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A question in monetary theory is explicated.

Let's estimate what happens to the exchange rate between the United States and the imaginary country of Oz.

The ruler of Oz is a totalitarian wizard. Since the economy of Oz is centrally planned, they lack three important ingredients that would make them more effective: free market efficiency, capital investment, and technological progress. An example is that cars in Oz are still being produced with plans that were stolen from a Ford factory in 1952.

In 2000, Oz decided to open its borders to the United States for the first time. It turns out that citizens in the United States are interested in four things that Oz produces: food, hotel accommodations, tourist attractions, and beautiful crystal vases. Citizens in Oz are interested in everything that the U.S. produces, but most of them cannot afford the U.S. dollar because it is too expensive. The evil wizard of Oz needs the U.S. dollar in order to buy weapons and weapon technology.

When citizens from the U.S. travel to Oz, they are forced to exchange money at the border of Oz with the evil wizard, who demands $1 for 10 ozzies. In fact, in order to enter the country, U.S. citizens must exchange $30.00 for every day they are in the country. Once they are in the country, U.S. tourists may obtain more ozzies by exchanging dollars at official exchange banks.

During the first year of open trade in 2000, 1 million U.S. tourists visited Oz for a total of 10 days per person. None of them exchanged money at official exchange banks, except for the amount that they were forced to trade at the border.

1. According to bank records, what was the official supply of U.S. dollars to Oz?
2. According to bank records, what was the official supply of Oz ozzies to the U.S?

In fact, the supply of U.S. dollars to Oz during the year of 2000 was $1 billion. The total U.S. demand for ozzies during the same year was 24 billion ozzies.

3. Explain why a black market for the U.S. dollar exists in Oz.
4. What is the black market exchange rate for the U.S. dollar? (Hint: make sure you subtract the transactions that took place at the official rate before you figure out the black market rate.)
5. A crystal vase costs $50.00 in the U.S. In Oz, it costs 300 ozzies. If a U.S. tourist visits Oz for 3 days and exchanges $90.00 at the official rate and another $90.00 at the black market rate, what is the average cost of the vase for this tourist? How much does the tourist actually spend in dollars for the vase? Did the tourist get a good deal?
6. What would happen to the official exchange rate in Oz if the rate were permitted to fluctuate with the free market?

It turns out that everything is less costly in Oz than the U.S. when you compare actual prices. Crystal vases appear cheap. A hotel room costs $5.00 a night, dinner at a four star restaurant costs $3.00, and drinks are 25 cents. This means that Oz has a comparative advantage over the U.S. in the production of these goods.

7. Assume that the wizard has had a change of heart and needs your advice on how to grow the economy of Oz. What will you advise?

Solution Preview

1, According to the bank records the official supply of US dollars to Oz is 1 million visitors X 10 days X 30$per day = $300 million dollars.

2. The official supply of ozzies to the U.S was 10 X $300 million = 3 billion ozzies.

3. The black market for the US dollar exists because the official price of the ozzies is highly overvalued and does not reflect the true value of the dollar.

4.1 billion dollars minus 300million(official figure) = $700 million.
24 billion ozzies - 3 billion ozzies = 21 billion ozzies. If we divide this figure by $700 million we get the rate of 30 ozzies for a dollar. This is the black market rate for the dollar.

5. The tourist pays $90 and gets 900 ozzies, then he pays another $90 and gets another 2,700 ozzies this gives him a total of 3600 ozzies, this gives him 12 vases @ 300 ozzies. The tourist spent a total of 180 ...

Solution Summary

Oz and United States Exchange Rate are contrasted.