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American University Department of Economics Comprehensive Exam International Economics January 2005 Page 1 of 2 Directions: You must answer both parts, I and II. Follow the directions in each part carefully (there is no choice in Part I but there is some restricted choice in Part II). Points will be allocated in proportion to the times indicated. Be sure to define all notation and carefully label all graphs. Part I: Long Answers – Answer Both Questions 1 and 2 (No choice) Allocated time: 60 minutes (1 hour) per question. 1. Consider the theory of exchange rate determination embodied in the monetary approach to flexible exchange rates. Lay out the crude monetary approach model algebraically and discuss its virtues and limitations as a model of exchange rate determination. Provide a detailed discussion of the problems that arise when formulating an empirically “testable” representation of this theory. How has the resulting model performed empirically? (Refer explicitly to the relevant literature.) Solve for the spot exchange rate under the assumption that expectations are rational. Then find an “observable reduced form” model by assuming that the data generating process for the fundamentals is a first-order autoregressive process. How has the resulting model performed empirically? (Refer explicitly to the relevant literature.) 2. Consider a small country that produces 2 goods (1 and 2), with relative price p = p1/p2. The country’s autarky price ratio is pa < p, where p is the world price ratio. What are the effects of opening up to free trade on income distribution (i.e., factor prices) in each of the following models: a. A Heckscher-Ohlin model, in which the two factors of production are unskilled labor (L) and skilled labor (H), and good 1 is L-intensive (you may assume that there are no factor intensity reversals and the country is in a cone of diversification). You may use w for the price of L and q for the price of H (or, alternatively, wL and wH, respectively). b. A specific factors model, in which capital (K, with price r) is the mobile factor, unskilled labor (L) is the immobile factor in industry 1, and skilled labor (H) is the immobile factor in industry 2. c. A model in which goods 1 and 2 are intermediate inputs into the production of a final good (n), and good 1 is L-intensive. For each model a.-c., provide the math, graphs, and intuition necessary to prove and explain your results. Also be sure to state any additional necessary assumptions for your results. Finally, discuss how the empirical implications of model c. differ from those of model a.— what data would one examine to test the validity of each model (a. and c. only)? (You do not need to discuss any actual empirical studies; just explain how you would test the predictions of each of these two models for the country specified in this question.) 2 Part II: Short Answers (choose 2 from Group A and 2 from Group B plus any 2 other questions, for a total of 6 questions). Allocated time: 20 minutes per question. Keep all answers short and focused! Group A (Finance Questions) 1. Present Frankel’s real interest differential model algebraically and briefly discuss its empirical performance. 2. What do we mean by “perfect capital mobility”? What do we mean by “perfect capital substitutability”? Given perfect capital mobility and perfect capital substitutability, show that the choice of exchange rate regime (floating or fixed) is an important determinant of the effects of fiscal and monetary policy. 3. Derive the risk premium in the foreign exchange market using mean-variance optimization. Give a detailed intuitive interpretation of your algebraic result. 4. If one assumes that LRPPP holds, how can the Houthakker-Magee result be turned into a theory of “balance-of-payments-constrained growth”? 5. Derive the “Marshall-Lerner condition” for a real depreciation to improve the trade balance. Give a detailed intuitive interpretation of your algebraic result. Group B (Trade Questions) 1. Using a partial equilibrium model of exports for a large country, assuming perfect competition, can such a country improve its welfare by using an export subsidy or an export tax? Analyze both policies graphically (no math is required) and compare the results intuitively. 2. In a Ricardian trade model with 3 commodities (labor is the only input), can a foreign technological improvement cause a decrease in the home country’s real wage, and if so, under what conditions? Analyze and explain. NOTE: You need only provide the math for the case in which the home country’s real wage decreases. 3. Does the factor-price equalization theorem hold if there is a factor intensity reversal? Why or why not? (Be sure to explain what a “factor intensity reversal” means.) 4. What is the optimal “strategic” trade policy for a country with a firm that is an exporter in an international Cournot duopoly (i.e., there are only 2 firms, one in each country, home and foreign)? Explain using graphs and intuition (math is not required). How does this policy affect welfare in a “third country” that does not produce the good, but only imports it? 5. How do the empirical predictions of the Heckscher-Ohlin-Vanek (HOV) model differ from those of Heckscher-Ohlin-Samuelson (HOS)? Which model is considered superior for empirical testing and why? How has each model been tested, and what are the main findings?