Sie sind auf Seite 1von 33

Examiners commentaries 2012

1
Examiners commentaries 2012
EC3016 International economics
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. In 2012 the format of the
examination changed to:
Candidates should answer FOUR of the following TEN questions:
Question 1 of Section A (40 marks) and THREE questions from Section
B (20 marks each).
The format and structure of the examination may change again in future
years, and any such changes will be publicised on the virtual learning
environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011).
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
Discuss and explain specific policy issues such as environmentalism as
protectionism; international dumping; the choice of an exchange rate
regime; the desirability of free capital flows.
Apply a specific framework to illustrate the connection between
Ricardian, Heckscher-Ohlin and the specific factors models in trade
theory, or between the monetary approach and the asset approach in
exchange rate theory.
Explain how international economic theory has been shaped by real
world events.
Planning your time in the examination
Both Zone A and Zone B papers of the International economics course
have followed the same format in recent years, namely an eight-part
compulsory question consisting of statements which candidates are
required to identify as true, false or uncertain and to justify their answers
briefly; and a second section of essay-type questions where candidates are
required to choose three questions from nine.
Question 1 carries 40 marks and each question from Section B carries 20
marks. In the three hours available, candidates should aim to spend no
more than ten minutes on each sub-question of Question 1 and around
twenty- five minutes for each other question. This leaves a few minutes to
read the questions carefully and make a selection.
Candidates waste time when they start a question and then abandon it
for one in which they believe they will perform better. It is worth taking
the time to read through all the questions carefully and to think carefully
EC3016 International economics
2
before making a selection. Once you have started your essay, it usually
makes sense to persevere and complete it, rather than switching to a new
question halfway through.
What are the Examiners looking for?
Examiners are looking for a sound grasp of the economic theory
in the subject guide and associated textbook reading, as well as a sense of
the empirical validity of the models. Moreover, candidates should
make use of examples and discuss theories through these examples.
For example, when discussing exchange rate regimes, candidates need
to show some familiarity with the Bretton Woods system, the ERM or
other systems. A working knowledge of current debates in the area of
international economics, through reading of The Economist or quality
newspapers is also rewarded, particularly when addressed with reference
to economic theory.
A breadth of knowledge is important. Candidates must have a good
grasp of most, if not all, of the subject guide in order to perform well in
Question 1. The choice offered in Section B allows candidates to focus on
areas that interest them for further reading.
The level of depth of analysis expected is similar to that shown in
the subject guide and suggested readings. Candidates are expected to
make use of diagrams and relevant equations to support their
explanations and arguments.
It cannot be overstressed that comments on the questions in the 2012
Examiners commentaries do not constitute model answers or sketches of
model answers. The Examiners are always looking to reward
candidates who take an original approach to a question.
Key steps to improvement
Candidates are urged to consider the allocation of marks to each
question and sub-question and to practise answering questions from
past papers under timed conditions.
Candidates are advised to spend a few minutes reading the questions
carefully before selecting the questions to be attempted.
Candidates should not answer more than three questions from Section
B.
If more than three questions are attempted, the first three will be marked.
Extra credit is not awarded for attempting more questions
than required.
Candidates would benefit from reading the question more carefully
to ensure they are answering the question asked. In Section A,
candidates should ensure that they do not forget to conclude whether
the statements are true, false or uncertain after they offer their
explanations.
It is important that candidates tailor their answers to address the
specific questions asked by picking and choosing the relevant and
important points in order to build a line of argument. Candidates
would benefit from spending a few minutes organising their answers
so that the flow of the argument is clear.
Candidates would benefit from ensuring that the appropriate level of
depth of analysis is employed when answering the questions.
Candidates are advised to be patient, and not leave the examination
until they are satisfied that they have thought as hard as possible about
each question.
Examiners commentaries 2012
3
Question spotting
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This can be due to a number
of different reasons and the Examiners commentaries suggest ways
of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question
spotting, that is, confining your examination preparation to a few
question topics which have come up in past papers for the course. This
can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that Examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the
section of the VLE dedicated to this course. You should read the
syllabus very carefully and ensure that you cover sufficient material in
preparation for the examination.
Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers every
topic on the syllabus is a legitimate examination target. So although
past papers can be helpful in revision, you cannot assume that topics
or specific questions that have come up in past examinations will occur
again.

EC3016 International economics
4
Examiners commentaries 2012
EC3016 International economics
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. In 2012 the format of the
examination changed to:
Candidates should answer FOUR of the following TEN questions:
Question 1 of Section A (40 marks) and THREE questions from Section
B (20 marks each).
The format and structure of the examination may change again in future
years, and any such changes will be publicised on the virtual learning
environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (201x).
Comments on specific questions
Candidates should answer FOUR of the following TEN questions: QUESTION 1 of
Section A (40 marks), and THREE questions from Section B (20 marks each).
Section A
Answer all parts of question 1 (40 marks in total).
Question 1
Consider the following market for the homogenous good, rice, in Home country:
The countrys demand curve for rice is: D
H
= 27 0.75P
H
, where D
H
is domestic
quantity of rice demanded and PH is the domestic price of rice.
The countrys supply for rice is: Q
H
=6 + 0.75P
H
, where Q
H
is the domestic
quantity of rice supplied and PH is the domestic price of rice.
Reading for the first part of this question (ae)
The instruments of trade policy: Subject guide, Chapter 7; Krugman, P.
and M. Obstfeld International economics: theory and policy. (Boston, Mass.;
London: Pearson/AddisonWesley, 2009) Pearson international edition;
eighth edition [ISBN 9780321553980] Chapter 6.
General equilibrium trade policy: Subject guide, Chapter 7 and Graph
7.10; Krugman and Obstfeld (2009), Chapter 9.
a. Determine home import demand for rice (2 marks)
Approaching the question
Solution: DH QH = 33 1.5*Pw
Let Foreign export supply be: (QF DF) = 3 + 1.5 PF, where PF is the
domestic price of the homogenous good.
Examiners commentaries 2012
5
b. Find the worlds free trade equilibrium price and the equilibrium level of
Foreign exports. Find also Home consumers surplus and Home producers
surplus. (3 marks)
Approaching the question
Solution: DH QH= QF DF. Hence Pw = 12. Export level = 15.
Consumer surplus: (36 12)*18/2 = 216. Producer Surplus:
(12 8)*3/2 = 6
c. Suppose the government in the home country decides to introduce an import
quota q. Let q = 9. What is the import tariff that is equivalent to the quota in
terms of its effects on home imports? (4 marks)
Approaching the question
Solution: 33 1.5*(pw + t) = 9. Hence, given pw = 12, the optimal tariff
level is t = 4
d. Let the Home country be a big country. What is the new world market
clearing price after Home introduces a tariff t=4? Draw a diagram for the
home country, the foreign country and the market clearing for import and
export market. Does the introduction of the tariff improve the welfare of
Home country? (6 marks)
Approaching the question
Solution: 33 1.5*(Pw + t)= 3 + 1.5 Pw. Hence 33 1.5 Pw 6 = 3
+ 1.5 Pw and Pw = 10
Consumers Surplus = (36 14)*16.5/2 = 181.5
Producers Surplus = (14 8)*6.5/2 = 19.5
Government Surplus = 4*(16.5 6.5) = 42
Hence the aggregate effect is an increase in countrys welfare:
TS = 243 > 232
e. Suppose now that the big Home country also produces manufactures. Use
a general equilibrium diagram to describe the welfare implications of the
introduction of the tariff on the imported goods. (5 marks)
Approaching the question
Consider:
2 countries: i = {H,F}
2 sectors: j = {1, 2}
Suppose H exports good 1 (imports good 2) and F exports good 2
(imports good 1).
Under an import tax in H: consider an ad valorem import tariff tax
P
2
d
= (1+T)P
2
w
P
1
d
= P
1
w
(P
1
/ P
2
)d = [P
1
w
/(1+t)P
2
w
] < (P
1
/ P
2
)
w
Thus, under an import tariff and given world prices, the relative
domestic price of good 1 falls.

