Solution Manual World Trade and Payments An Introduction

Chapter 1
Introduction
Chapter 1 provides a brief introduction to the subject of international economics. This material is useful in
providing students with some perspective of the issues at hand. The chapter outlines some of the basic
facts related to the international pattern of trade and international macroeconomics. The chapter also
provides some motivation for the study of international economics. Students should have some familiarity
with some of the recent debates in international economics with the recent publicity over NAFTA, the
formation of the European Union, protests of meetings of the World Trade Organization and the current
trade disputes with China. This chapter can then be used to discuss some of the basic facts about
international economics and to dispel some of the misperceptions that students may have. For example,
few students are generally aware that Canada, not Japan nor China, is the primary trading partner of the
US. A review of some of the basic facts of international economics has been found to be essential.
Chapter 2
The Gains from Trade
Chapter Organization
2.1 Background Behavior: Demand
The Budget Constraint and Relative Prices
Preferences: Indifference Curves
2.2 Background Behavior: Supply

The Transformation Curve
Special Cases
2.3 Gains from Trade and Free-Trade Equilibrium

Something for Nothing?
Example: A POW Camp
Gains from Trade with Resource Reallocation
Comparative Advantage and Comparative Costs
2.4 Winners and Losers: Autarky to Free Trade

A Compensation Scheme
2.5 Summary
Appendix A: The Box Diagram
Appendix B: Substitution and Income Effects
Appendix C: The Offer Curve Diagram
Chapter Summary
This chapter outlines the exchange model of international trade. This simple model of trade abstracts from
concerns about technologies, skills and factor endowments to focus on a basic motivation of trade:
differing endowments of final goods. Despite its simple structure, the model highlights several concepts
common to all trade models such as the gains from trade, the effects of trade upon goods prices, and the
notion of balanced trade. The chapter concludes with an introduction to some of the arguments against free
trade, which later chapters deal with in greater detail.
Section 2.1 involves a discussion of indifference curves and budget constraints. Although this is a review
for most students, it generally merits covering since it plays a central role in much of the analysis in the
first half of the text.
Chapter 2 The Gains from Trade 3
Section 2.2 introduces the transformation curve (production-possibilities schedule). Similar to section 2.1,
this should be a review for most students, but deserves to be covered since it critical in understanding the
material covered in the first half of the text. The production possibilities schedule introduces the ideas of
attainable production, efficient production and increasing opportunity costs. Appendix A supplements
some of this material as it concerns the shape of the production possibilities schedule.
Section 2.3 examines the gains resulting from trade. Figures 2.5 and 2.6 illustrate the gains from trade for
a country. If relative prices differ in autarky, there will be mutual gains from trade at a price intermediate
to the autarky price ratios. The autarky price ratios reflect consumers MRS at their endowments.
Therefore, any difference in tastes or endowments will lead to autarky price differences. The latter part of
this section discusses how the gains from trade can be assessed when the transformation curve is bowed
out and an international trading equilibrium is attained that coaxes each country to produce more of the
good which has become higher priced. The concepts of comparative advantage and comparative costs are
introduced a basis for mutually beneficial trade. The discussion of differences in production possibilities
provides a natural introduction to trade based upon technology differences (chapter 4) and differences in
resource endowments (chapter 5).
Section 2.4 provides an introduction to some of the disagreements over free trade. Students should be
familiar with many of the arguments for protectionism as a result of the recent debate over NAFTA and
angry protests at meetings of the World Trade Organization. Among the issues addressed here is the
consideration that the previous analysis of the gains from trade applies to countries and not individuals.
Therefore, at the individual level there will be both winners and losers from a move towards free trade,
whereas at the aggregate level, the country as a whole must benefit. This section also serves as an
introduction to trade policy, the subject of Part III of the text.
Appendix A expands upon many of the ideas introduced in Section 2.3 related to the gains from trade. The
basic idea of this section is that trade equates marginal rates of substitution across countries, and therefore
free trade is efficient. The box diagram in figure 2.A.1 provides an analysis of the mutual gains from trade
in a framework different from that in Section 2.1. Note that deviations from free trade will lead to gains for
one country at the expense of the other. This leads naturally into a discussion concerning the debate over
free trade, the subject of Section 2.4.
Appendix B abstracts from production to illustrate the substitution and income effects of a change in world
prices. Note that the size of the income effect depends upon both the size of the price change and the
volume of trade.
Appendix C provides an offer curve analysis of many of the issues discussed in the chapter. This material
may be particularly useful in reinforcing the discussion related to changes in the terms-of-trade and the
case of inelastic import demand discussed in Section 3.5.
The supplement to chapter 2 (at the back of the text) outlines the equations of exchange equilibrium. This
is important material since it introduces much of the notation used in later supplements and develops the
equivalence between balanced trade and market clearing.
Key concepts introduced in this chapter include:

the production possibilities schedule
comparative advantage
the mutual gains from trade
differences in endowments and tastes as a basis for trade
the determination of world prices under free trade
the trade triangle and balanced trade
gains from trade as a result of changes in production patterns
4 Caves/Frankel/Jones - World Trade and Payments: An Introduction, Tenth Edition
Suggested Answers to Textbook Questions

1. (a) The endowment in Figure 2.5 shifts towards the vertical axis by 10 percent. The country can then
trade along a line parallel to CED (as the world prices have not changed). This should lead to the
result that both imports and exports decline (i.e., the trade triangle will be smaller).
(b) An analysis similar to the one above should reveal that both imports and exports decrease.
2. This situation will not lead to a lack of trade. It will be analogous to the endowment being at point G
in Figure 2.5.
3. (a) tastes similar across countries, transformation schedules differ
E represents the home endowment, and E the foreign endowment. The countries share common
tastes, represented by the common indifference curve, labeled y y. The autarky price ratios for
the home and foreign country are given by AEB and AEB respectively. The countries can trade
at world prices represented by the dotted line CEFED. Along this line in the region EFE both
countries will gain from trade. The home country will be importing clothing and exporting food.
(b) transformation curves are the same across countries, tastes differ
4. (a) Consider that consumption of a given good is equal to production minus exports. In autarky,
exports are zero, and thus production equals consumption. If a good is exported with trade and
production cannot change, then there must be less available for domestic consumption.
(b) Consumption is production minus exports. If production rises more than exports as a result of
trade, then consumption must rise also.
(c) see figure 2.7
The common endowment is given by E. Countries differ in their preferences as represented by

the different indifference curves, y and y. The autarky price ratios are given by AEB for the
home country and AEB for the foreign. At an intermediate price ratio such as CED, home can
gain by exporting clothing and importing food (to reach a point such as F), whereas the foreign
country does the opposite (to obtain consumption at a point such as F).
5.
(a) The production possibilities schedule for this economy is the downward sloping straight line of
20 and horizontal intercept of 40. The indifference curves are right-angled with the corners lying
along the dotted line through the origin. In autarky, consumers will then consume at point E. This
can be found by finding the intersection of the PPF, represented by Qf 20 (1/2)Qc and the ray
along which the corners of the indifference curves lie, represented by Qf 2Qc This should yield
Qf 16 and Qc 8.
(b) In autarky, the relative price of food will be given by the inverse of the slope of the PPF, which
will be equal to 2.
(c) If the price of clothing doubles with trade, the relative price of food falls to 1. This will cause the
economy to shift all production into clothing, and they will then trade along the dotted line that
intersects both the horizontal and vertical axis at a value of 40 (which represents a relative price
of food equal to 1). They will trade along this line until they reach the line where Qf 2Qc This
point, E, corresponds to Qf 80/3 and Qc 40/3.
(d) The country is obviously better off with trade in that they are consuming more of both goods.
However, they are not consuming twice as much of both goods.
6.
In this diagram the autarky endowment is E with autarky prices for this individual of AEB. The
individual is then selling food to their fellow citizens and is consuming at G in autarky. After
trade, if the price of food falls to AEB this individual will be worse off. However, if the price of
food falls a great deal to AEB, the individual can import food and export clothing from their
fellow citizens to reach consumption at a point such as H. They will then obtain greater utility
than at G.
Multiple Choice Questions

Questions 1 through 5 concern Figure 2.5
The country has endowment at E. It faces autarky prices AEB. It can trade at relative prices represented by
CED. After trade, the country has consumption represented by point F.
1. Exports for this country are represented by

(a) FG.
(b) EG.
(c) OD.
(d) FE.
(e) OA.
Answer: (b)
2. Imports for this country are represented by

(a) FG.
(b) EG.
(c) OD.
(d) FE.
(e) OA.
Answer: (a)
3. If the world price of food fell, the country would generally

(a) export food.
(b) import less food.
(c) export more clothing.
(d) export less clothing.
(e) not change imports or exports.
Answer: (d)
4. With trade, the market value of exports is

(a) greater than the value of imports.
(b) less than the value of imports.
(c) equal to zero.
(d) equal to the value of imports.
(e) equal to the value of the endowment.
Answer: (d)
5. If this country were to lose 10 percent of its clothing endowment it would

(a) export more clothing, import less food.
(b) export more clothing, import more food.
(c) export less clothing, import more food.
(d) not change imports or exports.
(e) export less clothing, import less food.
Answer: (e)
Questions 610 concern a situation where 2 countries have identical preferences, but country A has an
endowment with more food and less clothing than B.
6. Under autarky, the relative price of food will be

(a) higher in B.
(b) higher in A.
(c) the same in both countries.
(d) 1.
(e) Not enough information is given.
Answer: (a)
7. Under autarky, country B

(a) consumes more food than A.
(b) consumes the same amount of food as A.
(c) consumes no food.
(d) consumes less food than A.
(e) consumes the same amount of food as country A does clothing.
Answer: (d)
8. With free trade between countries with equal incomes,

(a) country B consumes no food.
(b) country A consumes no clothing.
(c) the value of As clothing imports will be greater than Bs food imports.
(d) both consume exactly the same.
(e) relative prices differ across countries.
Answer: (d)
9. With free trade, country A will

(a) import clothing.
(b) produce no clothing.
(c) consume no clothing.
(d) export clothing.
(e) consume less clothing than is in its endowment.
Answer: (a)
10. If country Bs clothing endowment increases,

(a) world demand for clothing falls.
(b) As autarky relative price of food rises.
(c) Bs autarky relative price of clothing increases.
(d) world prices are the same in free-trade equilibrium.
(e) the world price of clothing in free-trade equilibrium falls.
Answer: (e)
11. In free trade equilibrium,

(a) domestic demand equals domestic supply for all goods in all countries.
(b) world demand equals world supply for all goods.
(c) domestic demand exceeds domestic supply for goods that are exported.
(d) world demand exceeds world supply for goods that are imported.
(e) world demand equals world supply only for goods not traded.
Answer: (b)
12. The slope (in absolute value) of the budget line represents
(a) the relative price of one good in terms of another good.
(b) how much of one good a consumer must give up to get one unit of the other good.
(c) the equilibrium proportion in which the two goods are consumed.
(d) all of the above.
(e) nothing.
Answer: (d)
13. Two countries produce different varieties of the same two goods, food and clothing. If there is zero
net trade in clothing, there must also be
(a) zero net trade in food.
(b) zero gross trade in food.
(c) high gross trade in food.
(d) high gross trade in clothing.
(e) zero gross trade in clothing.
Answer: (a)
Questions 1415 concern the following scenario:
There are two commodities, food and clothing. In autarky an individual is a net seller of food. His country
opens up to trade and the price of food drops. He remains a net seller of food.
14. He receives no compensation. How does opening up to trade change welfare in the country?
(a) He and his country (net) are worse off than before opening up to trade.
(b) He is worse off, but his country is better off than before opening up to trade.
(c) Everyone in the country is better off than before opening up to trade.
(d) He is better off, but his country is worse off than before opening up to trade.
(e) We cannot tell who benefits and who is hurt by opening up to trade.
Answer: (b)
15. All net sellers of food receive enough compensation to keep them at the same level of welfare. How
does opening up to trade change welfare in the country overall?
(a) The country is better off (net) and net sellers of clothing are better off than before
opening up to trade.
(b) The country is worse and net sellers of clothing are worse off than before opening
up to trade.
(c) The country is better off (net) and net sellers of clothing are worse off than before
opening up to trade.
(d) The country is worse off (net) and net sellers of clothing are better off than
before opening up to trade.
(e) The country cannot afford to compensate all of the net food sellers.
Answer: (a)
16. In a world with many countries and only food and clothing, if countries all have the same
endowments but different tastes,
(a) there will be no trade as endowments are all the same.
(b) the country with the lowest autarky relative price for food will import food in free
trade equilibrium.
(c) the country with the highest autarky relative price for food will import food in free
trade equilibrium.
(d) the country with the highest autarky relative price for clothing will export clothing.
(e) the pattern of trade cannot be determined as there are many countries.
Answer: (c)
17. If a country experiences an improvement in technology,

(a) indifference curves shift outwards.
(b) indifference curves shift inwards.
(c) the production possibilities frontier shifts outwards.
(d) the production possibilities frontier becomes bowed inwards.
(e) the production possibilities frontier shifts inwards.
Answer: (c)
18. Efficient consumption in autarky

(a) must be at a point below the production possibilities frontier.
(b) requires tangency between indifference curves and the production possibilities frontier.
(c) requires that a country produce only one good.
(d) requires indifference curves and the production possibilities frontier to cross.
(e) is not affected by changes in tastes.
Answer: (b)
19. In autarky, a preference shift towards food

(a) will result in a country producing less food and more clothing.
(b) will result in a country producing more food and more clothing.
(c) will result in a country producing more food and less clothing.
(d) will result in a country producing less food and less clothing.
(e) does not affect the amount of food or clothing produced.
Answer: (c)
20. If the relative world price of food is lower than the autarky price,
(a) trade will lead to no change in food production.
(b) trade will lead to increased food production.
(c) trade will lead to decreased food production.
(d) there will be no gains from trade.
(e) trade will lead to the country exporting food.
Answer: (c)
21. A sharply bowed-out production possibilities frontier embodies

(a) the law of decreasing costs.
(b) the fact that the consumers marginal utility of consumption decreases as they consume more of a
good.
(c) the fact that the costs of obtaining an extra unit of a good increase as more of that good is
produced.
(d) the fact that the country in question is in autarky.
(e) the variety of goods a country can produce
Answer: (c)
22. A country that has a comparative advantage in clothing production

(a) has a production possibilities frontier that lies outside the PPF of all other countries.
(b) must have better technology for making clothing than all other countries.
(c) will import clothing with trade.
(d) has the lowest relative autarky price for clothing.
(e) may have poorer clothing producing technology than some other countries.
Answer: (e)
23. In autarky, a country produces a number of varieties of an aggregate good. Trade will
(a) increase the number of varieties produced.
(b) increase production of all varieties, but keep the same number of varieties.
(c) decrease production of all varieties, but keep the same number of varieties.
(d) decrease the number of varieties produced.
(e) decrease production of some varieties, increase production of others, but keep the same number
of varieties.
Answer: (d)
24. All of the following are sources of gains from trade except
(a) increased product variety in consumption.
(b) production of goods in which a country has a comparative advantage.
(c) concentration of production in fewer varieties of goods.
(d) allowing a country to produce beyond its PPF.
(e) learning about new technology from abroad.
Answer: (d)
Chapter 3
Applications of the Basic Model
3.1 Disturbances From Abroad and the Terms of Trade
An increase in Foreign Demand
Supply Shocks: Energy Prices
3.2 Protecting the Import-Competing Commodity
3.3 Growth and International Trade
3.4 The Transfer Problem

The Transfer Problem: Purchasing Power
Is it Better to Give or to Receive?
The Transfer Problem: Real Resources
3.5 Wider Interpretations of the Basic Trade Model

Many Traded Final Commodities
Many Countries
Trade in Intermediate Goods and International Factor Mobility
Non-Tradeable Final Commodities
Intertemporal Trade
Trade in Assets
3.6 Trade and Market Structure
3.7 Summary
Appendix: The Stability Issue
Chapter Summary
This chapter focuses on some simple applications of the basic trade model. The emphasis is on the fact that
disturbances to a trading world have both direct and indirect effects. The indirect effects operate via
adjustments to world prices, and the presence of these effects often leads to interesting and surprising results.
An important point to emphasize is the fact that trade links countries, so that disturbances in one country will
have world-wide repercussions. The fact that world markets for goods must always clear should also be
emphasized, as it is via this market clearing process that the terms of trade are determined. In addition,
disturbances in a country will only impact upon world markets if the country is large enough such that they
affect world supply and demand. This is the distinction between small countries who cannot affect world
prices and large countries who can. The final important general point is that the magnitude of the
Chapter 3 Applications of the Basic Model 13
secondary effects is generally proportional to a countrys volume of trade. Therefore, countries that are more
involved in world markets are more likely to feel the effects of changes in these markets.
Section 3.1 introduces the idea that changes in domestic supply or demand for a commodity can lead to
changes in world supply and demand. This will lead to changes in the terms-of-trade, which will have an
impact upon all trading countries. The discussion of the oil price shocks is important as it illustrates the
mechanism through which a disturbance in a small number of countries can have a significant impact upon
the entire world.
Section 3.2 discusses the effects of government action upon world prices. The idea that governments can
advantageously manipulate world prices is the basic motivation for trade policy, which is the subject of
Part III of the text.
Section 3.3 discusses the paradox of immiserizing growth. Growth in a countrys export sector will lead to
a deterioration of the terms-of-trade for that country. This may lead to the country being worse off than
they were before growth occurred. This is an excellent illustration of the case where the secondary effects
of the disturbance outweigh the primary effects, leading to a somewhat paradoxical result. Note the
necessity for the presence of international trade. Elasticity is also an important element here since the more
inelastic is world demand, the larger will be the fall in the world relative price of the export good. The
secondary effects via world markets will dampen the gains from growth, and may not lead to losses for the
growing country. Therefore, immiserizing growth is not a necessary consequence of growth of the export
sector. Another important point is that growth must be biased heavily towards the export sector in order
for there to be a secondary burden. Growth in a countrys import sector will lead to a lowering of import
prices, and thus a secondary blessing of growth. A final important point is that the world as a whole must
gain as a result of the growth. The deterioration in the terms-of-trade for the growing country is also an
improvement in the terms-of-trade for countries that import their products.
The next section addresses the transfer paradox. A discussion of the policies adopted towards the losers of
W.W.I and W.W.II provides interesting background for this section. The transfer shifts world demand for
goods, with the direction of the shift reflecting taste differences between countries. A transfer of resources
across countries will also affect world supplies if countries differ in their technologies. The discussion of
immiserizing growth can be nested in the framework of the transfer problem, where the growth represents
a transfer of resources to a country from an agent uninvolved in the trading world. Note that transfers of
income cannot lead to gains for the transferring country as long as markets are stable. The issue of market
stability is discussed in detail in both the Appendix and Supplement to Chapter 3. This material may be
useful in supplementing the discussion of the transfer problem and immiserizing growth.
Section 3.5 considers some other issues and extensions of the basic trade model. Important among these is
intertemporal trade. This breaks the necessity for equality between the value of imports and the value of
exports and allows for trade deficits and surpluses.
Section 3.6 introduces the idea that market structure and trade are related, which is the subject of several
discussions later in the text.
The Appendix and Supplement to Chapter 3 both discuss the issue of stability of markets. This material,
although not in the main body of the chapter, has been found to be useful to cover as it helps in
understanding the transfer problem and immiserizing growth.
Key concepts introduced in this chapter include

disturbances to a trading world have effects on world markets and thus world prices
these secondary effects can outweigh the primary effects of the disturbance, leading to paradoxical
results such as immiserizing growth and the transfer problem
stability of markets may limit the extent of the movement of world prices trade across time can lead to
trade deficits and surpluses

1.
Initially, production will be at E and consumption at A. Growth proportional to the initial volume of
production will lead to a decline in the world relative price of clothing if the income elasticity of food is
greater than that for clothing. In this case the relative demand for clothing falls. If the decline is large
enough, consumption may shift to a point like, A, which represents a lower welfare level than at A.
2. If imports of food represent 20 percent of national income and the price of food rises by 10 percent,
then the country can purchase 10 percent less food imports. This will correspond to a 2 percent
decline in national income (as food imports are 20 percent of income).
3. Before the transfer, the home country imports food. The home country gives T dollars to the foreign
country. The foreign country spends T/2 on food and T/2 on clothing. The home country reduces
demand for food by 2T/3 units and clothing by T/3 units. Therefore, the world demand for food shifts
inward. The world relative price of food then falls. Since the home country imports food, its terms of
trade have improved as a result of the loan. There is then a secondary blessing to the home country.
4.
This growth will affect a countys terms of trade. The terms of trade will shift in favor of the
transferor.
5. If the home country discovers a new process that will raise productivity tomorrow then it will have
higher output in the future. Therefore, it will want to increase consumption today. It will do this by
running a trade deficit today and having a trade surplus in the next period (after production has
expanded). If this causes the terms of trade to worsen in the future (i.e. expanded production causes
world relative supply for the countrys export good to increase, leading to a fall in the relative price
of their exports), then this will make the gain in future income as result of technological progress
smaller. This will reduce the countrys desire to borrow from the future, making the current trade
deficit and future surplus smaller. However, the terms of trade change may make the other countrys
future income rise by more than the home countrys. In this case, the foreign country will want to
increase consumption today. The home country will then have a trade surplus now and a deficit later.

