Suppose that the United States and Spain both produce cognac and handbags. In the United States, cognac sells for $20 a bottle and handbags sell for $80. In Spain, cognac sells for 30 euros a bottle and handbags sell for 40 euros. Given this information, trade will flow in both directions if the price of a dollar is between

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For trade to flow in both directions, the relative prices of the goods must favor each country in at least one product. In the U.S., the price ratio of cognac to handbags is 1:4 ($20:$80), meaning 1 bottle of cognac is equivalent to 1/4 of a handbag. In Spain, the price ratio is 3:4 (30 euros:40 euros), meaning 1 bottle of cognac is equivalent to 3/4 of a handbag. For the U.S. to export cognac to Spain, 1 dollar must be worth less than 30/20 (1.5) euros, so that cognac is cheaper in the U.S. when priced in euros. For Spain to export handbags to the U.S., 1 dollar must be worth more than 40/80 (0.5) euros, so that handbags are cheaper in Spain when priced in dollars. Therefore, the exchange rate must be between 0.67 (2/3, which is the inverse of 1.5) and 2.0 euros per dollar for trade to flow in both directions.

Suppose That the United States and Spain Both Produce Cognac