EC3016 International economics
6

Good 1
Good 2
P0
P1
C0
C1
- (P
1
/P
2
)
w


- (P
1
/ P
2
)
d

Under free trade production is at P0 and consumption is at C0. With the
import tariff, given world prices, production is at P1 and consumption
at C1. Assuming the tax revenue is given to consumers, the domestic
price line shifts up. Consumers trade along the (P
1
/P
2
)
w
line through P
1

(feasibility condition). However, consumer decisions are based on
domestic prices; hence tangency of consumers indifference curve must be
with the domestic price line (optimality condition).
The volume of trade decreases after an import tariff, given world prices.
As the import tariff makes good 1 relatively scarce, the equilibrium TOT
(i.e. the relative world price of good 1 increases as the volume of trade is
reduced).
Welfare effects:
The import tariff distorts the economy, reducing the volume of trade.
For given world prices (small country case) this would result in an
unambiguous welfare decline.
However, since the countries are large there is an improvement in the
terms of trade. This yields a positive welfare effect.
Thus, for a large country, the net effect on welfare depends on the
relative size of the positive and negative welfare effects. If the TOT
effect outweighs the consumption and production distortions, there is
an increase in welfare (will be true for small import tariff rates). If the
distortions outweigh the TOT effect, there is a decrease in welfare. The
welfare effect is thus ambiguous.
Reading for the second part (f to k) of this question
Fixed exchange rates: Subject guide, Chapter 14 and Appendix 2.
Consider a small open endowment economy, which is pegging its exchange
rate to a foreign currency at the level e. There is perfect foresight and
uncovered interest rate parity (UIRP) holds. Purchasing power parity
holds and the foreign price level is normalised to 1, P
*
t
= 1. Assume that
the domestic central bank allows the amount of domestic credit (DC) to
expand steadily and that it will let the exchange rate float freely forever
if its foreign reserves (FX) fall to zero. Assume also that the central bank
will defend the peg by selling reserves as long as it has any to sell. The
structure of the model is given by:
Examiners commentaries 2012
7
Money Demand: (1)
Money Supply: (2)
Perfect Foresight and UIRP: (3)
Purchasing Power Parity: (4)
Suppose that domestic credit is expanding constantly in the following
way: DC
t
= DC
t1
+
f. What is the time path of the stock of foreign reserves held by the Central
Bank? Can the peg be sustained forever? (3 marks)
Approaching the question
The domestic credit component of the money supply expands constantly
at the rate .
DC
t
= DC
t1
+
In order to keep the exchange rate fixed the central bank needs to
maintain the overall money supply constant. If the nominal exchange rate
is fixed at the level e, we have from the UIP condition that the nominal
interest rate is equal to the foreign correspondent and equal to zero. Since
purchasing power parity holds, the money market equilibrium implies that
FT
t
+ DC
t
= oe
_
in each period t. If the domestic credit component is growing at the rate
3bc then the foreign reserve components must decline at the same rate for
the above equality to hold. So we have that:
FX
t
= FX
t1
t: FX
t
> 0
The peg cannot be sustained forever because at some point, that depends
on the initial reserve holdings and the rate of growth of domestic credit,
the reserve hits the zero bound.
g. Give the definition of shadow exchange rate and using the uncovered
interest parity and purchasing power parity conditions, express the shadow
exchange rate as a function of domestic credit. (4 marks)
(Hint: you can assume that the change in the shadow exchange rate is
constant e
t+1
e
t
= e
t+2
e
t+1
).
Approaching the question
The shadow exchange rate is the exchange rate that would prevail in the
market if there were no intervention in the foreign exchange market and
reserves were at their lower bound. That is,
FX
t
+ DC
t
= oe
s

t
+ |(e
s

t+1
e
s

t
)
with FX = 0. Note that the value of the current exchange rate depends
on its value one period ahead. To solve for the time path of the shadow
exchange rate:
ADC
t
= oAe
s
t
|(e
s
t+1
Ae
s
t
(3)
and maintain the assumption about the growth in domestic credit:
t
t
d
t
i
P
M
| o =
t t
s
t
DC FX M + =
*
t t
t
t 1 t
i i
e
e e
=

+
1 P ; 1
P
P e
*
t
t
*
t t
= =
EC3016 International economics
8
Ae
s
t
=


(5)
Since domestic credit is growing at a constant rate , and since the
shadow exchange rate depends on the path of money supply, we have
that the shadow exchange rate will depreciate also at a constant rate
proportional to .
h. Derive the time path of the shadow exchange rate and graph it. (3 marks)
Approaching the question
The time path of the shadow exchange rate is determined by equation (5)
above.
i. Explain why a speculative attack will occur when the shadow exchange
rate is equal to e and describe what happens to money supply after the
speculative attack. (4 marks)
Approaching the question
We have that, in order to defend the peg, the central bank will intervene
in the foreign market by selling foreign reserves at the same rate of
increase of the domestic credit component of the money supply. The
monetary authority will eventually run out of foreign reserves and will be
forced to abandon the peg.
Since we are in a framework in which everything is known in advance,
traders in the foreign market will anticipate the abandonment of the
peg and at a certain point will start selling the domestic currency so that
reserves will be driven to zero abruptly. When do the speculators sell the
currency?
Since domestic credit is growing at a constant rate , and since the
shadow exchange rate depends on the path of money supply, we have
that the shadow exchange rate will depreciate also at a constant rate
proportional to . The attack on the domestic currency will occur at time
T at which the shadow exchange rate is equal to the fixed rate.
Any individual trader has the incentive to exchange domestic currency
for foreign currency before reserves run out. Suppose the attack occurs at
time T
1
> T then the exchange rate would jump from the fixed value and
it would depreciate discretely. Traders that hold the currency will incur a
capital loss and since they know everything in advance they will sell the
currency before T
1
.
Suppose now that the attack will occur at time T
2
< T then the exchange
rate will appreciate discretely but this cannot be an equilibrium since
people do not want to sell a currency that will appreciate. The speculator
would prefer to sell as much foreign currency as possible to the central
bank and buy it back at the lower price that would prevail after the crisis.
The existence of a discrete jump in the nominal exchange rate prevents
speculative attacks at times like T
1
or T
2
.
Money market is in equilibrium at time T even though the exchange rate
doesnt jump: before the attack we had e
t+1
e
t
= 0 and i
t
= i
t
*
. After the
attack the nominal exchange rate is given by the shadow exchange rate
and it depreciates at a rate proportional to , which implies that the
domestic interest rate is higher than the foreign one in order to preserve
the UIP condition.
This would imply a discrete fall in money demand. Given PPP, the price
level will not jump and therefore we must have a fall in nominal money
supply to re-establish equilibrium in the money market. This fall in money
supply occurs through a discrete loss of reserves.
Examiners commentaries 2012
9
j. Suppose now that the money demand depends also on the level of current
income, Y
t
as follows:
Money demand:
t t
t
d
t
Y i
P
M
| o + =
where Y
t+1
=

Y
t
+ g so that the small open economy is growing by g > 0
every period. Suppose that = 0 and the exchange rate is pegged at e. What
is the time path of the stock of foreign reserves in this case? (2 marks)
Approaching the question
In this case the country accumulated foreign reserve by an amount that
is proportional to the rate of growth of the economy. The money market
equilibrium condition under a fixed exchange rate regime implies that
FX
t
+ DC
t
= oe
_
+ e
_

Y
t
(5)
Since Y
t+1
= Y
t
+ g while domestic credit is unchanged then
FX
t+1
= oe + e (Y
t
+ g
t
)
and
FX
t+1
FX
t
= e
_
g
t
.
k. Now let the domestic credit component expand constantly at = 0.
Determine the level of g > 0 at which there is no speculative attack in this
economy. (4 marks).
Approaching the question
g has to be sufficiently big for the peg to be sustained. There is pressure
for appreciation of the shadow exchange rate coming from growth of the
economy and pressure of depreciation coming from increasing domestic
credit. Sufficient condition for the peg to be sustained could be obtained
by looking at money market equilibrium in t and t+1:
FX
t
+ DC
t
= oe + eY
t