1. In a world with many countries,
(a) the value of exports and imports between each pair of countries must be equal.
(b) there must be zero net trade across varieties of any good.
(c) immiserizing growth cannot occur.
(d) there is no secondary effect of a transfer of resources from one country to another.
(e) the value of exports and imports between pairs of countries may not be equal.
Answer: (e)
2. An increase in foreign demand for homes exports must

(a) be caused by a drop in the price of homes export good.
(b) cause arise in the price of homes export.
(c) increase homes exports.
(d) decrease homes exports.
(e) none of the above.
Answer: (b)
3. An increase in demand for US exports may lead to

(a) a decline in US export volume.
(b) a deterioration of US terms of trade.
(c) a shift in the world supply for this good.
(d) a decrease in world demand.
(e) a decrease in US real income.
Answer: (a)
4. A decrease in the supply of US imports will
(a) shift world demand for the imports.
(b) increase world supply for the imports.
(c) not affect world prices.
(d) lead to increased volume of US imports.
(e) lead to a deterioration in US terms of trade.
Answer: (e)
5. Taxing imports leads to

(a) increased domestic production of the imported good.
(b) increased domestic consumption of the imported good.
(c) an increase in the world supply of the imported good.
(d) an increase in the world price of the imported good.
(e) an increase in the world demand for the imported good.
Answer: (a)
6. A small country that cannot affect world prices
(a) may experience immiserizing growth.
(b) may gain from making a transfer abroad.
(c) will experience welfare losses from a policy of import protection.
(d) will have no change in welfare from a policy of import protection.
(e) can only affect world demand and not world supply for goods.
Answer: (c)
7. A country can gain by restricting production of its export commodity
(a) only if it is small, so the negative effects are not large.
(b) if it is large and demand for its export is sufficiently inelastic.
(c) always.
(d) never.
(e) if it is small and demand for its export is sufficiently elastic.
Answer: (b)
8. Immiserizing growth is most likely to occur if
(a) world demand elasticity for the growing countrys exports is low.
(b) world demand elasticity for the growing countrys exports is high.
(c) world supply elasticity for the growing countrys exports is low.
(d) world supply elasticity for the growing countrys exports is high.
(e) elasticity does not matter.
Answer: (a)
9. Immiserizing growth is most likely to occur if
(a) growth is concentrated in a countrys import sector.
(b) growth is balanced across exports and imports.
(c) growth is concentrated in goods with high world demand elasticity.
(d) the country experiencing growth is small.
(e) growth is concentrated in a countrys export sector.
Answer: (e)
10. Growth concentrated in a large countrys import sector will lead to
(a) an increase in world supply of its imports, and thus an improvement in its terms of trade.
(b) an increase in world supply of its imports, and thus a deterioration in its terms of trade.
(c) an increase in world demand for its imports, and thus an improvement in its terms of trade.
(d) an increase in world demand for its imports, and thus a deterioration in its terms of trade.
(e) no change in the countrys terms of trade.
Answer: (a)
11. Which of the following statements is incorrect?

(a) Immiserizing growth is most likely to result from growth biased towards exports.
(b) Immiserizing growth is most likely to result if demand elasticity for a countrys exports is low.
(c) Balanced growth cannot be immiserizing.
(d) A small country cannot experience immiserizing growth.
(e) Immiserizing growth is most likely to result if trade volumes are large.
Answer: (c)
12. If country 1 transfers income to country 2, the terms of trade will worsen for country 1 if
(a) 1s marginal propensity to import is 0.5 and 2s marginal propensity to import is 0.5.
(b) 1s marginal propensity to import is 0.5 and 2s marginal propensity to import is 0.7.
(c) 1s marginal propensity to import is 0.7 and 2s marginal propensity to import is 0.5.
(d) 1s marginal propensity to import is 0.3 and 2s marginal propensity to import is 0.5.
(e) 1s marginal propensity to import is 0.3 and 2s marginal propensity to import is 0.8.
Answer: (d)
13. If there are only two countries and both have marginal propensity to import of 0.3, then
(a) giving away income may lead to welfare gains.
(b) giving away income will always lead to welfare losses.
(c) receiving money may result in welfare losses.
(d) the terms of trade move in favor of the giving country.
(e) receiving money will always result in welfare losses.
Answer: (b)
14. A transfer of purchasing power

(a) does not affect world prices.
(b) may shift world demand.
(c) may shift world supply.
(d) may shift both world supply and demand.
(e) always causes the terms of trade to move in favor of the giver.
Answer: (b)
15. A transfer of real resources

(a) does not affect world prices.
(b) may shift world demand.
(c) may shift world supply.
(d) may shift both world supply and demand.
(e) always causes the terms of trade to move in favor of the giver.
Answer: (d)
16. There are only 2 countries. Country 1 can produce only food and 2 only clothing. Country 2 transfers
resources to 1. Then
(a) world food output falls.
(b) world demand for food rises.
(c) the terms of trade will not change.
(d) the world relative price of food will fall.
(e) the world relative price of food will rise.
Answer: (d)
17. There are two countries in the world. Country A exports food while country B exports clothing.
Demand for both is highly inelastic and very little of each good is consumed in the country it is
produced. One year country A has an unusually large crop of food. As the As economic adviser,
what do you recommend? Country B will take no retaliatory action against you.
(a) Do nothing. Sell all the food crop.
(b) Burn some of, all or more than the excess food.
(c) Give the excess food away and take advantage of a secondary benefit of the gift.
(d) Try to produce even more food.
(e) You cant make any recommendation from the information given.
Answer: (b)
18. Suppose a small nation with balanced trade realizes that it overestimated its natural resources. It is
evident that its income will fall in the future. How will its trading pattern change?
(a) It will not change. Trade will remain balanced.
(b) The country will begin to import more now while income is high.
(c) The country will run trade surpluses to save for lower future income.
(d) The country will export less now so that exports will not fall in the future.
(e) It will not change now, but imports will fall in the future as income and exports fall. Trade will
always remain balanced.
Answer: (c)
19. The terms of trade for a country will change as a result of

(a) changes in tastes.
(b) changes in foreign technology.
(c) changes in foreign resource endowments.
(d) (a) and (c).
(e) all of the above.
Answer: (e)
20. Which of the following statements is incorrect?

(a) With growth, the world as a whole always gains.
(b) Growth in a countrys export sector will always be immiserizing.
(c) A transfer of real resources shifts world demands.
(d) A transfer of purchasing power shifts world demands.
(e) Expected future productivity increases may be an explanation for trade deficits.
Answer: (b)
Chapter 4
Technology and International Income
Distribution: The Ricardian Model
4.1 The Ricardian Setting
4.2 Free-Trade Equilibrium

Country Size
World Production Possibilities
The World Market for Food
4.3 International Wage Comparisons and Productivities

The Competitive Profit Conditions
Productivity and Wages
International Wage Comparisons
Recent International Wage Disparities
4.4 A Many Commodity and Many Country World

What Gets Produced at Home?
4.5 Winners and Losers from Productivity Shocks
4.6 Non-Traded Commodities

A Composite Traded Commodity
Technological Change in a Single Tradable Commodity
4.7 Summary
Appendix A Transitional Unemployment
Chapter Summary
Chapter 2 introduced the idea that differences among countries will lead to mutual gains from trade.
Section II of the text discusses how these differences lead to trade, and exactly what the pattern of trade
will tend to be. Chapter 4 begins this discussion by focusing on the Ricardian trade model.
The Ricardian trade model focuses on the role of technology in accounting for international trade. It is not
concerned with the reason for the existence of technological differences across countries, but instead the
effects of these differences.
Section 4.1 begins by describing the basic structure and assumptions of the model. It should be noted to
students that although this structure is extremely unrealistic, it is useful for isolating the effects of
productivity and technology. The main point of this section is that production uses only labor and
productivities are given exogenously. This leads to a straight-line production possibilities frontier, with the
slope determined by the countrys relative productivity in different goods. In addition, there is a full-
employment condition that must be satisfied. Figure 4.1 illustrates the autarky situation, where relative
prices are determined by the slope of the PPF.
Section 4.2 considers the effects of allowing trade between countries. It is useful to construct the world
PPF and illustrate the various possible production patterns in a trading world. Note that the model does not
make strong predictions about exactly what each country will produce. Rather it implies that they will not
specialize in goods in which they have a comparative disadvantage. The precise production pattern
depends upon the location of indifference curves along the world PPF. The subsection concerning country
size discusses the idea that large differences in country size are likely to produce the case where the large
country is incompletely specialized. Figure 4.2 illustrates how trade alters relative prices, thus leading to
gains for both countries, an idea that should be familiar to students from earlier discussions. Figure 4.3
displays a world production possibilities schedule and should prove useful in showing how a country can
be drawn into producing a good in which it has a comparative disadvantage only after the other nation can
no longer expand its production and if the price makes it attractive. This can also be shown using the more
traditional supply and demand framework (see figure 4.4). Both of the diagrams indicate that any world
equilibrium requires at least one country to be completely specialized. Numerical examples whereby the
two countries differ in their productivities can illustrate the main points of this section.
Section 4.3 discusses the effects of trade on wages (and thus incomes) in a Ricardian world. Once the
pattern of production is known, the competitive profit conditions determine relative wages across
countries. These conditions imply that profits will equal zero in a competitive equilibrium. Figure 4.5
summarizes this material. This material can facilitate discussions of some of the fallacies underlying
concerns about free trade between the US and China (where wages and absolute productivity levels are
much lower).
The remainder of the chapter (sections 4.4 to 4.6) discusses some extensions of the Ricardian model. This
material serves to enhance understanding of the basic model and it also illustrates the fact that although the
basic Ricardian model makes many restrictive assumptions, the results are robust to the relaxation of some
of these assumptions. Of particular interest is the material concerning technological change. Since the
Ricardian model isolates technology, the effects of technological change on production, consumption and
wages are clear within this model.
Appendix A discusses the likelihood of unemployment during the transition to a new equilibrium. An
example is presented whereby social gains can be attained even during a transition phase where some
labor becomes unemployed.

technology differences alone lead to gains from trade
the Ricardian model may lead to complete specialization in production
comparative, not absolute, advantage is the determinant of the pattern of trade
Chapter 4 Technology and International Income Distribution: The Ricardian Model 21

1.
The above diagram shows that the possible world outputs of food and clothing are given by the
parallelogram ABCD. Even in the absence of trade it is possible that countries are on the locus ABC
(for example if tastes are infinitely elastic and the same across countries). The menu of worst
combinations is given by ABC.
2. (a) If demand for good 2 decreases and the demand for the good produced abroad increases the price
of good 2 will fall and the price of the foreign good will rise. This will lead to an increase in
wages in the foreign country and a decrease in wages in the US. Production of good 3 will then
not be profitable abroad and thus all good 3 production will shift to the US. Alternatively, it is
possible that production of good 3 could still be shared between countries. In this case, there will
be no change in prices. The ratio of the foreign to American wage will rise, however.
(b) Fix the price of good 3 at $1. Since there is no change in technology in the production of good 3,
there will be no change in wages in either country. The price of good 1 will then fall by an
amount equal to the amount of the productivity increase in production of good 1. This will lead to
gains for both countries, with the gains being proportional to the amount of good 1 consumed.
3. (a) The home country has the greatest comparative advantage in commodity C.
(b) The home wage rate can be at most 7/10.
(c) The home country can produce only 1 commodity (c) for any wage rate greater than 1/2.
4. (a) Country has an absolute advantage in atomic reactors and tractors as they have higher absolute
labor productivity in the production of these goods.
(b) Country has a comparative advantage in cars, tankers, atomic reactors and wheat, relative to
tractors.
(c) The pattern of trade will be determined by world prices, which are determined by demand for the
products.
5. (a) (b)
In both of the above cases, the large country produces both goods and world relative prices are equal
to the productivity ratio in that country.
(c)
6. (a) The amount of commodity 1 to be given up to obtain 1 unit of 3 is aL3/aL1 6/5.

(b) The country will produce commodity 2 since its ratio of price to technical labor-hours required to
produce one unit of it (Pi/aLi)is highest.
(c) The real income of the worker before trade is 1/aL4 1/7. After trade, the real income is w/P4
where w is equal to P2 /aL2 1/2 (since the country specializes in the production of commodity 2).
7. If China gets better at producing something we both produce, and we still both produce it, we are
worse off whether we export or import that good. Reasoning: Let good 15 be the numeraire - its price
is fixed, and so is our wage rate and all other 14 goods we produce. In China, however, the wage rate
must rise (since its productivity in 15 goes up), and with it the prices of all other commodities China
produces. Hence our terms of trade worsen.

1. The labor theory of value assumes
(a) wages differ across jobs.
(b) land is a scarce factor of production.
(c) as output expands, so does the number of labor hours required to produce one unit of output.
(d) labor is the only scarce factor of production.
(e) labor is not homogenous.
Answer: (d)
2 Consider a two-country world where country A is a more efficient producer of food and B is a more
efficient producer of clothing. In the free trade equilibrium, both countries specialize. A discovers a
labor saving breakthrough which allows them to produce both goods with half the labor previously
required. A can now produce food and clothing more efficiently than B. What happens to trade and
production patterns?
(a) A specializes in clothing, B in food.
(b) A produces both food and clothing.
(c) Trade ceases since B can no longer compete in any good.
(d) We cannot say.
(e) Nothing.
Answer: (e)
Questions 3-11 refer to a situation where aLC 1, aLF 2, aLC 2, and aLF 1.
3. The autarky home relative price of food will be

(a) 1/4.
(b) 1/2.
(c) 1.
(d) 2.
(e) 4.
Answer: (d)
4. Home labor productivity in the food sector is

(a) 1/4.
(b) 1/2.
(c) 1.
(d) 2.
(e) 4.
Answer: (b)
5. If the foreign country can produce at most 10 units of clothing, then the most food they can produce is
(a) 2.
(b) 5.
(c) 8.
(d) 10.
(e) 20.
Answer: (e)
6. If home production of food is 3 and home clothing production is 6, then the labor endowment must be
(assuming full employment)
(a) 3.
(b) 6.
(c) 9.
(d) 12.
(e) 15.
Answer: (d)
7. Which of the following is true?
(a) Home has both a comparative and absolute advantage in clothing.
(b) Home has a comparative advantage in clothing and an absolute advantage in food.
(c) Home has a comparative advantage in food and an absolute advantage in clothing.
(d) Home has both a comparative and absolute advantage in food.
(e) None of the above.
Answer: (a)
8. With trade, which of the following cannot occur?
(a) Both produce food.
(b) Home produces both and foreign produces clothing.
(c) Home produces food and foreign produces both.
(d) Home produces food and foreign produces clothing.
(e) Both produce clothing.
Answer: (d)
9. Which are possible production patterns with trade?
(a) Both produce food.
(b) Home produces food and foreign produces clothing.
(c) Home produces both and foreign produces clothing.
(d) Home produces food and foreign produces both.
(e) All of the above.
Answer: (a)
10. If the foreign wage rate is 1, then the highest the home wage could be is
(a) 1/4.
(b) 1/2.
(c) 1.
(d) 2.
(e) 4.
Answer: (d)
11. If L 200 and L 10, and the world demand for food is perfectly inelastic at 100, then
(a) home must be incompletely specialized.
(b) foreign production must be incompletely specialized.
(c) foreign will produce all clothing.
(d) home will produce all food.
(e) world demand cannot be met.
Answer: (a)
12. It is observed that in a two-country Ricardian trading world, one country is incompletely specialized
and the other is not. Then the world relative price of the two goods
(a) must equal the labor input ratio in the specialized country.
(b) must lie between the two countrys labor input ratios.
(c) must be equal to one.
(d) must equal the labor input ratio in the incompletely specialized country.
(e) cannot be inferred from the above information.
Answer: (d)
13. In the Ricardian model, equilibrium relative wages depend on

(a) world demand for each good.
(b) labors productivity in each good it actually produces.
(c) world relative prices.
(d) none of the above.
Answer: (e)
14. Consider a two-country world with trade where both countries are completely specialized. An
increase in the price of clothing must
(a) decrease nominal wages in the clothing producing country.
(b) increase nominal wages in the clothing producing country.
(c) increase nominal wages in the food producing country.
(d) decrease nominal wages in the food producing country.
(e) will not change nominal wages in either country.
Answer: (b)
15. Compensation to labor is $16 in the US and $2.40 in Mexico. This can be explained by
(a) technology differences.
(b) better trained workers in the US.
(c) more capital in the US.
(d) better capital in the US.
Answer: (e)
Consider the following scenario for questions 1618.
There are two countries and five goods. A produces good 1 and 2 while B produces 3, 4, and 5. B
experiences a technological improvement in the production of good 5. Both countries continue
producing the same goods. Assume the price of good 3 does not change through the following
analysis.
16. If the prices of 1 and 2 do not change, who gains and what happens to wage rates?
(a) Wages in A fall and wages in B rise. B gains and A loses.
(b) Wages in B fall and wages in A rise. A gains and B loses.
(c) Wages in A and B remain constant. A gains and B loses since it is now getting less for good 5.
(d) Wages in A and B rise. Both countries gain because of the wage increase.
(e) Wages in A and B remain constant. Everyone who consumes good 5 gains.
Answer: (e)
17. If the prices of 1 and 2 rise significantly, which of the following is possible?
(a) Wages in A fall and wages in B rise. B gains and A loses.
(b) Wages in B fall and wages in A rise. A gains and B loses.
(c) Wages in B remain constant while wages in A rise. A gains and B loses.
Answer: (c)
18. If the prices of 1 and 2 fall significantly, which of the following is possible?
(a) Wages in A fall and wages in B remain constant. B gains and A loses.
(b) Wages in B fall and wages in A remain constant. A gains and B loses.
(c) Wages in A and B remain constant. A and B lose since they are now getting less for their exports.
Answer: (a)
19. Consider if home produces goods 1 and 2 and the foreign country produces good 3. An improvement
in the technology for producing good 1 with no change in the price of good 3 will lead to
(a) p1 declining, w increasing and w falling.
(b) p1 declining, w increasing and no change in w.
(c) p1 increasing and no changes in wages.
(d) p1 declining and no changes in wages.
(e) p1 declining, wincreasing and no change in w.
Answer: (d)
20. Consider if home produces goods 1 and 2 and the foreign country produces good 3. An improvement
in the technology for producing good 1 with a decline in the price of good 3 will lead to
(a) unambiguous welfare gains for the foreign country.
(b) wages falling both at home and in the foreign country.
(c) unambiguous home welfare gains and foreign welfare losses.
(d) unambiguous home welfare gains and falling foreign wages.
(e) falling home wages and foreign welfare losses.
Answer: (e)
Chapter 5
Factor Endowments and Trade I:
The Specific Factors Model
5.1 Diminishing Returns and Factor Hires
5.2 Outputs and Income Distribution in the Closed Economy
5.3 Outputs and Income Distribution with Free Trade
5.4 Growth in Factor Endowments
5.5 Consequences for Political Economy
5.6 The Pattern of Trade
5.7 Alternative Interpretations: Specific Capital or Specific Labor

Trade and Unskilled Wage Rates
5.8 Dutch Disease

The Fate of the Non-Traded Sector
5.9 Summary
Appendix A: The Transformation Schedule
Chapter Summary
Chapter 5 introduces the specific factors model of international trade. This model highlights the effects of
fixed inputs and decreasing returns to scale. The Ricardian model, in contrast, assumed that labor was
perfectly mobile between sectors, and that production exhibited constant returns to scale. The basic
production structure in the specific factors model has three inputs and two sectors. Each sector has an
input specific to that sector while the third input is mobile across both sectors. The basic problem is then
how to best allocate the mobile input across sectors.
Section 5.1 outlines the basic specific factors model. The decision to hire the mobile factor within a sector
proceeds as follows: the factor is hired until the value of its marginal product is equal to the return that
must be paid to that factor. Diminishing returns implies that the marginal product is falling as more of the
factor is hired. This section also discusses the effects of a change in commodity prices. Emphasize that
competitive profit conditions must always be satisfied. This drives the result that price changes must lie
between changes in factor returns. An understanding of this idea will also prove useful in understanding
the Stolper-Samuelson theorem in chapter 6. In section 5.2, Figure 5.1 illustrates the PPF for the economy.
It shows how increasing opportunity costs generate a bowed-out production possibilities schedule, as
Chapter 5 Factor Endowments and Trade I: The Specific Factors Model 29
compared with the flat PPF reflecting constant returns to scale in the Ricardian economy. Figure 5.2
illustrates many of the interesting results in this chapter. This diagram can be used to discuss changes in
resource endowments, changes in commodity prices and changes in resource prices. Note that analyzing
the effects of each of the above changes is simply a matter of examining how the mobile factor chooses to
reallocate across sectors. Emphasis should be placed on the fact that this factor moves to the sector where
it can earn the highest real return, and thus returns are equalized across sectors as a result of diminishing
returns.
Free trade will alter relative prices. The discussion of the distribution of income and free trade in section 5.3
illustrates that a move towards free trade generates both winners and losers, with the mobile factor being
affected in an ambiguous manner. The owners of the factor specific to the sector where the relative price has
increased gain, and the owners of the other specific factor lose. This material can be used to discuss some of
the objections to free trade. A mathematical approach to this section is presented in the chapter supplement.
Section 5.4 considers a change in factor endowments with commodity prices held fixed. Although the text
uses figure 5.3 to discuss these changes, they are also easily found from figure 5.2. The results can be
generalized fairly easily. First, as a factor becomes relatively more abundant, its real return falls. Second,
the returns to the specific factors always move in the same direction. Third, as a result of competitive
profit conditions, the return to the mobile factor must move in the opposite direction to that of the specific
factors. The chapter supplement discusses the material more formally.
Section 5.5 presents some possible political implications of this model.
Section 5.6 discusses the pattern of trade. Note that the discussion does not predict the pattern of trade
precisely, but instead suggests that the relative abundance of specific factors is an important determinant.
The effects of differences in the labor force are outlined in the supplement. Sections 5.7 and 5.8 discuss
how trade affects a variety of sectors. An important point to note is that unlike the Ricardian model, the
specific factors model does not allow for complete specialization in production due to the presence of
specific factors. The discussion of the Dutch Disease further reinforces the fact that trade can lead to
both winners and losers, leading to objections to free trade.
Appendix A describes how the PPF with increasing opportunity costs can be derived using a model with
full employment and diminishing returns to each factor of production.

diminishing returns and specific factors.
commodity price changes must lie between factor price changes
trade leads to both winners and losers
changes in resource endowments affect the distribution of income

1.
The average product can be found from the slope of a ray from the origin to points on the total
product curve. This reveals that the curve slopes downwards and lies everywhere above the marginal
product. The total wage payments are represented by the area of the rectangle formed by BODL0 and
the return to land is given by the area ABDC.
2. Both an increase in the price of food and an increase in the quantity of land will raise wages. Which
raises wages by a greater amount depends upon the slopes of the VMP curves. Both will also reduce
the return to capital. If both changes cause an equal increase in wages, then the second will be
preferred by workers, as prices will not increase as they do in the first case. A similar story can be
told for capitalists. Note that an increase in the price of food leads to landowners unambiguously
gaining, whereas an increase in the amount of land leads to landowners unambiguously losing.
3. If there is immigration, wages will fall. The competitive profit conditions then imply that the returns
to both capital and land should increase. A tariff on manufactures will raise their price. This will raise
the VMP of labor in the manufacturing sector, thus attracting workers away from sheep farming. The
loss of labor in the sheep sector will reduce the returns to land, thus hurting sheep station owners.
4. An increase in the amount of land raises the marginal product of labor in food production, and the
decrease in capital lowers the marginal product of labor in clothing production. Thus, labor will move
from the clothing sector to the food sector. In the absence of trade, this movement in the relative
supplies of goods will alter the relative prices of the two goods, with the relative price of food
decreasing. Thus, the return to land will fall and the return to capital will rise. With trade, the prices
of the goods are fixed. Thus, the factor returns will move due to the changes in the factor proportions.
The return to capital will rise and the return to land will fall. If the country trades at world prices, then
there will very little change in land rents.

