P S Pt Pe D Q
Quota government of the importing country, government of the exporting country or producers allotted quotas may gain (depends on how the quotas are allotted) Tariff tariff revenue goes to the government of the importing country Different Effects between Import Quotas and Import Tariffs
Quota domestic producers may benefit because of higher selling price domestic consumers will lose because now they have to pay a higher price Tariff domestic producers also benefit because of higher price domestic consumers will lose because now they have to pay a higher price
Quota foreign producers may gain because of higher selling price Tariff foreign producers will lose because they now sell less
Quota the quantity of import reduction is more definite with quotas Tariff the quantity of import reduction depends on the level of tariffs imposed as well as the elasticities of supply and demand
Purchasing Power Parity Theory • The Purchasing Power Parity Theory states that the exchange rate between any two currencies will adjust to reflect the difference in the price levels of the two countries. • The Purchasing Power Parity Theory implies that domestic inflation will be reflected in exchange rate movements.
Example a piece of cake Pd = HK$7.8 Pf = US$1 e = Pd/Pf = HK$7.8/ US$1
Suppose Hong Kong suffers from inflation and all the prices increase. Pd’ = HK$9 Pf = US$1 e = Pd/Pf = HK$7.8/ US$1 Now how can you grasp this opportunity to make money?
Pd’ = HK$9 Pf = US$1 e = Pd/Pf = HK$7.8/ US$1 Buy a piece of cake in ____ (which costs you ______) sell it to __________ consumers (you get ______)
Pd’ = HK$9 Pf = US$1 e = Pd/Pf = HK$7.8/ US$1 Buy a piece of cake in US (which costs you US$1) sell it to Hong Kong consumers (you get HK$9). Then you earn HK$1.2. (US exports increase and HK import increase)
Pd’ = HK$9 Pf = US$1 e = Pd/Pf = HK$7.8/ US$1 Because of the arbitrage, the demand for US currency increases and the supply of Hong Kong currency increases. This will lead to depreciation of HK currency.
Pd’ = HK$9 Pf = US$1 e1 = HK$8/ US$1 Suppose Hong Kong currency depreciates and the new exchange rate is HK$8/ US$1. Will the process of arbitrage go on? When will it stop?
Pd’ = HK$9 Pf = US$1 e2 = Pd’/Pf = HK$9/ US$1 The process of arbitrage will stop when the exchange rate equals Pd’/Pf . At this level, the exchange rate has adjusted to the difference in the price level of the two countries.
Why the Purchasing Parity Theory may not Hold 1. Absence of Trade 2. Presence of non-tradables 3. Presence of different price indices 4. Presence of transaction costs
AL 87/9 Y Y 200 50 X X 100 100
I AL 91/3 R Food B T I’ A D Clothing T’
I AL 91/3 R Food IN B S T I’ B’ A IN’ S’ Clothing T’ R’