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Unformatted text preview: ECN 162 International Economic Relations Ina Simonovska Practice Midterm 2 Thursday, November 5 Part I: Multiple Choice Questions Choose the best answer. Explanation is not required. 1. Tariffs and quotas tend to be similar in their domestic welfare effects (a) if quota licenses are given to foreigners. (b) if quota license are auctioned. (c) if quota licenses are given to domestic firms. (d) Both (b) and (c). University of California - Davis Fall 2009 2. __________ are a form of regional integration where member countries lower internal trade barriers but maintain existing barriers against nonmembers. (a) Customs unions (b) Free trade areas (c) Reciprocal trade agreements (d) None of the above. 3. The European Union (EU) is an example of a (a) customs union. (b) free trade area. (c) reciprocal trade agreement. (d) None of the above. 4. __________ is said to exist when the formation of a regional trading group leads to the reduction of trade with nonmember countries in favor of member countries. (a) Trade creation (b) Trade diversion (c) Trade exclusion (d) Trade distortion 5. __________ is said to exist when the formation of a regional trading group leads to an expansion of trade above pre-group levels. (a) Trade creation (b) Trade diversion (c) Trade exclusion (d) Trade distortion 6. The domestic currency is said to be if it has appreciated at a lower rate than the difference between the domestic inflation rate and the higher foreign inflation rate. (a) undervalued in the PPP sense (b) overvalued in the PPP sense (c) appreciated (d) risky 1 7. A tariff can __________ raise a country’s welfare (a) never (b) sometimes (c) always 8. Like tariffs, quotas tend to lead to (a) higher prices and reduced imports. (b) increased government revenue. (c) increased consumer surplus. (d) All of the above. 9. __________ are profits that accrue to whomever has the right to import the quota restricted good. (a) Quota licenses (b) Quota rents (c) Quota prices (d) None of the above. 10. Given that real interest rates are constant, an increase in the expected rate of inflation will tend to (a) decrease the nominal rate of interest. (b) increase the nominal rate of interest. (c) cause lower inflation rates. (d) cause no change in the nominal rate of interest. 11. If you as a lender expect the real interest rate of 4% from making a loan and you set the nominal interest rate at 9%, then (a) you will benefit from this loan if the actual inflation rate turns out to be 14%. (b) your expected rate of inflation is 5%. (c) your expected rate of inflation is 13%. (d) you will be worse off if the actual inflation rate turns out to be 4%. Answer questions 12-13 based on the following diagram. 2 12. The quota restricts trade by the same amount as a tariff of (a) $20. (b) $30. (c) $50. (d) Cannot answer without more information. 13. Quota rents equal (a) $2000. (b) $5000. (c) $6000. (d) $10000. Answer 14-17 based upon the following diagram which depicts country A's market for its importable. 14. If A imposes a per unit tariff of $10 on imports from both B and C, it will import (a) 40 units from B. (b) 10 units from C. (c) 40 units from each. (d) 40 units from B and 10 units from C. 15. If A forms a customs union with B, the quantity of trade creation will be (a) 100 units. (b) 60 units. (c) 40 units. (d) 30 units. 16. Domestic producers of this product in A would most prefer (a) a customs union with C. (b) a customs union with B. (c) a free trade agreement with both B and C. (d) no agreement with either country. 17. Domestic consumers of this product in A would most prefer (a) a customs union with C. (b) a customs union with B. (c) a free trade agreement with C. (d) no agreement with either country. 3 Part II: Problems 1. Answer the questions based upon the following diagram (assume the small country case). a) What is the autarky price and quantity exchanged? Autarky price = $25. Quantity exchanged = 25,000 units. b) Suppose the world price of this good is $10. With free trade, calculate the total quantity of imports. 60,000-10,000 = 50,000 units. c) With the tariff of $5 per unit, calculate quantity of imports. 