FX
t+1
+ DC
t
+

= oe + e(Y
t
+ g
t
)
from which we get that
FX
t+1
FX
t
= eg
t

a sufficient condition is that
g >

e

EC3016 International economics
10
Section B
Answer three questions from this section (20 marks each).
Question 2
Use a graphical approach to describe the equilibrium of the trade model with
monopolistic competition. What does the PP curve represent? What does the CC
curve represent? Discuss the effects of free trade on equilibrium price and product
variety compared to autarky.
Reading for this question
Monopolistic competition (Krugman model): Subject guide, Chapter 8
(pp.4953); Krugman and Obstfeld (2009), Chapter 9 (pp.194201) and
graph p.195.
Approaching the question
In the Krugman model consumers love variety and n firms produce n
differentiated varieties of a horizontally differentiated good. Consider the
average variety.
Call F and c its fixed and marginal cost, P its price, Q its output, n the number
of firms, S the size of the industrys market, b a constant term representing
the responsiveness of a firms sales to its price. The key equilibrium
relationships of the model are the average cost condition (CC curve):
AC = Fn/S + c
and the profit maximising pricing condition (PP curve):
P = c +1 (bn)
In autarky the two curves can be represented as CC
1
and PP in the following
diagram:
Consider now two identical economies. Under autarky these two economies
are represented by the same CC
1
PP diagram depicted above. The effect
of trade liberalisation is the same as if each economy experienced a
doubling of its market size. This shifts the CC curve downwards to CC
2
, so
the equilibrium price decreases and the equilibrium number of varieties
increases. However, considering firm heterogeneity, there is a further effect
due to firm selection. As P falls and n rises, the cut-off cost falls, which, in
turn reduces the average marginal cost c. Lower c drives both the CC and
the PP curves downwards (from CC
2
to CC and from PP to PP) and, as a
result, P falls further while the final effect on the number of varieties is
ambiguous
Examiners commentaries 2012
11
Question 3
Consider the specific factor model for a small open economy. There is a mobile
factor, labour, and two short-run sector-specific types of capital K1 and K2.
Discuss the short run implication of an increase in labour endowment L on the
allocation of the three production factors across sectors.
Suppose that in the long run the two K1 and K2 are freely mobile across sectors.
What is the long-run effect of the increase in L on the allocation of the three
production factors?
Reading for this question
Specific factor model: Subject guide, Chapter 3; Krugman and Obstfeld
(2009), Chapter 4 (Non-compulsory Figure 47 p.90).
Heckscher-Ohlin model: Subject guide, Chapter 3 (p.29); Krugman and
Obstfeld, Chapter 5 (pp.11819).
Approaching the question
Increase in Labour supply is represented by an extension of the horizontal
dimension of the figure.

w
Short run: The figure shows that an increase in L raises employment in
both sectors. Given that the two types of capital are sector-specific, their
allocation is not affected in the short run.
Long run: According to the Ribczinsky Theorem, an increase in L raises
(reduces) the amounts of capital and labour allocated to sector 2 (sector
1). Notice that the short-run and long-run outcomes are also contradictory
here.
Question 4
A large country has a greater incentive than a small country to use export
subsidies. True or false. Evaluate this statement in a partial equilibrium
framework.
Reading for this question
The instruments of trade policy: Subject guide, Chapter 7; Krugman and
Obstfeld, Chapter 9.
Standard trade model: Subject guide, Chapter 4; Krugman and Obstfeld
(2009), Chapter 6.
EC3016 International economics
12
Approaching the question
False. In both a large and small country an export subsidy has a negative
welfare effect. Nevertheless, in the large country case the negative effect is
bigger.

P
Q
X1 X0 Q0 Q1
Pd1
Pw0
Pw1
D
S
a
b
c
d
e f g
The subsidy raises the domestic price of the exported good. This has the
effect of reducing domestic demand and raising domestic supply of the good,
thus increasing Home Export Supply and resulting in a fall in the world price
for the good. The difference between the new world price (Pw1) and the new
domestic price (Pd1) is the size of the subsidy.
As to welfare effects, there is a fall in Consumer Surplus equal to (a+b), an
increase in Producer Surplus equal to (a+b+c), and a subsidy cost equal to
(b+c+d+e+f+g) (exports times per-unit subsidy). Therefore the net welfare
effect is (bdefg), which is negative. b and d represent the deadweight
losses (consumption and production inefficiencies) while the area e+f+g
represent the loss due to the worsening of the terms of trade.
For a small country the world price is given, so when the export subsidy is
imposed there is no effect on the world price e+f+g=0. The welfare effect
is still unambiguously negative (bd); but the overall effect is in general
smaller because the loss due to the terms of trade effect disappears and only
the inefficiency losses remain. Thus, a large country has a smaller incentive to
use export subsidies than a small country. The reason is that, by subsidising
its exports, a large country increases the world supply for the exported good,
hence reducing its price and worsening the countrys terms of trade.
Question 5
Let LDC be a developing country characterised by a segmented economy. A
traditional sector coexists with a modern sector. Segmentation is reflected in a
persisting differential in wages between the two sectors. Mr. B., president of LDC,
suggests the introduction of trade tariffs to protect the modern sector. He claims
that this policy will increase LDC production as the modern sector will expand
creating new jobs at the expenses of the traditional sector. Is he right? Suppose you
are the Secretary of State for work. What type of concern would you express about
this policy?
Reading for this question
Trade policy in developing countries: Subject guide, Chapter 10 (pp.9899).
Approaching the question
Candidates are expected to explain here the Harris-Todaro argument.
Examiners commentaries 2012
13
Harris-Todaro main points:
1. Difference in wages not only reflects differences in productivity; it also
reflects the possibility of remaining unemployed when moving form
the traditional sector to the modern one.
2. When the unemployment salary is positive, the creation of an
additional job in the modern sector might actually reduce output, by
increasing unemployment.
Question 6
People sometimes talk about twin deficits, where the twins are the current
account and the government budget deficit. Explain how these two deficits
are related economically so that changes in one are reflected in changes in the
other.
Reading for this question
Saving and the current account; private and government saving: Krugman
and Obstfeld (2009), Chapter 12.
Approaching the question
Current Account = CA = X M
Y = C + I + G + CA
Y C G = S = I + CA
Now we decompose savings S into private and governmental savings:
S = S
p
+ S
g
= (Y T C) + (T G)
Note that S
g
= (T G) = (G T) = (budget deficit)
So substituting we get:
S
p
+ S
g
= I + CA
CA = S
p
I S
p
CA = S
p
I (G T)
Interpretation:
For a given level of S
p
and I, an increase in the budget deficit must be
accompanied by a decrease in the CA surplus (or increase in the CA
deficit). For example, consider an increase in government expenditure (G)
such as the building of a bridge. If imported materials etc. are employed
for the construction of the bridge there is an increase in M giving rise to
the twin deficits phenomenon.
Empirical studies reveal a correlation between the budget deficit and the
CA deficit. However, the relationship is not as simple as it looks; S
p
, S
g
, I
and CA are jointly determined so the relationship does not give a clear
theoretical causal link.
Read the empirical discussion found in Krugman and Obstfeld, Chapter
12.
Question 7
Use the IS-LM model to determine how a fall in the world interest rate will
influence domestic output under fixed and floating exchange rate regimes. How
does your answer depend on the degree of capital mobility?
Reading for this question
Output and the exchange rate: Subject guide, Chapter 13.
EC3016 International economics
14
Approaching the question
In all cases, a decrease in the world interest rate will initially trigger a
capital inflow and therefore increase the demand for domestic currency.
Clearly the magnitude of these capital inflows and of the increase in
demand for domestic currency depends crucially on the degree of capital
mobility: the greater the degree of capital mobility then the greater their
magnitude. Note that with zero capital mobility there is no impact at all.
The consequences of these changes on output depend on the exchange
rate regime in operation. Recall the three key relationships derived from
the building blocks of the Mundell-Fleming model described in your
lecture notes:
Open economy IS: Y = C(YT) + I(r) + G + CA(Y, e)
(+) () () (+)
Open economy LM: M/P = L(Y, r)
(+) ()
Balance of Payments: BP = CA(Y, e) + K(rr*) = 0
() (+) (+)
(Note with Perfect Capital Mobility, r = r*)
Flexible exchange rate regime:
The capital inflows induced by the fall in the world interest rate trigger
a balance of payments surplus. With flexible exchange rates the incipient
surplus results in an appreciation of the exchange rate which has the effect
of lowering exports and raising imports. This balances the BOP and results
in a contraction of output, which has the further effect of lowering imports.
In general, the consequences are greater the greater the degree of capital
mobility. This part of the exercise shows that even with a completely
flexible exchange rate, the policies followed by trade partners matter for
domestic income.
It is, in general, impossible to state whether the current account is in
surplus or deficit. The ambiguity arises from two forces that work in
opposite ways. First, the exchange rate appreciation works to lower the
current account by lowering exports and raising imports. Second, the
contraction in output works to raise the current account by lowering
imports. Recall that the BP equation must hold at all times. If the
exchange rate effect outweighs the output effect, then the current account
is in deficit and financed by finite capital inflows (K > 0). Conversely, if
the output effect outweighs the exchange rate effect the CA is in surplus
(CA > 0) and there are finite capital outflows (K < 0).
Figure 1 depicts the effects of a fall in r* in the high capital mobility case
under a floating exchange rate. Point A is the initial equilibrium. From
the BP equation above it is clear that a fall in r* causes the BP schedule to
shift down to BP, the capital inflows giving rise to a balance of payments
surplus. The ensuing exchange rate appreciation shifts the BP schedule
from BP to BP and the IS schedule to IS. Point B is the new equilibrium
and the economy has experienced a fall in Y.
In the absence of precise functional forms we are unable to conclusively
state whether the current account is in deficit or surplus due to the
conflicting effects on CA though e and Y. Despite this, it is possible to
construct the two cases diagrammatically. In Figure 1, the distance AX
reflects the change in the domestic interest rate, r, brought about by the
decline in r*. AX is smaller than AZ the distance reflecting the decline in
Examiners commentaries 2012
15
r*. Therefore, we can conclude that the domestic interest rate falls by less
than the decline in r*. Since K () > 0 it follows that K is higher at B than
at A. The capital inflows finance a CA deficit.
It is possible to construct a diagram in which the fall in r exceeds the fall
in r*, thereby triggering finite K outflows and inducing a CA surplus. It
is theoretically impossible to distinguish between the two cases without
more precise functional forms.
Figure 2 depicts the effects under perfect capital mobility. A is one again
the initial equilibrium. Here r = r* and so the BP schedule is infinitely
elastic at r*. When r* falls to r* the BP schedule shifts down accordingly.
The ensuing exchange rate appreciation is much larger yielding a larger
shift in IS and thus a greater contraction in Y.
Once again, there is an ambiguity in the current account. Here K () =
and so we cannot construct two separate cases diagrammatically.
Fixed exchange rate regime:
In Figure 3 the fall in r* causes the BP schedule to shift to BP. The
ensuing increase in the money supply required to maintain e shifts LM to
LM. The new equilibrium is at B, where the domestic interest rate is lower
and there is an expansion of income Y. Figure 4 depicts the perfect capital
mobility case. In this case the increase in Y is larger.
EC3016 International economics
16

