1.0/$1 to 1.15/$1. Provide a short description (use a bullet point format) of the impact on local currency costs, prices, and profits of the FX rate depreciation. Assume the change in technology occurred at the same time. d) Using a bullet point format, describe the set of longrun adjustments that will occur given the change in technology and the exchange rate movement. (Treat this like the summary powerpoint slide that you might prepare for senior managers. Long, rambling answers are inappropriate for them and as an answer here.) 2 Problem 2: Exchange Rates Affect Industries (Don't They?) From the perspective of a Chilean firm exporting finished goods to the United States, prepare a welllabeled (marketlevel) diagram that shows the consequences for the quantity of Chilean exports to the United States market of Chilean Peso appreciation against the U.S. dollar. Use U.S. dollars to measure demand and supply, and assume the Chilean firm is producing an undifferentiated product. Repeat the exercise from the perspective of a representative American firm and comment on the factors that might determine the importance of a strong focus on cost control for the representative American firm. Problem 3: Exchange Rates Affect Optimal Prices (Don't They?) There is a group of Japanese customers who buy (firstclass only) tickets to fly from Tokyo to the U.S. Converted to U.S. dollars, the demand curve for Tokyobased firstclass passengers is given by Q fc = 225 - .25Pfc - .35(/$) where /$ indicates the yen/dollar exchange rate, Pfc is the price of firstclass seats in dollars, and Q fc is the number of firstclass seats being demanded. The marginal cost of transporting each passenger is constant at $100. a) Solve this demand curve for the inverse demand function and the associated marginal revenue schedule assuming first that the /$ rate is 85 and then under the assumption that the /$ rate is 130. b) Assume for the moment that the U.S. dollar price of firstclass tickets is determined in the usual way (i.e., the airline practices profit maximization). What will Tokyobased demand (and price) be for firstclass tickets at the two exchange rates that you used in part a)? c) Someone suggests that you have the method for answering part b) all wrong. The substance of their claim is that the optimal price (and therefore the quantity demanded) for firstclass seats must be solved simultaneously with the demand for coach tickets and it must be solved simultaneously for all customer groups. The demand for coach tickets on international flights is given by Pc = 600 - Qc where Pc is the price of coach seats in dollars and Qc is the number of coach seats being demanded. If the exchange rate is 130/$1, does this objection matter? d) Is the answer the same when the exchange rate is where 85/$1? Sketch out the method for solving the problem if it must be solved simultaneously. 3 Problem 4: Exchange Rates Affect Profits (or Do They?) Wolfgang Puck wants to expand his frozen food business to Canada. His preliminary analysis strongly suggests a sizable market for a new North America Premier (NAP) product exists among yuppies in Canada. The estimated aggregate demand curve for North American Premier in Canada is given by: C QNAP = 40 - 4 P where QNAP is in millions and P is in Canadian dollars. For this new product, the total U.S. dollar cost of production is given by C C = .5Q + .15Q 2 C where Q = QNAP and NAP is made exclusively in the United States. Q is measured in millions. The current exchange is (Canadian Dollar) C$1.3517/$. a. Write the cost functions (TC, AVC, ATC, and MC) in C$ terms. (Hint: multiply the lefthand side of the cost function by the exchange rate so that the units in which costs are measured are Can$. Then apply the same arithmetic to the righthand side.) b. Next, write the demand curves for Canadian demand in $ terms. (Hint: multiply the number in front of the price term in the demand curve by the exchange rate; this is the same trick for currency conversion as you just used on the cost functions.) c. For the Canadian market, find the profitmaximizing price and quantity measured in local currency. d. Compute the U.S. dollar price of North American Premier and the U.S. dollar value of profits in the Canadian market. e. Using the U.S. dollardenominated Canadian demand and cost functions used above, compute the U.S. dollardenominated price, and profits in the Canadian market. Compare these answers to those you computed in answering part d. Can you explain this outcome? f. As you are completing your analysis, Moody's downgrades Canadian government bonds. The resulting crisis of confidence hammers the Canadian currency to new lows against the US dollar: C$1.5545/US$1. Since there is little prospect the Canadian dollar will recover any time soon, Wolfgang wants to know whether your original assessments of profitability in the Canadian market will change in any consequential way. Please show Wolfgang how the profits of his proposed Canadian operations will change. Specifically, what does foreign currency depreciation do to the home currency value of foreign sales? (Hint: assume the currency movement does not change the relative demand for domestic and foreign goods in Canada. That is, you may assume that Canadian consumers do not feel as though their real income has changed, and, thus, the aggregate demand curve measured in C$ has not shifted.) ...
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