42,000 – 12,000 = 30,000 units. d) With the above tariff, how much will the government be able to collect as tariff revenue? $5 * 30,000 = $150,000 e) Calculate the deadweight cost of the tariff and illustrate it on the above diagram. DWL= ½* 2,000* $5 + ½* 18,000* $5= 5,000 + 45,000 = $50,000 f) If instead of a tariff, the government restricts trade by imposing a quota. What is the amount of quota that would produce the same effects on the amount of imports as the above tariff? The Quota of 30,000 units. 2. The 1-year interest rate on Swiss francs, , is 5 percent and the dollar interest rate, Use the uncovered interest parity relationship to answer the question below. If the current $/SF spot rate is $0.60, what would you expect the spot rate to be in 1 year? Answer: , is 8 percent. 4 3. Suppose in Zurich £/$ = 0.5, while in New York SF/$=2.5, but in London £/SF = 0.19. (a) Is there any arbitrage profit that could be made with a triangular arbitrage action? If so, describe an example of how such a profit may be earned. Start with either buying or selling SF 1 million in London. Buy SF 1 million in London for £190,000 Use it to buy $ in New York, so that SF 1m = $400,000. Buy pounds in Zurich so that $400,000 = £200,000 200,000 - 190,000 = £10,000 profit (b) What would you guess about the relationship between the dollar rates and cross-rates after arbitrageurs notice this profit opportunity? We expect the gap between rates to close as arbitrageurs buy pounds in Zurich and sell in London through the New York market, i.e., the relationship between rates is restored where cross-rates yield no potential profit. 4. Suppose we observe the following 1-year interest rates: Euro $ = 15% Euro SF = 12% The exchange rate is quoted as the dollar price of Swiss francs and is currently E = 0.40. (a) Given the information above, use the covered interest parity relationship to calculate the 12-month forward rate? 1.15 /1.12 = F/.40, F = 0.4107. (b) Suppose the actual 12-month forward rate is not what you found from (a), but instead is $0.42. What would profit-seeking arbitrageurs do? Buy SF, invest in SF and sell SF for dollars via forward. 5 Part III: Short Essay Questions 1. What are the main reasons for deviations from PPP? Give, at least, 2 reasons with a short explanation. • • • • • • • the presence of non-traded goods prices in price indexes financial asset prices adjust faster than goods prices due to the slow adjustment in goods markets relative price changes different consumption bundles across countries differentiated goods shipping costs, tariffs news, unexpected events 2. Briefly answer the following questions. (a) What is a foreign currency option? Is there any difference between a European and American option? The right to buy or sell a designated quantity of a foreign currency at a specified price is called an option. If the option can be used anytime before the expiration date, it is an American option; if only on the expiration date, it is a European option. (b) When can a gain be made by the holder of a call option? A put option? A gain can be made by the holder of a call option any time the exchange rate exceeds the exercise price. Similarly, the holder of a put option will gain if the option is exercised at any rate below the striking price. 3. Using the monetary model of exchange rate determination, discuss the consequences of the following events on the exchange rate Ehome/foreign. Hint: Use the equilibrium condition derived in class for the dollar/euro market. (a) The foreign inflation rate increases. Mu_foreign increases. Dollar appreciates. (b) A natural disaster destroys a significant fraction of domestic industry and therefore destroys productive capacity. G_us fall and the dollar depreciates. 4. Consider the foreign exchange market between Japanese yen and U.S. dollar. Suppose that the Japanese government decides to raise interest rates in Japan by reducing Japanese money supply. What happens to the yen/dollar exchange rate, Eyen/dollar? Mu_japan falls and yen appreciates. 5. Suppose that the domestic demand and supply for shoes in a small open economy are given by P = 100 - 2Q P= 4+Q (demand) (supply) where P denotes price and Q denotes quantity. Illustrate them on the demand and supply a) What are the autarky price of shoes and quantity produced? diagram for shoes. Solve 4+Q = 100-2Q →Q = 32 → P = $36. 6 Make sure to label the intercepts as well as the equilibrium P and Q on the above graph!!! b) What are the levels of domestic production, consumption, and imports if the world price is 10? Illustrate them on the demand and supply diagram for shoes. To find domestic production, use the domestic supply equation evaluated at the price of $10. 