Both for fixed and flexible exchange rates the fall in the world rate of
interest triggers a BOP surplus. Capital inflows increase the demand
for domestic currency and in order to maintain the fixed exchange rate
the central bank has to conduct foreign exchange intervention. Money
supply will increase and the domestic interest rate will decrease, fostering
investment and promoting an increase in income. The fall in the domestic
interest rate and the ensuing increase in domestic income are greater the
more mobile capital is.
Question 8
Suppose that in London e(/$)=0.6, while in New York e(/$)=120 and in Tokio
e(/$)=180.
a. Is it possible to exploit any arbitrage opportunity? Why?
b. Starting with 1,000,000 suggest a strategy from which you can profit
(assume that transaction costs are negligible).
Reading for this question
The foreign exchange market and the balance of payment: Subject guide,
Chapter 11.
The foreign exchange market: Krugman and Obstfeld (2009), Chapter 13.
Examiners commentaries 2012
17
Approaching the question
An arbitrage opportunity arises when the system of exchange rates is
internally inconsistent. That is, assuming negligible transaction costs,
one can end up with more money than he started with by exchanging his
currency with foreign currency and back again.
Under the assumption of negligible transaction costs any arbitrage
opportunity will be exploited through buying and selling of currencies
since such opportunities yield a riskless profit (unlike profits earned by
speculation which are associated with risk where the extent of investor
speculation depends on risk preference).
With significant transaction costs, arbitrage opportunities will be exploited
up to the point where the marginal benefit of taking the opportunity is
equal to the marginal transaction cost involved.
The exploitation of an arbitrage opportunity induces adjustment in
the exchange rates until the internal inconsistency and thus arbitrage
opportunity disappears. Under negligible transaction costs, there is no
arbitrage opportunity when:
e
/$
= e
/
e
/$

b. Checking to see whether the relationship holds we find that:
e
/$
= 120 e
/
e
/$
= 108
Therefore we can find a profitable strategy.
Starting with 1,000,000 one can convert the to $ yielding $1,666,666.667.
Converting the $ to yields 200,000,000 which when converted back
into gives 1,111,111.111, and amount greater than the original. This
strategy of converting to $ to and back to will be repeated until there
is no further arbitrage opportunity.
Question 9
Briefly describe the flexible price monetary approach to exchange rate
determination. Explain what happens when there is an exogenous increase
in income from y
0
to y
1
(i.e. y
1
< y
0
) under a floating and a fixed exchange rate
regime in the context of this model. In the floating exchange regime case, is it
possible for monetary authorities to use monetary policy to restore the initial
equilibrium in the domestic price level? How?
Reading for this question
Flexible prices; the monetary model: L. Copeland Exchange rates and
international finance. (Harlow: FT Prentice Hall, 2008) fifth edition [ISBN
9780273710271] Chapter 5.
Approaching the question
The monetary approach to exchange rate determination is characterised
by flexible prices, fixed supply and money demand equation that depends
only on income through velocity of money.
Under a floating exchange rate regime change in real income implies a
lower demand for money, other things being equal. In order to restore
equilibrium in the money market prices should be higher. On the external
side this decrease in the price level is matched by a depreciation of the
nominal exchange rate needed in order to have PPP holding (or otherwise
in order to restore competitiveness). Include graphs.
In the fixed exchange rate regime instead we will observe changes in
domestic price level.
EC3016 International economics
18
Consider an increase in real income level in the fixed case.
For given domestic prices, the demand of real money balances is lower.
In order to have equilibrium in the domestic money market prices will
be forced up.
At the fixed exchange rate, the economy is now undercompetitive and
a balance of payment deficit will arise.
Reserves will decrease in order to defend the parity up to the point in
which overall money supply has decreased to match the new lower
demand. (With graphs as well).
Under a floating exchange rate regime, the monetary authority can restore
the initial price level by reducing money supply.
M
ky
P =
s
and the required
money supply adjustment is such that
1
M
s
M
s
0
y
y
0
1
=