1. The law of diminishing returns states that as you use more of a variable factor in combination with a
fixed factor
(a) output falls at an increasing rate.
(b) output falls at a decreasing rate.
(c) output rises at a decreasing rate.
(d) output rises at an increasing rate.
(e) output rises at an constant rate.
Answer: (c)
2. At constant commodity price, labor growth
(a) can lead to a decrease in output of one good.
(b) leads to a balanced increase in output of both commodities.
(c) will lead to unemployment.
(d) (a) and (b) only.
Answer: (b)
3. If the value of the marginal product of labor exceeds the wage rate then firms will
(a) hire more labor.
(b) hire less labor.
(c) use more land.
(d) use more capital.
(e) both (c) and (d).
Answer: (a)
4. The owners of the specific factors will lobby together for

(a) an increase in the tariffs on imports.
(b) a decrease in the tariffs on imports.
(c) an increase in the endowment of one type of specific capital.
(d) an increase in the endowment of labor.
(e) nothing. They compete against each other.
Answer: (d)
5. Under constant returns to scale, if wages and the return to capital both rise by 10 percent, then
(a) output prices fall by 10%.
(b) unit costs of production fall by 10%.
(c) unit costs of production rise by 10%.
(d) firms profits rise by 10%.
(e) firms profits fall by 10%.
Answer: (c)
6. If wages rise by 10% and the return to capital rises by 20%, which of the following is a possible
increase in the price of a good that uses both labor and capital as inputs?
(a) 0%
(b) 5%
(c) 10%
(d) 15%
(e) 20%
Answer: (d)
7. In a specific factors model, if a firm wishes to increase output,

(a) the firm must use more of the specific factor.
(b) unit costs of production will stay the same.
(c) unit costs of production will increase.
(d) the marginal product of the variable factor must rise.
Answer: (c)
8. In a two sector specific factors model with labor mobile across sectors,
(a) the returns to the fixed factors are zero.
(b) wage rates will be the same in all sectors.
(c) the wage rate will be higher in the sector with a larger amount of specific factor.
(d) all labor must be employed in one sector.
Answer: (b)
9. If tastes shift towards food and away from clothing, then in a specific factors framework with labor
mobile across sectors,
(a) the value of the marginal products of labor must be equal across sectors in equilibrium.
(b) the value of the marginal product of labor in food production falls.
(c) the value of the marginal product of labor in clothing production falls.
(d) the value of the marginal product of labor in clothing production rises.
(e) the value of the marginal product of labor in food production rises.
Answer: (a)
10. In a specific factors framework with labor as the mobile factor, immigration will
(a) increase wages and reduce the returns to the specific factors.
(b) decrease wages and reduce the returns to the specific factors.
(c) increase wages and not change the returns to the specific factors.
(d) decrease wages and reduce the returns to one specific factor and raise the return to the other.
(e) decrease wages and increase the returns to the specific factors.
Answer: (e)
11. In a specific factors framework with labor as the mobile factor, an increase in the capital stock will
(a) increase the return to capital and increase wages.
(b) increase the return to capital and decrease wages.
(c) decrease the return to capital and decrease wages.
(d) decrease the return to capital and increase wages.
(e) not change the return to capital.
Answer: (d)
12. In a specific factors framework with labor as the mobile factor and land as the factor specific to the
food sector, an increase in food prices will
(a) cause labor to move to the clothing sector.
(b) create unemployment.
(c) cause labor to move out of the food sector.
(d) cause labor to move to the food sector.
(e) decrease wages.
Answer: (d)
13. In a specific factors framework with labor as the mobile factor and capital as the factor specific to the
clothing sector, which of the following is a possible result of a 10 percent increase in clothing prices?
(a) Returns to capital rise by 15 percent; wages rise by 8 percent and the return to land falls by
2 percent.
(b) Returns to capital rise by 8 percent; wages fall by 2 percent and the return to land rises by
15 percent.
(c) Returns to capital fall by 2 percent; wages rise by 15 percent and the return to land rises by
8 percent.
(d) Wages do not change, and the return to both capital and land rises by 12 percent.
(e) Returns to capital fall by 15 percent; wages rise by 15 percent and the return to land falls by
15 percent.
Answer: (a)
14. Assuming workers consume primarily the import good, labor will allocate large resources to lobby
with the specific factor used in the import competing sector to
(a) reduce the endowment of labor (allow emigration) in order to raise wages.
(b) reduce tariffs on imports.
(c) increase tariffs on imports.
(d) decrease the endowment of the specific capital used in the export sector.
Answer: (e)
15. In the specific factors framework, a 15 percent increase in the return to land and a 2 percent increase
in the wage rate could be the result of
(a) an 8 percent increase in the price of food.
(b) an 8 percent decrease in the price of food.
(c) a 17 percent increase in the price of food.
(d) a decrease in the price of clothing.
(e) an increase in the price of clothing.
Answer: (a)
16. In a specific factors framework with labor as the mobile factor, capitalists will promote policies that
(a) increase prices of goods that use capital in production.
(b) reduce the amount of available land.
(c) increase the labor supply.
(d) decrease prices of goods that use land in production.
Answer: (e)
17. In a specific factors framework, the Dutch Disease occurs when

(a) a boom in one sector decreases wages, creating unemployment.
(b) a boom in one sector increases wages, lowering profits in some other sectors.
(c) a boom in one sector decreases wages, raising profits in some other sectors.
(d) a boom in one sector leads to the destruction of other sectors.
(e) a boom in one sector reduces the return to the factor specific to that sector.
Answer: (b)
18. With non-traded goods, a boom in an export sector (assuming labor is mobile across sectors) without
a shift in demand will
(a) decrease wages and decrease prices of non-traded goods.
(b) increase wages and increase prices of non-traded goods.
(c) increase wages and decrease prices of non-traded goods.
(d) decrease wages and increase prices of non-traded goods.
(e) increase wages and not affect prices of non-traded goods.
Answer: (b)
19. If the price of clothing decreases by 10 percent, which of the following could occur?
(a) All rates of return and wages in the economy fall since the price of some outputs has fallen.
(b) The return to capital decreases by less than 10 percent, wages fall by more than 10 percent and
the rental rate on land rises.
(c) The return to capital decreases by more than 10 percent, wages fall by less than 10 percent and
the rental rate on land rises.
(d) The return to capital decreases by more than 10 percent, wages and the rental rate on land rise.
Answer: (c)
20. Which of the following groups is most likely to oppose immigration into the US?
(a) US capitalists
(b) US landowners
(c) US workers
(d) all of the above are equally likely to be opposed to immigration
(e) both (a) and (b)
Answer: (c)
Chapter 6
Factor Endowments and Trade II:
The Heckscher-Ohlin Model
6.1 If Technology is Rigid
6.2 Flexible Technology

Factor Intensities
A Bowed-Out Transformation Curve
6.3 Possible Trade Patterns and the Distribution of Income

Income Distribution in the Move From Autarky to Free Trade
Unit-Value Isoquants
6.4 International Trade with Many Commodities
6.5 How Concentrated is Production?

Transportation Costs
Protection of Local Industries
Specific Factors: Short Run and Long Run
6.6 Changing Comparative Advantage with Economic Growth
6.7 Heckscher-Ohlin Theory and Empirical Evidence

Testing the Heckscher-Ohlin Theorem
Looking Elsewhere for Explanations
What is at Stake: Trade and Wages
6.8 Summary
Appendix: The Production Box
Chapter Summary
This chapter focuses on differences in factor endowments as a motivation for international trade by
considering the Heckscher-Ohlin model of trade with two commodities and two inputs, capital and labor.
This differs from the previous two chapters in that both inputs are used in the production of both goods.
The chapter begins by considering the simple case where the relative factor intensities of the two goods are
exogenously fixed. Figure 6.1 illustrates the production possibilities. This section emphasizes that
production and prices must satisfy two sets of constraints: two resource constraints and the competitive
profit conditions. The numerical example in this section outlines two of the basic theorems in this chapter:
(i) the factor-price equalization theorem and (ii) the Heckscher-Ohlin theorem.
Section 6.2 expands the analysis to allow factors to move more freely between sectors by considering
flexible technology. Note that the definition of relative factor abundance has to be altered to account for
this flexibility. Figure 6.3 illustrates how actual factor intensities are chosen. The flexible technology
model also allows for situations where factor price equalization does not hold. This occurs when
endowments differ to such a degree that the two countries do not produce the same commodities in the
free trade equilibrium.
Figure 6.3 provides a good introduction to section 6.3 and the discussion of trade patterns and income
distribution. This section states explicitly and discusses two important results of the Heckscher-Ohlin
model of trade: the Factor-Price Equalization and Stolper-Samuelson theorems. The supplement to the
chapter also derives these results mathematically. This supplementary material, although somewhat
difficult, has been found to be valuable in assisting students in understanding both the Stolper-Samuelson
theorem and the Rybczinski theorem. Although the Rybczinski theorem is not presented in the main text, it
is an important result. Both the graphical and mathematical analysis are based on the idea that input prices
and production adjust such that there are zero profits and all resources are fully employed. Note the
similarity to the previous chapter in that commodity price changes must be trapped between factor price
changes. A move from autarky to trade, which will change commodity prices, will then produce both
winners and losers. Similarly, a change in an endowment must lead to the expansion of production of one
good and contraction of production of the other. These magnification results are important elements of
the material in this chapter. Note that endowment changes lead to production quantity changes, but not
commodity price changes, and that commodity price changes lead to factor price changes, but no change
in output quantities.
The concept of unit-value isoquants is introduced near the end of section 6.3 and continues in section 6.4
(see figures 6.5 and 6.6). Production will take place along the inner frontier of these isoquants, with the
exact mix of goods produced determined by the countrys resource endowment. Note that in equilibrium,
no more than two goods will be produced. In addition, the issue of technology appears briefly here in that
products in which the country has poor technology will have unit-value isoquants far from the origin and
thus they will not be produced with any resource endowment. This serves as one link between Heckscher-
Ohlin and Ricardian frameworks. An important feature of the analysis is that the factor-price ratio is given
by the slope of the unit-value isoquant. Finally, in a many-country, many-commodity world countries will
tend to export those commodities that require input ratios similar to their endowments and will import all
others.
The previous section leads to the unrealistic result that each country will produce only a small number of
commodities. Section 6.5 considers some of the reasons for the fact that this is clearly not the case in
practice. Among these are transport costs and political motives, the second of which is addressed in further
detail in Part III of the text. The final explanation relates to the fact that the Heckscher-Ohlin theory
assumes perfect factor mobility, and is thus a long-run approach. If some factors, such as capital and land,
were fixed for a period of time then this could generate a larger variety of goods being produced at any
point in time. Note that this analysis essentially presents the specific factors model as a short-run variant of
the Heckscher-Ohlin model.
Section 6.6 addresses the effects of economic growth. Using the recent development of a group of Asian
countries and their changing trade pattern with the US, it is shown that economic growth can change a
countrys comparative advantage. Note that this can occur if growth results in a change in a countrys
technology or in its resource base.
The final section discusses evidence about some of the strong empirical predictions of this model. The
Leontief paradox states that the US imports capital-intensive goods, yet it is a relatively capital-intensive
Chapter 6 Factor Endowments and Trade II: The Heckscher-Ohlin Model 37
country. This is in direct opposition to the theory outlined in the chapter. Possible explanations include
technology differences, biases in consumption and the geographic and regional clustering of industries. In
light of these explanations, the data actually may support the theory. Finally the section concludes with a
discussion of the implications of the factor content of US exports and imports. It is important to emphasize
that only a small part of the increasing income differential between skilled and unskilled workers is due to
trade; technological change has played a much more significant role.
The appendix introduces the production box diagram to explain the Heckscher-Ohlin theory of
international trade. This can be used to illustrate most of the main results of this chapter, and has been
found to be essential to understanding the material.

countries tend to export those commodities whose production uses resources in proportions similar to
the countrys endowment
commodity trade may equalize factor returns across countries
Stolper-Samuelson Theorem
Rybczinski Theorem
Heckscher-Ohlin theory in a many-commodity world
economic growth can lead to alterations in comparative advantage

1. If both goods are produced then to find prices use the competitive profit conditions. This should yield
that the price of food is $4 and the price of clothing is $10.
After the price of clothing rises to $15, to find the new wage and capital returns use the competitive
profit conditions once again. This yields that the new wage is $11/3 and the return to capital falls to
$1/3. Ranking the changes in percentage terms, wages increased the most, followed by the price of
clothing, the price of food (unchanged) and then the return to capital (which fell). This raking
corresponds to the results obtained from the Stolper-Samuelson theorem.
2.
At point A, there are 4xc units of labor being used. Thus the ray with the slope of 1/4 can be used to
represent the amount of clothing being produced.
(a) If L 1000 and K 500, then full employment conditions yield that there will be 500/3 units of
clothing produced and 1000/3 units of food produced.
(b) The minimum level of capital that will allow full employment of both factors is 250. At this
capital stock, only clothing is being produced. The maximum is 1000, where only food is
produced. These can be found by using the full employment conditions and setting food and
clothing production equal to zero respectively.
(c)
3. (a) If L/K 3, then the country will produce a mixture of goods 4 and 5. Constructing unit value
isoquants for each industry will determine this fact. Competitive profit conditions will then show
that w 1 and r 12.
(b) If the price of good 1 triples, then the unit value isoquant moves closer to the origin, showing that
production of good 1 dominates the production of all other goods except good 4. At the same
prices as in (a), the economy will produce a mixture of goods 1 and 4. Competitive profit
conditions give that w 8/7 and r 82/7.
(c) The economy will produce goods 1 and 2. The wage rate will be $12 and the return to capital
will be $1.
(d) If the price of good 3 increases to $14, then goods 3 and 5 will be produced. Competitive profit
conditions yield w 2/3 and r 13 1/3.
(e) Only good 3 will be produced.
4. An increase in the price of good will shift its unit-value isoquants closer to the origin, allowing this
good to be produced for a larger range of capital to labor ratios. The effects on the w/r ratio can be
shown in Figure 6.7.
The price increase then reduces the real wage at home (with K/L I) and increases it abroad
(where K/L M). This is because the home country is producing goods 1 and 2 and thus 2 is the
capital-intensive good. The Stolper-Samuelson theorem then implies that the wage rate should fall as
the price of the capital-intensive good has risen. In the foreign country, goods 2 and 3 are being
produced, and thus good 2 is the labor-intensive good. The increase in price will then lead to an
increase in real wages.
5. Consider if the contract curve is as in the above diagram. Production is initially at point D, where
both food and clothing are equally capital-intensive. If food production was expanded and clothing
reduced so that production was at E, then this would require that food use more labor-intensive
techniques and clothing use more capital-intensive techniques. Therefore, labor must flow from
clothing to food. However, this requires that the ratio w/r increase in food and fall in clothing, which
is not possible, as this ratio is equalized across sectors at all points on the contract curve.
6.
The foreign country has a larger labor endowment and the same capital endowment as the home
country. The fact that prices are the same in the two countries implies that they will be at points on
their respective contract curves that have the same slope. Consider then if the home country produces
at point A. Then point B (directly below A) has a slope that is less than at A. The foreign country will
then produce less food and more clothing than the home country (i.e. they will choose a point on their
contract curve that is closer to the food origin than at B). As drawn, the foreign country has a higher
labor endowment than the home country and produces more of the labor-intensive good and less of
the capital-intensive good. This result is consistent with the Rybczinski theorem.

1. In a Heckscher-Ohlin framework, the home country has 100 units of labor and the foreign has 200.
Which of the following is necessarily true?
(a) Home is relatively labor-abundant.
(b) Foreign is relatively labor-abundant.
(c) Home is relatively capital-abundant.
(d) Foreign is relatively capital-abundant.
Answer: (e)
2. Consider two countries with the same technology and factor endowment proportions close together.
If factor prices are equalized across the two countries, the relatively labor-abundant country must
(a) have a higher real wage rate.
(b) export more of the labor-intensive good.
(c) import more of the labor-intensive good.
(d) produce more of the labor-intensive good.
(e) (b) and (d).
Answer: (d)
3. In a Heckscher-Ohlin framework with flexible technology, which of the following is true?

(a) Factor returns will be equalized with trade.
(b) The capital-abundant country will generally export the capital-intensive good.
(c) The wage to rent ratio will be higher in the capital-abundant country.
(d) None of the above.
Answer: (b)
4. In a Heckscher-Ohlin framework with clothing as the capital-intensive good, an increase in the price
of clothing will generally result in
(a) wages increasing, returns to capital decreasing.
(b) wages increasing, returns to capital increasing.
(c) wages decreasing, returns to capital decreasing.
(d) wages decreasing, returns to capital increasing.
(e) wages unchanged, returns to capital increasing.
Answer: (d)
5. In a Heckscher-Ohlin framework with clothing the capital-intensive good, a 20% increase in the price
of clothing could induce
(a) an increase in the rental rate of more than 20% and a fall in the wage rate.
(b) a fall in the rental rate and an increase in the wage rate of less than 20%.
(c) a fall in the rental rate and an increase in the wage rate of more that 20%.
(d) an increase in both the rental and wage rates.
(e) an increase in the rental rate of less than 20% and a fall in the wage rate of more than 20%.
Answer: (a)
Questions 610 concern the following situation:
Technology is the same across countries. The inputs necessary for production are fixed and it requires
2 units of labor and 1 unit of capital to make a unit of food. To make a unit of clothing, it requires 1 unit of
labor and 4 units of capital. The home country has 200 units of labor and 200 units of capital. The foreign
country has 100 units of labor and 200 units of capital.
6. Which of the following is true?

