ANSWERS
Chapter 2
True/False
1. False: consumers of the exported good lose as its price increases.
2. True.
3. False: producers of the domestic import-competing good see lower prices for their goods.
4. True.
5. True: but both are rare at times!
Multiple Choice
1. A
2. A
3. C
4. A
5. C
Problems
1. a. The equilibrium price of bread in Leinster is 0.6 telephones per loaf; in Saxony the price is 0.2
telephones per loaf.
b. Yes. Since Saxony’s bread price is lower than Leinster’s, there will be an incentive for Leinster
bread consumers to buy Saxon bread. Saxon bread producers have an incentive to sell in
Leinster, where the price is higher.
c.
Figure 2.1c
d. The equilibrium trade price must be the same in both countries (that’s why it is the price at which
they trade with each other): it is 0.25 telephones per loaf. Notice that this is the price at which
import demand from Leinster equals export supply from Saxony.
e. At the trade price of 0.25 telephones per loaf, excess demand for bread in Leinster equals 80
million loaves—exactly the amount of excess supply in Saxony at the trade price.
f. Looking at Figure 2.1, consumer gain in Leinster = a + b + c, where producer loss in Leinster =
1
a; consumer loss in Saxony = d; and producer gain in Saxony = d + e.
g. Bread consumers in Leinster and bread producers in Saxony will be happy about the opening of
free trade. However, Leinster bread producers will not be happy (they are undercut by cheaper
imported Saxon bread), nor will Saxon bread consumers, who used to pay a lower price before
the people in Leinster were able to buy the bread.
h. The net gain to Leinster is the area labeled “L”; this is equal in magnitude to the net gain b + c
from the domestic graph. The net gain to Saxony is the shaded area labeled “S”; this is equal in
magnitude to the net gain e from the domestic graph.
i. The country with the less elastic trade curve (usually the result of less elastic domestic supply
and demand curves) will gain the most from trade. In our case, this is Leinster. It was able to
“drive” the price it pays for bread far below its previous domestic bread price. As a percentage of
the free-trade price, Leinster’s price for bread changed 140 percent, whereas in Saxony the price
changed only 20 percent.
j . The losses from closing trade would just be the net gain the countries had obtained from free
trade: “L” in Leinster, “S” in Saxony.
2. With more elastic domestic supply and demand curves, Leinster’s import demand curve will also
become more elastic. Using Figure 2.1c as a guide, you can see that, as a consequence of an increase
in elasticity, the international price of bread will rise, and be closer to Leinster’s pre-trade price. The
quantity of bread traded will rise; Leinster’s net gains from trade will fall, but Saxony’s gains will
rise.
3. They would lose 5 percent per board-foot on the 48 billion board-feet they continue to sell at home,
plus sell four billion less board-feet in total, summing to a total loss of $2.5 billion.
Price of lumber
(per board-foot)
Figure 2.3
0.30
0.25
Supply (U.S.)
a
bc
d
Demand (U.S.)
40 48 52
Producer surplus loss
Lumber in billions of board-feet
= a + b + c : price decline on remaining sales
+d : reduction in total sales
= $2.4 billion
+0.1 billion
$2.5 billion
2
4. a. Bean consumers will lose and bean producers will gain as the relative price of beans rises; jeans
consumers will gain and jeans producers will lose as the relative price of jeans drops.
b. The net national gain from trade can be measured as the difference in the size of the consumer
and producer surpluses as a result of the opening of trade.
Chapter 3
True/False
1. True: that was David Ricardo’s point.
2. True: with constant costs, the opportunity cost of a good is the same, regardless of tastes.
3. True.
4. False: Arbitrage means everyone will pay the same price.
5. False: As long as a comparative advantage exists, trade will benefit even “unproductive” countries.
Multiple Choice
1. D
2. B
3. A
4. A
5. B
Problems
1. a. Leinster has an absolute advantage in both goods since it takes less labor to make bread and less
labor to make telephones than in Saxony.
b. Leinster has a comparative advantage in telephones; in Leinster, the price of one telephone is 5/3
of a bread loaf, while in Saxony the price of one telephone is 5 loaves of bread. At the same time
Saxony has a comparative advantage in bread: in Saxony, the price of one loaf is 1/5 telephone,
while in Leinster the price of one loaf of bread is 3/5 telephone.
2.
There is a basis for trade: Saxons can buy inexpensive telephones from Leinster and sell their
bread there for a higher price than at home. Leinsterian telephone manufacturers can sell in
Saxony for more than the pre-trade price; consumers in Leinster can buy bread more cheaply
from Saxony.
3
3. a.
Figure 3.3a
b. At a price of one telephone per four loaves of bread, Saxony will export bread to Leinster in
exchange for telephones.
c. With complete specialization, Leinster produces at point T, and Saxony produces at point B.
Each country can then trade their good for the other country’s good, at a price of one telephone
for four loaves of bread. The “consumption possibilities curve” is just the ray emanating from the
production point with slope 1/4. Notice that the consumption line lies outside each country's
production possibilities curve. That’s a good illustration of the benefits that come from trade.
Figure 3.3c
4
4. a.
Figure 3.4a
Cloth (yards)
The pre-trade price is calculated from the slopes of the PPCs, which are constant. In Chile, the
price of one yard of cloth is 1.5 bushels of wheat, and the price of one bushel of wheat is 2/3 yard
of cloth. In Brazil, the price of one yard of cloth is 2.5 bushels of wheat; the price of one bushel
of wheat is 2/5 yard of cloth.
b. Chile is the low-cost cloth producer; Brazil is the low-cost wheat producer. Thus, Chile will
export cloth; Brazil will export wheat. But the maximum that Brazil will pay for one yard of
cloth is 2.5 bushels of wheat (its own pre-trade price).
c.
Figure 3.4c
500
Brazil after productivity growth
Brazil
200
Chile
300 500
Wheat
(bushels)
With this change in the productivity of labor in cloth, Brazil’s PPC rotates upward, and the country’s
pre-trade price for a yard of cloth changes from 2.5 bushels of wheat to 1 bushel of wheat. Now,
Brazil is the low-cost cloth producer and Chile is the low-cost wheat producer. The trade patterns
will be reversed!
5. Suppose that you, as the older sibling, are absolutely better at washing dishes and taking out the
garbage. Your younger brother could do these chores too, but he is absolutely worse at them than
you. It is likely, however, that his comparative disadvantage lies in washing the dishes. Your parents
could have you do a less-than-complete job on both tasks by splitting your limited time between them
and let your brother go ride his skateboard. It would be more efficient (and more equitable) to have
you focus on washing the dishes well, and let your brother use his labor resources to take out the
garbage.
5
To be more precise: Let’s say it takes you 15 minutes to do the dishes and five minutes to take out
the trash. Your brother, on the other hand, would need 45 minutes to wash the dishes properly, and
ten minutes to take out the trash. Clearly you have an absolute advantage in “production” of these
services.
Labor to do
dishes (minutes)
Labor to take out
trash (minutes)
You
Your brother
15
45
5
10
Notice your brother has a comparative advantage in taking out the trash. While he would have to
“give up” 4 1/2 trash runs to do the dishes, you would only lose out on doing three runs.
Alternatively, you could say that the cost to you of taking out the trash is getting one-third of the
dishes done, whereas the cost to your brother is getting less than one quarter of them done. You are
the low-cost producer of clean dishes; your brother is the low-cost producer of trash disposal.
Chapter 4
True/False
1. False: it is the abundance of land relative to other factors that matters.
2. True: with increasing costs, there will come a point at which the opportunity cost of producing
another unit is far greater than anyone would be willing to pay for that extra unit.
3. True.
4. True.
5. True. In H-O, it is because factor intensities differ that differing relative endowments of those factors
across countries will lead one country to have a comparative advantage over another in the
production of the good that intensively uses its abundant factor.
Multiple Choice
1.
2.
3.
4.
5.
A
A
B
D
A
Problems
1. a. The ratio of land to labor in Leinster is 8 million acres to 2 million laborers or 4:1. The ratio in
Saxony is 2 million acres to 400,000 laborers or 5:1. Therefore, although Saxony has absolutely
fewer acres of land than Leinster, Saxony is “land abundant.” Leinster is the “labor abundant”
country since it has one laborer for each four acres.
b. Telephones are labor-intensive goods; bread is land-intensive. According to H-O, then, Leinster
will export telephones and import bread; Saxony will export bread and import telephones.
6
2. In this case, we have to modify our measurement of “labor.” Now, although Leinster has more
workers, Saxony’s workers supply more days of labor per person per week.
So, if we were to measure factor abundance as the ratio of person-days to acres, we would get the
following:
For Leinster: Labor/Acres = (10 million person-days)/8 million acres = 1.25
For Saxony: Labor/Acres = (2.8 million person-days)/2 million acres = 1.40
So Saxony now looks like the relatively labor-abundant country!
3.
Figure 4.3
The PPCs of the two countries can be represented by the one drawn. The country with tastes skewed
toward pizza will have a higher pre-trade price for pizza in terms of beer than the country that has
tastes skewed toward beer. The two countries should trade: the pizza-loving country will produce
more beer and export it in exchange for pizza; the beer-loving country will make more pizza and
export it in exchange for beer, such as with points PL and BL. We get the interesting result that trade
causes each country to specialize less in production—at some middle point like P*—and trade for the
preferred good.
4. It doesn’t really matter what each country’s supply and demand curves (or production possibilities
and indifference curves) look like; what drives trade is what autarkic price results from those curves.
7
For example, the two countries illustrated below have very different demand and supply curves. And
yet, they do not have any obvious reason to trade with each other because those very different curves
yield exactly the same pre-trade price!
Figure 4.4
5. Heckscher and Ohlin don’t have much to say in this case. Factor endowments will still determine
relative factor prices (so that the labor-abundant country will tend to have lower wages than the
capital-abundant country), but we can’t predict what the pre-trade prices of the goods will be if labor
and capital are equally suited to producing both goods.
Chapter 5
True/False
1. True.
2. False: just the reverse is the case, with owners of scarce factors seeing their incomes fall.
3. True: that’s why Joan Robinson will never receive the prize for her work on imperfect competition–
proof that it is an imperfect world!
4. True.
5. True: unskilled labor is used relatively more in the import-competing industries in the United States.
Multiple Choice
1. C
2. A
3. B
4. A
5. D
8
Problems
1. When trade opens up, the price of bread falls in Leinster and rises in Saxony. At the same time, the
price of telephones rises in Leinster and falls in Saxony.
a. In the short run, Leinster’s bread workers see their wages fall, while telephone workers see their
wages rise. In the long run, all workers see their wages rise as labor moves out of the declining
bread industry and into the labor-intensive telephone industry.
b. In the short run, Saxony’s bread workers see their wages rise, while telephone workers see their
wages fall. In the long run, all workers see their wages fall as labor is released from the
labor-intensive telephone industry but is not needed in the same amounts in the land-intensive
bread industry.
c. If the factor price equalization theorem holds, the wages of the abundant workers in Leinster
should rise to meet the falling wages of the scarce workers in Saxony. Similarly, the scarce land
in Leinster will earn less than before, abundant land in Saxony will earn more than before, and
they should equal each other if FPE holds.
2. Some possible explanatory factors include: trade barriers that prevent commodity price equalization;
differences in labor productivity or skill levels between the countries; and immobility of labor
between sectors in each country.
3. a. If a factor is immobile between sectors, its income is a function of whether it is employed in the
price-rising industry or in the price-falling industry. So capital owners, landowners, and laborers
in the computer sector would gain; capital owners, landowners, and laborers in the wheat sector
would lose.
b. If a factor is mobile between sectors, its income is a function of whether it is the country’s
relatively scarce factor or relatively abundant factor. So capital owners would gain and
landowners would lose. Labor would migrate from the losing sector to the gaining sector.
