1. (a) Assume there are only two countries in the world, China and U.S., and both countries are considered as small open economies with rigid prices. U.S. has positive net capital outflow 0 > 0 at world real interest rate 0 (which implies world real interest rate is above the domestic equilibrium real interest rate ). The foreign exchange market for the U.S. dollar ($ ) is in equilibrium with real exchange rate 0. Suppose the U.S. government suddenly imposes a quota on imports from China such that at every level of the real exchange rate, imports must be reduced by in order to improve its trade balance with China. Use two properly labeled graphs to help you explain the step-by-step analysis on policy effectiveness of import quota. No need to discuss the setup of the model. You must relate your explanation to every point in your graph or you will lose at least half the marks for this question.

1. (b) Answer this question according to lecture discussion related to Chapter 2 material. Suppose you operate a world event ticket agency in Vancouver that sells tickets to the 2020 Tokyo Olympics and your agency has been allotted 50 tickets to the opening ceremony at 200,000 each in which the payment must be settled in full by August 31, 2019.

(i) Suppose you have purchased five foreign exchange call option contracts on yen with a standard amount of 2,000,000 each, standard date August 31, 2019 at $/ = 0.01 and each contract costs you $2,000. Assume the spot exchange rate is $/ = 0.009 on August 31, 2019. Explain why you will or will not exercise the call options. Will you change your mind if the contracts cost you $5,000 each?

(ii) Independent from part (i), suppose you have won five foreign exchange put option contracts on Canadian dollars in a lucky draw with a standard amount of $20,000 each, standard date August 31, 2019 at $/ = 0.01. Assume the spot exchange rate is $/ = 0.011 on August 31, 2019. Explain why you will or will not exercise the put options? Will you change your mind if the contracts actually cost you $4,000 each rather than receiving them as the prize of a lucky draw?

(iii) Explain in details the economic intuition behind your decision in parts (i) and (ii).