(a) Food production is labor-intensive and the foreign country is relatively labor-abundant.
(b) Food production is labor-intensive and the home country is relatively labor-abundant.
(c) Food production is capital-intensive and the home country is relatively labor-abundant.
(d) Food production is capital-intensive and the home country is relatively capital-abundant.
(e) The home country is neither relatively capital-abundant nor relatively labor-abundant.
Answer: (b)
7. If in autarky, clothing costs $3 at home and food costs $1 at home then what is the home return to
capital?
(a) 1
(b) 2/7
(c) 3/4
(d) 5/7
(e) 2
Answer: (d)
8. In a Heckscher-Ohlin framework with food the labor-intensive good, a 10% increase in the wage rate
is most likely caused by
(a) an increase in the price of clothing of less than 10%.
(b) an increase in the price of clothing of more than 10%.
(c) an increase in the price of food of more than 10%.
(d) an increase in the rental rate on capital.
(e) an increase in the price of food of less than 10%.
Answer: (e)
9. If in autarky, foreign wages are $1 and the return to capital is also $1, what are foreign autarky
prices?
(a) food $4, clothing $5
(b) food $2, clothing $5
(c) food $3, clothing $4
(d) food $3, clothing $5
(e) food $6, clothing $4
Answer: (d)
10. If in autarky, the home price of food was $1, the home clothing price was $3, the foreign price of
food was $3 and the foreign clothing price was $5, then the following gain from trade:
(a) home capitalists, foreign laborers.
(b) home laborers, foreign capitalists.
(c) only home laborers.
(d) laborers in both countries.
(e) capitalists in both countries.
Answer: (b)
11. In a Heckscher-Ohlin framework with clothing as the capital-intensive good and fixed coefficient
technology, capitalists would tend to encourage policies that
(a) increase the price of capital-intensive goods.
(b) promote immigration.
(c) decrease the amount of capital in use.
(d) increase the price of all goods by an equal amount.
Answer: (a)
12. Consider a Heckscher-Ohlin framework with clothing as the capital-intensive good where the home
country imports food. A tariff on imports of food will be encouraged by
(a) home capitalists.
(b) home labor.
(c) foreign capitalists.
(d) both (b) and (c).
Answer: (b)
13. The Leontief paradox is based on the observation that

(a) the US is relatively capital-abundant, but US exports tend to be relatively capital-intensive.
(b) the US is relatively capital-abundant, but US imports tend to be relatively capital-intensive.
(c) the US is relatively labor-abundant, but US imports tend to be relatively capital-intensive.
(d) the US is relatively labor-abundant, but US imports tend to be relatively labor-intensive.
(e) factor prices are not equalized between the US and its major trading partners.
Answer: (b)
14. The increase in the differential between the hourly earnings of skilled and unskilled labor can be
explained by
(a) increasing imports intensive in their use of low-skill workers.
(b) shifts in demand away from low-skill manufactures.
(c) labor-saving technology shifts.
(d) immigration of low-skill workers.
Answer: (e)
15. In the production box diagram used to illustrate the Heckscher-Ohlin model of trade, the slopes of
lines from the origin to points on the contract curve represent
(a) relative output prices.
(b) relative factor prices.
(c) relative factor intensities.
(d) relative resource endowments.
Answer: (c)
16. If clothing production is relatively labor-intensive, and the home country is relatively labor-abundant,
then with free trade (assume the home and foreign countries are of equal size),
(a) the home country will produce more clothing varieties than the foreign.
(b) the home country will produce more clothing varieties than they did under autarky and the
foreign will produce less.
(c) clothing firms will be smaller in the home country.
(d) the production pattern will be the same as it was in autarky.
(e) food producing firms will be smaller in the foreign country.
Answer: (a)
17. Unit value isoquants represent

(a) combinations of inputs that produce one unit of output.
(b) technologies that produce one unit of output.
(c) prices of goods.
(d) combinations of inputs that produce one dollar of output.
Answer: (d)
18. If the price of a good increases, the unit value isoquant for the production of that good
(a) becomes more curved.
(b) shifts outward.
(c) shifts upwards.
(d) shifts right.
Answer: (e)
19. In Heckscher-Ohlin model with many goods, trade allows countries to

(a) produce goods whose relative factor requirements are different from the countries
relative factor endowments.
(b) concentrate production in a few goods whose relative factor requirements are similar to the
countries relative factor endowments.
(c) produce more goods than it could in autarky.
(d) produce goods whose production costs are above the production costs in the rest of
the world.
Answer: (b)
20. An increase in the world price of clothing results in

(a) higherprofits forclothing producers.
(b) fewer countries producing clothing.
(c) a taste shift towards clothing.
(d) clothing being produced in a larger number of countries.
Answer: (d)
21. It is observed that a country in a trading world is producing only one good. An increase in the world
price of that good will
(a) raise wages and lower the return to capital.
(b) raise the return to capital and lower wages.
(c) increase profits for firms in that country.
(d) not change wages and the return to capital.
(e) raise both wages and the return to capital.
Answer: (e)
22. In a Heckscher-Ohlin trading world where there are many countries and many goods, which of the
following must be true?
(a) Factor prices will be equalized across countries.
(b) The country with the most labor will produce the most labor-intensive good.
(c) Larger countries will produce more goods.
(d) All of the above.
Answer: (e)
23. Assume a Hecksher-Ohlin world with many countries and free trade. If countries have similar tastes,
factor intensities in a countrys aggregate consumption bundle reflect
(a) average world factor endowments.
(b) the countrys factor endowment.
(c) the factor endowment of the countrys exports.
Answer: (a)
24. The Heckscher-Ohlin model can be viewed as

(a) a framework in which intra-industry trade can be incorporated.
(b) a model which the prevalence of intra-industry trade refutes.
(c) a long-run Specific-Factors model where overtime all factors become essentially mobile and can
be reallocated across sectors.
(d) a short-run Specific-Factors model where in short periods of time factors are not mobile across
sectors.
(e) (a) and (c).
Answer: (c)
25. In a two-country Heckscher-Ohlin model, growth in country As (but not Bs) physical and human
capital leads to
(a) higher real wage rates in A.
(b) changes in which goods B has a comparative advantage.
(c) changes in which goods A has a comparative advantage.
(d) changes in country As factor prices.
Answer: (e)
Chapter 7
Imperfect Competition, Increasing Returns
and Product Variety
7.1 The Prevalence of Intra-Industry Trade
7.2 Consumer Behavior and the Demand for Variety
7.3 Increasing Returns in Production

Monopolistic Competition
Firm Size and Product Variety in Autarky
Differentiated Products in a World Market
The Combination of Intra-Industry Trade and Inter-Industry Trade
Quality Differences and Intra-Industry Trade
7.4 Summary
Chapter Summary
The primary objective of this chapter is to discuss the role of increasing returns and imperfectly
competitive behavior as a basis for international trade. This is evidenced by the prevalence of intra-
industry trade in whichh countries export and import goods from the same industry.
Intra-industry trade, the phenomenon whereby a good is both imported and exported simultaneously by the
same country, is discussed in section 7.1. Table 7.1 documents the large volume of intra-industry trade.
This serves to highlight one of the main shortcomings of the basic trade models presented earlier.
Section 7.2 introduces the typical consumers preference for a variety of goods within a commodity group.
Figure 7.2 shows how relative prices help determine a consumers choice to consume a particular combination
of similar but differentiated goods. Variety is shown to increase the gains from trade by increasing real
incomes as well as providing a wider selection of each type of commodity from which to choose.
Section 7.3 discusses one of the main explanations for the prevalence of intra-industry trade: the idea that
products, and product quality, differ slightly across countries. Countries then exchange different varieties
or qualities of the same good. Figure 7.3 illustrates the workings of monopolistic competitive markets.
Note that there are zero profits in equilibrium, with the zero profit constraint determining the number
of firms endogenously. The fact that the AC curve slopes downwards reflects the presence of fixed costs,
which in turn imply that addition of new varieties is costly. Figure 7.4 illustrates that with trade, there is
an expansion of markets, leading to both larger firms and more firms. Figure 7.5 shows that, with trade,
the transformation curve can be shifted out for a good produced by an industry that displays increasing
returns. Vertical intra-industry trade can help explain trade of goods of differnet quality in which capital
abundant nations may produce and export a higher quality of a particular good (assuming higher quality
Chapter 7 Imperfect Competition, Increasing Returns and Product Variety 47
goods tend to be produced employing capital-intensive techniques) whereas the lower quality version
of the good would be produced and exported by a relatively labor abundant nation.
Key concepts discussed in this chapter include:

there is a large volume of intra-industry trade, which can be explained, to some degree, by markets that
are not perfectly competitive
consumers tend to prefer a variety of goods within a given commodity group; such a variety can be
attained more efficiently through intra-industry trade than in autarky

1. In autarky, 4,000 units of resources are used in the production of food and 10,000 units in the
production of clothing. After trade, since there are only 4 varieties of each produced, there will be
800 units of each variety of food produced and 1150 units of each of the 4 varieties of clothing
produced. Trade allows the economy to produce a limited variety of each good. Since there are fixed
costs in the production of a variety, trade thus allows for a smaller fraction of resources to be used in
setup costs. In autarky, production cannot be cut back to 4 varieties per good as demand dictated that
10 varieties per good are produced. With trade, the varieties not produced domestically are imported.
The economys PPF is illustrated above. If the country cannot trade, then relative supplies will be
such that there will always be twice as much food as clothing. The supply curve will then be perfectly
elastic. Therefore, the autarky relative price of food will always be 1/2, and will thus will be
insensitive to changes in demand.
2. The fact that the home country is labor-abundant and clothing production is labor-intensive could
lead to there being more clothing producers in the home country than abroad. This could lead
to a situation whereby the smaller home country has more clothing producers than the larger foreign
country.

1. We are more likely to observe intra-industry trade in
(a) industries with complex and highly differentiated goods.
(b) industries with increasing returns in production.
(c) goods in which consumers value variety.
(d) goods in which a country possesses neither a clear advantage nor disadvantage in production.
Answer: (e)
2. If a country exports 300 units of food and imports 200 units of food, then its index of intra-industry
trade in food would be
(a) 0.2.
(b) 0.4.
(c) 0.5.
(d) 0.6.
(e) 0.8.
Answer: (e)
3. Between 1964 and 1985 intra-industry trade has risen by about

(a) 1/10.
(b) 1/4.
(c) 1/3.
(d) 1/2.
(e) 2/3.
Answer: (c)
4. Intra-industry trade is most prevalent in what type of goods?

(a) agricultural products
(b) simple, homogeneous goods
(c) manufactured goods
(d) complex, differentiated goods
(e) natural resources
Answer: (d)
5. Increasing returns to scale imply that a doubling of all inputs results in

(a) less than double the output.
(b) a doubling of the unit cost of production.
(c) exactly double the amount of output.
(d) lower profits for firms.
(e) less than double production costs.
Answer: (e)
6. If there were increasing returns to scale and no product variety, then

(a) firms profits would be negative.
(b) all production would be in one good.
(c) the country would produce an infinite number of products.
(d) unit production costs would be zero.
Answer: (b)
7. If a monopolistic competitive firm unilaterally raises its price a small amount, then
(a) its profit falls to zero.
(b) sales of its product will fall to zero.
(c) its profits become infinite.
(d) sales of its product will rise.
(e) its sales fall, but not to zero.
Answer: (e)
8. Tangency of average cost and average revenue in monopolistic competitive markets imply that
firms profits are
(a) dependent solely upon costs.
(b) increasing as more firms produce varieties.
(c) zero.
(d) equal to the difference between average revenue and marginal cost.
(e) none of the above
Answer: (c)
9. As market size expands, firm size expands as a result of

(a) a decline in the number of products.
(b) a lack of close substitutes in demand.
(c) demand becoming more elastic.
(d) average production costs increasing.
Answer: (c)
10. In autarky, two countries share a common technology, markets are monopolistic competition, and the
home market is larger than the foreign. Then
(a) there will be more foreign firms and they will be larger than home firms.
(b) there will be fewer foreign firms and they will be larger than home firms.
(c) there will be more foreign firms and they will be smaller than home firms.
(d) profits will be higher for home firms than foreign firms.
Answer: (e)
11. If clothing production is relatively labor intensive, and the home country is relatively labor abundant,
then with free trade (assume the home and foreign countries are of equal size),
(a) the home country will produce more clothing varieties than the foreign.
(b) the home country will produce more clothing varieties than they did under autarky and the
foreign will produce less.
(c) clothing firms will be smaller in the home country.
(d) the production pattern will be the same as it was in autarky.
(e) food producing firms will be smaller in the foreign country.
Answer: (a)
12. In the presence of scale economies, trade (that does not change the number of varieties
of goods produced) will
(a) shift a countrys production possibilities frontier outwards.
(b) shift a countrys indifference curves outwards.
(c) shift a countrys indifference curves inwards.
(d) cause a countrys production possibilities frontier to become bowed inwards.
(e) shift a countrys production possibilities frontier inwards.
Answer: (a)
13. All of the following are sources of gains from trade except
(a) increased product variety in consumption.
(b) production of goods in which a country has a comparative advantage.
(c) concentration of production in fewer varieties of goods.
(d) allowing a country to produce beyond its PPF.
(e) learning about new technology from abroad.
Answer: (d)
14. In autarky a country produces many varieties of food. Opening up to trade can improve its welfare by
allowing it to
(a) concentrate its production in fewer varieties of food.
(b) reallocate production between food and clothing according to world prices.
(c) consume a different combination of goods that it produces.
(e) (a), (b) and (c).
Answer: (e)
15. In autarky, a country produces a number of varieties of an aggregate good. Trade will
(a) increase the number of varieties produced.
(b) increase production of all varieties, but keep the same number of varieties.
(c) decrease production of all varieties, but keep the same number of varieties.
(d) decrease the number of varieties produced.
(e) decrease production of some varieties, increase production of others, but keep the same number
of varieties.
Answer: (d)
16. For two nations that are trading food and clothing, the addition of variety
(a) can only improve real incomes if the nations differ in terms of their initial endowments
(b) can only improve real incomes if the nations engage in inter-industry trade
(c) can improve real incomes if the nations engage in intra-industry trade
(d) can only improve real incomes if the nations export the good in which it has a comparative
advantage
(e) all of the above
Answer: (c)
17. Producers are affected by intra-industry trade in which of the following ways?
(a) face greater competition
(b) number of firms producing the good is reduced
(c) each firm becomes larger
(d) all of the above
Answer: (d)
18. The transformation curve can shift out with an intra-industry trade due to:
(a) more efficient use of inputs
(b) increasing returns to scale
(c) an improvement in real income
(d) the nation producing the good in which it has a comparative advantage
(e) the transformation curve cannot shift out due to trade
Answer: (b)
19. How does trade affect a monopolistically competitive firm?

(a) the elasticity of demand that it faces increases
(b) the elasticity of demand that it faces decreases
(c) it increases its potential for long-run profit
(d) profits will no longer be maximized when marginal revenue equals marginal cost
(e) it will no longer be able to maximize its profit
Answer: (a)
20. Increasing returns can best be described as

(a) increasing output given the same inputs
(b) producing a greater variety of goods due to intra-industry trade
(c) marginal cost declining as output increases
(d) increased profitability resulting from increased trade
(e) doubling of inputs resulting in more than doubling of output
Answer: (e)
Chapter 8
Resource Trade, Outsourcing,
and Product Fragmentation
8.1 Given Resources and Footloose Production Processes
Natural Resource Endowments
Scarce Natural Resources and the Terms of Trade
The Newly Industrializing Countries and Footloose Production Processes
8.2 Footloose Inputs: The Joint Role of Absolute and Comparative Advantage
Who Produces What?
National Tax Treatments and Absolute Advantage
Comparative Advantage and Dutch Disease
8.3 Outsourcing and the International Fragmentation of Production
8.4 Outsourcing and Advanced Country Wage Rates
8.5 Summary
Chapter Summary
This chapter extends the basic trade models discussed in the previous chapters to account for the large
fraction of trade not in final products. The chapter begins by presenting some empirical evidence on this
subject and then proceeds to provide theoretical explanations for these facts. The introduction of trade
in producer goods creates some modifications to the results presented earlier. Note that this chapter
assumes that production occurs in stages, with raw materials being turned into intermediate goods, which
are then assembled into final products.
The analysis also includes the migration of labor and the presence of international capital markets. A focal
point of this analysis is the conclusion that movement of factors can serve as both a complement to and
a substitute for trade in the goods produced by these factors. In addition, this chapter addresses the
existence of multinational corporations.
Section 8.1 begins with one of the key ideas of this chapter. This is the notion that production occurs
in stages and countries specialize in stages and not in final products. Natural resource endowments are
discussed in the context that they are a major determinant of which processes each country will choose
to undertake. In addition, trade in natural resources is addressed. The text also presents some specific trade
shares of intermediate goods. Note that this analysis is somewhat uncertain due to problems of classifying
a large number of goods, but the conclusion is relatively robust. The discussion of whether the relative
price of resources is rising or falling relative to final products illustrates the fact that changes in the supply
or demand for primary products can have important welfare consequences.
Chapter 8 Resource Trade, Outsourcing, and Product Fragmentation 53
Section 8.1 continues to document the phenomenon whereby countries have experienced growth while
importing intermediate goods and then exporting finished products. Production consists mainly of the
assembly of raw materials. The term footloose production process refers to a process that requires
no special inputs or skills and is attracted thus to any country where it will be profitable. The discussion
concerning policy measures to attract these industries can be related to some of the arguments that arose
during the recent debate over NAFTA, specifically arguments concerning the loss of low-skill
manufacturing jobs to Mexico. The Heckscher-Ohlin theorem is used to explain how industries that
generate low value-added per worker in the Unites States are most likely to be footloose and migrate
to developing countries.
In previous models, the notion of comparative advantage was the sole determinant of trade patterns. The
addition of intermediate inputs, however, may lead to absolute advantage being a key factor. Section 8.2
constructs a model of this type by using footloose sectors. Competitive profit conditions determine the
maximum that can be offered to attract the footloose sector. This analysis reveals that both comparative
and absolute advantage are important in determining the pattern of trade. Figure 8.1 reveals the main
points of this section. The discussion of taxes illustrates the fact that differences in policies across
countries will affect absolute advantages (but may not affect comparative advantages) and are thus
important in this framework but not in the simpler trade models discussed earlier.
Section 8.3 addresses the issue of fragmentation of production through outsourcing. Reducing costs by
outsourcing labor-intensive parts of production must be compared to increased costs of coordination to
assess whether outsourcing is profitable. As output increases, the benefits of reduced average costs of
production tend to rise in industries characterized by increasing returns while coordination costs tend to
remain stable, thus making outsourcing more profitable.
Section 8.4 considers the issue of how outsourcing affects wages in advanced countries. Its shown that
outsourcing, under certain conditions, can be compared to a technological improvement for a home
countrys labor-intensive good thus increasing the wage in that industry.

there is a large volume of international trade that is not in final goods
trade in intermediate goods expands production opportunities
outsourcing has increased in recent years as the benefits of outsourcing from reducing average costs
has outweighed the increased cost due to the need for coordination of production across countries

1 According to equation 8.4, if the foreign country becomes more efficient in producing food
(i.e., a*LF becomes smaller), the vertical intercept for the foreign country shifts upwards while the
slope remains the same. If foreign labor becomes equally more efficient in producing both goods,
the vertical intercept does not change.
2. If the country was originally capital abundant such that the initial endowment ray would pass through
point C, the country would initially produce goods 2 and 3 with good 2 being the labor-intensive
good of the two. International fragmentation would result in the country producing good 3 and
B with the new unit-value isoquant being 3BF1 (where B is slightly to the left of F on the solid line
shown in figure 8.4). The resulting increase in the capital-labor ratio indicates an increase in the
wage/renatl ratio.
3. (a) If the world price of clothing is $2, then the home country can offer the footloose factor at most
$2.25 and the foreign country can offer only $1.50. Therefore, the footloose factor is attracted to
the home country. Thus, the home country produces both food and clothing and the foreign
country produces only food. Wages are found from competitive profit conditions. They will be
$1 in both countries.
(b) If the world price of clothing rises to $8, then the home country can offer the footloose factor at
most $3.50 and the foreign country can offer $4. Therefore, the footloose factor is attracted to the
foreign country. Thus, the foreign country produces both food and clothing and the home country
produces only food. Wages are found from competitive profit conditions. They will be $1 in both
countries. Wages do not change as they are determined by the world price of food and each
countrys productivity in food production, none of which have changed. If the foreign country
becomes more efficient in the food sector, then wages must rise. At a fixed world-clothing price,
the return to the footloose factor used in clothing production must then fall. Thus, the foreign
country may lose the footloose factor, resulting in a loss of the clothing sector.

1. Footloose industries are generally characterized by
(a) high skill requirements.
(b) simple assembly.
(c) imported raw materials.
(e) (b) and (c).
Answer: (e)
2. Developing countries tend to export products that

(a) use a lot of capital.
(b) use large amounts of natural resources.
(c) have low value added per worker in the US.
(d) are near the beginning of the product cycle.
Answer: (c)
3. Innovative goods are generally

(a) produced in low income countries.
(b) produced using capital intensive technology.
(c) mass produced.
(d) produced with skilled labor.
(e) produced in high income countries over the entire life of the product.
Answer: (d)
Questions 49 refer to a situation where production is Ricardian in nature. Food is produced by labor
alone, with the home country requiring 2 units of labor per unit of food and the foreign requiring only 1.
Clothing is produced with labor and an international footloose factor. Both the home and foreign country
require 1 unit of labor per unit of clothing. The home country requires 2 units of the footloose factor and
the foreign requires 3 per unit of clothing. The world price of food is $1.
4. Which of the following describes this situation?

(a) The foreign country has comparative advantage in labor costs and the home country has
an absolute advantage in attracting the footloose input.
(b) The foreign country has comparative advantage in labor costs and absolute advantage
in attracting the footloose input.
(c) The home country has a comparative advantage in labor costs and an absolute advantage
in attracting the footloose input.
(d) The home country has a comparative advantage in labor costs and the foreign country has
an absolute advantage in attracting the footloose input.
Answer: (a)
5. If the world clothing price is $2, what is the most the home country can offer the footloose factor?
(a) $0.50
(b) $0.75
(c) $1
(d) $1.50
(e) $1.75
Answer: (b)
6. If the world price of clothing is $2, and the footloose factor requires $0.50 to be attracted, then
(a) neither country attracts the footloose factor.
(b) home produces food and the foreign country produces both goods.
(c) both countries produce some clothing.
(d) home produces both goods and the foreign country produces food.
(e) the home wage rate will be higher than the foreign.
Answer: (d)
7. If the world price of clothing is $2, and the return to the fixed factor is $0.50, then the home wage
rate will be
(a) $1.00
(b) $0.75
(c) $0.50
(d) $1.25
(e) $1.50
Answer: (a)
8. If the world price of clothing rises from $2 to $3, and the return to the fixed factor remains at $0.50,
then
(a) wages in both countries will fall.
(b) the amount that can be offered to the footloose factor will fall at home.
(c) there will be no change in wages in either country.
(d) the foreign country will be able to offer a greater return to the footloose factor.
(e) the amount that can be offered to the footloose factor and wages will both rise at home.
Answer: (e)
9. If home productivity in food rises to one unit of labor per 2 units of food, then at a world price
of clothing of $2,
(a) the footloose factor will not be affected.
(b) home wages will fall.
(c) home production of clothing will expand.
(d) the footloose factor will be attracted to the foreign country.
(e) the home country can offer the footloose factor at most $0.25.
Answer: (d)
10. Fragmentation of production is most evident by

(a) production of services as opposed to goods
(b) increases in intra-industry trade
(c) increases in inter-industry trade
(d) increased trade in intermediate goods
(e) more industries being characterized by monopolistic competition
Answer: (d)
11. Which of the following is an example of a service link associated with outsourcing?
(a) transportation
(b) insurance
(c) communication
Answer: (d)
12. Most service link areas tend to exhibit

(a) increasing returns
(b) decreasing returns
(c) constant returns
(d) high variable costs
(e) no fixed costs
Answer: (a)
13. Outsourcing will become more prevelant as

(a) coordination costs tend to rise as output increases
(b) reductions in average costs increasingly exceed coordination costs
(c) in industries characterized by decreasing returns
(d) marginal costs rise due to increased product fragmentation
Answer: (b)
14. Outsourcing has become more common in recent years due to

(a) reductions in the cost of service link activities
(b) reductions in wages in less developed countries
(c) increases in barriers to trade
(d) higher costs of capital in advanced countries
(e) the amount of outsourcing has remained stable for decades
Answer: (a)
15. Which of the following increased the fastest in the 1990s?