4. a. Bread is more labor-intensive than wine: 4/9 of the cost of making bread is labor cost, whereas
only 1/3 of the cost of making wine is labor cost. Conversely, wine is capital-intensive.
b. If inputs cannot move between sectors, everyone in the wine sector will likely gain and everyone
in the bread sector will likely lose.
c. Since bread prices are pushed down, bread consumers will celebrate open trade. But since wine
prices rose, wine consumers will commiserate with the bread makers.
5. This is a case of reversing the Stolper-Samuelson effects of free trade. Now, bread will be the pricerising industry and telephones will be the price-falling industry.
a. Because labor is intensively used in the price-falling industry, real wages will fall by more than
14% (due to the magnification effect).
b. Conversely, real land rents in Leinster will rise by more than 14%.
9
Chapter 6
True/False
1. True. For example, if the United States exports $1 billion worth of Coors beer and imports $1billion
worth of Heineken beer, net trade in beer is zero, but intra-industry trade in beer is $2 billion.
2. False: IIT is more prevalent in imperfectly competitive industries.
3. False: economies of scale reduce average costs.
4. True: Consumers of the export good may benefit both from product differentiation and from cost
reductions that result from scale economics in production.
5. False: In intra-industry trade, factor incomes are relatively unaffected because, as imports of one
variety of product increase, exports of another variety expand as well. So we would expect exports of
fine riding boots from England to rise as well-made Swiss hiking boot imports to England also rise.
So employment and incomes of workers in the British footwear industry are relatively unchanged.
But the increased variety of footwear available raises the well-being of those workers in their role as
buyers of shoes. This might be an example of product differentiation being founded on peculiarities
of each country: the passion for horse racing in England and for mountain climbing in Switzerland.
Multiple Choice
1. B
2 B
3. B
4. B
5. B
Problems
1. a. Recall from Figure 2.1 that Leinster imports 80 million loaves of bread from Saxony; in return it
exports 20 million telephones because the “price” of the imported bread is 0.25 telephones per
loaf. So, for Leinster:
IIT Share = 1 –
=1–
=1–
=1–
sum of X  M
sum of (X  M )
{ X telephones  M telephones  X bread  M bread }
{( X t  M t )  (X b  M b )}
{ 20  0  0  80 }
{( 20  0)  (0  80)}
100
100
=0
In other words, there is no intra-industry trade between the two countries: there is only a straight
barter of Leinster’s telephones for Saxon bread. This is entirely consistent with Heckscher-Ohlin;
in their model, all trade is based on swapping different goods that are manufactured using
different relative factor endowments.
b. Recall the notion of product differentiation and the increased importance of luxuries as incomes
rise. It is possible that the Leinster bakers who are still in business (recall that we do not have
complete specialization in our hypothetical world) might switch from baking the universal,
generic white bread to baking specialty breads and pastries. In that case “bread” (as broadly
defined) will be exported from Leinster to Saxony.
10
2. Under a situation of identical tastes and production possibilities, we could not turn to standard theory
for why countries would trade (i.e., differences in pre-trade price ratios arising from different tastes).
Instead, countries could gain by trading with each other if the goods they produce and buy are subject
to economies of scale. For example, suppose both the U.S. and Germany can produce ships or
airplanes under the same conditions of increasing returns to scale in both products. Suppose they
both had the same tastes, causing each country to “consume” ships and airplanes. The countries
could gain from trade only if one country specialized in ships and the other specialized in airplanes.
With all conditions identical, they could even flip a coin to see who specializes in what.
Figure 6.2
Ships
(In thousands)
100 B
D
60
I1
30
A
I0
40
C
60
Airplanes
(In thousands)
In Figure 6.2, both countries could gain as they move from the common production point A to point
B for the ship specialist and point C for the airplane specialist. The two countries could then
consume at point D.
3. We are likely to see the rise of intra-industry trade in liquor between the U.S. and France. Consumers
in each country will benefit from a greater variety of alcoholic beverages (both domestic and
imported) at lower prices. Think of it: cheaper Jack Daniels! Cheaper Remy Martin!
4. IIT share = 1 – [sum of absolute value of (X – M)]/(sum of X + M)
a. With Japan: IIT = 1–{(75 – 60 + 70 – 150)/ (145 + 120)}
IIT = 0.817
With Sudan: IIT = 1–{(50 – 55 + 70 – 0)/ (115 + 55)}
IIT = 0.559
b. IIT with Japan is higher than IIT with Sudan. This is also likely true in the real world because IIT
is largely based on a rising demand for knowledge-intensive luxuries. The higher the level of
consumer income, the greater the proliferation of near-substitute varieties of goods and services.
Higher incomes make it possible to value variety for its own sake. Thus, since the United States
and Japan have higher income levels, they are buying each others’ version of similar products
(e.g., cars, entertainment equipment, etc.).
5. The standard H-O model suggests that the opening of trade in computers would reduce the well-being
of domestic buyers of computers by raising the price they must pay. But we might also consider the
possibility that economies of scale exist: when domestic computer manufacturers face additional
demand from Eastern Europe, production will increase. With scale economies, costs will fall as
production expands. As a result, domestic computer buyers may actually end up better off due to
lower computer prices.
11
Chapter 7
True/False
1. True.
2. True.
3. True! Ask the people who raised you.
4. False: export-based growth tends to raise trade volumes.
5. True insofar as isolation cuts the country off from new technologies that could raise productivity in
the country.
Multiple Choice
1. C
2. C
3. A
4. D
5. B
Problems
Figure 7.1
a. Saxony is experiencing export-biased growth. We would expect the volume of trade between
Saxony and Leinster to increase—the Saxon telephone industry will decline (Rybczynski), and
Saxony will import more telephones from Leinster instead.
b. Since Saxony is a small country, we would not expect bread’s trade price to change.
Consequently, Saxony can reach a higher level of utility as the new indifference curve suggests.
c. Leinster is experiencing “export-biased decline.” We would expect that the volume of trade
between Leinster and Saxony would fall. In a reverse of immiserizing growth, the level of
economic welfare in “large country” Leinster might actually rise: the terms of trade will move in
its favor as the supply of telephones (and likely the demand for bread) fall. Whether or not
welfare does rise will depend on the degree to which prices change and on the shape of
Leinster’s indifference curves.
This is a good example of how economic analysis can miss the broader picture: although the
terms of trade move in favor of Leinster, it is the result of a human catastrophe.
12
2. a. This export-biased growth may result in a reduction in Canadian well-being (a case of
immiserizing growth) if the price of wheat falls far enough and if Canada is highly dependent on
international trade in wheat and cloth.
b. The rest of the world will gain as a result of the decrease in the price of wheat.
c. The Rybczynski theorem tells us that the cloth sector will contract as the wheat sector expands.
Because the wheat sector absorbs fewer unskilled laborers than the cloth sector releases unskilled
wages will fall.
d. Canada should benefit from an increase in the world’s supply of labor. This will tend to reduce
the price Canada pays for cloth and increase the price (and quantity) of Canada’s wheat exports.
3. Not only can growth affect trade, but openness to trade can affect growth. Because Leinster has a
large telephone industry, it is likely that R&D there is significant. Productivity in Saxony may
increase as more technologically sophisticated imported telephones reduce the costs of doing
business in that country. At the same time, telephone producers in Saxony will have to innovate and
improve their products to compete with the imported units; some of the Leinsterian technology may
even be diffused into Saxony. Clearly, this can be good for Saxony.
4. a. According to H-O, Kazakhstan will export land-intensive and unskilled-labor-intensive goods. It
will import capital-intensive and skilled-labor-intensive goods.
b. To achieve import-biased growth to replace imports with a domestically-produced substitute,
Kazakhstan would need to increase its endowments of capital and skilled labor. If Kazakhstan
were a large country, this would turn the terms of trade in its favor: the price of imports in
particular would fall as the demand for them from Kazakhstan declines. As you might have
guessed, however, there are few (if any) goods for which Kazakhstan could have an impact on
the price.
5. a. This would be a case of import-biased growth: oil imports should fall.
b. In a strict one-dollar one-vote metric, well-being will rise as the terms of trade move in favor of
the U.S.
c. If the expansion of the oil sector is large enough, the Dutch disease could very well plague the
U.S.
d. Here, you should think about externalities—both positive and negative—to increased production
of oil and decreased production of other goods.
6. Assuming the increased savings on the part of American consumers will be transferred to investors
and not just hoarded under our collective national mattress, the rate of capital formation in the
economy should increase. This would amount to export-biased growth of a large country. In theory,
this would raise trade volumes with the rest of the world, while reducing the price of American
exports and increasing the price of imported goods. At an (unlikely) extreme, this could result in
immiserizing growth if the adverse terms-of-trade movement offsets any gains in our ability to
produce capital-intensive goods.
Chapter 8
True/False
1. False: a tariff may be welfare-increasing for a large country, but such a tariff always reduces world
welfare.
2. False: that is characteristic of an ad valorem tariff.
3. True, at least until Chapters 10 and 11 explore some counter-examples.
4. False: but you may think so at the end of the sections on tariffs.
5. True.
13
Multiple Choice
1. A
2. D
3. C
4. D
5. D
Problems
1. In Figure 8.1, the tariff that reduces imports from 80 million loaves to 40 million loaves raises the
price in Leinster to 0.44 telephones per loaf and reduces the price in Saxony (the “world price”) to
0.23 telephones per loaf.
a. Consumer surplus in Leinster falls by a + b + c + d; in Figure 8.1: consumer surplus in Saxony
rises by e + f.
b. Producer surplus in Leinster rises by a; in Figure 8.1: producer surplus in Saxony falls by e + f +
g + h + i.
c. To get the net change in welfare in Leinster, you must take into account that government tariff
revenues equal c + h. Therefore, the net change in welfare is (producer gain + government
revenue) – (consumer loss) = h – (b + d). Notice that, since the portion of the government
revenues coming from abroad (h) does not exceed the deadweight losses (b + d), this tariff is not
optimal for Leinster. And in Saxony, the tariff is a clear loss. The loss of producer surplus e + f +
g + h + i outweighs the gain in consumer surplus e + f.
d. The “world” welfare is reduced by the sum of the deadweights. On Figure 8.1 below, this shows
up as the triangles, b + d, and g + i.
Figure 8.1
2. a. The net U.S. national gain = the rectangle of foreign-price markdown [(3.00 – 2.50) x 300
million] – the triangle of deadweight loss [1/2 x (4.00 – 3.00) x (1200m – 300m)], for a total net
loss of $300 million in this case.
b. Unit value added with the tariff = $4.00 – $2.00 = $2.00. Unit value added without the tariff =
$3.00 – $2.00 = $ 1.00. The effective rate of protection for the beer industry, then, is (2.00 –
1.00) / 1.00 = 100 percent.
14
3.
Figure 8.3
Pbats
SUS
$100
$80
$65
a
b
c
e
d
P’world + tariff
Pworld
P’world
DUS
160 220 320 360
Qbats (000)
United States
Note that the U.S. is a “large country” when it comes to purchases of baseball bats: a $35 tariff
reduces the world price of bats from $80 to $65.
a. Bat consumers lose a total of $6.8 million, represented by area a + b + c + d.
b. Bat producers gain $3.8 million, represented by area a.
c. The government earns a tariff of $35 on each bat imported, for a total of $3.5 million, shown as
area c + e.
d. The net effect on well-being in the U.S. consists of government and producer gains totaling $7.3
million, minus consumer loss of $6.8 million. So, the net effect of the baseball bat tariff on the
U.S. is a gain of $500,000.
e. We don’t have numbers for all other countries in the world, but we do know that the bat buyers’
gain from the decrease in price will be less than bat producers’ losses, so there will be a net loss
for the rest of the world.
f. The net loss for the rest of the world will exceed the net gain to the U.S. because we know that in
each country the tariff causes deadweight losses.