10 = 4 + Q → Q1 = 6 ; domestic production = 6 To find domestic consumption, use the domestic demand equation evaluated at the price of $10. 10 = 100 - 2Q → Q2 =45 ; domestic consumption = 45 Imports = domestic consumption – domestic production = Q2 -Q1= 45-6 = 39. (demand) (supply) 7 c) Use the diagram you drew in part b) to prove that the country is better off with free trade. Hint: You need to show the net welfare change of a move to free trade. Net welfare change = the sum of the change in consumer surplus and the change in producer surplus. You do not need to calculate anything. Indicating the area of each object is enough. 8 A move to free trade increases consumer surplus by $(a+b+c) but decreases producer surplus by $a. Thus, national welfare improves by $( b+c) with free trade. Gains from free trade (imports side) – the market for an importable ∆CS ∆PS ∆Welfare $(a+b+c) (better off) -$a (worse off) $(b+c) d) What are the levels of domestic production , consumption , imports , and government revenue if this country were to impose a specific tariff of $2? With a specific tariff of $2, the domestic price = free trade price + $2 = $12. At this price, we can calculate domestic production, consumption and imports. Domestic production (using the supply curve) = 8; Domestic consumption (using the demand curve) = 44; Imports = 36; Government Revenue = imports * tariff per unit = 36*$2 = $72. e) In a separate diagram, illustrate the effect of the import tariff in part d) on the society’s net welfare i.e. illustrate the net welfare change of a move from free trade to trade with tariff . 9 A specific Tariff = $t ∆ imports does not affect the world price as it is an economically small country. ∆CS ∆PS ∆Govt Revenue ∆Welfare -a -b -c-d a c -b -d The economy as a whole has lost $(b+d) - the deadweight Cost of the tariff. Since the amount goes to no one. It is economic waste. f) Calculate the deadweight cost of the tariff in part d) (if there is any) . (1/2 * 2* 2) + (1/2 * 2*1) = $3 6. Answer questions below based upon the following information about country A's market for its importable. Country A’s supply curve: Country A’s demand curve: where denotes price and denotes quantity 10 Suppose that country C would be willing to export the product to A for $15 per unit, while country B, the low-cost world producer, is willing to export at a price of $10 per unit. A per unit tariff of $10 on imports from both B and C will be considered. a) Illustrate this market in country A on a demand and supply diagram. (Please show all the intercepts.) Let the lines SB and SC denote the export supply curves to A’s market from countries B and C, respectively. Similarly, let the lines (SB + tariff) and (SC + tariff) denote the domestic price of the product imported from countries B and C if the above tariff is imposed, respectively. b) Under free trade, from whom will country A import this product? How many units will it import and what will be the domestic price of this product in country A? 100 units from B. $10 per unit. c) If A imposes a per unit tariff of $10 on imports from both B and C, from whom will it import this product? How many units will it import and what will be the domestic price of this product in country A? A still imports from B. The domestic price goes up to $20 so it will import 40 units. d) If A forms a customs union (CU) with C, from whom will it import this product? How many units will it import and what will be the domestic price (the post agreement price) of this product in country A? A will import 70 units from C. The domestic price will be $15. e) If A forms a customs union with C, what will be the quantity of trade creation? Hint: Determine the increase in the volume of trade (in units of the product) from part c) to d). 30 units. 11 f) Use the diagram you drew in part a) or you can draw a new diagram to illustrate A’s welfare change from the CU with C. According to my diagram, if A forms a customs union with C, A's welfare will change by $a + $e - $h - $i - $j g) What will be the value of trade diversion if A forms a customs union with B, the low-cost world producer? $0. No trade diversion. 12 ...
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- Winter '09