(a) world GDP
(b) world trade
(c) trade in parts and components
(d) intra-industry trade
(e) all of the above have increased at a similar rate
Answer: (c)
16. Firms consider which of the following when deciding whether to outsource part of production?
(a) relative wages
(b) infrastructure
(c) relative productivity
Answer: (d)
17. Inputs that are internationally mobile will seek to be used in countries where
(a) costs are low
(b) returns are maximized
(c) productivity is low
(d) they have a comparative advantage
(e) increasing returns exist
Answer: (b)
18. Which of the following statements best describes the status of outsourcing in the US?
(a) economists generally agree that outsourcing has reduced average wages of US workers
(b) economists generally agree that outsourcing has led to a net decline in the number of jobs in the US
(c) there is some evidence that the number of jobs created by insourcing exceeds those directly lost
by outsourcing
(d) outsourcing has become less common in recent years
(e) outsourcing has reduced the standard of living of the average American
Answer: (c)
19. International trade in parts and components has increased rapidly in recent decades due to
(a) rising incomes leading to larger scales of output
(b) significant reductions in the costs of serivce link activities
(c) steady reductions in barriers to trade
(d) freeing up of domestic restrictions on service activities
Answer: (e)
20. Which of the following would be least likely to be outsourced by a firm in an advanced economy?
(a) research and development
(b) furniture production
(c) footwear production
(d) textile production
(e) assembling of manufactured products
Answer: (a)
Chapter 9
International Factor Movements:
Labor and Capital
9.1 Factor Movements, Efficiency, and Welfare
Effect of Factor Movements on Commodity Trade
Migration and Income Distribution
9.2 International Capital Movements: Selected Issues

British Foreign Investment in the Nineteenth Century
Recent Flows of Portfolio Capital
9.3 Multinationals and Foreign Direct Investment

Causes of Direct Investment
MNEs and Merchandise Trade
MNEs and Technology Transfer
Direct Investment and Economic Welfare
9.4 Summary
Chapter Summary
This chapter extends the basic trade models discussed in the previous chapters to account for the large
fraction of trade not in final products. The chapter begins by presenting some empirical evidence on this
subject and then proceeds to provide theoretical explanations for these facts. The introduction of trade
in producer goods creates some modifications to the results presented earlier. Note that this chapter
assumes that production occurs in stages, with raw materials being turned into intermediate goods, which
are then assembled into final products.
The analysis also includes the migration of labor and the presence of international capital markets. A focal
point of this analysis is the conclusion that movement of factors can serve as both a compliment to and
a substitute for trade in the goods produced by these factors. In addition, this chapter addresses the
existence of multinational corporations.
Section 9.1 addresses the effects of factor mobility on welfare and commodity trade. Factors move to the
location where they can earn the highest return. To the extent that factor returns reflect productivity,
the international movement of factors then leads to increases in world production and hence welfare.
The results related to commodity trade are summarized by the notion that factor movements serve as
a substitute for trade if the basis for trade is factor endowments, and serve as complement to trade if
the basis for trade lies in other reasons. Thus the addition of factor flows to the Heckscher-Ohlin and
Ricardian models of trade leads to very different results. The material concerning the migration of
unskilled labor addresses some of the concerns about this issue. Although immigration of unskilled
Chapter 9 International Factor Movements: Labor and Capital 61
workers may reduce wages to home unskilled workers, these losses will be less than the gains to all other
factors. This parallels the basic analysis of the gains from trade, except that the nature of the traded
commodity has changed.
Section 9.2 focuses on international capital flows. The analysis proceeds with a series of case studies. Each
of these illustrates the main point that capital flows freely to the location where it earns the highest return.
Note that the discussion of the British case relates to the earlier discussion of the transfer problem. The
case studies also illustrate that capital flows may be limited to the extent that capitalists may forgo the
opportunity to earn excess returns in order to achieve other goals (such as reduced risk, international
portfolio diversification).
Section 9.3 presents the unique nature of direct investment, in particular the fact that these investments are
industry-specific and tend to pass through multinational enterprises (MNEs). The rationale for direct
investment given here is based in industrial organization. In fact, several of the reasons discussed here are the
same as those given in Chapter 7 for the diversity of production within a country (transport costs, local inputs).
This section also has an extensive discussion of policy and multinationals. It provides an empirical and brief
theoretical overview of some of the concerns over direct foreign investment. Underlying this discussion is the
conclusion that multinationals move resources to their most productive use and serve to transfer technology
across countries. The material in this section highlights many aspects of international economic policy and
thus provides a convenient introduction to later chapters of the text.

resources flow to the location of their most productive use
resource flows may be either a complement to or substitute for trade in final goods
immigration generally leads to welfare gains
direct foreign investment occurs for reasons related to industrial organization

1. The migration in labor from country A to B will make country A more labor abundant, and B less
labor abundant. Therefore, the ratio w/r will fall in A and rise in B. If capital is internationally
mobile, then capital also moves abroad with the labor until w/r is equal across countries. If capital
is not internationally mobile, then country A will produce more labor-intensive goods and country
B will produce more capital-intensive goods. Country A will export some of the labor-intensive
goods to country B in return for their excess capital-intensive goods. The labor migration will then
lead to expanded world trade.
2. The fact that bilateral trade between countries tends to increase with the number of immigrants shared
between the countries can be accounted for by several things. First, the immigrants have a taste bias
for types of products that are produced in their native country. They would then import these
products. Second, immigration may lead to consumers having greater knowledge of the goods and
markets available in the immigrants home country. These types of arguments could also apply to the
issue of foreign direct investment.
3. Multinational enterprises may be producing in two places. For example, US firms in the automotive
industry could have plants in Japan, just as Japanese automotive firms have plants in the US. There
would then be intra-industry flows of foreign direct investment.
4. This is consistent with the microeconomic theory of MNEs as well as with equilibrium for the US
economy as a whole for several reasons. For example, US MNEs that are expanding their domestic
output and capital may expand their foreign output and capital as well in order to provide inputs for
their domestic operations. Also, if the MNE has some rent-yielding skill, it may seek to benefit from
it both domestically and internationally by expanding its capital stock and output.

1. The product cycle is
(a) the exporting of intermediate goods and importing of final goods.
(b) the circular production process a good goes through as it is transformed from a raw input to
a final good.
(c) the progression production of a new good or innovation goes through, first being produced in
developed countries, then having its production shifted to lower skilled, developing countries.
(d) the fact that different countries like to consume different products.
(e) (a) and (b).
Answer: (c)
2. International factor movements

(a) lead to welfare gains for all countries.
(b) lead to welfare losses to workers in countries that experience capital inflows.
(c) lead to world welfare gains.
(d) lead to welfare losses for the owners of the factors that move.
Answer: (c)
3. The use of tariffs to attract foreign capital

(a) must benefit the country which attracts the capital.
(b) must benefit the world as a whole.
(c) must lower output in the country which attracts the capital.
(d) may harm the country which attracts the capital and may lower world output.
(e) none of the above. Tariffs cannot be used to attract capital.
Answer: (d)
4. In a Heckscher-Ohlin world,
(a) allowing capital flows does not affect trade volume.
(b) allowing capital flows increases trade volume.
(c) allowing capital flows decreases trade volume.
(d) allowing capital flows increases trade in some countries and decreases it in others.
(e) allowing capital flows does not affect production.
Answer: (c)
5. In general, immigration of labor

(a) increases wages and reduces the returns to other factors.
(b) increases wages and increases the returns to other factors.
(c) reduces wages and reduces the returns to other factors.
(d) reduces wages and increases the returns to other factors.
(e) will not change wages.
Answer: (d)
6. Direct foreign investment

(a) is a general form of international capital flow.
(b) does not increase profits of MNEs.
(c) is accounted for by general differences across countries.
(d) is typically highly industry specific.
Answer: (d)
7. Foreign direct investment by a foreign firm is more likely to occur when

(a) transportation costs are high.
(b) the foreign firm has some proprietary asset or rent-yielding skill.
(c) presence in the local marketplace allows the firm to more readily conform to local legal
requirements.
(d) selling in the local market a dealer network or distribution system.
Answer: (e)
8. Recent flows of portfolio capital have resulted largely from

(a) differences in savings rates across countries and the desire to diversify investments.
(b) the same causes they resulted from in the latter part of the last century and the beginning of this
century.
(c) differences in investment opportunities between lenders and borrowers.
(d) the product cycle.
Answer: (a)
9. MNEs tend to concentrate their activities in industries that

(a) are highly competitive.
(b) require little human capital.
(c) firm reputation is not important.
(d) are based in developing countries.
Answer: (e)
10. Foreign direct investment

(a) is a substitute for international trade.
(b) is a complement to international trade.
(c) can be either a substitute or complement to international trade, but empirical evidence suggests it
is a complement.
(d) can be either a substitute or complement to international trade, but empirical evidence is unclear.
(e) can be either a substitute or complement to international trade, but empirical evidence suggests it
is a substitute.
Answer: (e)
11. Political challenges to MNEs may come from

(a) labor unions in the source country.
(b) governments seeking to achieve foreign political goals.
(c) taxing authorities who seek to tax worldwide incomes or MNEs operating within their borders.
Answer: (d)
12. Which of the following statements best describes the stock of foreign capital received by developing
countries?
(a) a shift towards portfolio investment and away from direct investment
(b) a shift towards direct investment and away from portfolio investment
(c) an increased emphasis on official loans
(d) a shift towards long-term lending and away from short-term lending
(e) an overall decline in both portfolio and direct investment
Answer: (d)
13. Which of the following nations engaged in the most foreign direct investment in recent years?
(a) United States
(b) Japan
(c) United Kingdom
(d) Germany
(e) France
Answer: (a)
14. Which of the following nations has been the largest recipient of foreign direct investment in recent
years?
(a) United States
(b) Japan
(c) United Kingdom
(d) Germany
(e) France
Answer: (a)
15. Horizontal MNEs tend to

(a) rely more on outsourcing than other MNEs
(b) produce intermediate goods in one country for assembly in another country
(c) produce similar goods in different countries
Answer: (c)
16. Vertical MNEs tend to

(a) rely more on outsourcing than other MNEs
(b) show an affinity for product differentiation
(c) produce similar goods in different countries
Answer: (a)
17. Which of the following statements most accurately describes immigration to the US in recent
decades?
(a) most immigrants tend to come from developed countries
(b) the percent of the US population that is foreign born has nearly doubled since 1980
(c) virtually all of the growth in US population during the 1990s was due to immigration
Answer: (b)
18. Most foreign direct investment is placed in

(a) developing countries
(b) developed countries
(c) nearly equal in both developed and developing countries
(d) foreign stock markets
(e) foreign bond markets
Answer: (b)
19. Approximately what percent of US trade is passed between domestic and foreign branches of MNEs?
(a) very little
(b) almost half
(c) approximately 75%
(d) almost all
Answer: (b)
20. Transfers of foreign portfolio capital can best be described as

(a) purchases of bonds or other liabilities issued by foreign enterprises or governments
(b) purchases of equity resulting in voting control of foreign companies
(c) acquisition of harbors and other forms of infrastructure by MNEs
(d) firms that acquire subsidiaries in another country
(e) transactions that involve foreign exchange
Answer: (a)
Chapter 10
Protection and the National Welfare
10.1 Protection by a Small Country
Tariffs and Partial Equilibrium
Tariffs and Production
Tariffs and Demand
Tariffs and Imports
Tariffs and Welfare
Tariffs and Export Taxes
Application: Harmonization and the Environment
10.2 Protection by a Large Country
10.3 Taxing Trade: Domestic Welfare
10.4 Taxing Trade: World Welfare

Protection and World Production
Protection and World Consumption Losses
10.5 Summary
Appendix: Tariffs and the Offer Curve

The Optimal Tariff
The Protective Effect of a Tariff
The Tariff and the Box Diagram
Chapter Summary
Part III of the text is concerned with commercial policy, or policies that act as barriers to free trade. The
previous material emphasized that free trade is an optimal situation in terms of a countrys overall welfare
level. However, impediments to free trade are common. The rationale for and effects of these trade barriers
are the focus of this section. Chapter 10 begins this discussion by considering the addition of tariffs on
imported goods to a simple trade model.
Section 10.1 analyzes tariffs for a small country. In this case the tariff does not alter world prices of goods.
The analysis begins with the standard graphical partial equilibrium approach to tariffs, which illustrates the
winners and losers from tariffs. In particular, consumers are hurt by tariffs, producers and the government
sector gain, and the overall losses exceed the gains.
Figures 10.2, 10.3 and 10.4 can be used to analyze the effects of tariffs in a general equilibrium setting.
Central to this analysis is the fact that tariffs drive a wedge between world prices and domestic prices.
Domestic producers respond by increasing production of the import good. However, the value of the new
production bundle falls when evaluated at world prices. The effects on demand are somewhat more
complicated, as the distribution of tariff revenue must be taken into account. It is assumed in the analysis
here that it is rebated to consumers. Figure 10.3 illustrates the substitution and income effects of a tariff while
assuming that production does not change. Note that in equilibrium, the new consumption bundle must be at
a point on an indifference curve that is both tangent to the new budget line, and on the world budget line.
These requirements correspond to the assumptions that consumers maximize utility and that the country has
balanced trade. Figure 10.4 combines the effects on demand and the effects on production. The final result is
that the demand for imports declines, and thus there is less trade (both imports and exports fall) as a result of
the tariff. In addition, there are unambiguous welfare losses for consumers. Note that the overall effect on
production is ambiguous, as although the import sector expands, the export sector shrinks. Section 10.1
continues to discuss the harmonization of environmental policies and its effect on trade. Without
harmonization, local producers may push for protection based on fairness. Harmonization can also play a role
in negotiations of trade agreements such as NAFTA. Finally, in the context of global environmental
concerns, the selling of rights to pollute provides an efficient economic solution to asymmetries in
preferences over pollution across countries.
Section 10.2 made the assumption that world prices would not change as a result of the tariff. Since a tariff
reduces demand for imports, it can lower the world price of imported goods and can improve a countrys
terms of trade. An extreme case of this is the Metzler tariff paradox, where the world price may fall by
more than the tariff, thus causing the domestic relative price of imports to fall as well. The export sector
then expands while the import sector contracts and the tariff does not protect the import sector. The
supplement includes a simple mathematical discussion of this paradox. The Appendix discusses the
Metzler tariff paradox using offer curves.
The fact that a large country can alter its terms of trade in a favorable way through tariffs leads to the
possibility that tariffs can lead to welfare gains. Note that this is not possible in the small country case.
Section 10.3 discusses this fact. The Appendix to chapter 10 provides a more thorough and technical
discussion of this subject. In particular, it is concerned with the optimal choice of tariff level. For low tariff
levels, the effect of falling world prices outweighs that of foregone import opportunities. As tariffs rise,
however, the second of these effects begins to dominate and thus further tariff increases lead to welfare
losses.
The next section addresses the effect of tariffs on world welfare. While a tariff may lead to gains for the
tariff levying country, they are smaller than welfare losses abroad. This result follows from the fact that a
tariff creates a wedge between prices at home and abroad. There are then further potential gains from
trade. This is considered using the box diagram in the Appendix.
Key concepts introduced in this chapter include;

tariffs lead to world welfare losses
tariffs shift domestic production out of the export sector and into the import sector
tariffs lead to a decline in the demand for imports
for a large country, imposing a tariff will improve the terms of trade
Chapter 10 Protection and the National Welfare 67

1.
For a small country, an increase in tariff rates will reduce import demand from M to M. The world
relative price of imported food does not fall. Thus the level of imports of food falls by greater amount
than in the large country case. This is a movement from point A to point C above (versus A to B in
the large country case). The optimal tariff rate is zero, as real incomes are monotonically falling as
tariff rates increase.
2.
If foreign import demand is inelastic over some range, then as the price of clothing falls over that
range, the total revenue from imports must fall. Since trade must be balanced, the total value of their
food exports must fall over that range, which implies that the volume of food exports will fall as the
price of food is fixed. This is the backward-bending portion of the foreign export supply curve in the
above diagram. Therefore, in this range, a tariff will increase food imports, which is obviously not
favored by local food producers. The tariff then fails to protect the local producers.
3. If the world price falls by the exact amount of the tariff, then domestic prices will remain unchanged.
There will the be no substitution effect left upon demand. The tariff revenue will lead to an income
effect that will shift demand upwards. Therefore, import demand falls by less than the amount
required to have the world price of the imported good fall by the full amount of the tariff. The fall in
the terms of trade will then be less than the tariff rate (the Metzler tariff paradox is the exception
to this situation).
4.
If the tariff eliminates trade, then consumption must occur at a point where the indifference curve is
tangent to the PPF. Initially production was at A and consumption at C. A tariff on food imports will
increase the relative price of food. A tariff that eliminates imports will lead to production and
consumption at point D. There is no tariff revenue at this point as imports are zero. If the tariff rate
is higher, it will have no additional effects, as imports are zero for any tariff rate above this rate.
5. (a) If all the tariff revenue is spent on the exported commodity then this will lead to an improvement
in the terms of trade. This will occur as the relative demand for the imported good will fall as a
result of this rebate plan.
(b) If the entire tariff revenue is spent on the import good, then the terms of trade could worsen.
This is the Lerner effect.

1. At the conclusion of the Uruguay round of GATT negotiations, the average tariff rate on
manufactured goods was about
(a) 2%.
(b) 4%.
(c) 8%.
(d) 15%.
(e) 40%.
Answer: (b)
2. In a small country which imports food and exports clothing, a tariff on food
(a) increases exports.
(b) increases the domestic relative price of clothing.
(c) decreases production of food.
(d) increases production and decreases imports of food.
(e) can raise its aggregate welfare.
Answer: (d)
3. A tariff on imports in a small country will lead to

(a) a gain in consumer surplus, a gain in producer surplus and a loss in government revenue.
(b) a loss in consumer surplus, a gain in producer surplus and a loss in government revenue.
(c) a gain in consumer surplus, a loss in producer surplus and a loss in government revenue.
(d) a loss in consumer surplus, a loss in producer surplus and a gain in government revenue.
(e) a loss in consumer surplus, a gain in producer surplus and a gain in government revenue.
Answer: (e)
4. Lack of harmonization of environmental policy across countries

(a) can lead to industries in the more stringent country to call for protection in the name of fairness.
(b) can arise out of an economically efficient mechanism of allowing countries to buy rights to pollute
and thus implement different environment policies.
(c) has lead to opposition to trade agreements.
Answer: (e)
5. Post-tariff demand must satisfy the conditions that

(a) trade is balanced.
(b) the value of consumption at world prices must match the value of production at domestic prices.
(c) the indifference curve must be tangent to the budget line representing world prices.
(e) (b) and (c) only.
Answer: (a)
6. A tariff in a small country will

(a) raise the level of both the import good and the export good produced.
(b) raise the level of both the import good and the export good demanded.
(c) expand trade volume.
(d) increase production in the export sector and decrease the demand for imports.
(e) decrease production in the export sector.
Answer: (e)
7. With tariffs in small countries

(a) trade is increased.
(b) countries are able to expand their export sectors.
(c) marginal rates of substitution are equated across countries.
(d) there are world welfare gains.
Answer: (e)
8. Tariffs reduce welfare by

(a) reallocating resources into goods people dont want.
(b) equating marginal rates of substitution across countries.
(c) shifting demand from imports to exported goods.
(d) creating a difference between the domestic valuation of commodities and the cost of obtaining
them via trade.
(e) increasing government revenue, which is then wasted.
Answer: (d)
9. An export tax
(a) will increase domestic employment.
(b) will increase domestic welfare.
(c) will have ambiguous effects on domestic employment.
(d) will have ambiguous effects on domestic welfare.
(e) will have effects that differ from that of a tariff.
Answer: (c)
10. If a country can influence world prices by levying a tariff on its import,
(a) it is a small country.
(b) it is a large country.
(c) any tariff will improve its welfare.
(d) it can only decrease, but not increase the world price of its import good.
(e) (b) and (d).
Answer: (b)
11. For a large country, a tariff will

(a) reduce the demand for imports, thus improving the terms of trade.
(b) reduce the supply of imports, thus improving the terms of trade.
(c) reduce the supply of imports, thus deteriorating the terms of trade.
(d) reduce the demand for imports, thus deteriorating the terms of trade.
(e) lead to unambiguous welfare losses.
Answer: (a)
12. In a large country, a tariff that produces an improvement in the terms of trade leads to an increase in
the domestic relative price of import that
(a) is greater than the amount of the tariff.
(b) may be negative if there is a high foreign elasticity of supply.
(c) is necessarily less than the amount of the tariff, but a fall in the domestic price is not possible.
(d) is the result of increased foreign demand for exports.
Answer: (e)
13. In a small country, the optimal tariff rate is

(a) 0%.
(b) determined by the extent that the tariff decreases the world relative price of imports.
(c) determined by the losses from decreased access to imports.
(d) determined by a trade-off between (b) and (c).
(e) greater than the revenue maximizing tariff.
Answer: (a)
14. In a large country, a tariff on imports will be more likely to lead to a reduction in the domestic price
of imports
(a) if foreign import demand elasticity is small.
(b) if foreign export supply elasticity is high.
(c) if the home country has a low marginal propensity to import.
(e) (a) and (b).
Answer: (d)
15. Tariffs have the effect on world production that

(a) there is an expansion of production of all goods.
(b) resources are allocated efficiently.
(c) resources are not allocated to their most productive uses.
(d) resources are not allocated to their most productive uses, but the effect on total world output is
ambiguous.
(e) total world output is not altered by tariffs, as they merely reallocate production across industries.
Answer: (c)
16. If the foreign country has an elasticity of demand for imports of 3 then the optimal tariff rate for a
large country is
(a) 0.25.
(b) 0.33.
(c) 0.5.
(d) 1.
(c) 3.
Answer: (c)
17. If goods are produced using imported inputs that are subject to duty, then
(a) tariffs will not affect production.
(b) the effective rate of protection must be less than the tariff rate.
(c) the effective rate of protection must be equal to the tariff rate.
(d) the firm will import more inputs.
Answer: (e)
18. In a large country which imports food and exports clothing, a fall in the domestic price of clothing
can be caused by the home country
(a) levying a tariff on food, if foreign demand is inelastic.
(b) levying a tariff on food, if foreign demand responds elastically to price changes.
(c) A country cannot cause a fall in the domestic price of its import by levying a tariff.
(d) increasing an existing optimal tariff on food.
(e) burning some of the food crop, if foreign and domestic demand are inelastic.
Answer: (a)
19. In a large country, the optimal tariff