4. If the effective rate of protection on clothing is less than zero, it indicates that trade policies of
Pakistan reduce the value added per unit of clothing. This can occur if tariffs on the inputs to clothing
(i.e., textiles) are higher than tariffs on imports of clothing. To provide the clothing industry more
protection, tariffs on imported textiles can be reduced, or tariffs on imported clothing can be raised.
5. Another way of measuring the effective rate of protection is
[toutput] – [share][tinput]
1 – share
where toutput is the tariff rate on the final good
tinput is the tariff rate on the imported input
and
share is the share of the imported input in the final good’s value under free trade
In this problem, the e.r.p. equals
[0.12] – [0.10][0.10]
= 0.122, or 12.2% .
1– [0.10]
In general, when the tariff on the final good exceeds the tariff on the imported inputs, the e.r.p. will
exceed the tariff on the final good.
6. Leinster’s import demand is much less elastic than Saxony’s export supply. (This should not be
surprising, since bread is a staple/necessity.) So if Leinster places a tariff on Saxon bread it is almost
certain that welfare in Leinster will decrease. (We can say with certainty that welfare will decrease
only if the supply of exported bread is infinitely elastic, and that is not the case here.)
15
Chapter 9
True/False
1. True.
2. False: insofar as a quota allows a domestic producer to act as a monopolist, the quota will reduce
welfare for the country that imposes it.
3. True: the U.S. government collected much of its revenues from tariffs for the first 50 to 100 years of
its existence.
4. True, if they had been auctioning the quota licenses.
5. True!
Multiple Choice
1. C
2. B
3. C
4. B
5. A
Problems
1. You should refer back to Figure 8.1. The illustration of a tariff that reduces imports to 40 million
loaves is the same as a quota or VER that reduces imports to 40 million loaves.
a. A quota can be a very effective way of reducing imports; it strictly limits quantities, whereas
tariffs do not. The quota licenses can be auctioned to the highest bidders (thus gaining revenues c
+ h) or can be passed out as political favors—buying votes or “good behavior.” The Leinster
government should be aware that a domestic bread monopolist may arise under the protection of
the quota, and this would be a welfare-reducing event.
b. Leinster could try to force a VER of 40 million loaves on Saxony. Then either the
first-at-the-dock Saxon exporters get a windfall from the higher price paid for their bread in
Leinster, or the Saxon government could auction export licenses and capture the revenues
(c + h) for itself. Either way the Leinster government doesn’t get any revenues when it
implements a VER, but it gets to appear as if it still promotes free trade.
Figure 9.2
Telephones
(loaves/phone)
2. a.
5
4.25
4
SS
R
DS
M2
M1
Saxony
16
Telephones
Suppose Saxony places a tariff of 0.25 loaves of bread per telephone on imports. As a small
country, this merely raises the Saxon price of telephones to 4.25 loaves of bread per telephone,
reducing imports from the free trade level of M1 to a level of M2. Suppose, instead, the Saxon
Minister of Trade had decreed an import quota of M2. This would exactly push up the price of
telephones in Saxony from the free trade level of 4 loaves/telephone to the quota-barriered price
of 4.25 loaves/telephone.
b. The Saxon Ministry of Trade could allocate quota licenses by:
i. auctioning them to the highest bidder, who would pay, at most, the difference between what
she pays in Leinster for telephones (4 loaves of bread) and what she can sell the telephones
for in Saxony (4.25 loaves of bread).
ii. The Minister of Trade can give the import rights to his brother-in-law Dave (an example of
fixed favoritism or nepotism), in which case Dave has a windfall of R and should be very
nice to the Minister at all future family reunions.
3. In Johnson’s technique, we express the deadweight losses from trade restriction as a percentage of
GDP. Referring to Figure 8.1, you can see that the area of the deadweights b + d is
(1/2)(base)(height):
= (1/2)(80m loaves – 40m loaves) (0.44 telephones/loaf – 0.25 telephones/loaf)
= 3.8 million telephones
So the cost to Leinster of protecting its bread market is 1.9 percent of its GDP each year. This is not a
small number in itself, but it doesn’t even attempt to measure other costs such as enforcement (a
coast guard to keep bread smugglers under control) or possible retaliation by Saxony against
Leinster’s telephone exports. We might say this is offset somewhat by the government revenue
collected from Saxony’s bread exporters, but in this case the amount is trivial: on each of the 40
million loaves of bread imported, Leinster collects 0.02 telephones per loaf, for a total of 800,000
telephones, or 0.4 percent of GDP.
4. a. Government revenue = (license fee)(# imports allowed)
= ($50)(100,000)
= $5 million.
b. Producer surplus rises by the higher price received on all cameras sold by domestic suppliers
before the quota (= $7.5 million) plus the value of extra sales of domestic cameras generated by
the limit on imports (= $1.25 million). So producer surplus rises by a total of $8.75 million.
c. Consumer surplus falls by the higher price paid on the cameras consumers still buy (= $15
million) plus the value of consumer surplus lost by those buyers who drop out of the market due
to higher prices on cameras (= $1.25 million). So consumer surplus falls by a total of $16.25
million.
d. The net effect, subtracting consumer loss from the government’s and producers’ gains, is a loss
of $2.5 million. (Notice that this is exactly the value of the consumption and production
deadweights.)
17
5.
Figure 9.3
Price
(dollars per CD)
Supply of exports
$15
$12
$10
b+d
c
e
a
Demand for imports (U.S.)
8 10
CDs (millions)
a. The U.S. gains (e – b – d) = 13 with the import quota, assuming quota rents are kept in the
United States. With the VER, the United States “gains” (– c – b – d) = –27. From a “one-dollar,
one-vote” point of view, the import quota is far better for the United States.
b. With the import quota, exporting firms/countries “gain” (–e – a) = –18. With the VER, the
exporting firms/countries gain (c – a) = 22. So exporters would prefer a VER to an import quota.
Chapter 10
True/False
1. True.
2. True, though they are “first” in the hearts of die-hard patriots.
3. False.
4. True!
5. True.
Multiple Choice
1. D
2. C
3. D
4. A
5. B
Problems
1. There would definitely be a national welfare loss for Saxony from a telephone tariff. There would be
both a production effect and a consumption effect, which would not be offset by any terms-of-trade
effect.
To justify incurring that welfare loss, the Saxon government could make an infant industry argument.
Or it could present the telephone industry as somehow strategic in national defense (the ability to
communicate is crucial to a country). There are also important spillover benefits from light industry
that would not result from agricultural processing, such as electronic innovation. Of course, the
national pride issue might come up (as it has in the electronics sector in the U.S.).
If Saxony did not want to place a tariff on imported telephones (perhaps because it feared retaliation
18
2.
3.
4.
5.
from Leinster), it could subsidize the domestic telephone industry or provide funds for
telecommunications R&D. This, of course, will mean that the Saxon government will have to come
up with funds rather than collecting revenues as in a tariff.
What a one-dollar one-vote econometrician would want to know is whether the present value of all
the irretrievable deadweight losses associated with the tariff is larger or smaller than the value of the
increased producer surplus that might be obtained once the “infant” grows up to be a more efficient,
low-cost producer. Not only are the magnitudes of these losses and gains important, but an economist
would also want to take into account the “discounted present value” notion, which argues that the
benefit of a dollar received in twenty or thirty years has less absolute value than a dollar’s cost
experienced today.
Although Saxony is a small country and so cannot hope to levy a nationally optimal tariff on
Leinster’s telephones, there may still be an argument for the tariff. As long as the tariff is not
prohibitive, it will generate revenues to replenish the government’s resources to fight the disease. But
more importantly, this tariff fits the specificity rule. Use of telephones is creating a negative
externality in Saxony, raising the social cost of telephones above the private cost. Levying a tariff
raises the price of imported and domestically produced telephones, so consumption will likely fall, as
will the number of citizens developing brain tumors.
Tariffs are second-best methods for income redistribution: they have associated deadweight costs. On
the other hand, import protection might be a better solution than doing nothing at all, particularly if
those scarce factors of production are difficult to mobilize into new sectors after trade opens. A more
“efficient” means of addressing the problem is retraining those factors of production to work in
expanding (perhaps export) sectors. As we have seen in many industrialized countries, however, this
is easier said than done. In that case, a government subsidy to maintain the factor’s employment is a
less costly approach than an import tariff or quota.
The import tariff might be better than doing nothing—it depends on how high the tariff barrier is,
among other things. But the specificity rule warns that something else is probably better. Since the
problem is that firms lack the capital to see themselves through until the later increases in efficiency,
the government should lend funds to them. Alternatively, a temporary production subsidy is virtually
as good as a loan, although raising the tax rates to get revenue for the subsidy might have negative
incentives elsewhere in the economy.
Chapter 11
True/False
1. True.
2. True.
3. False, except insofar as countries go to war over trade!
4. True, but depending on the year, Japan rivals China as a steel exporter.
5. True.
Multiple Choice
1. C
2. B
3. A
4. D
5. D
19
Problems
1.
Price of telephones
(loaves per telephones)
Figure 11.1
Demand for imports
(Saxony)
4
a
b
3
c
World price
Price after
Export subsidy
700 800
Telephones (thousands)
If the Leinsterian government subsidizes the export of telephones to Saxony, it will reduce the price
Saxons have to pay. As Figure 11.1 shows, a subsidy could reduce the price from four loaves of
bread per telephone to three loaves of bread per telephone. This cost to Leinster will be the amount
of the subsidy times the number of exported units, or area a + b + c. Saxony, on the other hand, will
gain consumer surplus of a + b, as more units are imported at a lower price. As a result, the world as
a whole will lose area c. This represents wasted resources as Saxony buys “too many” telephones at a
price less than the cost of production (as embodied in Leinster’s original export supply curve).
2. a. Although cheap telephones are a boon for Saxon consumers, they represent a threat to Saxon
telephone manufacturers who must compete with the lower-priced (and probably below-cost)
imports. Some portion of the domestic industry is likely to go out of business. If telephones could
be considered a strategic good, or a product with beneficial spillover effects for the rest of the
economy, the Saxon government might want to counteract the subsidy. Plus, if Leinster is trying
to drive out Saxon import-competing producers to create an international monopoly (and later
raise prices above the competitive level), Saxony would want to nip this subsidy in its bud.
b. One reason Leinster’s government might subsidize telephone exports (although they are unlikely
to admit it) is to undercut the Saxon telephone industry and create a monopoly for the Leinster
industry. In this situation an export subsidy would act to finance predatory dumping. (This would
be more likely if some political patronage is involved, e.g., if government officials in Leinster
have a financial stake in telephone exports!)
But keep in mind that Leinster’s own telephone buyers are not going to be pleased about the
whole scheme. Not only are they taxpayers who have to fund the subsidies, but they will also end
up paying a higher domestic price for their telephones, since no Leinsterian producer will sell
them telephones at anything less than the subsidized price he receives for exported telephones.
c. If the Saxon government levies a countervailing duty of one loaf of bread per telephone, the price
of telephones in Saxony will return to four loaves per telephone, and exports will be reduced. In
Figure 11.1 this would be illustrated by an upward shift of the world price line back to its
original level.
