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Equilibrium will thus occur at a price at which the hori-
tion imposes a quota limiting imports to 30 million
zontal distance AB in Figure 3(a) (the excess of the ex-
bushels. The free-trade equilibrium with imports of
porter™s quantity supplied over its quantity demanded)
45 million bushels is now illegal. Instead, the market
is equal to the horizontal distance CD in Figure 3(b)
must equilibrate at a point where both exports and im-
(the excess of the importer™s quantity demanded over
its quantity supplied). At this price, the world™s quantity ports are only 30 million bushels. As Figure 4 indi-
demanded equals the world™s quantity supplied. cates, this requirement implies that there must be
different prices in the two countries.
Imports in Panel (b) will be 30 million bushels”the
HOW TARIFFS AND QUOTAS WORK distance QT”only when the price of wheat in the im-
porting nation is $3.25 per bushel, because only at this
However, as noted in the text, nations do not always price will quantity demanded exceed domestic quan-
let markets operate freely. Sometimes they intervene tity supplied by 30 million bushels. Similarly, exports
with quotas that limit imports or with tariffs that in Panel (a) will be 30 million bushels”the distance
make imports more expensive. Although both tariffs RS”only when the price in the exporting country is
and quotas restrict supplies coming from abroad and $2.00 per bushel. At this price, quantity supplied ex-
drive up prices, they operate slightly differently. A tar- ceeds quantity demanded in the exporting country by
iff works by raising prices, which in turn reduces the 30 million bushels. Thus, the quota raises the price in
quantity of imports demanded. The sequence associ- the importing country to $3.25 and lowers the price in
ated with a quota is just the reverse”a restriction in the exporting country to $2.00. In general:
supply forces prices to rise.
An import quota on a product normally reduces the
The supply and demand curves in Figure 4 illus-
volume of that product traded, raises the price in the
trate how tariffs and quotas work. Just as in Figure 3,
importing country, and reduces the price in the export-
the equilibrium price of wheat under free trade is
ing country.
$2.50 per bushel (in both countries). At this price, the
A tariff can accomplish exactly the same restriction
exporting country produces 125 million bushels”
of trade. In our example, a quota of 30 million bushels
point B in Panel (a)”and consumes 80 million



F I GU R E 4
Quotas and Tariffs in International Trade




Importing Importing
country™s country™s
Exporting supply demand
country™s
Exporting
Price of Wheat per Bushel




Price of Wheat per Bushel




supply
country™s Q T
demand $3.25

A B C D
$2.50 2.50
R S
2.00




0 80 85 115 125 0 50 57.5 87.5 95
Quantity of Wheat Quantity of Wheat

(a) Exporting Country (b) Importing Country

NOTE: Quantities are in millions of bushels.




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Part 4
360 The United States in the World Economy



Any restriction of imports that is accomplished by a
leads to a price that is $1.25 higher in the importing
quota normally can also be accomplished by a tariff.
country than in the exporting country ($3.25 versus
$2.00). Suppose that, instead of a quota, the importing In this case, the tariff corresponding to an import
nation were to impose a $1.25 per bushel tariff. Inter- quota of 30 million bushels is $1.25 per bushel.
national trade equilibrium would then have to satisfy We mentioned in the text that a tariff (or a quota)
the following two requirements: forces foreign producers to sell more cheaply. Figure 4
shows how this works. Suppose, as in Panel (b), that a
1. The quantity of wheat exported by one country must
$1.25 tariff on wheat raises the price in the importing
equal the quantity of wheat imported by the other,
just as before. country from $2.50 to $3.25 per bushel. This higher
price drives down imports from an amount repre-
2. The price that consumers in the importing country
sented by the length of the brick-colored line CD to the
pay for wheat must exceed the price that suppliers in
smaller amount represented by the blue line QT. In the
the exporting country receive by the amount of the
tariff (which is $1.25 in the example). exporting country, this change means an equal reduc-
tion in exports, as illustrated by the change from AB to
By consulting the graphs in Figure 4, you can
RS in Panel (a).
see exactly where these two requirements are met. If
As a result, the price at which the exporting coun-
the exporter produces at S and consumes at R, while
try can sell its wheat is driven down”from $2.50 to
the importer produces at Q and consumes at T, then
$2.00 in the example. Meanwhile, producers in the im-
exports and imports are equal (at 30 million bushels),
porting country, which are exempt from the tariff, can
and the two domestic prices differ by exactly $1.25.
charge $3.25 per bushel. Thus, as noted in the text, a
(They are $3.25 and $2.00.) But this is exactly the same
tariff (or a quota) can be thought of as a way to “rig”
equilibrium we found under the quota. What we have
the domestic market in favor of domestic firms.
just discovered is a general result of international
trade theory:


| SUMMARY |
1. The prices of goods traded between countries are deter- 2. When trade is restricted, the combinations of prices and
mined by supply and demand, but one must consider quantities in the various countries that are achieved by a
explicitly the demand curve and the supply curve of quota can also be achieved by a tariff.
each country involved. Thus the equilibrium price must 3. Tariffs or quotas favor domestic producers over foreign
make the excess of quantity supplied over quantity de- producers.
manded in the exporting country equal to the excess of
quantity demanded over quantity supplied in the im-
porting country.


| TEST YOURSELF |
1. The following table presents the demand and supply b. If the United States and Japan do not trade, what are
curves for microcomputers in Japan and the United the equilibrium price and quantity in the computer
States. market in the United States? In Japan?
c. Now suppose trade is opened up between the two
Quantity Quantity Quantity Quantity countries. What will be the equilibrium price in the
Price per Demanded Supplied Demanded Supplied world market for computers? What has happened to
Computer in U.S. in U.S. in Japan in Japan the price of computers in the United States? In Japan?
1 90 30 50 50
d. Which country will export computers? How many?
2 80 35 40 55
e. When trade opens, what happens to the quantity of
3 70 40 30 60
4 60 45 20 65 computers produced, and therefore employment, in
5 50 50 10 70 the computer industry in the United States? In Japan?
6 40 55 0 75 Who benefits and who loses initially from free trade?
NOTE: Price and quantity are in thousands.

a. Draw the demand and supply curves for the United
States on one diagram and those for Japan on
another one.