Question 10
Propose a model that rationalises the fact that richer countries tend to have
higher price levels (describe the needed assumptions and the implications of
such a model).
Reading for this question
Purchasing power parity and the Balassa-Samuelson argument: Subject
guide, Chapter 12.
Why price levels are lower in poorer countries: Krugman and Obstfeld
(2009), Chapter 15.
Approaching the question
To address the empirical regularity we should refer to the Balassa
Samuelson model characterised by difference in productivity among rich
and poor countries.
We will assume that there are two countries and they produce two goods:
a tradeable (T) and non-tradeable (NT). The key assumptions are that:
labour is the only factor of production and is perfectly mobile within
countries but completely immobile between countries;
countries are equally productive in the N sector, but Foreign (*), the
rich country, is more productive in the T sector:
Y
N
= A
N
L
N
Y
*
N
= A
*
N
L
*
N
, A
N
= A
*
N

Y
T
= A
T
L
T
Y
*
T
= A
*
T
L
*
T
, A
T
= A
*
T

the law of one price holds for tradeable.
Note that we havent specified anything in terms of the demand side of the
model.
Profit maximisation by firms in all sectors implies (there is perfect
competition and prices are equal to marginal costs):
W
N
= A
N
P
N
W
N
= A
N
P
N
and W
T
= A
T
P
T
W
T
= A
T
P
T
,
W
*
N
= A
*
N
P
*
N
W
*
N
= A
*
N
P
*
N
and W
*
T
= A
*
T
P
*
T
W
*
T
= A
*
T
P
*
T
,
Labour mobility within countries ensures wage equalisation between
sectors in each countries:
W
*
N
= W
*
T
W
*
N
= W
*
T
and W
N
= W
T
W
N
= W
T
.
Examiners commentaries 2012
19
This implies that
P
N
P
T
A
T
A
N
= and
P
N
P
T
A
T
A
N
=
* *
* *
By assumption we have that A
T
< A*
T
and A
N
=

A*
N
so that
P
N
P
T
P
N
P
T
<
*
*
=
eP
N
eP
T
*
*
and if the law of one price holds for traded goods it follows
P
N
< e P*
N
.
The price level of the non-tradeable is higher in the rich country and PPP
fails.
Low wages in poor countries (due to low productivity in the tradeable
sectors) result in relatively low prices in non-tradeable sectors, as
productivity in these sector is approximately the same as in rich countries.
It is plausible to assume that international productivity differences are
sharper in traded than in non-tradeable goods. Note that a key assumption
is that labour is perfectly mobile within a country.
As transition economies are catching up, their productivity in the
tradeable sectors may well increase at a higher rate compared both to
the developed world and to the productivity in their own non-tradeable
sectors. This would imply that
P
N
P
T
increases over time which in turn implies
real appreciation in these countries. This appreciation will not last forever.
It will stop when the productivity levels in the transition economies
become closer to the levels of developed countries.
EC3016 International economics
20
Examiners commentaries 2012
EC3016 International economics Zone B
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. In 2012 the format of the
examination changed to:
Candidates should answer FOUR of the following TEN questions:
Question 1 of Section A (40 marks) and THREE questions from Section
B (20 marks each).
The format and structure of the examination may change again in future
years, and any such changes will be publicised on the virtual learning
environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (201x).
Comments on specific questions
Candidates should answer FOUR of the following TEN questions: QUESTION 1 of
Section A (40 marks), and THREE questions from Section B (20 marks each).
Section A
Consider the following market for the homogenous good, rice, in a small
country:
The countrys demand curve for rice is: D
H
= 24 0.75P
H
, where D
H
is domestic
quantity of rice demanded and P
H
is the domestic price of rice.
The countrys supply for rice is: Q
H
= 9 + 0.75P
H
, where Q
H
is the domestic
quantity of rice supplied and P
H
is the domestic price of rice.
The free trade equilibrium price of rice is P
w
=16. Assume now that the country
begins from a free trade equilibrium and introduces an ad valorem tariff of 25%
on the rice imports:
Reading for the first part (a to e) of this question
The instruments of trade policy: Subject guide, Chapter 7; Krugman, P.
and M. Obstfeld International Economics: Theory and Policy. (Boston,
Mass.; London: Pearson/AddisonWesley, 2009) Pearson international
edition; eighth edition [ISBN 9780321553980] Chapter 6.
General equilibrium trade policy: Subject guide, Chapter 7 and Graph
7.10; Krugman and Obstfeld (2009), Chapter 9.
a. What is the new domestic price, domestic quantity supplied and domestic
quantity demanded after the introduction of the tariff? (5 marks)
Approaching the question
Solution: Domestic price Pd = 20. D
H
= 9, Q
H
= 6
Examiners commentaries 2012
21
b. What is the new quantity of imports and tariff revenues? (2 marks)
Approaching the question
Solution: Import quantity = 3, tariff revenue = 3*4 = 12
c. What is the loss of consumer surplus and producer surplus from the tariff?
(4 marks)
Approaching the question
Consumer surplus = 12*(32 16)/2 = 96
New consumer surplus = 9*(32 20)/2 = 54
Producer surplus = 3*(16 12)/2 = 6
New producer surplus = 6*(20 12)/2 = 24
d. Suppose that the country also produces manufactures. Use a general
equilibrium diagram to describe the welfare implications of the introduction
of the ad valorem tariff on the imported goods. (5 marks)
Approaching the question
Due to the introduction of the import tariff, the domestic price of the
imported good increases. This leads home producers to increase supply
and home consumers to reduce consumption. As a result, imports fall
causing an overall reduction in the countrys trade with the rest of the
world.
The graphical analysis is presented in the following figure.
Starting for the free trade equilibrium with production in G and
consumption in H, the tariff increases the domestic price of the imported
good 1, thus flattening the domestic price line. The new production point
is given by point E at the tangency of the new domestic price line with
PPF. This implies an increase in the production of the imported good and
a decrease in the production of the exported good. After the tariff the
country produces a mix of goods that is worth less at international prices
than the value of the output mix produced under free trade.
Assuming that the government gives tariff revenue to consumers implies
an upward shift of the domestic price line. The country can still trade at
world prices, so consumers can move along the worlds price line that
goes through the new production point E. However, their decisions are
driven by domestic prices and thus the tangency condition for utility
maximisation must be with the domestic price line at point F. Accordingly,
the indifference curve attained under the tariff is below the indifference
curve attained under free trade.
.
.
. .
Y
1
Y
2
0
E
F
G
H
EC3016 International economics
22
e. How would your answer to question d) change if the country was big? Draw
a diagram. (4 marks)
Approaching the question
Consider:
2 countries: i = {H,F}
2 sectors: j = {1, 2}
Suppose H exports good 1 (imports good 2) and F exports good 2
(imports good 1).
Under an import tax in H: consider an ad valorem import tariff tax
P
2
d
= (1+T)P
2
w
P
1
d
= P
1
w
(P
1
/ P
2
)
d
= [P
1
w
/(1 + t)P
2
w
] < (P
1
/P
2
)
w
Thus, under an import tariff and given world prices, the relative
domestic price of good 1 falls.
Good 1
Good 2
P0
P1
C0
C1
- (P
1
/P
2
)
w


- (P
1
/
2
)
d



P
Under free trade production is at P0 and consumption is at C0. With the
import tariff, given world prices, production is at P1 and consumption
at C1. Assuming the tax revenue is given to consumers, the domestic
price line shifts up. Consumers trade along the (P
1
/P
2
)
w
line through P1
(feasibility condition). However, consumer decisions are based on
domestic prices; hence tangency of consumers indifference curve must be
with the domestic price line (optimality condition).
the volume of trade decreases after an import tariff, given world prices.
As the import tariff makes good 1 relatively scarce, the equilibrium TOT
(i.e. the relative world price of good 1 increases as the volume of trade is
reduced).
Welfare effects:
The import tariff distorts the economy, reducing the volume of trade.
For given world prices (small country case) this would result in an
unambiguous welfare decline.
However, since the countries are large there is an improvement in the
terms of trade. This yields a positive welfare effect.
Thus, for a large country, the net effect on welfare depends on the
relative size of the positive and negative welfare effects. If the TOT
effect outweighs the consumption and production distortions, there is
an increase in welfare (will be true for small import tariff rates). If the
Examiners commentaries 2012
23
distortions outweigh the TOT effect, there is a decrease in welfare. The
welfare effect is thus ambiguous.
Reading for the second part (f to k) of this question
Purchasing power parity and the Balassa-Samuelson argument: Subject
guide, Chapter 12.
Why price levels are lower in poorer countries: Krugman and Obstfeld
(2009), Chapter 15.
Assume that the domestic price level P is given by P = P
a
N
P
T
1-a
and that the
foreign price level P
*
is given by P
*
= P
*b
N
P
T
*1-b
where P
N
(P
*
N
) is the domestic
(foreign) price index for non-traded goods, P
T
(P
*
T
) is the domestic
(foreign) price index for traded goods and 0 < a,b <1 .
The real exchange rate is defined as
P
EP
RER
*
.
f. Show that if the law of one price holds for traded goods and if P
*
N
/P
T
*
is
approximately constant, then variation in the real exchange rate can be
mainly explained by variations in the ratio P
N
/