Although Saxon telephone consumers won’t be happy, Saxon producers will no longer be
undercut by imports. In addition, the Saxon government now collects area a in duties on the
remaining 700,000 imported telephones. On the other hand, Leinster not only shells out area a in
subsidies on the remaining exports, but it has not ended up with any net increase in the quantity
of exports.
On net, this “strike-counterstrike” policy only results in Leinster’s subsidies being transferred
into the Saxony government coffers.
20
3. Assuming the domestic price in the exporting country is the price at which TVs left the factory
destined for domestic distribution, then both Philips and Sharp are guilty of dumping: 250 > 200 for
Philips; 325 > 310 for Sharp. RCA is not guilty of dumping because 300 = 300.
Alternatively, if you interpret “average unit cost” as the price at which TVs leave the factory for
domestic distribution, then only Philips is guilty (250 > 200), while Sharp is not (300 < 310), and
RCA is not (295 < 300).
4. In general, a firm has an incentive to dump if the good has a lower elasticity of demand at home than
abroad.
Consider Figure 11.4, in which Hibernian demand is inelastic and demand in the rest of the world
(ROW) is infinitely elastic.
Figure 11.4
PSteel
PH
MCRigid Inc.
PRow
MRRow = DRow
DH
MRH
QH
QTotal
QSteel
As a profit-maximizing company, Rigid Inc. will produce where MR = MC, at a level of Qtotal.
Because re-export of steel is costly, Rigid Inc. can price discriminate, charging PH for sales of QH in
Hibernia and PROW for exports of Qtotal – QH to the rest of the world.
5. You can see from Figure 11.5a given in the guide that Venezuela is a large country when it comes to
coffee. With the export subsidy, Venezuelan growers will export 1 million pounds of coffee to the
rest of the world at a price of $9 per pound; on top of this they will receive a $2 per pound subsidy
for a net price of $11 per pound. (And this is what they will charge Venezuelan consumers for a
pound of coffee.) When the export subsidy is removed, the world price rises to $10 per pound and
exports drop to 600,000 pounds.
After the subsidy, production and exports of coffee both decline, as does the price that Venezuelan
growers receive. In Figure 11.5b, you can see that they lose area a + b + c, which totals $2.9 million.
On the other hand, Venezuelan coffee drinkers win: now they pay the world price of $10 per pound.
They gain area a + b, which totals $2.1 million. And the Trade Minister is especially pleased to hear
that the government no longer has to cough up export subsidies that had totaled $2 million. In fact,
you assure him that the country as a whole gains, on net, $1.2 million (the difference between the
government’s and the consumers’ gains and the producers’ losses).
To really strut your stuff, you tell the Minister that you’ll throw in an analysis of what happens in the
rest of the world, too. While the news is a bit grim for ROW coffee drinkers (they pay more and
import less, areas e + f + g, for a loss of $21.9 million), ROW coffee growers cheer, since they now
don’t have to try to compete with artificially cheap Venezuelan coffee. ROW producers gain area d,
which equals $21.1 million. So, unfortunately, the rest of the world loses $800,000 when the coffee
export subsidy ends.
21
But, you reassure the Trade Minister (who is now feeling guilty about all those unhappy coffee
drinkers in the rest of the world) that the world as a whole gains $400,000 by stopping the subsidy;
this is shown as the triangle bounded by the 3 dots on Figure 11.5a. You smile and inform him that
this is exactly the sum of the deadweight losses no longer incurred.
[P.S. Next time, find a more secluded beach to hang out on!]
6.
Figure 11.6
a. With this support price for bread, Leinsterian bakers now crank up their production while the
domestic consumers cut back on purchases. This creates a surplus of bread (AB) in Leinster.
Clearly, Leinster no longer will import bread. In fact, it is likely that this bread surplus—which
the government must buy up in order to maintain the support price—will become an exportable
commodity.
To recoup some of the cost of the support, the government can sell the bread on the world market
for whatever it will bear. This will be no more than the original free-trade price of 0.25
telephones/loaf; if Leinster can be considered a “large country,” the release of this excess bread
onto the world market could force the world price down.
Bread has become a switch-over good in Leinster, just as butter did under the real-world price
supports of the European Union.
b. Leinster’s bakers will have an enormous increase in their welfare: not only are they selling more,
but they are doing so at a higher price. The increase in producer surplus equals area a + f + g + h.
But consumer surplus loss equals a + b + c + f + g, which exceeds the producer gain, so the
residents of Leinster lose in the first instance.
At the same time, the Leinsterian government must buy up the excess bread on the market (AB)
at a price of 0.75 telephones/loaf. At best, this surplus can be resold on the world market for the
going price of 0.25 telephones/loaf, yielding an additional loss to the government (and so the
citizens) of (AB loaves) x (0.50 telephones/loaf). But as a large country, it is likely that this
exported Leinsterian surplus will bring in something less than the original world price, draining
the treasury even more.
This should, of course, make you wonder about the wisdom of price-support schemes. It seems
clear that they cannot be justified by the one-dollar, one-vote metric.
22
Chapter 12
True/False
1. True.
2. False: there may be welfare-decreasing trade diversion.
3. False: gains would be smaller.
4. True.
5. True.
Multiple Choice
1. C
2. B
3. C
4. B
5. B
Problems
1. With no tariffs between them, Leinster and Saxony could be considered a free trade area. To be a
customs union, however, they would have to have a common tariff against other countries of the
world, and remember—you have not been told that any countries exist in the “world” discussed here
except Leinster and Saxony!
Leaving aside the issue of the external tariff, Leinster and Saxony could be a common market if they
allowed the factors of production to move freely between the countries. For the two countries to
comprise an economic union, however, the governments in Leinster and Saxony would have to
develop joint fiscal and monetary policies.
You might want to speculate on the possibility of an agricultural nation joining together with an
industrial nation. That is to say, are there factors other than economic ones that could make this
problematic or beneficial?
2. Assume that the elasticity of demand and supply are the same.
Figure 12.2
23
If the U.S. joins a free trade area with Mexico (a higher-cost producer than South Korea), American
shoe consumers will gain area a + b + c + d (= $9,750), American shoe producers will lose area a
(= $4,250), and the U.S. government will lose tariff revenues c + e (= $10,000).
On net, the U.S. loses $4,500 from joining the free trade area with Mexico. The loss of tariff revenue
e is larger than the gain of deadweight losses b + d.
3.
Figure 12.3a
Price of telephones
(loaves per telephones)
Supply in Saxony
6
5 1/3
5
a
b
c
1 2/3
Demand in Saxony
Telephones
a. With an initial nondiscriminatory tariff of 4 1/3 loaves of bread, the price in Saxony of Leinster’s
telephones would be six loaves; the price of Avalon’s telephones would be 5 1/3 loaves. Under
this tariff, Saxony would initially produce its own telephones and import none, because domestic
telephones are less expensive than telephones imported from either Leinster or Avalon. However,
if the tariff were selectively removed on Leinsterian telephones, Saxon consumers would switch
to telephones imported from that country (at an untaxed price of 1 2/3 loaves per telephone). The
result is trade creation. As illustrated in Figure 12.3a, while Saxon telephone producers lose area
a, Saxon consumers gain areas a + b + c, for a net national gain of b + c.
Figure 12.3b
Price of telephones
(loaves per telephone)
Supply in Saxony
5
2 2/3
2
1/23
1
b
e
a
c
f
d
g
Demand in Saxony
Telephones
24
b. On the other hand, if the initial nondiscriminatory tariff had been 1 loaf of bread, the price of
Leinster’s telephones would be 2 2/3 loaves; the price of Avalon’s telephones would be 2 loaves.
Under this tariff, Saxony would import telephones from Avalon. However, if the tariff were
selectively removed on Leinster, Avalonian telephones would remain at the tariffed price of 2
loaves while Leinster telephones would enter without tariff at a price of 1 2/3 loaves. This
customs union would divert trade away from Avalon and towards Leinster. As illustrated in
Figure 12.3b, Saxon producers would lose area a, while Saxon consumers would gain area a + b
+ c + d + e. The Saxon government, however, loses all the tariff revenues it used to collect on
Avalonian imports, area c + d + f + g. As a result, Saxony incurs a net loss from this customs
union with Leinster. (Notice, however, that depending on the size of the revenue losses versus
the recovery of previous deadweights, Saxony might have an increase in its welfare from the
customs union with Leinster—just not as large a welfare gain as it would have if the customs
union had been with Avalon.)
4. a. For an embargo to be effective (in economic terms), the trade ban should reduce welfare in the
target country without causing much welfare loss to the people of the embargoing country. This
will be the case if import demand in the target country is low (inelastic) and export supply from
the embargoing country is high (elastic). Looking back at Figure 2.1c, you should see that
Saxony’s bread export curve is much more elastic than Leinster’s demand for imported bread.
(This is probably because bread is a staple food in Leinster.) So in economic terms, we would
expect the Saxon bread embargo to be economically effective.
b. Whether or not the Saxon embargo is politically effective will depend upon a number of things.
First, insofar as Saxony is a small country, the attempt to punish a larger country might bring
down upon Saxony unimaginable kinds of retaliation. In a broader sense, denying the export of a
necessary foodstuff could backfire politically and socially. (Recall some of the reactions to the
American embargo on wheat exports to the Soviet Union in the late 1970s.)
Chapter 13
True/False
1. True.
2. True: when the tax imposed on domestic producers reflects the social costs of the damage the
factories cause, it will raise the cost of production and so the autarky price of the good. If that
autarky price rises enough (i.e., above the world price), the country could turn into a net importer of
the good.
3. False: much of the conflict is between the “green” developed countries and the developing countries.
4. False: it doesn’t matter to whom the property rights are assigned, as long as they are assigned to one
of the parties.
5. True: as long as that world government assigns property rights.
Multiple Choice
1. E
2. C
3. A
4. D
5. C
25
Problems
1. Since this “greenhouse” problem is between only two countries, it might be resolved by some
international negotiation, or by levying a tax on all bread producers (including those in Leinster) and
using the proceeds to develop new filters for bakeries or new gas-free yeast strains.
2. Assuming that the pollution produced is domestic (rather than trans-border), migration of these
industries to other countries could increase world welfare if the perceived marginal social cost of
pollution in the richer countries exceeds the perceived marginal social cost of pollution in poorer
countries. Migration will also be welfare-increasing if the decreased production in the richer
countries causes a smaller absolute reduction in utility (because incomes are already high) than the
increase in utility associated with expanded production in poorer countries (because incomes are so
low).
3. The tax will increase the price of owning a telephone in Leinster, reducing domestic demand. As a
result, there will be an excess supply of telephones in the country, leading to more units available for
export to Saxony. Prices of imported phones will fall in Saxony, increasing national welfare as
consumer gains exceed local producer losses.
However, a broader measure of welfare in Saxony should include any external effects of increasing
telephone communication there. We could imagine a number of possibilities, including two of
opposite sign. In one scenario, Saxony could experience the same kind of negative externality that
Leinster was facing when its citizens were using their telephones and avoiding social interplay. On
the other hand, if Saxons are a dispersed, agricultural populace, increased access to telephones could
improve levels of communication across the country. This positive external effect would be well
served by increased imports of Leinster’s telephones. (In fact, the Leinsterian tax might end up
raising welfare significantly in “the world” as a whole by causing import-export patterns to better
reflect social measures of tastes.)
4. First, insofar as trade increases per capita incomes, the demand for a cleaner environment will
increase. Second, if diffusion of technology follows greater openness, developing countries are likely
to gain access to cleaner methods of production developed in industrialized countries. Finally, if
trade liberalization is accompanied by the removal of government protection of producers, we may
see less over-fertilization in developed countries’ agriculture, and less overuse of energy in the
nationalized industries in developing or transition economies.
