Assume now that the world consists of only two countries: Brandtlandia and Hollandia. Every year many...

Assume now that the world consists of only two countries: Brandtlandia and Hollandia. Every year many tourists visit each other’s countries. The only other good Brandtlandia imports is tulip bulbs. Brandtlandia uses the Thaler as currency, and Hollandia the Florin.

The policy options in Brandtlandia are copied here for your convenience.

Policy 1: Open the economy to trade with no trade protection.

Policy 2: Open the economy to trade but impose a tariff on the import of tulip bulbs that would set the price of tulip bulbs to 40 Thaler per tulip bulb.

Policy 3: Open the economy to trade but limit imports to a quota of 15 tulip bulbs.

Brandtlandia currently uses policy option 1, the equilibrium exchange rate (e) is 0.50 Florin for 1 Thaler (and this is the exchange rate notation you need to use for this question).

a. (4 points) If Brandtlandia implements policy option 2, what will be the initial effect on the exchange rate if the exchange rate is flexible? Explain your answer.

b. (5 points) Suppose that the central bank of Hollandia wants to offset the effect of policy option 2 on the exchange rate. How would it do so? What might be the reasons for doing so?

c. (6 points) Assume that the exchange rate is flexible and Brandtlandia chooses policy option 1. The price of a tulip bulb in Hollandia is 7.50 Florin, and 10 Thaler in Brandtlandia. Also assume that all prices (including the exchange rate) are fixed in the short-run. Is there purchasing power parity here? Explain your answer. Is the Florin overvalued or undervalued? What will happen in the long run to the exchange rate? Explain your answer.

Solutions

Expert Solution

Answer a) Flexible exchange rate is based on market demand for and supply of foreign exchange, export increased demand for domestic currency while an increase in import increases demand for foreign currency. In this case, imposing a tariff reduced import level, and encourage domestic production. Export of tulip bulbs from Hollandia will be reduced due to high price while Hollandia receives the same price before imposing tariff while tariff amount will go to Brandtlandia. So the demand for foreign exchange (Florin) by Brandtlandia will be reduced. Then the value Florin against Thaler will be lower than before.

b) In response to a decline in the exchange rate value due to tariffs, Central bank may enhance interest rate to attract financial investment from Brandtlandia. This will provide in a higher return on an investment relative to Brandtlandia Hence doing so will enhance the demand for Florin. And the exchange rate declined earlier will be offset.

c) Purchasing Power Parity argues that goods are priced equal in both countries, taking into account the exchange rates if free trade occurs. Hence measuring the price in one currency will be equal.

price of a tulip bulb in Hollandia is 7.50 Florin, and 10 Thaler in Brandtlandia. the exchange rate is 0.50 Florin for 1 Thaler

The price of tulip bulb in Brandtlandia expressed in Florin will be 10*0.5 = 5 it is less than the price in Hollandia as 7.5. So Purchasing Power Parity not hold here.

The current rate of Florin is undervalued as per purchasing power parity it would be higher to equalise the value of tulip bulb in both country.

As free trade occurs exchange rate will adjust to 7.5/10 = 0.75 in long-run

Rahul Sunny answered 5 months ago

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