P
T
. If the foreign country is a
developed country, how reasonable is the assumption on P
*
N
/P
T
*
? (4 marks)
Approaching the question
The real exchange rate is defined as
P
eP
RER
*

.
We assume that the domestic price level P is given by P = (P
N
)
a
(P
T
)
1a
and
that the foreign price level is given by P
*
= (P
*
N
)
b
(P
*
T
)
1b
where P
N
(P
*
N
)
is the domestic (foreign) price index for non trade goods, P
T
(P
*
T
) is the
domestic (foreign) price index for trade goods and 0 < a,b <1. We can
write
P
eP
RER
*
=
P
eP
*
=
T
T

(P
N
*
/P
T
*
)
b
N
P / P
T
)
a
.

If the law of one price holds for traded goods then. From inspection it
follows that if (P
*
N
P
*
T
) is approximately constant then variations in the real
exchange rate can be explained in terms of variations in the ratio (P
N
P
T
).
If the foreign country is a developed country, it is likely to experience
slower technological change than some developing countries. If this is the
case then the relative price between its tradeable and non-tradeable goods
will be fairly stable compared to the developing country.
g. Give a brief summary of the Balassa-Samuelson model (you are expected to
write down the key equations of the model). Discuss the assumptions of the
model. (4 marks)
Approaching the question
The presence of non-traded goods suggests that international variations
in the prices of non-tradeable goods could be a source of international
differences in price levels between a rich and a poor country. We will
assume that there are two countries and they produce two goods: a
tradeable (T) and non-tradeable (NT). The key assumptions are that:
labour is the only factor of production and is perfectly mobile within
countries but completely immobile between countries;
countries are equally productive in the N sector, but Foreign (*), the
rich country, is more productive in the T sector:
Y
N
= A
N
L
N
, Y
*
N
= A
*
N
L
*
N
A
N
= A
*
N
Y
T
= A
T
L
T
, Y
*
T
= A
*
T
L
*
T
A
T
< A
*
T
EC3016 International economics
24
the law of one price holds for tradeable.
Note that we havent specified anything in terms of the demand side of
the model.
Profit maximisation by firms in all sectors implies (there is perfect
competition and prices are equal to marginal costs):
W
N
= A
N
P
N
W
N
= A
N
P
N
and W
T
= A
T
P
T
W
T
= A
T
P
T
,
W
*
N
= A
*
N
P
*
N
W
*
N
= A
*
N
P
*
N
and W
*
T
= A
*
T
P
*
T
W
*
T
= A
**
T
P
**
T
.
Labour mobility within countries ensures wage equalisation between
sectors in each country:
W
*
N
= W
*
T
W
*
N
= W
*
T
and W
N
= W
T
W
N
= W
T
.
This implies that

P
N
P
T
A
T
A
N
=
and
P
*
N
P
*
T
A
*
T
A
*
N
=
By assumption we have that A
T
< A
*
T
and A
N
< A
*
N
so that

= <
e P
N
P
T
*
P
N
P
T
*
e
*
P
N
P
T
*
and if the law of one price holds for traded goods it follows
P
N
< eP
*
N

The price level of the non-tradeable is higher in the rich country and
PPP fails.
Low wages in poor countries (due to low productivity in the tradeable
sectors) result in relatively low prices in non-tradeable sectors, as
productivity in these sector is approximately the same as in rich
countries. It is plausible to assume that international productivity
differences are sharper in traded than in non-tradeable goods. Note
that a key assumption is that labour is perfectly mobile within a
country.
h. The real exchange rate of transition economies such as the Baltic countries,
Poland, the Czech Republic, have appreciated a lot vis a vis the dollar
between the beginning of the 90s and end 2007. Using your answers to (a)
and (b) could you propose an explanation for what may happen in these
economies? (3 marks)
Approaching the question
If the foreign country is a developed country, then its technology changes
slowly and
P
*
N
P
*
T
does not change a lot. If we make the approximation that
the law of one price holds for trade goods then all changes in the real
exchange rate are caused by
P
N
P
T
. As transition economies are cat ching up
their productivity in the tradeable sectors may well increase at a higher
rate compared both to the developed world and to the productivity in
their own non-tradeable sectors. This would imply that
P
N
P
T
increases
over time which in turn implies real appreciation in these countries. This
appreciation will not last forever. It will stop when the productivity levels
in the transition economies become closer to the levels of developed
countries.
Examiners commentaries 2012
25
i. The appreciation of the real exchange rate in these economies is generally
higher when the real exchange rate is measured with Consumer Price Indices
instead of Producer Price Indices. Should you expect this? If so, why?
(2 marks)
Approaching the question
The Consumer Price Index (CPI) takes into account prices of goods
consumed by domestic households while the Producer Price Index (PPI)
takes into account prices of goods produced by domestic households.
In this case the goods produced and consumed coincide so that there
is no difference between the two indices and we should not expect any
differences between the two.
j. The Balassa-Samuelson model is one way of rationalising why Purchasing
Power Parity does not hold very well empirically. Could you think of other
reasons? (3 marks)
Approaching the question
The Balassa-Samuelson model explains one possible factor that generates
deviations of the real exchange rate from purchasing power parity (PPP).
Changes in the prices of non-traded goods across countries might then
generates deviations from PPP. Other factors include the existence of
transport costs and barriers to trade.
Imperfectly competitive markets and the ability to price discriminate
across countries might induce firms to charge difference price for the same
good depending on the market where the good is sold. Another reason for
PPP deviations is that it has been checked using data based on different
commodity baskets (people living in different countries have different
preferences).
Assume now that domestic (foreign) consumers spend a share (
-
) of
their tradeable-spending on home produced tradeable goods (H) and
a share 1 (1
-
) on foreign produced tradeables (F). Price indices
(using a Cobb-Douglas utility function) are

=
1
F H T
P P P and

=
1 * * *
F H T
P P P .
Define the real exchange rate for tradeables as .
k. What would the law of one price for tradeables suggest to you about goods
H and F? (2 marks)
Approaching the question
The law of one price would imply that
EP
*
H
P
H
= 1
EP
*
F
P
F
= 1
So that prices of individual tradables are equalised across countries once
converted in a common currency

l. If the law of one price holds then the real exchange rate, RER, is equal to one.
True or false? (2 marks)
It is false because even if the law of one price holds at the level of
individual goods, differences in preferences (captured by the spending
shares (
-
)) might imply departure from purchasing power parity since
movements in the relative price of imports over exports affects the real
exchange rate.
P
EP
RER
*

T
T
T
EC3016 International economics
26
Section B
Answer three questions from this section (20 marks each).
Question 2
Consider the standard trade model with two goods and two factors, labour and
capital. Suppose that a country experiences an increase in its capital stock. How
would the Production Possibilities Frontier change as a result?
Reading for this question
Standard trade model: Subject guide, Chapter 4; Krugman and Obstfeld
(2009), Chapter 6 (p.150).
Approaching the question
The PPF will shift outward: the Y intercept shifts upwards and the X
intercept shifts to the right. The relative size of these two movements will
depend on the relative capital intensity of each good. Here we assume that
good X is labour intensive and good Y capital intensive.
Y
X