5. There are a number of these “debt-for-nature” swaps already in existence, such as the United States’
Tropical Forest Conservation Act. Both sides in the swap benefit: lending countries get something
that otherwise might be difficult to obtain (preservation of biodiversity); borrowing countries get
debt relief, and the funds that otherwise would have gone out to pay international debts now stay at
home in the form of conservation activities.
Chapter 14
True/False
1. False: remember that “developed” refers to variables other than simply wealth or income.
2. False: they can be quite different.
3. True.
4. False: just as in the “optimal tariff,” world welfare is reduced by cartels.
5. True: as with taking off a Band-Aid, the record shows a short but sharp removal of controls is less
painful for transition economies. Although output levels will decline dramatically at first, GDP
recovers relatively quickly. Poland, for example, used shock therapy in 1990 but had resumed real
growth by 1992; the country is now a full member of the WTO and the EU. In contrast, Russia
liberalized more slowly starting in 1992 and did not see a return to real GDP growth until after 1996.
26
Multiple Choice
1. B
2. B
3. D
4. D
5. B
Problems
1. a. Among other reasons, the Saxon government could talk about the strategic importance of
telecommunications equipment and the spillover benefits gained from a light industry sector.
Saxony might also want to reduce its reliance on trade in bread since Engel’s Law suggests that
food producers stand to lose in a world of increasing incomes (the income elasticity of demand
for food is less than one). Arguments against industrialization include negative externalities of
urban-industrial areas, loss of traditional occupations in farming, and the chance that the “infant
industry” never matures.
b. A subsidy to Saxon telephone manufacturers would be a better idea than a tariff or a quota since
Saxony could avoid the consumption deadweight loss. A subsidy assumes, however, that the
Saxon government’s coffers have enough in them to fund the subsidy.
2. Recall Engel’s Law relies on an assertion that “food” is a staple and has an income elasticity of less
than one. When incomes rise, demand shifts towards luxuries (that have an income elasticity greater
than one) and away from staples. But what if the Ministry of Agriculture in Saxony developed a
program to move resources out of basic bread production and into more “luxury” foods, such as
exotic fruits and vegetables? Then, as incomes rise in both countries, the Saxon farmers would see
their prices and sales increasing.
3. Raw rubber is subject to a declining price, largely because of the development of synthetic
substitutes. On the other hand, it seems clear that worldwide demand for surgical supplies will grow:
the income elasticity of health care is probably greater than one. So on price grounds alone, it would
be wise for Malaysia to move away from exporting the primary product of rubber and toward the
manufacture of rubber-based goods. In addition, one could argue that the spillover benefits from light
manufacturing are likely to be far larger than those resulting from the extraction of raw rubber.
Possible policies to promote the development of a surgical goods industry are export subsidies for
those goods, or government support for research and development into the production of those goods.
(A problem for each of these policies, of course, is the limited size of the Malaysian government’s
revenues.)
4. Given d = –0.5, SO = 1.0 and c = 0.5, the optimal cartel markup t* = c / [d – SO (1 – c) ] = 50%.
Chapter 15
True/False
1. True.
2. False: FDI usually includes a large component of “human capital” such as management skills and
entrepreneurship.
3. True: their wages tend to rise as the domestic labor supply decreases.
4. True: the taxes paid by those workers are correlated with the level of their skills and wages.
5. True!
27
Multiple Choice
1. D
2. A
3. B
4. C
5. A
Problems
1. a. Since we have talked about the possibility of trade barriers, perhaps Leinster’s telephone
executives want to avoid being caught in a trade war.
b. FDI would be preferable if the profitable manufacture and distribution of telephones in Saxony
requires skills and assets that are unique to Leinster. Telecommunications equipment is typical of
the kinds of goods that are produced with firm-specific advantages.
c. The Leinster government would certainly want to warn telephone executives about the possibility
of political instability in Saxony, and the resulting likelihood that a manufacturing plant there
could be seized and nationalized. Leinster’s government might actually try to prevent this FDI if
the executives were moving their plant to Saxony simply to evade taxes in Leinster. And,
importantly, workers in Leinster (who otherwise would have been employed in the telephone
industry) will not be pleased about their jobs being “shipped overseas.”
d. The Saxon government will actively seek the employment and tax proceeds that would come
from hosting a new telephone plant, even if it is controlled by foreign owners. If there are
positive spillover benefits for the Saxon economy, the FDI will also be attractive. However, to
the extent that the Leinster telephone executives start to throw their weight around the Saxon
political arena, the FDI could turn out to be a Trojan horse.
2. You might see two different forces at work here. First, insofar as the cost of transporting finished
goods between countries is prohibitive, a foreign corporation might find it cost-effective to
manufacture goods in the host country for sale in that country. FDI would then decline as these sorts
of transportation costs were reduced.
On the other hand, when we consider the costs of transporting people and information, a reduction in
those costs would make it much easier for a corporation to maintain long-distance control over dayto-day operations of its foreign subsidiary. FDI would rise as a result.
3. a. In the absence of immigration, the wage in each country would reach equilibrium where the
quantity of labor demanded just equaled the quantity of labor supplied at that wage. Looking at
the graphs, you can see that this occurs at a wage of 10 scudos in Leinster and 14 scudos in
Saxony.
b. If labor has the possibility of moving between countries, workers from Leinster are sure to seek
the higher wages available in Saxony. This will tend to raise wages in Leinster (as the local
supply of labor declines) and to reduce wages in Saxony (as the local supply of labor rises).
c. i. If the flow of labor from Leinster to Saxony is restricted, wages will rise in Saxony and fall
in Leinster.
ii. “Stay behind” workers in Leinster will lose as their wages fall with the return of the
immigrants. “Stay behind” workers in Saxony, however, will gain as Leinsterian immigrants
leave the labor market. The immigrants themselves are clear losers—presumably, the reason
they emigrated in the first place was to improve their economic welfare.
iii. Leinster’s employers will gain as wages are bid back down again. Saxon employers will lose
as wages are bid back up again. Any employer who counted on immigrant workers will
definitely lose.
28
iv. The loss of welfare to the world as a whole can be illustrated by the two small triangles
bounded by the countries’ curves and the 12 scudo wage line on Figure 15.3.
4. Because farm labor is largely unskilled, the guest worker program fits a kind of specificity rule.
Increased immigration quotas would not guarantee that the extra immigrants are agricultural workers;
at least some are likely to be “brain drain” immigrants who would not (and, in a sense, should not)
work in agriculture.
Second, guest workers are usually given only temporary labor permits. In this way, after the labor
needs of the harvest, these immigrants would be required to exit the country. Cyclical labor demands
would be exactly matched by cyclical labor supplies.
Finally, in contrast to many undocumented immigrants, the guest workers’ wages would be taxed,
and so the immigrants would be much less likely to represent a fiscal burden to the host country.
5. This is a bit of factor price equalization on its head. Instead of commodities moving, the factors that
produce them do. Instead of equating commodity prices on the way to equating factor prices, we
might just have factors of production move between countries until the income each kind of factor
can earn is equated internationally.
Chapter 16
True/False
1. False: a net debtor is a country that has had mostly negative net foreign investment in the past, not
necessarily this year.
2. True.
3. False.
4. True: since Y = C + I + G + (X – M), when G increases, (X – M) must decrease.
5. Perhaps!
Multiple Choice
1. A
2. B
3. D
4. C
5. A
Problems
1. a. We know that Y = C + Id +G + (X – M), so for Leinster, 100 = 60 + 15 + 15 + (20 – M). Imports
(M) from Saxony are 10 billion lira.
b. Since Leinster is running a trade surplus with Saxony (exports from Leinster exceed imports into
Leinster by 10 billion lira), Leinster is “lending” to Saxony. Saxony pays for the extra imported
telephones by sending Leinster an IOU or by giving Leinster title to assets worth 10 billion lira.
2. a. The cottage purchase is a debit on the financial account.
The baseball bats are a credit on the current account.
The profits are a credit on the current account.
The interest paid is a debit on the current account.
The remittance to Dublin is a debit on the current account.
The Las Vegas fling is a credit on the current account.
The hot dog stand purchase is a credit on the financial account.
29
The purchase of wine is a debit on the current account.
b. The balance on goods and services is (credits of $2,004) – (debits of $1,002) = a trade surplus of
$1,002.
The balance on the current account includes the balance on goods and services as well as net
income and unilateral transfers. Here, net income = (Costa Rican profits – Treasury interest paid)
and unilateral transfers (the remittance to Dublin). So the overall current account balance is
(+$1,002) + (–$2) + (–$996) = $4.
In this case, both of the listed capital flows are direct investment. Net private capital flows equal
(the Greek’s purchase of a NYC hot dog stand) – (Trump’s purchase of a French cottage) = –$2.
c. Because
CA + FA + OR = O,
we know that OR = – (CA + FA)
so
OR = – ($4 – $2) = –$2.
This means that the Federal Reserve must be buying $2 worth of foreign currency.
d. Since this is a very small change in official reserves, it is unlikely that the Fed is engaging in
some scheme to fix the value of the currency.
3. The only credit item for the current account is (c) the sale of weapons to the Israelis.
4. a. The merchandise trade balance = (electronic goods exports) – (food imports) = –$200.00
The current account balance = merchandise trade balance + (service exports – service imports)
= –$200 + (computer consulting – vacations abroad)
= –$200 + ($1,600 – $200)
= $1,200.00
(Notice that the current account is in surplus—despite a merchandise trade deficit—thanks to a
big surplus on services.)
b. Because the current account is in surplus, Avalon must be increasing its net holdings of foreign
assets. This is clearly the case: capital outflows to buy Saxon summer homes ($500) and shares
in a telephone firm in Leinster ($800) exceed capital inflows to buy Avalon corporate bonds
($100). The balance on the financial account is –$1,200 and this exactly equals the balance on
the current account ($1,200).
c. Because Avalon had positive foreign investment abroad in 2011 does not mean that the country
is a net creditor. Whether a country is a net creditor or debtor depends on the entire spectrum of
capital flows over the country’s history. In the past, Avalon may have run massive current
account deficits and so amassed a great deal of overseas debt. The net capital outflow of 2011
alone would probably not negate this accumulated debt.
5. No. The “twinning” of the budget and trade deficits in the U.S. reflected, at least in part, low private
saving rates. Domestic investment and government spending exceeded the amount of saving by
American residents; households were on a spending spree too. As a result, the quantity demanded of
output was greater than our own production. The result was a need to import goods and services from
abroad. So, we could have looked at the 1980s as a period of low saving “twinned” with a trade
deficit.
A useful contrast is the case of Japan during the same period, when the Japanese government was
running a budget deficit but the country was running a trade surplus. In this case, saving rates of
residents were so high that they provided not only for domestic investment and government
expenditure, but for America’s needs as well.
30
Chapter 17
True/False
1. False: to purchase the imports, we supply dollars in exchange for francs.
2. False: intervention is more prevalent under pegged rates.
3. True.
4. True (unless you are Swiss and are bidding at Sotheby’s!)
5. True.
Multiple Choice
1. C
2. B
3. B
4. C
5. A
Problems
1. a. The equilibrium exchange rate is 100 scudos per lira, or Ss 100/Ll.
b. Since this is a nominal “bilateral” exchange rate, just invert it (or yourself) to find that the
exchange rate from Leinster’s point of view is 0.01 Ll/Ss.
c. You would expect the supply of lira in exchange for scudos to increase, shifting the supply curve
to the right and pushing the exchange rate down. So it would take fewer scudos to buy a lira, or a
lira would not exchange for as many scudos. This is an appreciation of the scudo and a
depreciation of the lira.
d. If the minister had wanted to keep the exchange rate at Ss 100/Ll, she would have to satisfy the
excess demand for scudos that would arise when the supply of lira increased. (In fixed exchange
rate terminology, the scudo would be undervalued at the old exchange rate of Ss 100/Ll.) This
would require the Saxon minister of finance to sell scudos and buy up lira.