(a) is 0%.
(b) depends on the elasticity of supply of a countrys export good.
(c) depends on the elasticity of demand of a countrys import good.
(d) is less than 0%.
(e) is the tariff that generates the most tariff revenue for the country levying it.
Answer: (c)
20. In a large country, if tariff revenue is not rebated to consumers, but is instead used to subsidize
purchases of imports, then
(a) there will be large movements in the terms of trade.
(b) the domestic demand for imports will increase relative to the pre-tariff situation.
(c) there will be welfare gains to domestic consumers.
(d) the terms of trade will not change.
Answer: (e)
Chapter 11
The Political Economy of Protection
11.1 Protection as a Device for Raising Revenue
11.2 Commercial Policy as a Second-Best Device
11.3 Protection and Rent Seeking Activities

Tariffs and Political Choice
Evidence on US Tariff Structure
Interconnections Among Special Groups
11.4 Growth, Protection and Welfare

Protection as an Attraction to Foreign Investment
11.5 Protection and Unemployment
11.6 Summary
Chapter 10 discussed the theoretical effects of tariffs. Chapter 11 addresses the fact that although tariffs
are harmful to society as a whole, they may serve some other political purpose. The material in the
previous chapter gave some hint of this fact in that although the world experiences welfare losses due
to tariffs, these losses are not equally distributed across countries, nor are the gains and losses equally
distributed within a countrys borders. Hence, there will be groups within the economy who gain as a
result of tariffs, and their influence on the political process may help to account for the presence of barriers
to free trade. The recent debate over NAFTA can be used to help in discussing many of the issues raised
in this chapter.
The first issue addressed is that tariffs are a source of revenue for the government. Figures 11.1 and 11.2
show that there is a tariff level that maximizes this revenue, and that this level exceeds the welfare
maximizing tariff level (an algebraic proof of this argument is given in the supplement to chapter 11).
Tariffs that exist solely for the purpose of revenue generation will then be too high. Note that the
discussion in this section applies only to large countries, since the welfare of a small country is
monotonically decreasing in the tariff rate.
Tariffs alter the pattern of production and consumption within a country. Therefore, they can be used as
policy instruments in order to meet goals related to production and consumption. If domestic production
is too low, tariffs will (usually) raise production levels in the industries that receive protection. However,
they are not the best policy in that subsidies to producers will be preferred. This occurs because tariffs
distort both the decisions of producers and consumers, whereas subsidies affect only producers. Similarly,
a tariff imposed to force the society to meet consumption goals is also second-best in that it affects both
consumers and producers, whereas a direct tax on consumers does not affect producers. In general, tariffs
are suboptimal policies in that they impact directly on a wide range of decisions.
Section 11.3 discusses the fact that there may be incentives for certain groups to exert political pressure
upon commercial policy makers. To the extent that tariffs alter domestic prices, they will create winners
and losers within the economy. The precise effects depend upon the structure of production assumed.
For example, the Heckscher-Ohlin and specific factors model of production may have very different
implications about changes in real wages as a result of a price change. Those groups that will gain as a
result of a tariff will then have an interest in lobbying for the imposition of that tariff and may expend
resources doing so, creating a situation involving rent-seeking. The discussion relating to political choice
illustrates that assumptions about tariff determination are also relevant, in addition to the assumptions
about production discussed above. Empirical evidence suggests that US tariff policy generally protects
low-wage, small-scale industries.
Chapter 3 introduced the phenomenon of immiserizing growth, whereby growth biased heavily towards
a large countrys export sector will lead to a deterioration in that countrys terms of trade and potential
welfare losses. Section 11.4 discusses the idea that a tariff will cause production to shift from the export
sector to the import sector, and thus may serve to counteract the effect of growth in the export sector.
However, this argument applies only for a large country. In the small country case, tariffs in a growing
country will result in output expansions that are too heavily biased towards imports. This is illustrated
in Figure 11.4. The Supplement to Chapter 11 provides a mathematical analysis of this subject in addition
to further graphical analysis.
The chapter concludes by considering the effect of tariffs on foreign investment and on unemployment.
Of particular interest is the fact that there is little evidence indicating that tariffs can affect unemployment,
a claim that was central to some of the worries over NAFTA. Tariffs generally serve to reallocate
employment from export goods to import goods, with ambiguous effects upon total employment. There
may, however, be some transitional unemployment in the adjustment process. Tariffs therefore neither
create nor destroy jobs, but instead stimulate reallocation of labor across sectors.

tariffs for revenue generation are generally at levels greater than that which maximizes welfare tariffs
are generally second-best policy instruments
tariffs create both winners and losers within a country, creating the potential for rent-seeking behavior
the overall effect of tariffs on unemployment is ambiguous
Chapter 11 The Political Economy of Protection 75

1.
In the absence of tariffs, production is at A and consumption at D. If the government wishes to have
clothing consumption no greater than level OF, then they could impose a tariff on food imports, leading
to production at B and consumption at C. A consumption tax would leave production at A and could
force consumers to consume OF clothing and more food than is consumed at C, which will be preferred
to consumption at C. This occurs as the consumption tax distorts only consumption, whereas the tariff
affects both production and consumption. The consumption tax would alter the prices at which
consumers could trade away from point A. A tax on food consumption would result in the budget line
PP in the above graph (which is flatter than the line representing initial world prices).
2. A tariff on labor-intensive imports will increase the price of the countrys labor-intensive products.
This will lead to an increase in the wage rate greater than the increase in the price level
(by the Stolper-Samuelson theorem). Thus the real wage will increase. If the foreign country
increases tariffs on their imports, then this will reduce the world price of the capital-intensive good,
thus increasing the domestic real wage.
3. (a) A tariff on food will raise the price of food. In a specific factors model this will lead to an
increase in the return to land greater than the price increase, an increase in the wage rate less than
the price increase, and a fall in the return to capital. Production will shift from the exported good
to the imported good. The demand for imports will fall. The volume of trade will also decline.
(b) If capital is mobile, then the fall in the return to capital will lead to an outflow of capital. This
will increase the return to capital until it is equalized across countries. The capital outflow
implies a labor flow from clothing to food and thus a further reallocation of production from the
export sector to the import sector. Therefore, there will be a larger decline in the volume of trade
than in part (a).
(c) Home welfare falls in cases above. However, in the second case, the loss of capital produces an
inwards shift in the countrys PPF, leading to a welfare loss beyond the direct effect of the tariff.

1. Which of the following groups gain from a tariff on imports?
(a) consumers
(b) producers of the imported good
(c) laborers in the export sector
(e) (b) and (c)
Answer: (b)
2. If the revenue maximizing tariff is currently being levied, a small increase in the tariff rate will
(a) increase domestic aggregate welfare.
(b) increase tariff revenue.
(c) decrease domestic aggregate welfare.
(d) significantly decrease tariff revenue.
(e) be the most efficient way of achieving domestic production goals.
Answer: (c)
3. In a large country, if at the current tariff rate, an increase in the tariff rate would lower tariff revenue, then
(a) the current rate is above the optimal rate.
(b) this increase may lead to welfare gains.
(c) the revenue maximizing tariff rate is above the current rate.
(d) the revenue maximizing tariff rate is below the optimal rate.
(e) the optimal tariff rate must be zero.
Answer: (a)
4. If a reduction in tariff rates will raise welfare and reduce revenue, then
(a) the optimal rate must be zero.
(b) the current rate must be below the optimal rate.
(c) the current rate must be above the revenue maximizing rate.
(d) the current rate could be between the optimal rate and the revenue maximizing rate.
(e) This situation is not possible.
Answer: (d)
5. Tariffs that are designed to meet production goals are second-best because
(a) export taxes are better policy instruments.
(b) they do not affect producers decisions.
(c) they are preferred to taxes on producers.
(d) they affect the decisions of both producers and consumers.
(e) they are the best policy instrument to use.
Answer: (d)
6. Tariffs that are designed to impose consumption restrictions are second-best when compared to
(a) export taxes.
(b) taxes on producers.
(c) consumption taxes.
(d) import quotas.
Answer: (c)
7. In a specific factors model, which of the following groups is most likely to lobby the government for
a tariff on imports?
(a) laborers
(b) owners of the specific factor used in production of exports
(c) owners of all specific factors
(d) owners of all inputs
(e) owners of the specific factor used in production in the import competing sector
Answer: (e)
8. A economically rational small country levies a tariff on food imports. Which is the likely motivation?
The country wanted to
(a) increase domestic food production to be less dependent on imports.
(b) increase domestic welfare, as measured by real income.
(c) increase food consumption.
(d) decrease domestic food production.
(e) (a), (b) and (c).
Answer: (a)
9. Rent-seeking activities are

(a) activities undertaken by labor to earn a wage.
(b) activities undertaken by capital to earn the rental rate.
(c) activities which directly produce a good.
(d) activities undertaken to gain access to protected streams of income.
(e) (a), (b) and (c).
Answer: (d)
10. The voting model of political choice suggests that the tariffs that are chosen will be that which
(a) maximize tariff revenue.
(b) no tariffs will be chosen if this is a large country.
(c) redistribute income from a minority to a majority.
(d) redistribute income from the rich to the poor.
(e) redistribute income from a majority to a minority.
Answer: (c)
11. In the lobbying model of political choice, tariffs are chosen

(a) to maximize social welfare.
(b) that redistribute income from a minority to a majority.
(c) usually in the interests of consumers.
(d) to maximize tariff revenue.
(e) according to the interests of special interest groups.
Answer: (e)
12. It is observed that tariffs generally are raised in order to protect unskilled labor, and are often raised
when an industrys competitive position becomes threatened. This evidence lends support to which
theory of political choice?
(a) lobbying
(b) voting model
(c) conservative social welfare function
(d) both (a) and (c)
(e) both (b) and (c)
Answer: (c)
13. Tariff protection in the U.S. tends to favor

(a) industries that also have heavy nontariff protection.
(b) geographically dispersed industries.
(c) low-wage industries.
(d) small-scale industries.
Answer: (e)
14. Consider a country that is experiencing welfare losses as a result of rapid growth of its export sector.
This country could counteract the effects of this growth by
(a) if they are small, putting tariffs on imports.
(b) using export subsidies.
(c) if they are large, levying export taxes.
(d) puffing tariffs on imports, regardless of country size.
Answer: (c)
15. A tariff improves domestic welfare as a result of

(a) changes in the terms of trade.
(b) changes in the volume of trade.
(c) changes in production.
(e) potentially, all of the above.
Answer: (e)
16. Trade with tariffs and subsidies will be preferable to autarky

(a) never.
(b) always for a large country.
(c) if there is negative net tariff revenue.
(d) if there is a small change in world prices as a result of the tariff
(e) if there is positive net tariff revenue.
Answer: (e)
17. A tariff will attract foreign investment by

(a) reducing demand for foreign made products.
(b) reducing the size of domestic export production.
(c) lowering the price of imported goods.
Answer: (a)
18. Tariffs affect employment by

(a) increasing employment in all sectors.
(b) decreasing employment in all sectors.
(c) decreasing employment in the import sector and increasing it in the export sector.
(d) increasing employment in the import sector and decreasing it in the export sector.
(e) reducing aggregate unemployment.
Answer: (d)
19. A small country which exports food and imports only clothing levies a tariff on all clothing imports.
The country then grows by 25 percent measured at domestic prices. In which of the following
scenarios does the country have the highest welfare after growth?
(a) The growth is most concentrated in clothing, but both industries grow.
(b) Only the food industry expands.
(c) The growth is in the exact proportions of home prices.
(d) Only the clothing industry expands.
(e) The growth is most concentrated in food, but both industries grow.
Answer: (b)
20. In a specific factors model, if tariff is placed on clothing, then the owners of the factor specific to
other goods will lobby for
(a) tariffs on their goods.
(b) export subsidies on their goods.
(c) taxes on laborers in the clothing sector.
(e) no change; the tariff will make them better off.
Answer: (d)
Chapter 12
Trade Policy and Imperfect Competition
12.1 Monopoly and the Gains From Trade
Monopoly and Import Competition
Monopoly and Export Opportunities
Monopoly and Exports in Practice: US Steel in 1900
12.2 Cartels and the Interests of Producing and Consuming Countries

The Organization of Petroleum Exporting Countries
Commodity Agreements
12.3 Monopoly and Policies of Importing and Exporting Countries

Exploiting Monopoly Power Over Exports
National Welfare and International Oligopoly
Fighting Off Monopoly Power Over Imports
A Monopoly Practice: Dumping
Boeing versus Airbus
12.4 Intellectual Property Rights

Public Policy
Counterfeit Goods
12.5 Summary
Appendix: International Duopoly and National Strategy
Chapter Summary
Chapter 12 considers trade policy in situations where markets are not competitive. The analysis includes
both theoretical and empirical considerations of some of the main issues related to international trade
policy. The addition of imperfect competitive markets changes some of the basic results presented in
Chapters 10 and 11.
The first situation considered has monopolies operating in home markets. Tariffs then decrease the amount
of foreign competition that these monopolies face. Free trade is doubly beneficial to consumers, as in
addition to the standard gains from trade, there will be a reduction in monopoly power as a result
of foreign competition. Tariffs then bear extra costs. These results are illustrated using Figure 12.1.
Section 12.2 discusses the formation and effects of international cartels. The international cartel essentially
acts as a monopoly producer of a good. It can then easily be shown that cartels transfer income from
consumer countries to producer countries, just as monopolies in domestic markets transfer income from
Chapter 12 Trade Policy and Imperfect Competition 81
consumers to producers. The formation of cartels also leads to world welfare losses as they are able to
keep world prices above their competitive levels. The discussion of commodity agreements brings out the
point that cartels may not be troublesome, as they are by nature unstable collusive agreements, and
therefore policies designed to eliminate them may be unnecessary.
Trade policy can be used to exploit foreign consumers or to extract rents from foreign monopolists. This is
the subject of Section 12.3. The discussion of the case of an export monopolist illustrates the basic point
that most policy instruments involve a trade-off, in this case higher profits from foreigners versus welfare
losses to domestic consumers. Note that the case of an export monopolist is rare in practice, and the
discussion of international oligopolies is more relevant. The optimal situation in terms of profits is that of
a cartel. However, in less co-operative environments, trade policy may have a role. Note that many of the
results in this section are extremely sensitive to assumptions about how the firms compete with each other.
For example, under Cournot competition, the optimal policy is one of subsidies, yet under Bertrand
competition the optimal policy involves taxation of firms. However, the general result emerges that in each
case the optimal policy is designed to induce less aggressive behavior by foreign firms. The Appendix to
Chapter 12 discusses these cases more formally using simple tools of industrial organization. The chapter
supplement provides a more formal analysis.
The situation where there is a foreign monopoly in imported goods involves the home country designing
policies to best help consumers counteract the negative effects of the monopoly. A tax on the sales of
imports can be used, the effects of which are shown in Figure 12.3. Note that the use of a consumption tax
lowers welfare to consumers but raises welfare for the country as a whole. Compensating consumers with
tax revenues could than make consumers better off. Note that the results are somewhat sensitive to
assumptions about the shape of the demand curve. Note also that the solutions to the problem of a country
facing an export monopolist discussed here are suboptimal.
Empirically, there have been many recent debates about the practice of dumping commodities abroad in
order to maintain a monopoly position in foreign markets. This leads to gains for consumers in the
importing country as they are being offered goods at lower prices. Producers in the importing country
experience losses as they now face stiffer competition from abroad. This is the rationale for anti-dumping
legislation. Note that there may be welfare gains for the country as a whole, yet producers have been able
to convince politicians to put anti-dumping measures in place. The welfare effects in the exporting country
are ambiguous. The section closes with a case study of the rivalry between Boeing and Airbus.
Section 12.4 addresses the issue of intellectual property rights (IPRs). IPRs are needed to encourage
innovation but also result in monopoly pricing. International aspects of IPRs are examined including the
necessity for collective action among nations to enforce them. Particular attention is paid to the case of
counterfeit goods, using China as an example.

free trade may have additional gains in the form of increased competition in markets
cartels transfer income from consuming countries to producing countries, leading to world welfare losses
optimal policies in oligopoly situations are sensitive to assumptions about demand and market structure
tariffs are not optimal forms of industrial policy

1.
Initially, the monopolist produces 0Q units and sells them at price pm. With trade it may be the case
that the world price is below the monopoly price. In this case, the monopolist will be forced to reduce
its price to the world price and sell more units. This will result in a loss in profits to the monopolist,
a gain to consumers, and a welfare gain to the country as a whole.
2. If a commodity has low storage costs, then a buffer stock of the commodity can be maintained.
Therefore, the quantity available for sale each period can be maintained at a constant level. If demand
is relatively stable, this will then imply that the price of the commodity will be stable. If the good is
not storable, the changes in the amount of the good produced will lead to changes in the amount sold
and thus changes in the price. The price of storable goods thus changes only with demand shocks,
whereas the price of non-storable goods reacts to both demand and supply disturbances.
3. The export tax yields a higher level of welfare than the formation of a monopoly. This occurs because
the export tax does not change the prices that the domestic consumers face, whereas the monopoly
increases the price faced by domestic consumers.
4. The policy of banning imports would lead to welfare losses for the country. This policy would not
alleviate the problem caused by having a monopoly seller of the good, while at the same time
it would create inefficient production.
5. If the watch is equal in quality to the Swiss watch and is sold at a lower price, then US welfare is
improved as they now have goods available at lower prices. However, if the trademark owner were
American, then the selling of the Taiwanese watch would lead to a welfare loss to the trademark
owner. However, there would still be welfare gains to the country as a whole, as the gains to
consumers would exceed the losses in profits to the trademark owner (monopolist).
6. Subsidies, even indirect ones, can lead to a misallocation of resources. Production and resources are
shifted towards the industry (firm) being subsidized (Boeing) and away from other parts of the
economy. If the subsidies artificially reduce cost below its true social level, the result will be too much
production in that industry. Purchases by the government using cost plus pricing may reduce Boeings
incentive to improve efficiency by lowering costs. Government funds used to subsidize Boeing cannot
be used for other purposes (for example, tax reduction or provision of other government services).
Efforts to discourage the EU from engaging in subsidizing Airbus, if successful, can enhance social
welfare by reducing social welfare losses similar to those described above.
7. If the exporter exports to the US, it may be subject to penalties with some positive probability.
If the value of these penalties multiplied by the probability they are imposed exceeds the profits the
exporter would receive from sales in the US market, then the exporter will choose not to export to
the US market. Doing so would lead to negative expected profits.
8. If the elasticity of demand is 1, then the percentage change in quantity and percentage change in price
are equal in magnitude. The decrease in price from $2 to $1.50 would then result in a 33 percent
increase in the demand for the good. Therefore, to keep the price at $2, the Ivory Coast must withhold
33 percent of the world cocoa supply, which is all of their domestic supply. If the demand elasticity is
1/2, then the Ivory Coast needs to withhold only 16.5 percent of the world cocoa supply, which is half
of their domestic supply.