PPF
As Y is assumed to be K-intensive relative to X, the economy produces
proportionally more of Y than X: the Y intercept shifts up by a greater
percentage than the X-intercept shifts right (i.e. a skewed shift of the PPF).
Question 3
Consider the case of Thailand, a small open economy that faces constant goods
prices. Assume that there are two sectors, manufacturing and farming. There are
three productive factors. Labour is employed in both sectors and is freely mobile
between them. Capital is used only in manufacturing and land only in farming.
After the recent floods a relevant part of arable land has been destroyed: discuss
the effect on wages and the incomes of capital and land owners.
Reading for this question
Specific factor model: Subject guide, Chapter 3; Krugman and Obstfeld
(2009), Chapter 4 (Non-compulsory Figure 47 p.90).
Approaching the question
In a small open economy factor prices and labour allocation are
determined as follows:
In each sector i (with i=m, f), labour is demanded up to the point
where the value marginal product of labour equals the wage rate:
VMPL
i
p
i
MPL
i
p
i
F
p
(K, L
i
)/L
i
= w.
Labour is mobile so the wage must be the same in both sectors: p
m

MPL
m
= w = p
f
MPL
f
.
Labour is fully employed, L
m
+ L
f
= L
Examiners commentaries 2012
27
Graphically, the equilibrium is at point E in the figure below where:
For each sector, the area under the VMPL schedule is the value of total
output.
In each sector, the return to the specific factor is the value of total
output minus the wage bill.
w
m
E
1
E
2
w
f
VMPL
1
f
VMPL
2
f
Because of the floods the land endowment of the economy decreases.
The fall in T decreases the marginal product of labour in the farming
sector. The new equilibrium wage is lower and labour moves to the
manufacturing sector.
Under the small open economy assumption, the price of both sectors
remains constant. Given that labour moves to manufacturing, the marginal
product of capital increases (hence r rises); thus, the income of capital
owners (rK= p
m
MPK
m
K) increases. As labour in farming decreases, the
value marginal product of land (v) goes down, but the reduction in land
has a positive effect on v so that the overall effect on the value marginal
product of land is ambiguous. However, under reasonable assumptions,
given that T diminishes the overall effect on the income of landowners
(vT) is negative.
Question 4
Suppose you were an import competing producer in a perfectly competitive
setup. Which policy instrument would you prefer: an import tariff or an import
quota? Would your answer change in a monopolistic setup?
Reading for this question
Tariffs and import quotas in the presence of monopoly: Subject guide,
Chapter 7 (pp.7172); Krugman and Obstfeld, Chapter 3 (pp.24548).
Approaching the question
If the firm is perfectly competitive, then a tariff and an import quota have
identical effects on the firm. See Figure 1. A tariff will raise domestic price
to Pw+t, resulting in a gain to Producer Surplus equal to area (a). An
equivalent quota (which raises domestic price to Pw+t as well) will also
result in an identical gain in Producer Surplus.
So, for a perfectly competitive firm, a tariff, a quota, and a production
subsidy are equivalent.
EC3016 International economics
28
But suppose that the firm is a monopoly. Now a quota will be better for
the firm. Under free trade, the monopoly must charge a price equal to the
world price, Pw, since if it sets a higher price, it will not be able to sell its
product (goods are homogeneous!).
For a monopoly, a tariff of size t raises the domestic price of the good from
Pw to Pw+t. This reduces demand from X0 to X1, and raises domestic
production from Q0 to Q1. Producer Surplus rises by area (a). With the
tariff, the monopoly will set a price equal to the world price plus the tariff,
Pw+t, since it cannot sell any units if it sets a higher price.
A quota on the other hand limits the quantity of imports to (Q1Q0). This
is equivalent to shifting the demand curve faced by the monopoly inwards,
from D to D (the actual demand curve remains at D). There is a Marginal
Revenue curve MR associated with D. Given the new demand curve, with
the quota the firm can set price to maximise its profit (MC=MR), and sell
output Q0. The gain in Producer Surplus is the area bounded by Pd, Q0,
MC, and Pw. This gain will be greater than the gain in Producer Surplus
under the tariff, as long as the new domestic price as a result of the tariff
is lower than Pd.
The intuition behind this result is that, with a quota, the monopoly can
raise its price without losing the entire market to import competition,
since there is a maximum limit to the number of units that can be
imported. Thus, after taking into account the loss of demand due to
imports, the monopoly can charge a price that maximises profits.
Result: If the domestic import-competing firm is a monopoly, then it will
prefer a quota to a tariff.
Question 5
(Heckscher-Ohlin model) Suppose the world is made of two countries: Home
and Foreign. Home is a small labour-abundant country, while Foreign is capital-
abundant. Both Home and Foreign produce two goods: food and cloth. Food
production is labour-intensive and cloth production is capital-intensive. What is
the effect of the introduction of an export subsidy in the Home country on the
return to each factor of production in the Home country?
Reading for this question
Heckscher-Ohlin model: Subject guide, Chapter 3 (p.27); Krugman and Obstfeld
(2009), Chapter 5 (pp.11819).
P
Q
Q0 Q1 X1 X0
D
MR
Pw
Pw+t
MC
a
P
Q
Q0 Q1
Pw
Pd
MC
D
D
MR
Examiners commentaries 2012
29
Approaching the question
Let good 1 be relatively labour intensive and good 2 be relatively capital
intensive. The Heckscher-Ohlin theorem states that a country will export
the good that uses relatively intensively its relatively abundant factor of
production. Since H is assumed to be labour abundant it will export the
labour-intensive good (good 1) and import the relatively capital-intensive
good (good 2).
World prices are fixed at (P
1
/P
2
)
w
. Calling t the subsidy, P
1
d
and P
2
d
the
domestic prices of good 1 and 2 in country H gives:
P
2
d
= (1 t)P
2
w