2. a. Keep in mind throughout this problem that an appreciation of the scudo means it costs more lira
to buy one scudo (or that it takes fewer scudo to purchase one lira).
Because it will take more lira to buy the scudo, the Saxon goods denominated in scudo will be
more expensive for someone in Leinster to purchase.
b. The Saxon goods will now bring in more lira than before. Unfortunately, the increase in the price
of those goods to Leinster residents may mean that fewer Saxon goods are purchased by
Leinster’s residents than before.
c. The Leinsterian goods will now bring in fewer scudo than before. The upside to this is that
Saxons see Leinster’s goods becoming cheaper and may purchase more of them.
d. If the retiree is a Saxon, the appreciation of the scudo means she can buy more Leinsterian goods
than before, although it won’t change her ability to purchase domestic goods. If the retiree lives
in Leinster, she has protected her ability to purchase imports, and if she cashes the scudo in for
lira, she will get many more lira than before.
e. If those who expected a depreciation of the lira had sold them all for scudos, the appreciation of
the scudo (that is, the depreciation of the lira) will turn out to have been a very good thing. Their
scudos are now worth many more lira.
31
3
a. Since the supply of euros would fall, we would expect the $/€ exchange rate to rise: the euro
would appreciate and the dollar would depreciate.
b. The American demand for euros would rise, so the exchange rate would rise: the euro would
appreciate and the dollar would depreciate.
c. The American demand for euros would rise, so the euro would appreciate and the dollar would
depreciate.
d. The French supply of euros would rise, so the euro would depreciate and the dollar would
appreciate.
e. The American demand for euros will fall as American speculators dump the euro, and the
exchange rate would fall, too: the euro would depreciate, in a “self-fulfilling prophecy.”
4. a. The U.S. must sell euros and buy dollars to keep the dollar from depreciating.
b. As in 4.a., the U.S. must sell euros and buy dollars to keep the dollar from depreciating.
c. Once again, the U.S. must sell euros and buy dollars.
d. The U.S. must buy euros and sell dollars to keep the dollar from appreciating.
e. The U.S. must buy euros and sell dollars to keep the dollar from appreciating.
5. The “route to follow” would be Tokyo yen to New York dollars to Munich euros to Tokyo yen.
In Tokyo: take the million yen and trade them for dollars, receiving $10,000.
In New York: take the $10,000 and trade them for euros, receiving €30,000.
In Munich: take the €30,000 and trade them for yen, receiving Y2.1 million.
You would end up with a profit of 1.1 million yen for being so observant and taking advantage of
triangular arbitrage.
Chapter 18
True/False
1. False: the forward rate may approximate what investors think the future spot rate will be, but it will
not determine the actual future spot rate.
2. False: speculation may occur through both short and long positions.
3. True.
4. False, at least insofar as you can see many flattened hedgehogs along the roads in England.
5. True.
Multiple Choice
1. B
2. A
3. C
4. B
5. D
Problems
1 a. If you sell lira forward (buy scudos forward) you will receive 95 scudos for each of the 10,000
lira, for a total of Ss 950,000.
b. If your high guess about the future spot rate (Ss 105/Ll) turns out to be correct, when you sell
your 10,000 lira you will receive a total of Ss 1.05 million instead of the guaranteed Ss 950,000
from a forward contract. But if the future spot rate turns out to be on the low side, you will get
only Ss 850,000.
32
c. How much risk do you like in your life? Will you have to work in the bakery the rest of your life
to make up the Ss 100,000 you lost? Just how understanding are your parents?
2. a. To start off this question, you want to express interest rates and exchange rates in the same
periodicity. So convert the annual interest rates into semi-annual (180-day) rates by dividing by
2: the 180-day interest rate in Saxony is 4%; the 180-day rate in Leinster is 3%.
To figure out whether financial capital will flow between the countries, we want to compare the
risk-free returns Saxons can earn at home and abroad, and the risk-free returns Leinsterians can
earn at home and abroad. This means we need to look not only at the interest rates offered but at
what, if any, exchange rate gains or losses may be incurred.
A Saxon who keeps her money at home will, at the end of 180 days, have Ss 104 for each 100
scudos she invests in a Saxon bond, for a net return of 4%.
A Saxon who decides to send her funds to Leinster will go through the following calculation: She
will buy one lira spot for Ss 100 and purchase a Leinster bond with it. In 180 days, she knows
that (barring the possibility of a default by Leinster’s government), she will get back Ll 1.03. If
she signs a forward contract today to redeem those 1.03 lira for scudos at the forward rate of Ss
110/Ll, she will have Ss 113 in 180 days. This is a risk-free return of 13.3% on her Ss 100
investment.
Clearly, Saxons are going to want to send their funds to Leinster. What are Leinsterians going to
do?
A Leinsterian who keeps her money at home will, at the end of 180 days, have Ll 103 for each
100 lira she invests in a Leinster bond, for a net return of 3%.
A Leinsterian who decides to send her funds to Saxony will go through the following calculation:
She will buy 100 scudos spot for one lira and purchase a Saxon bond with them. In 180 days, she
knows that (barring the possibility of default by Saxony’s government) she will get back Ss 104.
If she signs a forward contract today to redeem those 104 scudos for lira at the forward rate of
1Ll per 110 Ss, she will have Ll 94.54 in 180 days. This is a risk-free loss of 5.46%!
Clearly, Leinsterians are going to keep their money at home.
b. With lots of Saxons wanting to purchase Leinster’s bonds, the spot rate will rise above the initial
Ss 100/ Ll . At the same time, those investors are going to be signing forward contracts to redeem
the lira in 180 days, and this will push the forward rate below its initial Ss 110/Ll .
c. What we’re looking for here is the spot rate that yields covered interest parity.
This occurs where
f/e
=
(1 + iSaxony)/(1 + iLeinster)
Or
(Ss110/Ll)/e
=
(1.04)/(1.03)
(Ss110/Ll)/e
=
1.0097
(Ss110/Ll)/1.0097
=
e
So
e
=
Ss108.9/Ll.
The lira must become much more expensive in the spot market before Saxons will be indifferent
between investing at home and investing abroad.
3 a. You should sign a contract to buy lira at a forward rate of Ss 100/Ll. If your guess is correct, you
will pay Ss 100 for every lira in 180 days, then take those lira to the spot market and sell them for
Ss 120 each. You would make a profit of Ss 20 for each Ss 100 you bet.
b. You will make positive profits as long as the spot rate that prevails in 180 days is higher than
Ss 100/Ll. You will make losses if the future spot rate turns out to be less than Ss 100 / Ll.
c. Speculators put their money where their mind is. You have bet that the scudo is going to
depreciate over the next 180 days. If there are more speculators like you, the increased demand to
purchase lira will push up the forward rate on the lira until it approximates your average guess of
Ss 120/Ll. This is how the forward rate comes to reflect market participants’ expectation of the
future spot rate.
33
4. a. For uncovered interest parity to hold, the following equality must hold:
eex/e
=
(1 + home interest rate)/(1 + foreign interest rate)
Here, (Ss 102/Ll)/(Ss 100/Ll) must equal (1.08)/(1.06).
Close, but no cigar! The ratio of exchange rates is 1.02; the ratio of interest rates is 1.018. That
may seem close but, when you are talking about millions of scudo or lira, the difference is huge.
b. Uncovered interest parity will hold only if the current spot rate rises to Ss 100.11/Ll .
c. Arbitrageurs who don’t mind risk will notice that, given the rates listed in 4. a., they can profit
from buying scudos, investing them in Saxony, and redeeming them in the future. As a result,
there will be an increased demand for scudos in the spot market, and the price will rise. Only
when the spot rate on the lira rises to Ss 100.11 will arbitrageurs be indifferent between holding
scudos and holding lira.
5. Notice first that the British pound is at a forward discount of 2.5 percent: (ef – e)/e = (1.95 –
2.00)/2.00 = –0.025. Also, there is a 3 percent interest differential in favor of Britain.
a. The interest differential (the extra interest you earn by putting your funds in British assets)
exceeds the forward discount on the pound (the amount you lose by paying a higher dollar price
for the pounds than you will ultimately redeem them for). So, it would be a good idea (and a
riskless one) to trade your dollars for pounds today, invest in Britain, and sell the pounds
forward.
With $100, the scheme would go like this: buy 50 pounds with your $100, invest the 50 pounds
at a 7 percent rate, and sell forward the 53.5 pounds you expect to get for a price of $1.95 each.
Expected total return = $104.325.
If you had “stayed at home” and bought a U.S. asset earning an interest rate of 4 percent, your
total return on an investment of $100 would be $104.00.
So, “going through Britain” would earn you an extra 32.5 cents per $100 invested—not much on
a $100 transaction, but a whole lot on a million dollar transaction.
b. You will earn zero profit if the forward discount rate on the British pound exactly offsets the
interest differential in favor of Britain (or against the United States). This is the covered interest
parity condition: (ef – e)/e should equal approximately –3 percent.
Since the spot price is $2.00/£, the forward rate would have to fall to approximately $1.94/£ for
covered interest parity to hold.
Chapter 19
True/False
1. True: this is one of many “self-fulfilling prophesies” in economics.
2. False: the home currency will appreciate as investors buy assets denominated in the home currency.
3. True.
4. True.
5. True.
Multiple Choice
1. D
2. C
3. D
34
4. A
5. A
Problems
1. a. There will be a rush to purchase scudos before they become more expensive (in terms of lira);
this will cause the scudo to appreciate immediately.
b. People will expect a contractionary monetary policy in the near future. They know that this is
likely to cause the scudo to appreciate, so they will purchase scudos now (or sell off their lira
now), causing the scudo to appreciate now.
c. A higher interest rate in Leinster will attract funds from Saxony. As Saxons exchange scudos for
lira (in order to purchase Leinster financial assets), the scudo will depreciate and the lira will
appreciate.
d. A surprisingly high trade deficit usually causes the country’s currency to depreciate.
e. Real income in Leinster is likely to fall in the wake of the natural disaster. (Exports of telephones
will fall, and imports of bread to feed the displaced may rise.) This probably will cause the lira to
depreciate and the scudo to appreciate.
f. Such political disasters are not uncommon. They usually create uncertainty about the future
course of a country, and the currency depreciates.
2. a. The scudo is expected to depreciate by 1 percent. The interest differential is 0.5 percent in favor
of Saxony. So the expected depreciation is greater than the interest differential, and uncovered
interest parity does not hold.
b. For uncovered interest parity to hold,
(1 + iL) eex/e = (1 + iS)
Since iL = 0.015, iS = 0.02; and eex = Ss 101/Ll, the current spot rate must equal Ss 100.5/Ll. That
way, the expected depreciation of the scudo (0.5 percent) is just offset by the extra 0.5 percent
interest earned on Saxon assets.
3. a. Let us assume that two years is sufficient time for prices of goods to be fully flexible. If real
output and the behavioral k’s in each country are unchanged, the decreased stock of lira should
cause prices in Leinster to fall by one-third, from L1 120 to Ll 80.
The students should expect the two-year exchange rate to reflect purchasing power parity. So,
e = PS/PL = Ss 12,000/Ll 80 = Ss 150/Ll in the long run.
b. In the shorter term, however, prices are sticky. The reduction in Leinster’s money stock will have
two more immediate effects. First, interest rates in Leinster will rise due to this “credit crunch.”