1. Which of the following are sources of gains from trade?
(a) increased product variety
(b) specialization of production
(c) increased competition
(d) (a) and (b).
Answer: (e)
2. A movement from autarky to free trade will cause a monopolist to

(a) reduce prices and output.
(b) increase prices and output.
(c) increase prices and reduce output.
(d) reduce prices and increase output.
(e) reduce prices and not change output.
Answer: (d)
3. In the absence of trade a monopolist will

(a) produce more than the competitive output.
(b) set price equal to marginal cost.
(c) produce less than the competitive output.
(d) set price below marginal cost.
(e) have zero profits.
Answer: (c)
4. In the move from autarky to free trade, the price of a good produced by a monopolist could rise if the
monopolist is in the _________ sector and
(a) export , the nation has a strong comparative advantage in the good.
(b) import, the nation has a strong comparative advantage in the good.
(c) import, the nation has a strong comparative disadvantage in the good.
(d) import, the move to free trade forces it to act more competitively.
(e) The price cannot rise.
Answer: (a)
5. Welfare in a competitive economy without trade is

(a) lower than in a monopolistic economy without trade.
(b) higher than in a competitive economy with trade.
(c) low due to a lack of international specialization in production.
(d) higher than a monopolistic economy in a large trading world.
Answer: (c)
6. A movement from autarky to trade with export monopolists will cause

(a) the domestic price of the export good to fall.
(b) the domestic price of the export good to rise.
(c) a decrease in the output of the export good.
(d) both (b) and (c).
(e) an ambiguous movement in the domestic price of the export good.
Answer: (e)
7. Allowing a monopoly in an export sector

(a) can improve the economys welfare if the country is small.
(b) always will lower domestic welfare.
(c) can improve domestic welfare if the industry exports a large proportion of its output.
(d) must lower domestic welfare if the industry exports a small proportion of its output.
(e) must lower domestic welfare if there is also a monopolist in the import sector.
Answer: (c)
8. A country importing from a monopolist

(a) will have a difficult time identifying the precisely best policy to gain some of the welfare the
monopolist is keeping.
(b) can use an import duty to reduce demand for the monopolists good.
(c) can use an import duty to reduce the foreign monopolists price.
Answer: (e)
9. Dumping is the practice of

(a) buying goods from the cheapest possible source.
(b) burning some goods to avoid immiserizing growth.
(c) selling good cheaply to damage foreign competitors.
(d) levying an import duty to protect against a foreign monopolist.
Answer: (c)
10. An export monopolist

(a) leads to domestic welfare losses as the price of exported goods is too high.
(b) leads to domestic welfare gains as the price of domestic goods rises.
(c) leads to some domestic welfare gains as prices of exported goods are higher.
(d) does not affect domestic welfare and reduces foreign welfare.
Answer: (c)
11. OPEC reduced world oil consumption as a result of

(a) high prices, lowering demand for oil.
(b) high oil prices, reducing employment in industrial economies.
(c) high oil prices, leading to an increase in the demand for other imports.
(d) (a) and (b).
Answer: (d)
12. OPEC experienced a decline in profits over time as a result of

(a) development of less petroleum-intensive production techniques.
(b) discovery of alternative oil sources.
(c) member countries cheating on the cartel agreement.
(e) (a) and (b).
Answer: (d)
13. Cartels
(a) increase welfare in member countries, reduce welfare in consumer countries, and reduce welfare
in the world as a whole.
(b) decrease welfare in member countries, reduce welfare in consumer countries, and reduce welfare
in the world as a whole.
(c) decrease welfare in member countries, increase welfare in consumer countries, and reduce
welfare in the world as a whole.
(d) increase welfare in member countries, reduce welfare in consumer countries, and increase
welfare in the world as a whole.
Answer: (a)
14. The formation and maintenance of a successful cartel is more likely if

(a) demand for the product is price-elastic.
(b) there are many close substitutes for the product.
(c) members want to choose price equal to marginal cost.
(d) consumers cannot organize easily.
(e) most producers costs are not sunk.
Answer: (d)
15. An optimal domestic policy towards the export sector

(a) will not allow monopoly prices to be charged to any consumer.
(b) will allow monopoly prices to be charged to all consumers.
(c) may be to allow collusion in export sales, but not in domestic sales.
(d) involves subsidization of exports.
(e) involves restricting domestic sales at the monopoly level.
Answer: (c)
16. In an international oligopoly, the optimal policy involves

(a) taxing exports under Bertrand competition and subsidizing exports under Cournot competition.
(b) always taxing exports.
(c) always subsidizing exports.
(d) subsidizing exports under Bertrand competition and taxing exports under Cournot competition.
(e) inducing the foreign firm to be more aggressive.
Answer: (a)
17. The optimal policy for a country facing a monopolist seller of its imported goods is to tax imports.
This will lead to a
(a) welfare gain for consumers, an increase in tax revenue and a loss to foreign producers.
(b) welfare gain for consumers, an increase in tax revenue and a gain to foreign producers.
(c) welfare loss for consumers, an increase in tax revenue and a gain to foreign producers.
(d) welfare loss for consumers, a decrease in tax revenue and a gain to foreign producers.
(e) welfare loss for consumers, an increase in tax revenue and a loss to foreign producers.
Answer: (e)
18. Dumping can occur when

(a) the world price is less than the domestic monopoly price, but greater than marginal cost.
(b) monopolists do not equate marginal revenue across markets.
(c) firms are purely competitive.
(d) monopolists choose the price that equates marginal revenue and marginal cost in only the
domestic market.
(e) prices are lower in the domestic market than if no trade were occurring.
Answer: (a)
19. Infant industry protection

(a) in one country is likely to lead to similar protection in other countries.
(b) is a policy protecting an industry while it grows and learns.
(c) is an effective commercial policy for perfectly competitive industries.
(d) is a permanent strategy of protection for an industry.
(e) (a) and (b).
Answer: (e)
20. Industrial policies may be welfare improving in situations where

(a) product markets are not competitive.
(b) the policies have strategic effects.
(c) the protection of an industry may have long-term benefits.
(d) resource markets are not competitive.
Answer: (e)
Chapter 13
Trade Controls in Practice
13.1 Tariffs: Levels and Trends
13.2 Multilateral Tariff Reduction

Evolution of the Tariff Agreements Program
World Trade Organization
Gains from Trade Liberalization
13.3 Devices for Special Protection

Theory of Quantitative Restrictions
Voluntary Export Restraints
Management through VERs
13.4 Special Protection in Action

Antidumping Measures
Multifiber Agreement
U.S. Sugar Market
13.5 Prospects for Special Protection
13.6 Summary
Chapter Summary
Chapters 10 through 12 considered many of the theoretical aspects of restrictions on international trade.
Chapter 13 examines the issue of how these trade controls have fared in practice for the US and many of
its major trading partners. With the recent completion of the Uruguay round of GATT negotiations, and
the debate over NAFTA, some of the basic points should be familiar to students. In addition, the concept
of managed trade is introduced.
In the early nineteenth century, the US was a high-tariff country in order to protect its developing
industries. Since this time, there has been a dramatic, steady reduction in tariffs on manufactured goods
imported into the US. The experience of other industrialized nations over this time has been similar.
However, the experience of the agricultural sector has been quite different as agricultural products are still
subject to high rates of protection via tariffs and subsidies to farmers.
Section 13.2 addresses the fact that since 1930 there have been several multinational agreements to reduce
tariffs worldwide. These began in the 1930s with the US entering into bilateral trade agreements with
twenty of its major trading partners. These were replaced by GATT, which has undergone several major
revisions. The Kennedy Round of negotiations led to weighted-average tariff cuts of about 35 percent.
Chapter 13 Trade Controls in Practice 89
In the Tokyo Round, countries agreed to reduce tariffs by a further 33 percent, and many of the non-tariff
barriers to trade were removed. The most recent round of negotiations was the Uruguay Round, completed
in 1993. Major changes in this round included further tariff reductions, standardization of laws protecting
intellectual property rights, conversion of non-tariff restrictions on agricultural products and clothing to
tariffs. In addition, the World Trade Organization (WTO) was established for dealing with international
trade disputes and monitoring the GATT. It has been estimated that this trade liberalization will lead to an
increase in the volume of international trade of between 5 and 20 percent and there will be world welfare
gains of about 1 percent of world GDP. The major items in the Doha round (launched in 2001) include
protection and subsidies that developed nations give to farmers and the service sector.
Sections 13.3 consider various forms of special protection for particular industries. There is evidence that,
although tariffs have been uniformly reduced, they have been replaced by non-tariff barriers to trade.
These include policy instruments such as quotas, voluntary export restraints, health and safety standards
and taxation of specific industries. These may be better able to target specific industries than tariffs, and
thus will be used commonly under a regime of managed trade. This refers to a situation where there is a
general reduction of tariffs, with high levels of protection given to specific industries. The effects of
quotas are illustrated in Figure 13.1. Note that the government does not obtain revenue directly from
quotas but instead might sell the rights to supply the domestic market. Another difference between quotas
and tariffs is illustrated in figure 13.2: for a monopolistic industry, a quota results in considerably more
pricing power than does a tariff. A special case of a quota is the voluntary export restraint (VER), where
the government of the importing country pays the exporters in the foreign country to reduce their
shipments. Note that the use of VERs imposes high welfare costs on the importing country as they must
transfer resources to foreign producers.
Section 13.4 provides several realworld examples of special protection such as anti-dumping measures,
the Multi-Fiber Agreement and the US sugar market. The future of devices for special protection is
explored in section 13.5

tariffs have been steadily declining in the last century
there is some evidence that non-tariff barriers to trade have been increasing over this time many non-
tariff trade barriers are designed to protect specific industries

1. The welfare loss will be represented by areas 2 and 4 in the figure. The sum of these areas will be
equal to $5 million.
2. If the policy were a VER, then the tariff revenue (area 3 in the figure) must also be sent abroad This
area will be equal to $10 million. The total welfare loss will then be $15 million.
3. Exporters must be making at least $20 in profits for each $60 in shirts that they export. The tariff
revenue from the equivalent tariff restraint must then exceed this amount, implying that the tariff rate
must be at least 1/3 for the equivalent tariff.
4. If demand increases, then the market has grown in real terms. With a quota in place, domestic
producers can sell to all of the new consumers in the market, as the volume of imports will not
change. However, if a tariff is being used to protect the market, then an increase in demand will lead
to an increase in both domestic sales and in imports of the product. Domestic producers will then only
be able to sell to a fraction of the new consumers. They would then prefer the quota to the tariff.
5. Welfare will be higher if domestic sales are subsidized as well as export sales. The subsidization of
domestic sales leads to gains for domestic consumers, whereas the subsidization of export sales does
not. The subsidization of domestic sales requires revenue that must be collected from domestic
consumers, and thus domestic subsidization is rarely used.
6. An increase in the supply of Japanese semi-conductor chips could cause the price to fall. This
increased supply could be produced by using the excess capacity that was present in the Japanese
semi-conductor chip market.
7. The US is a net importer of sugar; thus the government would not want to enact policies that
discourage domestic production (resulting in more imports). The EU is a net exporter of sugar and
thus it can impose policies that restrict production in order to provide higher prices for EU producers
and still satisfy domestic consumption (while still resulting in exports).

1. Which of the following is evidence that tariffs have curbed international specialization?
(a) Production is less specialized across cities within a country than across countries.
(b) There have been few efforts to reduce tariffs in the last 50 years.
(c) Tariffs on agricultural products generally exceed tariffs on manufactured goods.
(d) Production is more specialized across regions of the US than between the US and Canada.
Answer: (d)
2. Customs revenues represent what percent of US government revenue?

(a) less than 1%
(b) 5%
(c) 7%
(d) 10%
(e) 25%
Answer: (a)
3. Since the early 1930s U.S. tariff rates have decreased around
(a) 90%.
(b) 67%.
(c) 33%.
(d) 20%.
(e) 10%.
Answer: (a)
4. Average tariffs on manufactured goods are around what level?

(a) less than 1%
(b) 3%
(c) 10%
(d) 25%
(e) 40%
Answer: (b)
5. In the 1930s, the world volume of trade decreased, chiefly as a result of

(a) the Smoot-Hawley Act.
(b) a decline in world-wide tariffs.
(c) the Great Depression.
(e) (a) and (c).
Answer: (c)
6. A reduction in tariffs leads to

(a) a terms of trade loss to the exporter, if the importer is large.
(b) a terms of trade gain for a small country.
(c) a terms of trade loss for a small country.
(d) a terms of trade gain to the exporter, if the importer is large.
Answer: (d)
7. Reciprocal tariff cutting

(a) must lead to all countries gaining.
(b) must lead to one country gaining at anothers expense.
(c) is never consistent with the political economy of tariffs.
(d) may lead to a deterioration in all countries terms of trade.
Answer: (e)
8. During the last 40 years tariff barriers were substantially reduced. What happened to nontariff barriers
in developed countries over the same period?
(a) They were reduced more than tariffs.
(b) They were reduced, but less than tariffs.
(c) They remained relatively constant.
(d) They increased significantly.
(e) There are no clear studies of the trend on nontariff barriers.
Answer: (d)
9. The Tokyo Round of GATT talks was concerned with

(a) a cut in tariffs of about 35 percent.
(b) reductions in non-tariff barriers to trade.
(c) increased tariffs on agricultural products.
(d) establishment of the World Trade Organization.
(e) improved monitoring of trade disputes.
Answer: (b)
10. The Uruguay Round of GATT talks established policies for

(a) tariff cuts of around 40 percent.
(b) protection of intellectual property rights.
(c) reductions in non-tariff barriers to trade.
(d) the establishment of the World Trade Organization.
Answer: (e)
11. The tariff reductions in the GATT have led to

(a) reductions in world trade volume.
(b) welfare losses for the world as a whole.
(c) an increase in non-tariff barriers to trade.
(d) decreased specialization in production.
Answer: (c)
12. Quotas
(a) cannot generate for the government the same revenue as tariffs.
(b) must be auctioned or sold to generate revenue.
(c) can have the same effects on the market as tariffs.
(d) have the same effects on the market despite its industrial and competitive structure.
(e) (b) and (c).
Answer: (e)
13. If there is a monopoly in the domestic import competing industry, then

(a) the producer will prefer a quota and the government will prefer a tariff.
(b) both producer and government will prefer a tariff to a quota.
(c) both producer and government will prefer a quota to a tariff.
(d) the producer will prefer a tariff and the government will prefer a quota.
(e) the producer will be indifferent between a tariff and a quota.
Answer: (a)
14. VERs have been shown to have large negative welfare consequences yet they are common. This can
be explained by
(a) lobbying from domestic consumers.
(b) fear of retaliation as a result of other types of restrictions.
(c) lack of bargaining power possessed by foreign exporters.
(d) quotas and tariffs have more severe welfare consequences.
Answer: (b)
15. Which of the following involves the greatest cost to the importing countrys real income in restricting
imports to a given level?
(a) tariffs
(b) export subsidies
(c) quotas
(d) voluntary export restraints
(e) All of the above involve the same welfare loss.
Answer: (d)
16. Economic analysis supports legislation that promotes fairness by

(a) allowing higher cost competitors some degree of protection from their competitors.
(b) ensuring that all producers have equal access to markets.
(c) preventing firms from charging low prices.
(d) preventing subsidization of exports.
Answer: (b)
17. The practice of foreign firms dumping products into domestic markets benefits
(a) domestic consumers.
(b) domestic producers.
(c) foreign producers.
(e) (a) and (c).
Answer: (e)
18. VERs are

(a) rounds of multilateral tariffs reductions.
(b) tariffs voluntarily adopted by a country.
(c) quotas on a countrys exports to another country adopted under pressure.
(d) quotas that can be auctioned, adopted by a country to protect its import competing sector.
Answer: (c)
19. Nontariff barriers to trade can take the form of:

(a) quotas.
(b) border tax adjustments.
(c) technical safety standards.
(d) health and safety standards.
Answer: (e)
20. Which of the following statements concerning anti-dumping measures is true?

(a) the Commerce Department tends to find evidence of dumping in most cases that it considers
(b) the International Trade Commission finds evidence of injury due to dumping in most cases it
considers
(c) there is some evidence that the finding of injury is less likely when it involves another country
thats a large importer of American goods.
(d) the annual welfare cost of US anti-dumping policy is estimated to be about $4 billion.
Answer: (e)
Chapter 14
Preferential Arrangements and
Regional Issues in Trade Policy
14.1 Regional Preferences and Regional Trade
14.2 Welfare Effects of Trade Preferences

Trade Creation and Trade Diversion
Net Gains or Losses?
Distribution of Gains and Losses
14.3 Preferential Agreements in Practice

Trade Creation and Diversion in the European Union
Europe in 1992
Free-Trade Arrangements in North America
14.4 Trade Problems of the Economies in Transition

The Legacy of Central Planning
Trade Patterns Transformed
14.5 Trade and Growth: China and the Asian NICs

China
The Asian NICs
From Import Substitution to Export Orientation
Openness and Economic Growth
14.6 Preferential Arrangements: New Policy Issues

Spillovers and Harmonization
Preferential versus Multilateral Trade Liberalization
14.7 Summary
Chapter Summary
With the implementation of NAFTA and the formation of the European Union, there has been much recent
attention focused on regional trading issues, in particular, the formation of free trade areas. Chapter 14
completes the discussion of trade policy by addressing the formation of regional trading areas. The
previous chapter dealt with global impediments to trade, and the focus of this chapter is on a smaller
regional scale. In addition to the North American experience, there is a discussion of trade in former
centrally planned economies and in the rapidly developing economies of Asia.
There are several basic types of regional preferential trading arrangements. These include customs unions,
free-trade zones, common markets and economic unions. In theory, these arrangements lead to two basic
distortions to trade, trade diversion and trade creation. The removal of tariff barriers between countries
within the agreement may lead to expanded trade amongst member countries. This is trade creation, which
is analyzed in Figure 14.1. There is a positive net benefit from trade creation as it moves production to the
most efficient producer within the agreement. Trade diversion occurs when production is moved from the
most efficient producer who is outside the agreement to a less-efficient member country when the
agreement comes into effect. This occurs when the removal of tariffs amongst member countries protects
their import competing industries to some degree. There is a net welfare loss associated with trade
diversion as production is moved from more efficient to less efficient locations. The effects of trade
diversion are illustrated in Figure 14.2. The overall effects of preferential trade agreements must be looked
at on an individual basis. However, they are more likely to be beneficial the larger are the initial tariffs,
and the more competitive is the member countries production prior to the agreement. In general, there are
welfare gains in situations where protected production is reduced, and welfare losses where it is increased.
Evidence on preferential trading arrangements can be gathered by looking at some of those that have been
formed, such as the European Union, NAFTA, LAFTA, and the Central American Common Market.
Examination of the European Union shows that there has been a reduction in the share of consumption
provided by domestic manufacturers and an increase in the share of imports coming from other member
countries. This suggests that there has been both trade diversion and trade creation. There is also clear
evidence that trade creation has been several times larger than trade diversion. The gains may be
understated as they do not consider dynamic gains associated with non-competitive markets. Evidence
suggests that there are further welfare benefits of this type. One major problem that the European Union
has faced is their commitment to protecting agriculture has led to large excess supplies of food, the export
of which must be subsidized, exhausting a large portion of the EU budget.
In 1989, Canada and the US signed a free trade agreement. This was replaced in 1993 by the North
American Free Trade Agreement (NAFTA) which expanded the free trade area to include Mexico. As the
agreement has been in place for only a short period of time, there is little empirical evidence on its effects.
In theory, Canada stands to gain substantially from the removal of tariffs as a result of its small economy.
Mexico should also gain as the agreement has the potential to greatly increase their rate of economic
growth. The gains to the US will largely be in the form of the standard gains from trade. It has been
suggested, however, that as a result of the extreme differences in resource endowments across the three
countries there is potential for large amounts of trade diversion to occur. Thus far, it is difficult to assess
the effects of NAFTA since Mexico had already reduced its trade barriers substantially prior to NAFTA;
however, NAFTA probably helped to lock in these changes in trade policy.
The problems facing former centrally planned economies as they move to market economies are addressed
in Section 14.4. Figure 14.3 considers the fact that these economies generally set prices that differed from
world prices, and thus there were unexploited opportunities for trade. This is confirmed by Table 14.1
which shows that upon the collapse of the centrally planned economies there was greatly increased trade
with market economies. This represents a large gain to these economies in the form of trade creation.
There have been further gains in the form of access to better resources and technology, and the updating of
inefficient technologies. There have been some attempts to determine which types of commodities these
countries have a comparative advantage in, as determined by their resource endowments. Evidence
generally indicates that they are relatively good at producing products that are labor and energy intensive.
Chinas rapid economic growth including becoming a major trading nation is discussed in section 14.5
along with the experiences of the Asian NICs. Protection of infant industries generally involves welfare
losses as resources are being allocated to inefficient uses. Many developing nations have shifted to export-
oriented policies and away from import substitution. The Asian NICs in particular, experienced rapid
economic growth as a result of this change in policy combined with policies that encouraged the
Chapter 14 Preferential Arrangements and Regional Issues in Trade Policy 97
accumulation of physical and human capital. Openness has been found to enhance economic growth by
enabling a country to adopt more advanced technology, attract more foreign direct investment and more
efficiently make potentially valuable international contacts.
In recent years, new issues such as pollution and harmonization, have been raised during multinational
trade negotiations. Distinction should be made between pollution that affects one country as opposed
to pollution that crosses national borders. The latter is clearly an appropriate topic for international
negotiations. However, with regard to the former, nations are likely to place differing values on pollution
due to differences in geography and standards of living and thus enact different remedies. Another issue of
on-going concern is that of regional versus global trade talks. Regional trade agreements have the potential
to become competing trade blocs, though this has not been the case thus far.

preferential trading arrangements can be beneficial to the extent that they move production from less
efficient to more efficient producers
preferential trading arrangements lead to trade creation and trade diversion
the economic impact of import substitution versus export orientation

1. As a customs union encompasses a larger portion of the trading world, it becomes more likely that
production will be taking place within a member country. Therefore, the chance that the formation
of the customs union leads to trade creation increases, while the chance of trade diversion decreases.
Thus, customs unions that include a larger fraction of the trading world are more likely to lead to
welfare gains.
2. If tariffs are eliminated only on some goods but not on others, then tariffs are distorting the relative
prices between goods across countries. This leads to the situation where production may occur in the
inefficient location. To eliminate this possibility, tariffs must be eliminated on all goods. This is
simply a restatement of the fact that it is comparative, not absolute, advantage that is important in
determining trade patterns.
3. If real incomes increase for member countries within a customs union, then the demand for all goods
increases. If the demand for exported goods is more income elastic than the demand for imported
goods, then the relative price of imported goods will fall, leading to an improvement in the terms of
trade for the customs union vis-a-vis the rest of the world. However, if the demand elasticities are not
as above, then the terms of trade may worsen for the customs union.
4. The eight central European economies recently added to the EU were already experiencing significant
increases in trade with EU nations. Admission to the EU should lead to trade creation as tariffs and
barriers to trade are eliminated. The amount of trade diversion depends on the level of tariffs on
products from outside the EU. Its likely that external tariffs are lower than prior to joining the EU
and thus trade diversion is likely to be small.
5. Other sources of possible welfare gain include increased efficiency by producers due to the increase
in foreign competition; ability to attain greater economies of scale due to an enlarged market; and
increased access to differentiated products from abroad.
6. A good answer to this question should include reasons how the regional agreement changes the gains
and incentives of a move toward multilateral tariff reduction. For example, a preferential agreement
might remove a monopolist who might oppose trade liberalization. This could reduce resistance to
further liberalization. On the other hand, a bilateral trade agreement could shift the gains of further
liberalization between export and import-competing industries. This could lead to either higher or
lower rates of protection between trading blocks. Finally, the larger is the trading block, the greater is
its market power and its ability to influence world prices. This can lead to higher tariffs following a
bilateral agreement.