P
1
d
= P
1
w

(P
1
/ P
2
)
d
= [P
1
w
/(1 t)P
2
w
] > (P
1
/P
2
)
w
Hence an import subsidy increases the relative domestic price of good 1.
The Stolper-Samuelson theorem states that an increase in the price of a
good will result in an increase in the price of the factor used intensively in
its production, in relative, nominal and real terms, and a decrease in the
price of the other factor, assuming both goods continue to be produced.
Furthermore, the increase in the price of the factor used relatively
intensively will be more than proportional to the original increase in the
price of the good (magnification effect).
Thus an import subsidy, which increases the domestic relative price of the
exported labour-intensive good 1, will increase the relative, nominal and
real wage and will decrease the relative, nominal and real rental rate.
Question 6
Let LDC be a developing country characterised by a segmented economy. A
traditional sector coexists with a modern sector. Segmentation is reflected
in persisting differential in wages and marginal productivity of labour in the
two sectors. Mr. B., president of LDC, suggests the introduction of trade tariffs
to protect the modern sector. He claims that this policy will increase LDC
production as the modern sector will expand creating new jobs at the expenses
of the traditional sector. Is he right? Suppose you are the Secretary of State for
work. What type of concern would you express about this policy?
Reading for this question
Trade policy in developing countries: Subject guide, Chapter 10
(pp.9899).
Approaching the question
Candidates are expected to explain here the Harris-Todaro argument.
Harris-Todaro main points:
1. Difference in wages not only reflects differences in productivity; it also
reflects the possibility of remaining unemployed when moving form
the traditional sector to the modern one.
2. When the unemployment salary is positive, the creation of an
additional job in the modern sector might actually reduce output, by
increasing unemployment.
EC3016 International economics
30
Question 7
Suppose that there is perfect capital mobility and a fixed exchange rate
regime. The government increases public spending permanently. What are the
implications for output and the current account if you use the IS-LM model?
How does your answer change in the case in which there is imperfect capital
mobility?
Reading for this question
Output and the exchange rate: Subject guide, Chapter 13.
Approaching the question
In the Mundell-Fleming model the increase in G induces a higher level of
output and a current account deficit. In Figure 5, IS shifts to IS when G
rises permanently. This induces large capital inflows which push the BOP
into surplus. The central bank intervenes to maintain e by increasing the
money supply which shifts LM to LM. The result is an increase in Y and
a current account deficit. When capital mobility is imperfect the BP line
becomes steeper and the effects on output and current account will be
smaller.
Question 8
Compare the currency board regime with a fixed exchange rate regime. Describe
the main characteristics of the two emphasising the costs and benefits of
adopting the two regimes.
Reading for this question
Monetary system: Subject guide, Chapter 15.
Currency board: L. Copeland Exchange rates and international finance.
(Harlow: FT Prentice Hall, 2008) fifth edition [ISBN 9780273710271],
Chapters 11.4.1 and 11.4.2.
Approaching the question
Currency board: a monetary institution that only issues domestic currency
that is fully backed by foreign assets. The domestic currency is convertible
into a foreign anchor currency at a fixed rate and on demand.
Anchor currency: it is a currency chosen for its expected stability and
international acceptability.
Examiners commentaries 2012
31
Convertibility: a currency board maintains full and unlimited convertibility
between its noted and coins and the anchor currency at a fixed rate.
Foreign reserves: composed by low-risk, interest bearing bonds and other
assets denominated in the anchor currency. Currency board reserves are
equal to 100 per cent or more of its notes and coins in circulation, as set
by law.
Currency board generates profits (seignorage) from the difference
between interest earned on its reserve assets and expense in maintaining
its liabilities (notes and coins in circulation).
No discretion in monetary policy market forces determine money
supply. The only function of a currency board is to exchange notes
and coins for the anchor currency at the fixed rate. It does not lend to
domestic banks or to the government.
Fixed rate between the domestic currency and foreign anchor currency
tends to keep interest rates and inflation in the currency board country
roughly the same as those in the anchor currency country.
Currency board does not act as a lender of last resort to protect domestic
banks from losses.
Fixed exchange rate: similar implications but can issue money (more
discretion in monetary policy).
Question 9
State the uncovered interest parity relationship and compare it with covered
interest rate parity.
a. Suppose that the US nominal interest rate is 6% and the comparable UK rate
is 9%. What is the expected behaviour of the pound dollar exchange rate if
uncovered interest rate parity holds?
b. Suppose the US interest rate is 8% per year and the UK rate is 12% per
year, and the spot exchange rate is e{/$}=0.48 and the one year forward is
f{/$}^{1year}=0.5. Does the covered interest rate parity hold?
c. Suppose that the spot exchange rate is e{/$}=0.48 and that in the UK the
3-month, 6-month and 1-year rates are respectively 12%, 10% and 8% on
a yearly basis. The corresponding US interest rates are 8%, 10%, and 12%
on a yearly basis. Describe the expected future path of the exchange rate
assuming that uncovered interest rate parity holds.
Reading for this question
The foreign exchange market and the balance of payment: Subject guide,
Chapter 11.
The foreign exchange market: Krugman and Obstfeld (2009), Chapter 13.
Approaching the question
Uncovered interest parity (UIP): the domestic interest rate must be
higher (or lower) than the foreign interest rate by an amount equal to the
expected depreciation (appreciation) of the domestic currency.
i = i* + [E(e
t+1
) e
t
]/ e
t
Assume this holds.
Suppose i = i
UK
= 9% and i* = i
US
= 6%
From UIP,
9% = 6% + expected depreciation
Thus the is expected to depreciate by 3%.
EC3016 International economics
32
b. CIP: the domestic interest rate must be higher (or lower) than the foreign
interest rate by an amount equal to the forward discount (premium) on the
domestic currency.
i = i* + [f
t+1
e
t
]/ e
t
Suppose i = i
UK
= 12% and i* = i
US
= 8% while the spot exchange rate is
e
/$
= 0.48 and the one year forward rate is f
/$
= 0.5.
Applying the CIP relationship:
12% 8% + [0.5 0.48]/0.48 = 12.16%
Therefore CIP does not hold. There is thus an opportunity for arbitrage.
(c) e
/$
= 0.48
3 month i
UK
= 12%
6 month i
UK
= 10%
1 year i
UK
= 8%
3 month i
US
= 8%
6 month i
US
= 10%
1 year i
US
= 12%
Assume UIP holds: i
UK
i
US
= [E(e
t+1
) e
t
]/ e
t
Since the interest rates are calculated on a yearly basis we have to convert
them back to 3-months, 6-months and 1-year rates in order to describe the
expected future path of the exchange rate.
3 months: t = today, t+1 is in 3 months.
[E(e
t+1
) e
t
]/ e
t
= [12/4]% [8/4]% = 1%
There is an expected depreciation of 1% over 3 months
E(e
/$
3 months
) = 0.4848
6 months: t = today, t+1 is in 6 months.
[E(e
t+1
) e
t
]/ e
t
= [10/2]% [10/2]% = 0%
There is no expected depreciation or appreciation over 6 months.
E(e
/$
6 months
) = 0.48
1 year: t = today, t+1 is in 1 year.
[E(e
t+1
) e
t
]/ et = 8% 12% = 4%
There is an expected appreciation of 4% in 1 year.
E(e
/$
1 year
) = 0.4608
Thus the exchange rate is expected to depreciate in 3-months, appreciate
back to its original level in 6-months and then appreciate by a further
4% in 1 year.
Note that the above calculations of the 3-month and 6-month interest
rates are approximations. For more accuracy one could use compounding:
3 months: (1.12)
1/4
1 = 0.028 and (1.08)
1/4
1 = 0.019
The difference is 0.009 = 0.9% which is very close to the 1% found above
using the simple approximation.
6 months: (1.10)
1/2
1 = 0.0488 for both the UK and US.
On a yearly basis
}
Examiners commentaries 2012
33
Question 10
What do we mean by overshooting of the nominal exchange rate? Describe the
assumption of the Dornbuschs overshooting model and explain the adjustment
mechanism following a permanent increase in money supply.
Reading for this question
Sticky prices; the Dornbusch model: Copeland (2008), Chapter 7.
Approaching the question
Dornbuschs overshooting
(Foreign international interest rate and prices, r* and P* are taken as
given)
Building blocks are:
Aggregate demand block: (IS-LM mechanism in open economy)
Aggregate demand:
y
d
= h(e +p* p) (1)
Money demand:
m p = k y lrm p = k y lr (2)
Aggregate supply block: (goods prices are sticky). The aggregate supply
curve is horizontal in the immediate impact phase, increasingly steep in
the adjustment phase and vertical in the long run.
Ap = (y
d
y) (3)
Uncovered interest parity:
r = r* + Ae
e

Expectations:
Ae
e
= (e e)

(5)
Monetary expansion in the Dornbusch model: First step is determining the
long-run effect:
We know that aggregate demand has to be equal to y in the long run.
Since r* hasnt changed, we know that in the long-run equilibrium,
r = r*: our IS and LM curve need to go back at the original equilibrium. In
particular the increase in money supply requires a proportional increase
in the price level. Since the IS curve depends only on the real exchange
rate, this means that the real exchange rate has to return to the initial
equilibrium. Impact effect: (keep in mind that goods markets adjust slowly
while financial markets adjust instantaneously). The increase in money
supply determines a decrease in the domestic interest rates (liquidity
effect) in order to accommodate the excess supply of real money balances
(the excess supply arises because of sticky prices). Uncovered interest
parity implies that the fall in the domestic interest rate is compatible
only if there is an equilibrating change in the nominal exchange rate. In
order to keep domestic assets in their portfolio, households should expect
the nominal exchange rate to appreciate along the path that goes to the
long-run equilibrium. In order to generate expectation of appreciation,
the nominal exchange rate overdepreciates (overshooting), so that the
domestic currency is so undervalued that it is expected to appreciate in
the future. Given the depreciation of the nominal exchange rate the IS
curve shifts outward.