Second, the expected future spot rate on the lira will rise because agents know that, in the long
run, PPP will hold.
These two effects will cause a rush to purchase the lira as agents see a higher return on that
currency in the form of both interest income and expected appreciation. As a result, the students
should expect the lira to appreciate to a value greater than the PPP rate of Ss 150/Ll.
Just what this value is depends on the new Leinsterian interest rate and the expected future spot
rate. The current spot rate will overshoot to reestablish uncovered interest parity.
4. You would expect inflation to be higher in Saxony than in Leinster. Referring to the purchasing
power parity condition, the higher inflation rate in Saxony would require the Saxon scudo to take a
downward (depreciating) trend versus the lira. That way, the “cheapening” of the scudo will
counterbalance the inflating Saxon prices, and Saxon goods can remain competitive.
5. The real exchange rate on the pound is ($2/£) x (£150/$200) x 100 = 150.
In this case, the British pound has a nominal exchange rate “above its implied PPP value.” The pound
is overvalued; the dollar is undervalued.
35
6. In the ten years between 2001 and 2011, the United States experienced a total of 20% inflation.
During the same period, Mexico experienced 80% inflation. Using the approximation for relative
PPP, we would expect the peso/dollar exchange rate to change by the difference between the
Mexican and the American inflation rates. So, the price of the dollar must rise by 60%, from 150
peso/dollar to 240 peso/dollar.
7. a. If “k” is smaller, the demand for money will be lower.
b. Since the ratio kf/k rises (assuming that credit card use has not proliferated in Mexico as well),
the exchange rate e rises too. The dollar depreciates while the peso appreciates.
Chapter 20
True/False
1. True.
2. False: swings will be less severe.
3. True.
4. True.
5. False: factors other than a “fixed exchange rate” contributed to that stability.
Multiple Choice
1. D
2. A
3. B
4. D
5. D
Problems
1. a. As you can see from Figure 19.1, swings in the demand for lira would cause the exchange rate to
vary between a summer high of Ss 125/Ll and a winter low of Ss 75/Ll.
b. Saxony might be able to defend an exchange rate of Ss 100/Ll if it bought up (BC) lira in January
and then sold them off to fund the excess demand (CD) for lira in July. For this to work
correctly, the Saxon government must be sure that (BC) lira purchased will be enough to satisfy
(CD) lira demanded. You should notice that the government would find it very difficult to defend
a rate of, for example, Ss 80/Ll.
There are a number of reasons why a country might want to peg its exchange rate. A fixed rate
eliminates exchange rate risk, and this may increase economic welfare. And there are national
pride arguments that can be made—witness Britain’s struggle to return to the earlier gold value
of the pound after WWI. (Later chapters will illustrate the usefulness of a fixed exchange rate
under certain macroeconomic circumstances.)
2. In essence, Saxony wants to keep its currency artificially expensive (or, some might say, “valuable”).
Recall again Britain’s attempt to return to the pre-WWI parity—or glory—of the pound.
Because the market values the scudo at only Ss 150 per lira, the Saxon government must somehow
force the price to Ss 100 per lira. This might be accomplished in the following ways:
 The Saxon government could restrict its residents’ ability to buy lira (i.e., to sell scudos) through
exchange controls.
 The government could restrict its residents' ability to import Leinster’s telephones and so limit
the supply of scudos in exchange for lira through tariffs or quotas.
36

The government could raise interest rates to attract capital into Saxony and so push up the
demand for (and price of) scudos.
 The government could undertake some other sort of contractionary macro policy that would
reduce the income of Saxons and so their demand for imported telephones (and the foreign
exchange to pay for them).
 The government could enter the exchange rate market to buy up scudos (and sell lira).
The last method in this list is usually the first remedy tried, but it has a limited life span. In time, the
lira reserves of the Saxon central bank will be depleted, and no further intervention of this sort will
be possible.
3. a. The exchange rate between the dollar and the pound is $4/£.
b. If there is a chance that holders of dollars will insist on converting them into gold, the maximum
supply of dollars would be $280 billion. Of course, if no one ever cashes in their dollars, there
would be an incentive to increase the money supply as needed to achieve domestic objectives.
4. Returning to the gold standard will not guarantee greater economic stability for the United States. In
particular, price stability (which is often the goal cited by those political pundits) will depend largely
upon the growth rate of real output relative to the growth rate of the gold stock. As the history of
California has shown us, a gold rush can cause significant inflation.
It is true, however, that a country on a gold standard is protected against the vagaries of monetary
authorities. They cannot change the money supply at will but, instead, are subject to “price
discipline.” Of course, this also means that the country loses monetary policy as a potential tool of
macroeconomic stabilization.
5. Among other things (including social, historical, and cultural factors), we would want to know if
Canada, the United States, and Mexico comprise an optimal currency area: a set of countries that
could benefit from having a common currency. Key features of such a set include a high proportion
of trade among member countries, high labor mobility between members, and common exposure to
economic shocks. Keep in mind, though, that a common currency (the most fixed of fixed exchange
rates!) comes with a serious cost to each member country—the loss of independent monetary policy.
Chapter 21
True/False
1. True.
2. False: while limiting (or even prohibiting) borrowing from abroad reduces the chance that a country
will be unable to repay loans, it is like cutting off your nose to spite your face. (Or, as economists
would say, it’s a second-best solution.) Instead of avoiding the risks by prohibiting the activity, it
makes more sense for a country to determine (and correct) those problems leading to over-borrowing
and ill-advised borrowing. Keep this in mind when you answer Problem 2 in this chapter.
3. True.
4. False: the U.S. has been a BIG borrower since the 1980s.
5. False.
Multiple Choice
1. B
2. A
3. B
4. D
5. D
37
Problems
1.
8
a
c b
d
MPKSaxony
Wealth of Leinster
(Ll)
Capital in
Leinster
Percent per year
Percent per year
(i, MPK)
Figure 21.1
6.6
6
MPKLeinster
X Wealth of Saxony
(Ll)
Capital in
Saxony
a. There is an incentive for funds to flow out of Leinster, where the interest rate is only 6 percent,
and into Saxony, where borrowers are offering 8 percent.
b. The equilibrium interest rate with these funds flows is where the MPK schedules cross. Here this
happens at approximately 6.6 percent.
c. Saxon borrowers will be happy to borrow at a 6.6 percent rate as opposed to the 8 percent rate
they had been paying; Saxon lenders will be angry at being undercut by the new funds inflows.
Saxony as a whole, however, will be better off.
To see this, remember that with the LI X borrowed from Leinster, Saxony can produce more.
How much more is illustrated by the increase in area under Saxony's MPK curve, which is equal
to a + b + c + d.
Of course, Saxony must pay interest on the loan (equal to [6.6%]L1 X], but this amounts to only
b + c + d. So Saxony has a net gain of a.
d. Leinster borrowers now will have to share the wealth of their country with Saxony; this pushes
the interest rate up and hurts the Leinster borrowers. Leinster lenders, however, will be happy to
get a 6.6 percent return. Leinster as a whole will be better off.
For Leinster, lending capital means that Leinster itself will have fewer resources and thus
reduced production. This reduction is area c + d under Leinster's MPK curve. But, the tradeoff is
the interest received from Saxony, and this totals area b + c + d. So Leinster, too, gains from the
international lending in the amount of b.
e. This kind of international lending raises world welfare. In fact, this model is like a financial
goods version of the standard trade model. By moving resources out of relatively less
remunerative investment in Leinster and into projects with higher marginal productivity in
Saxony, the world as a whole gains area a + b.
38
2.
Figure 21.2
a. If Saxony has some monopsony power, a tax on international borrowing will force down the
interest rate that Leinster’s lenders can demand. But Saxon borrowers will have to pay that rate
plus the tax, so the interest rate in Saxony will be higher than it would be with freedom of
financial flows.
b. The increased interest rate in Saxony will reduce borrowing from abroad by R lira. Whether or
not this tax will be nationally optimal for Saxony depends on the size of the deadweight loss e
compared to area f, the tax revenue generated from the remaining loans from Leinster. As you
can see in Figure 21.2, it's a close call.
3. a. The Saxon debt of Ll 10 billion is initially within the "pay range" indicated in Figure 21.3. The
costs of not repaying exceed the benefits of default, so the Saxon government has an incentive
not to default.
b. When interest rates on the debt rise, Saxony has an incentive to default—at least on Ll 2 billion
of the debt.
4. It is true that, should foreign investors lose confidence in the United States, a massive capital outflow
(with all its associated costs) could occur. Of course, this hasn’t happened to any great degree yet. On
the other hand, there is some benefit to being able to “tap into” the savings of other countries. If we
use those funds to finance capital formation, our long-term productivity increases, and we are able to
enjoy greater output per capita and still have enough left over to service the debt. Of course, if the
proximate cause of capital inflows is excessive consumption spending or wasteful government
budget deficits, we might want to rethink the matter.
5. This is a thinly veiled question about direct investment versus portfolio investment. If you move to
Ireland and set up your own shop, you will be protected from exchange risk and the possibility that
the corporate goals of the local managers will not match your own. On the other hand, with direct
investment you do have to move (if, in fact, the immigration policies of the country would allow it at
all), and the possibility of nationalization of your corporation still exists.
Chapter 22
True/False
1. True.
2. True, as long as other domestic components of spending do not decline.
3. False: capital may flow out in the long run.
4. True.
5. False: the foreign country’s goods will become less competitive, and we will import less.
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Multiple Choice
1. A
2. C
3. B
4. E
5. A
Problems
1. a. Leinster has a Ll 10.0 billion trade surplus with Saxony.
b. We know that saving = domestic investment + foreign investment, where foreign investment
= (X – M). So saving in Leinster = Ll 25.0 billion.
c. Leinster is lending Ll 10b—the excess of its domestic saving (Ll 25 b) over domestic investment
(Ll 15 b)—in Saxony.
2. a. If the teenagers’ parents give in to their whining, Leinster will be exporting many more
telephones to Saxony. This will increase income in Leinster and improve its trade balance.
b. A higher marginal propensity to import in Leinster will reduce the size of Leinster’s multiplier.
Income in Leinster will fall; the trade balance will worsen.
c. Assuming that the decrease in production costs is passed on in lower lira prices for telephones,
Leinster will export more telephones and its income will rise.
d. The rise of a local telephone competitor in Saxony is likely to reduce Leinster’s exports,
reducing its income and worsening its trade balance.
3 a. Saxony has a Ss 1 trillion deficit with Leinster. Notice this is the same as Leinster’s Ll 10 billion
surplus, but is evaluated at an exchange rate of Ss 100 / Ll.
b. The open economy multiplier in Saxony = 1 / (m + s) = 5.
c. With a multiplier of 5, an increase in domestic investment of Ss 500 billion should lead to an
increase in Saxon income of Ss 2.5 trillion.
d. With an increase in income of Ss 2.5 trillion, Saxons will increase their purchases of imports
from Leinster by m x (2.5 trillion) or Ss 375 billion. If exports to Leinster are unchanged at Ss 1
trillion, Saxony’s trade deficit will increase to Ss 1.375 trillion.
4. If saving rates in Japan fall (and so consumption rates rise), income in Japan will increase. At least
some of this extra income will be used to purchase imports from the United States. This will increase
income in the U.S. That’s why, of course, the American trade representative would be urging
Japanese households to spend, spend, spend!
