EC271 Exam 2013/14 mark Scheme
Question 1
a)
Distinguish between Absolute and Comparative Cost Advantage.
Marks for correct definitions (5 marks each).
b)
Which of the countries has an absolute advantage in the production of the two commodities?
A has the absolute advantage in the production of each good i.e. they require fewer labour inputs
in their production (10)
c)
Calculate the opportunity cost of coats in terms of shoes and shoes in terms of coats for each
country.
The opportunity cost of a coat is 2 shoes for A and for B 3 shoes (5)
The opportunity cost of a shoe is one-half of a coat for A and for B one-third. (5)
d)
Which country has a comparative advantage in the production of coats?
A has the comparative advantage in the production of coats as it has the lower opportunity cost 2
vs 3.(10)
e)
Trade now takes place under the following conditions: the country with the comparative
advantage in shoe production produces only shoes. The other country produces sufficient coats
to maintain the world ‘no trade’ output devoting the remaining resources to shoe production.
Comment on the gains from trade.
As B has the comparative advantage in shoe production and devotes all its resources to its
production 300 shoes can be produced (12000/40). In order to maintain world output of coats
(150) A has to devote 9000 man hours to coat production (9000/60). This leaves 3000 man hours
for further shoe production 3000/30 = 100.(30)
f)
On a single diagram, plot the production possibility frontier for each country. What aspects of you
diagram is indicative of potential gains from trade? (30 marks for correct exposition with A’s PPF
outside B’s) students may also show pre and post trade PPFs.
Question 2
a)
What is the ‘interest rate parity’ condition?
Correct definition with explanation (20)
b)
Carefully explain how the foreign exchange market achieves equilibrium if interest rate parity
holds. Use a suitable diagram to explain your reasoning.
Correct equation (10) and its association with an appropriate diagram (10)
c)
Show, using a suitable diagram, how the following changes will influence the exchange rate.
a. A rise in the domestic money supply (depreciation) (20)
b. A rise in foreign income (depreciation) (20)
c. An expected depreciation of the domestic currency (depreciation) (20)
Question 3
a)
Using appropriate diagrams assess the effectiveness of fiscal and monetary policy in raising the
level of output and employment under both fixed and floating exchange rate regimes.
Students are expected to show that monetary policy is ineffective under fixed exchange rates but
fiscal policy is effective – the reverse is true under floating regimes (assuming no capital controls).
Students are expected to utilise either AADD or ISLM analysis. Marks awarded for correct
discussion and diagrammatic exposition (80)
b)
Briefly explain why a government may wish to fix its exchange rate.
For any two correct reasons (10 marks each)
Question 4
a)
Outline how a currency crisis may emerge in the context of Krugman’s first generation model.
A full description of the FGM is expected with the fundamental equations. Students should
recognise that the lack of foreign exchange results in countries being unable to defend their
currency at a fixed rate in the face of speculative attacks (70)
b)
To what extent does this model explain the crisis experienced by South East Asian economies in
the late 1990s?
For a correct application (30)
Question 5
a)
Under what conditions will it be beneficial for a country to join an optimal currency area? Use an
appropriate diagram to explain your answer.
A discussion of the Mundell’s assumptions: free movement of capital, goods/services and labour is
expected along with the monetary gains and the stability losses associated with the level of
integration is required using the GGLL framework (60)
b)
To what extent can the EU be described as an optimal currency area?
Marks awarded for correct and accurate discussion (40)
Question 6
a)
Briefly outline the key characteristics of Euro-currency and Euro-bond markets.
Students should note that E-currency market provides short term borrowing and lending (less than
1 year) and the bond market more than 1 year. Students should also note who the participants are
e.g. national governments and international institutions (IMF, World Bank MNCs). (20)
b)
What factors have contributed to the rapid growth of the Euro-currency and Euro-bond markets?
Students should discuss the growth of international trade, political factors, the avoidance of
domestic banking regulations/taxes – leading to off-shore banking, etc. (40)
c)
Assess the impact that the growth in Euro-deposits has had on international debt and its potential
effect on international financial stability.
For a correct analysis citing specific issues e.g. money available to: speculators and countries in
debt and its effects are expected (40).