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Licensed to:




The International Monetary
System: Order or Disorder?
Cecily, you will read your Political Economy in my absence. The chapter
on the Fall of the Rupee you may omit. It is somewhat too sensational.
M I S S P R IS M I N O S CA R WIL D E ™ S T HE
I M P O RTA N C E O F B E I N G E A RN E ST



M iss Prism, the Victorian tutor, may have had a better point than she knew. In the
summer of 1997, the Indonesian rupiah (not the Indian rupee) fell and eco-
nomic disaster quickly followed. The International Monetary Fund rushed to the
rescue with billions of dollars and pages of advice. But its plan failed, and some say it
may even have helped precipitate the bloody riots that led to the fall of the Indonesian
government.
Like the demure Miss Prism, this chapter does not concentrate on sensational politi-
cal upheavals. Rather, it focuses on a seemingly mundane topic: how the market deter-
mines rates of exchange among different national currencies. Nevertheless, events in
Southeast Asia in 1997“1998, in Brazil and Russia in 1998“1999, and in Turkey and
Argentina in 2001“2002 have amply demonstrated that dramatic exchange rate move-
ments can have severe human as well as financial consequences. Even in the United
States, some people are now worried about the consequences of the declining value of
the dollar. This chapter and the next will help you understand why.




CONTENTS
WHEN GOVERNMENTS FIX EXCHANGE WHY TRY TO FIX EXCHANGE RATES?
PUZZLE: WHY HAS THE DOLLAR SAGGED?
RATES: THE BALANCE OF PAYMENTS
WHAT ARE EXCHANGE RATES? THE CURRENT “NONSYSTEM”
A BIT OF HISTORY: THE GOLD STANDARD The Role of the IMF
EXCHANGE RATE DETERMINATION
AND THE BRETTON WOODS SYSTEM The Volatile Dollar
IN A FREE MARKET
The Classical Gold Standard The Birth and Adolescence of the Euro
Interest Rates and Exchange Rates: The Short Run
The Bretton Woods System
PUZZLE RESOLVED: WHY THE DOLLAR
Economic Activity and Exchange Rates:
ROSE AND THEN FELL
The Medium Run ADJUSTMENT MECHANISMS UNDER FIXED
EXCHANGE RATES
The Purchasing-Power Parity Theory: The Long Run
Market Determination of Exchange Rates: Summary




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 4
362 The United States in the World Economy



PUZZLE: WHY HAS THE DOLLAR SAGGED?
Many observers speak of “American exceptionalism.” One way in which
America differs from other countries is that its media and citizens almost
never pay much attention to the international value of its currency. But 2007
proved to be an exception to the exceptionalism. The dollar fell so low against
the euro, the British pound, and, especially, the Canadian dollar that”at least
for a few days”it grabbed the headlines. The euro flirted with $1.50 (which
it later surpassed), the pound topped $2, and the Canadian dollar became more valu-
able than the U.S. dollar.
These events in foreign currency markets had a lot of people scratching their heads.
What caused the dollar to fall so far? Will it fall further? Does the decline signal some
deep-seated problem with the U.S. economy? We will learn some of the answers to
these and related questions in this chapter. But to do that, we first need to understand
what determines exchange rates.




WHAT ARE EXCHANGE RATES?
We noted in the previous chapter that international trade is more complicated than
domestic trade. There are no national borders to be crossed when, say, California lettuce is
shipped to Massachusetts. The consumer in Boston pays with dollars, just the currency
that the farmer in Modesto wants. If that same farmer ships her lettuce to Japan, however,
consumers there will have only Japanese yen with which to pay, rather than the dollars
the farmer in California wants. Thus, for international trade to take place, there must be
some way to convert one currency into another. The rates at which such conversions are
made are called exchange rates.
The exchange rate states
the price, in terms of one There is an exchange rate between every pair of currencies. For example, one British
currency, at which another pound is currently the equivalent of about $2. The exchange rate between the pound and
currency can be bought.
the dollar, then, may be expressed as roughly “$2 to the pound” (meaning that it costs $2
to buy a pound) or about “50 pence to the dollar” (meaning that it costs half a British
pound to buy a dollar).
Exchange rates vis-à-vis the United States dollar have changed dramatically over time.
In a nutshell, the dollar soared in the period from mid-1980 to early 1985, fell relative to
most major currencies from early 1985 until early 1988, and then fluctuated with no clear
trend until the spring of 1995. From then until early 2002, the dollar was mostly on the
rise. Then, from February 2002 through December 2004, the dollar reversed course and fell
steadily. From then until 2007, the dollar was relatively stable, on balance until early 2007
when, as noted above, it started dropping once again. This chapter seeks to explain such

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