5. a. Figure 22.5 shows that income in this country is $700 billion.
b. The interest rate is 4.5 percent.
c. Since the intersection of the IS and LM curves at point E is above the FE curve, this country has
a balance of payments surplus. You can remind yourself of this by noting that returning to FE
requires either an increase in income (which would raise imports and reduce a CA surplus) or a
decrease in the interest rate (which would cause a capital outflow and reduce a FA surplus).
d. An increase in consumption spending would shift the IS curve out to the right. The new IS-LM
intersection will definitely occur at a higher income level and a higher interest rate. Depending
on how far the IS curve shifts, the country could still have a payments surplus (if the IS shifts to
intersect LM to the left of point A), a balanced payments stance (if the IS shifts to intersect both
LM and FE at point A), or a payments deficit (if the IS shifts to intersects LM to the right of
point A).
e. An increase in exports would shift both the IS curve and the FE curve to the right. The new
IS-LM intersection will definitely occur at a higher interest rate and a higher income level.
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Depending on the size of the shifts, the IS curve may now intersect LM at A, which would be to
the left of the new FE curve and thus represent a payments surplus.
6. a. A vertical FE curve suggests that when domestic income rises (with its accompanying CA
deficit), it would take an infinitely large increase in interest rates to attract enough capital to reequilibrate a nation’s overall balance of payments. The implication is that capital is exceedingly
immobile internationally.
b. A horizontal FE curve, on the other hand, suggests that the required interest rate increase is
infinitely small. Capital must be extraordinarily mobile internationally.
c. So, you can use the FE curve’s slope as an indicator of capital mobility: The greater the upward
slope, the less mobile is capital internationally.
Chapter 23
True/False
1. True.
2. True: higher interest rates cool spending and attract foreign capital.
3. True! (Well, the last part is true.)
4. True.
5. True: the volumes traded will not change, but net payments will increase.
Multiple Choice
1. A
2. B
3. B
4. C
5. D
Problems
1. a. Using the assignment rule, Saxony would employ tighter fiscal policy to ease the inflationary
pressure and tighter monetary policy to correct the payments deficit.
b. Since Saxony is considered a small country (facing elastic import demand and export supply
curves from Leinster), a devaluation should improve the trade deficit.
2. a. Under a fixed exchange rate regime, perfect capital mobility turns out to be very good news for
Saxony’s fiscal policymakers. An increase in government spending, for example, will raise both
Saxon income and Saxon interest rates. The higher interest rates will attract capital from
Leinster, putting upward pressure on the scudo. In order to defend the fixed value of the scudo,
the central bank in Saxony must increase the money supply. This will push interest rates back
down and augment the expansionary impact of the increased government spending.
b. Unfortunately, perfect capital mobility is not such good news for the central bankers of Saxony.
Now, if they try to expand domestic production by increasing the monetary base (and so reducing
interest rates), capital will flow out of Saxony and into Leinster in search of higher interest rates.
To defend the fixed value of the scudo, the central bankers must reverse their course and buy up
scudos. Interest rates (and so domestic spending) end up unchanged.
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3. Now that capital flows freely between Saxony and Leinster, a reduction in the Saxon interest rate
will cause capital flight as Saxon bankers find that they can earn a higher interest rate lending to
Leinster’s contractors and homeowners than they can lending in Saxony. Saxon bankers will attempt
to exchange massive amounts of scudos for lira so that they can lend these funds to Leinsterians. This
will place tremendous pressure on the value of the scudo.
If Saxony is committed to keeping the exchange rate fixed, CBS would have to intervene in the
foreign exchange market, buying up scudos—and so pushing the domestic money supply back down
and forcing interest rates back up. There will be no net effect on the Saxon housing market. An
economic goal has trumped a cultural goal.
4. With inelastic demand for imports, devaluing the currency will actually worsen the trade balance. A
cheaper currency will not increase the world’s purchases of oil, it will only reduce the foreign
exchange earnings from the sale of that oil.
5 a. The IS and FE curves both shift to the left, causing a decrease in income and a payments deficit.
This is a dilemma situation for aggregate demand policy. You might consider devaluing the
currency.
b. The IS curve shifts to the right, causing an increase in income and a payments deficit. There is an
easy aggregate demand response here: cut spending.
c. The IS curve again shifts to the right, increasing income and causing a payments deficit. Again,
the answer is (theoretically) simple: reduce spending.
d. The IS and FE curves both shift to the right, causing an increase in income and a payments
surplus. This is a dilemma situation for aggregate demand policy. You might consider revaluing
the currency.
e. The FE curve shifts to the right but the IS curve is stable. The country will have a payments
surplus and should use expansionary fiscal policy and perhaps a revaluation of the currency.
f. The LM curve shifts to the left, reducing income, and causing a payments surplus. The easy
solution to correct both imbalances is an expansion of the money supply.
Chapter 24
True/False
1. True.
2. True.
3. False: the shocks would be less disruptive.
4. False.
5. True.
Multiple Choice
1. B
2. C
3. B
4. B
5. D
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Problems
1. a. When the scudo can float, it will depreciate to correct Saxony’s payments deficit.
b. A depreciation of the scudo would cause an improvement in the trade balance, and this would
increase the level of income (and so the inflationary pressure) in Saxony. In other words,
achieving external balance would push the country further away from internal balance.
c. A contractionary monetary policy will raise interest rates and reduce the level of income in
Saxony. The inflow of capital and the reduction in import spending will cause the scudo to
appreciate, reducing the level of income even further as the current account worsens.
d. A contractionary fiscal policy will reduce interest rates, causing an outflow of capital. Falling
income will also cause a reduction in import purchases. The first effect will cause the scudo to
depreciate, the second will cause the scudo to appreciate. As a result, income will not fall much
at first, but will eventually be pushed down.
2. A flexible exchange rate (assuming capital mobility between Saxony and Leinster) will be more
likely to protect the Saxon economy from the political business cycle. If, for example, incumbents
increase spending and reduce taxes in the hopes of gaining votes in an upcoming election, the
resulting increase in interest rates can elicit large capital inflows, causing the scudo to appreciate and
so draining off some of the inflationary impact of the expansion. The extent to which this offset
occurs will depend upon the degree of capital mobility between the two countries.
3. a. With a floating exchange rate, a sudden capital outflow from Saxony will cause the scudo to
depreciate. The improvement in the trade balance may push income levels up.
b. If the value of the scudo is fixed, however, the capital outflow will be quite disruptive. The
capital outflow will put downward pressure on the scudo, and the central bank will have to
intervene and buy up scudos. The reduction in the money supply in Saxony will increase the
interest rate and this will cause a reduction in income.
4. a. The increase in income will be greater under a fixed exchange rate regime, since the
improvement in the trade balance will put upward pressure on the currency. The central bank
must increase the supply of money to reduce that pressure; this will increase the level of income
even further.
b. The increase in income will be greater under a flexible exchange rate regime. The decrease in
interest rates will cause an outflow of capital, and this will cause the currency to depreciate. As a
result, net exports and income will rise even further.
c. The decrease in income will be greater under a fixed exchange rate regime. The outflow of funds
will put downward pressure on the currency. The central bank must buy up that currency to
reduce the pressure; this will reduce the level of income even further.
d. Assuming that capital is highly mobile, the decrease in income will be even larger under a fixed
exchange rate regime. As higher taxes reduce spending and cause interest rates to fall, capital
will flow out of the country, putting downward pressure on the currency. The central bank must
buy up that currency to reduce the pressure; this will reduce the level of income even further. (If,
instead, capital is not very mobile between countries, the most disruption to income will occur
with floating exchange rates: the reduction in income increases the trade surplus, and the
currency appreciates. This pushes down net exports and income.)
e. The decrease in income will be even larger under a fixed exchange rate regime. As imports rise,
the worsening of the trade balance will put downward pressure on the value of the currency. The
central bank must buy up that currency to reduce the pressure; this will reduce the level of
income even further.
f. A decrease in the saving rate will increase income and interest rates in the country. (1) If the
trade balance effect of higher income dominates, there will be downward pressure on the
currency in response to higher imports. Under a floating exchange rate regime, the currency
would depreciate, augmenting the expansion of income. This is the more disruptive regime. (2)
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5.
On the other hand, if the financial account effect of higher interest rates dominates, there will be
upward pressure on the currency. Under a fixed exchange rate regime, the central bank would
have to increase the money supply. This will augment the expansion of income and is more
disruptive.
Figure 24.5
The increase in spending in Leinster pushes the IS curve to the right, causing an increase in
income, an increase in interest rates, and a payments surplus at point 2. (The latter is the result of
high international capital mobility, as illustrated in a rather flat FE curve.)
a. There will be upward pressure on the lira as high interest rates attract funds from Saxony. To
defend the exchange rate, Leinster monetary authorities will have to buy scudos and sell lira.
This will push the LM curve out to intersect IS and FE at point 3. Income in Leinster will
increase dramatically to Y3.
b. If intervention to fix the exchange rate is sterilized, Leinster monetary authorities will be
conducting open market operations to soak up all the lira. The LM curve will then stay fixed and
Leinster will remain at point 2 with the increased income level Y2.
c. With floating rates, the lira is likely to appreciate and the current account will worsen. This will
push the IS and FE curves to the left to intersect the LM curve at point 4. Income in Leinster will
increase only to Y4.
In this case, with relatively high capital mobility, the Leinster economy is best protected from a
spending shock by floating exchange rates. The economy has the largest income swings under
fixed exchange rates without sterilization.
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(You may wonder why it is disruptive to have the income level increase. If Y1 were the fullemployment level of income for Leinster, any increase in income above that would be inflationary.)
6. b. up; down; down (depreciate)
c. up; up; up
d. up; up; down
e. down; down; down
f. down; down; up
g. up; up; up
Chapter 25
True/False
1. False: the country will be less stable.
2. True.
3. True.
4. False: with a currency board, a country still has the option of abandoning the target exchange rate
and increasing the domestic money supply. With dollarization, a country surrenders its own currency
and monetary policy and is, in essence, completely dependent upon the decisions of a foreign
country’s central bankers.
5. False!
Multiple Choice
1. C
2. D
3. C
4. A
5. D
Problems
1. a. To protect itself against international trade shocks generated by Saxony, Leinster should choose
a floating exchange rate.
b. To dampen the impact of internal instability (by, in essence, sending it abroad to Leinster),
Saxony should choose a fixed exchange rate.
2. Things you should consider in contemplating a monetary union between the two countries: A
common currency does reduce the uncertainty, risks, and transactions costs of dealing with different
currencies. On the other hand, a monetary union will take away independent monetary policy in each
country. It will also cause spending shocks in one country to be felt in the other country.
Can you think of political aspects of a common currency? Cultural aspects?
3. In general, monetary policy has its greatest power under a flexible exchange rate regime. This
conclusion is reinforced in a world of capital mobility: expansionary monetary policy will worsen
both the current account (by increasing income) and the financial account (by reducing interest
rates). The incipient outflow of funds will put strong downward pressure on the currency, and the
resulting depreciation will cause net exports to expand.
4. Because of populism and notions of states’ rights, the Federal Reserve system was designed as a
supra-regional bank that would keep financial power from being completely centralized. The ECB is
intended to be a supra-national bank. Both banks have policymaking coordinated by a board that
consists of some at-large appointments and representatives from the constituency. In the case of the
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Federal Reserve, the committee that formulates policy is comprised of governors appointed by
Washington, as well as presidents of the regional reserve banks.
Both banks, too, have to deal with the problem of diverse economic conditions within their spheres
of influence. For example, while there might be a recession in the Midwestern states, the
Southwestern states might be in an inflationary boom. Clearly, setting a monetary policy that
addresses both regions would be impossible. (Fiscal policy is somewhat easier to target
geographically, as with schemes such as “enterprise zones.”)
Those of you with some coursework in money and banking should be able to compare regulatory
functions, instruments of monetary policy, and so on.
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