1. Which of the following involves the greatest degree of economic unification and harmonization
among its members?
(a) Economic Union
(b) Customs Union
(c) The World Trade Organization
(d) Free Trade Area
(e) Common Market
Answer: (a)
2. Three countries eliminate all tariffs between themselves, set a common tariff against the rest of the
world, and allow for free movements of factors of production. This is an example of a
(a) voluntary export restraint.
(b) common market.
(c) free-trade area.
(d) customs union.
(e) economic union.
Answer: (b)
3. Three countries agree to form an economic union. Which of the following will not occur?
(a) the use of a common currency
(b) restrictions on capital flows between member countries
(c) common tax rates on capital gains
(d) a common external tariff
(e) common growth rates of money
Answer: (b)
4. Trade creation requires that

(a) the most efficient world producer of a good not be a member of the customs union.
(b) the most efficient world producer of the good must be a member of the customs union.
(c) production moves from a non-member to a member country.
(d) production of the good moves to the most efficient member country.
Answer: (d)
5. Countries A and B form a customs union, and country A ceases to produce food, importing it from B
instead. In country A, this will lead to
(a) decreased food consumption and welfare losses.
(b) decreased food consumption and welfare gains.
(c) increased food consumption and welfare losses.
(d) increased food consumption and welfare gains.
(e) increased food consumption and no change in welfare.
Answer: (d)
6. Countries A and B form a customs union, and country A ceases to produce food, importing it from B
instead. This is known as
(a) trade creation.
(b) common market.
(c) quantitative restriction.
(d) comparative advantage.
(e) trade diversion.
Answer: (a)
7. Countries A and B form a customs union. Production of semi-conductor chips shifts from the rest of
the world. This is an example of
(a) trade creation.
(b) common market.
(c) quantitative restriction.
(d) comparative advantage.
(e) trade diversion.
Answer: (e)
8. Countries A and B form a customs union, resulting in trade diversion. This will imply that
(a) consumption in B increases, but decreases in A.
(b) production within member countries decreases.
(c) consumption in all member countries increases.
(d) the most efficient producer of the good is either A or B.
(e) A and B will experience welfare gains.
Answer: (c)
9. The benefits of the formation of a customs union will be greater if

(a) initial tariffs are lower.
(b) the common external tariff is higher than previous external tariffs.
(c) the customs union includes only a small fraction of world economic activity.
(d) there was no variation in external tariffs prior to the formation of the customs union.
Answer: (e)
10. Countries A and B form a customs union, and trade diversion results. This may be beneficial to the
customs union as it may
(a) allocate resources to the most efficient producer.
(b) lead to a decline in consumption.
(c) shift production to the outside world.
(d) lead to an improvement in the member countries terms of trade with the rest of
the world.
Answer: (d)
11. NAFTA is an example of a

(a) voluntary export restraint.
(b) common market.
(c) free-trade area.
(d) customs union.
(e) economic union.
Answer: (c)
12. Which of the following are true for the gravity model of trade?
(a) It is intended to explain bilateral trade flows.
(b) Empirically estimates that an increase in GDP, but not in per capita GDP, will increase trade by
relatively more than the increase in GDP.
(c) Empirically finds that trade and the distance between countries are negatively related.
(d) Empirically finds that poorer countries are more likely to trade with each other than are wealthier
countries.
Answer: (a)
13. The volume of trade diversion can be best detected by examining changes in
(a) the share of each countrys consumption supplied by domestic manufacturers.
(b) the volume of trade.
(c) the share of imports coming from exporters in partner countries.
(d) growth of national incomes.
(e) movements in prices between member countries and the rest of the world.
Answer: (c)
14. The formation of a customs union may lead to dynamic gains in the form of
(a) scale economies.
(b) increased competition.
(c) protection of industries with learning effects.
(d) increased incentives to innovate.
Answer: (e)
15. Consider a framework where markets are monopolistic competitive. The formation of a customs
union
(a) will lead to larger more efficient plants.
(b) must lead to welfare losses.
(c) will not lead to any trade diversion.
(d) will increase the rate of capital formation.
(e) will not lead to dynamic gains.
Answer: (a)
16. Country A is considering forming a customs union with either B or C. A and C have very similar
factor endowments while A and B are very different. Relative to a customs union between A and C, a
customs union between A and B will lead to
(a) more trade diversion, less trade creation.
(b) less trade diversion, less trade creation.
(c) less trade diversion, more trade creation.
(d) more trade diversion with the same amount of trade creation.
(e) more trade diversion, more trade creation.
Answer: (e)
17. Distortions and problems generally faced by centrally planned economies include
(a) the lack of incentives for managers or plants to operate efficiently.
(b) the separation of production quantity decisions and the needs and wishes of the
purchasers.
(c) the failure of final goods to be similar to what consumers would choose in a free market.
(d) the excess supply of some goods and excess demand for other goods.
Answer: (e)
18. In a centrally planned economy, prices are needed to

(a) ration goods to consumers.
(b) determine the pattern of production.
(c) allocate resources across industries.
(d) trade goods in international markets.
(e) determine patterns of comparative advantage.
Answer: (a)
19. The Asian NICs include

(a) South Korea, Hong Kong, Singapore and Taiwan.
(b) Malaysia, Indonesia and Thailand.
(c) Laos and Cambodia.
(d) (a) and (b).
Answer: (a)
20. In the past two decades, the Asian NICs have

(a) increased their policies of infant-industry protection.
(b) expanded their policies toward import substitution.
(c) captured less of offshore production processing activities in sectors such as footwear, clothing
and electronics.
Answer (d)
Chapter 15
The Balance of Payments Accounts
15.1 Breakdown of the Accounts
Breakdown of the Current Account
Breakdown of the Capital Account
15.2 How International Transactions are Recorded

Credits and Debits on the Capital Account
15.3 Double-Entry Bookkeeping

Paying for Imports
Paying for Asset Purchases
What if the Importer Pays in Foreign Currency?
15.4 The Balances

The Adding-Up Constraint
Where to Draw the Line?
Are There Really Accommodating Transactions?
15.5 Statistical Errors in the Payments Accounts
15.6 Summary
Chapter Summary
Chapters 2 through 14 concerned the movement of goods and services across international boundaries. The
focus now turns away from analysis of real variables to considerations of monetary transactions. Note
that this implies that absolute prices are now relevant (as opposed to only relative prices earlier). Part IV of
the text provides an introduction to international monetary economics. In general, chapters 214 have been
used for a one-term course on international trade, and 1528 used for international finance. However, this
does not imply either of these two sections is independent of the other.
Chapter 15 provides an introduction to balance of payments accounts and accounting. In order to fully
understand how changes in monetary variables affect the world economy, it is important to have an
understanding of precisely what these variables mean. For example, many students may have heard of the
current account deficit, yet are not sure precisely what it is.
Table 15.1 breaks down a nations balance of payments into three basic accounts. The first of these is the
current account, which represents trade in goods and services. The private capital account reflects trade in
assets by private individuals, as opposed to the official reserves transactions account which reflects asset
trades by central banks. Each of these accounts is further divided into subaccounts. For example, the
current account can be divided into merchandise trade, services, investment income and unilateral
transfers. The details of the breakdown of the accounts are outlined in Table 15.1, with the definitions
of each of the sub-categories outlined in the chapter text.
Section 15.2 outlines how transactions are recorded in the national accounts and presents special cases
concerning each of the accounts and sub-accounts. The general principle throughout the discussion is that
whatever enters the country is a debit, and anything that exits is a credit (whether it be goods or money).
Investment abroad may lead to some confusion, as this represents a debit. This can be reconciled by the
above general rule by considering investment in foreign countries as the purchase of an asset from abroad.
Section 15.3 illustrates the concept of double entry bookkeeping. Each transaction must be recorded as
both a debit and a credit. The examples relating to the import of goods are useful in explaining how this
works; a purchase from abroad is a debit on the current account and a credit on the short-term capital
account. This material may be useful in helping students keep track of what should be recorded as debits
and what are credits.
The convention of double-entry bookkeeping implies that every credit is associated with a debit and vice-
versa. Thus adding up across the current account, the capital account and the official reserves transactions
account should yield zero. However, these are generally not the statistics of interest. Instead, interest is
focused on the current account balance and the sum of the current and capital accounts. The second of
these is often referred to as the balance of payments. Debate exists as to which measure is the best
indicator of overall international economic activity for an economy. Some economists have argued that the
trade balance may be the best indicator; however, these numbers are usually subject to large errors and
often require updating. The balance on goods and services is also widely reported. Inclusion of interest and
investment income yields the balance of goods, services and income. Addition of transfers to this measure
yields the current account balance. Other measures can be constructed by adding other flows. Table 15.2
illustrates how this works and provides some figures for recent years for the US economy. One fact to note
is that these numbers should be interpreted with some degree of caution, as statistical error in collecting
these data is not a trivial problem. Note the size of the statistical discrepancy in Table 15.2. In addition,
summing of moneys owed internationally across all countries should yield a sum close to zero, yet it does
not. One of the main reasons for this statistical discrepancy is that exports are often undervalued or not
counted at all.

the breakdown of a nations balance of payments accounts
anything that enters the country is a credit and anything that exits is a debit
each transaction is recorded as both a credit and a debit
there is no consensus as to what measure is the best indicator of international economic flows
Chapter 15 The Balance of Payments Accounts 105

1. Answers are provided in the following table:
Debit Credit Current Account Balance of Payments

1 merchandise short-term K 0
2 short-term K merchandise 0
3 merchandise short-term K 0
4 services short-term K 0
5 long-term K merchandise 0
6 short-term K ORT 0
7 long-term K short-term K 0 0
8 direct investment short-term K 0 0
9 transfers short-term K 0
10 short-term K merchandise 0
11 income transfers long-term K 0
12 long-term K investment income 0
13 short-term K direct investment 0 0
14 short-term K services 0
15 short-term K ORT 0
2. (a) In the US this will be a merchandise debit and a short-term K credit when the US imports the
goods. The deposit will appear as a short-term K debit and a long-term K credit. It would appear
as the opposite (change debits to credits and vice-versa) in South America.
(b) If the exporters transaction with the Miami bank is not recorded in South America, then there
will be no long-term K debit in South America. There will then be a South American current
account surplus (as there will be a credit with no corresponding debit), and thus a world current
account surplus.
(c) If the claim on the bank is not recorded in either country, then the US will have a current account
deficit and the South American country will have a current account surplus. These two will
cancel each other out in accounting for the world current account deficit.

1. An international transaction involving an asset traded between private citizens is recorded in the
(a) merchandise trade balance.
(b) current account.
(c) official reserve transactions.
(d) capital account.
(b) investment income.
Answer: (d)
2. Which of the following are included as services?

(a) transportation
(b) tourist spending
(c) legal services
(e) (a) and (b) only
Answer: (d)
3. A firm invests 100 million dollars in capital abroad. This will appear as
(a) a debit in the capital account.
(b) a credit in the capital account.
(c) a debit in interest income.
(d) a credit in interest income.
(e) an official reserve transaction.
Answer: (b)
4. Foreign purchases of treasury bills are considered

(a) short-term capital flows.
(b) long-term portfolio investments.
(c) foreign direct investment.
(d) Special Drawing Rights (SDRs).
Answer: (a)
5. A resident of the US sends $200 to a relative in Guatemala. This is recorded as

(a) a debit under short-term capital.
(b) a debit under investment income.
(c) a debit under unilateral transfers.
(d) a credit under unilateral transfers.
Answer: (c)
6. Since 1982, the U.S. capital account has

(a) been largely in balance.
(b) shown more debits than credits.
(c) shown more credits than debits.
(d) shown that foreign citizens have been lowering their holdings of assets in the U.S.
(e) (c) and (d).
Answer: (c)
7. The current account balance is

(a) merchandise trade plus services.
(b) balance on goods and services plus unilateral transfers.
(c) basic balance minus foreign direct investment.
(d) balance on goods and service plus investment income.
Answer: (e)
8. The basic balance is defined as

(a) the overall balance of payments minus short-term capital.
(b) current account balance plus foreign direct investment.
(c) current account balance plus investment income.
(d) the overall balance of payments minus foreign direct investment.
Answer: (a)
9. The importation of an automobile into the US will be recorded as

(a) a credit under merchandise trade.
(b) a debit under merchandise trade.
(c) a credit under investment income.
(d) a debit under investment income.
Answer: (b)
10. The purchase of a 2 year Mexican bond by a US citizen is recorded in the US as

(a) a debit under short-term capital.
(b) a credit under short-term capital.
(c) a credit under long-term capital.
(d) a debit under long-term capital.
(e) a debit under investment income.
Answer: (d)
11. Canada sends wheat to Japan in exchange for televisions. In Canada, this will lead to
(a) no change in the current account.
(b) a merchandise trade deficit.
(c) a balance of payments deficit.
(d) a capital account surplus.
Answer: (a)
12. Canada sends wheat to Japan, which the Japanese pay for in Canadian dollars. In Canada, this will
lead to
(a) no change in the current account.
(b) a merchandise trade deficit.
(c) a balance of payments deficit.
(d) a capital account surplus.
Answer: (e)
13. A country running a current-account surplus is

(a) building up a positive net foreign asset position.
(b) reducing claims on foreigners.
(c) accumulating claims on foreigners.
(d) reducing its net foreign asset position.
(e) (a) and (c).
Answer: (e)
14. A country is running a current-account deficit. Which of the following might be true?
(a) The central bank is reducing its holdings of foreign assets, but its residents are not reducing their
holdings of foreign assets. The capital account is in balance.
(b) The central bank is increasing its holdings of foreign assets, but its residents are not reducing
their holdings of foreign assets. The capital account is in balance.
(c) Official reserve transactions are zero and its residents are acquiring foreign assets.
(d) The capital account is in balance and Official Reserve Transactions are in deficit.
Answer: (a)
15. Which of the following transactions fall in the category of services?

(a) Freight and insurance charges for shipment of goods between countries.
(b) Royalties paid for use of an invention when the patent is held by a foreigner.
(c) Payment for tourist expenses such as hotel stays, food and entertainment.
(d) Travel expenses for tourists traveling between countries.
Answer: (e)
16. The balance on goods, services and income is defined as

(a) the balance on goods and services plus unilateral transfers.
(b) the capital account balance minus unilateral transfers.
(c) the basic balance minus unilateral transfers.
(d) the balance on goods and services plus investment income.
(e) the merchandise balance plus services.
Answer: (d)
17. If the central bank is allowing the exchange rate to float freely, then
(a) they are buying and selling reserves.
(b) the basic balance must be zero.
(c) the balance of payments must be zero.
(d) the current account balance must be zero.
(e) the country can have both a current account and capital account deficit.
Answer: (c)
18. The world as a whole runs a large current account deficit. This is caused in part by
(a) unreported asset purchases.
(b) misreporting of central bank gold purchases.
(c) central banks efforts to stabilize exchange rates.
(d) undervaluation of exports.
Answer: (d)
19. A US firm receiving profits from a factory built 20 years previously in Mexico leads to a credit under
(a) the current account.
(b) foreign direct investment.
(c) short-term capital.
(d) long-term capital.
(e) overall balance of payments.
Answer: (a)
20. An American buying a controlling interest in a Mexican company and paying in dollars will lead to
(a) a current account surplus.
(b) a capital account surplus.
(c) a balance of payments surplus.
(d) a basic balance surplus.
Answer: (d)
Chapter 16
The Foreign Exchange Market and Trade Elasticities
16.1 The Flow of Supply and Demand for Foreign Exchange
Deriving Supply and Demand for Foreign Exchange from Exports and Imports
The Marshall-Lerner Condition
16.2 Empirical Effects of Devaluation on the Trade Balance

Elasticity Pessimism
The J-Curve
16.3 Summary
Appendix: Stability of the Foreign Exchange Market
Chapter Summary
Chapter 16 provides a brief introduction to foreign exchange markets. Much of the analysis in this chapter
uses a simple supply and demand framework, which should be familiar to students. In presenting this
material, the exchange rate should be introduced as the price of foreign exchange, or the amount of the
domestic currency required to purchase one unit of foreign currency. Thus, an appreciation is a fall in the
exchange rate and a depreciation is an increase in the exchange rate. This counterintuitive fact can be the
source of some confusion.
Section 16.1 introduces foreign exchange markets. Under a floating exchange rate regime, the exchange
rate is determined by the intersection of supply and demand for foreign currency, whereas with fixed rates,
central banks intervene in foreign exchange markets to stabilize the exchange rate. The effects of
movements in demand for foreign exchange under each of these regimes are illustrated in Figure 16.1.
Movements in the supply and demand for foreign exchange create movements in the exchange rate. This
material differs very little from the standard analysis of final goods markets, with which students should be
very familiar.
Since the supply and demand for foreign exchange are determined by the pattern and volume of trade, this
material is linked to the analysis presented in the first half of the text. Without capital account flows, trade
flows determine both the supply of and demand for foreign exchange. Foreign currency is required to pay
for imports (thus imports determine foreign exchange demand) and is received as payment for goods
exported. The text makes two additional assumptions: residents evaluate prices only in their domestic
currency; and quantities are determined only by demand (supply is infinitely elastic). Later chapters relax
these assumptions.
Figure 16.2 plots import and export demand curves under these assumptions. Note that a change in the
exchange rate shifts the import demand curve. An appreciation reduces the domestic currency price of
imports thus leading to greater demand at each foreign price. The demand for exports, however, does not
Chapter 16 The Foreign Exchange Market and Trade Elasticities 111
shift as the exchange rate changes. Rather, an appreciation results in movement down the export demand
curve. Using the demand for imports and exports, the demand for and supply of foreign exchange can
be found by examining the total expenditure on imports (in foreign currency) and revenue from exports
respectively. Note that the assumption of no capital flows implies that the net supply of foreign exchange
is equal to the trade balance measured in foreign currency.
As discussed earlier, intervention in foreign exchange markets is common. One example of this type
of intervention is a devaluation of the domestic currency, the real effects of which are considered in this
chapter. A fall in the value of domestic currency reduces the demand for imports and, since the price in
foreign currency remains fixed, total import spending declines. The demand for foreign exchange then
unambiguously slopes downwards (recall that a devaluation is an increase in the price of foreign exchange).
The effect on export revenues is unclear. The elasticity of export demand determines whether total export
revenue increases or falls. An export demand elasticity greater than unity leads to an increase in total export
revenue, and thus an upward sloping supply of foreign exchange. If the elasticity of export demand is less
than unity, export revenue will fall, and the supply of foreign exchange will slope downwards. If it is flatter
than the demand curve, a devaluation will lead to excess demand for foreign exchange (and a trade deficit).
This situation of an unstable foreign exchange market is ruled out by the Marshall-Lerner condition which
states that the sum of import demand elasticity and export demand elasticity is greater than one. A simple
proof is outlined in the supplement to the chapter.
Section 16.2 examines some empirical evidence relating to the stability of foreign exchange markets.
Exchange rates have been relatively volatile under floating exchange rate regimes, suggesting that
elasticities may be too low to satisfy the Marshall-Lerner condition. There may also be lags in responding
to changes in the exchange rate. In particular, import demand may be slow to respond, implying that
import demand elasticities rise over time. While a depreciation may initially worsen the terms of trade, this
effect may be reversed in the long-run as imports respond. This phenomenon, known as the J-curve effect
of a devaluation, is represented in Figure 16.3. Several reasons for the delay in import response are
discussed in the text.
In addition to implying that a devaluation will lead to a trade deficit, violation of the Marshall-Lerner
condition indicates that the foreign exchange market will be unstable. Thus, once disturbed, there will
be no tendency for the exchange rate to return to its equilibrium level. The Appendix discusses the
relationship between market stability and the Marshall-Lerner condition.

the exchange rate is the price of foreign exchange
the supply and demand for foreign exchange are determined by trade in final goods
the elasticity of import demand and export demand must sum to greater than one in order for foreign
exchange markets to be stable

1. (a) The value of the dollar has fallen relative to the mark and the value of the mark has risen relative
to the dollar. However, no conclusions can be made about the overall strengths of the currencies.
(b) It is more likely that the dollar/yen rate has gone up than down, although it is possible that it
could have declined.
(c) It is more likely that the mark/yen rate has gone down than up, although it is possible that it
could have increased.
2. (a) (b) (c) (d) (e)

Export Quantity 10 m 10 m 10.5 m 11 m 14 m
Import Quantity .002 m .002 m .002 m .0019 m .0018 m
In Dollars:
Export Price $10 $10 $10 $10 $10
Import Price $50,000 $55,000 $55,000 $55,000 $55,000
Export Revenue $100 m $100 m $105 m $110 m $140 m
Import Spending $100 m $110 m $110 m $104.5 m $99 m
Trade Balance 0 $ 10 m $ 5 m $5.5 m $41 m
In Euros:
Export Price 20 euros 18.18 euros 18.18 euros 18.18 euros 18.18 euros
Import Price 100,000 euros 100,000 euros 100,000 euros 100,000 euros 100,000 euros
Export Revenue 200 m euros 181.8 m euros 190.9 m euros 200 m euros 254.5 m euros
Import Spending 200 m euros 200 m euros 200 m euros 190 m euros 180 m euros
Trade Balance 0 18.2 m euros 9.1 m euros 10 m euros 74.5 m euros
3. (a) In parts (d) and (e) of question 2, the trade balance improves, whereas it worsens in (c) and
(b). This is a result of the fact that the Marshall-Lerner condition is satisfied in (d) and (e) but not
in (b) and (c).
(b) In case (e), import spending does not change. This is a result of the fact that import elasticity is one.
(c) In case (d), export elasticity is one, and therefore export revenue in euros is unchanged.
(d) The initial trade balance would be $50 million. The 10 percent devaluation will lead to the same
percentage change in quantities as in the above case, as the elasticities have not changed.
However, since the initial quantity of imports is larger, there will then be a larger absolute change
in imports, import revenue, and the trade balance.
4. (a)
The devaluation will increase the domestic price of imports, and there will then be a movement
along the import demand curve from B to A. The effect on total import spending in the domestic
currency will be ambiguous. Export demand will shift outwards, thus leading to an increase in
export revenue.
(b) If import elasticity exceeds one, then total spending on imports will fall, as the percentage fall in
import quantity will exceed the percentage increase in the price of imports. Since total revenue
from exports unambiguously increases, the trade balance must improve.
5. (a) Start from TB X(E) EM(E). Differentiate with respect to E:

dTB/dE dX(E)/d(E) M(E) E dM(E)/dE
Divide by M(E) and note that dTB/dE 0
0 dX(E)/dE 1 (E/M(E))(dM(E)/dE)
Note that the last term is m. When the trade balance is zero, X(E) EM(E). Rearranging and
using this fact, we obtain:
1 (dX(E)/dE) (E/X(E)) m and note that x (dX(E)/dE) (E/X(E))
Thus, the Marshall-Lerner condition is obtained.
(b) If we start from an initial trade deficit, then dTB/dE is not zero. The Marshall-Lerner condition
can then be shown to be too weak by following the same steps as in part (a).
(c) (i) Yes. This would imply that E TB* 0 and thus TB* 0.
(ii) No. dTB/dE = E dTB*/dE TB*
Since TB E TB*, this can be rewritten as dTB/dE E dTB*/dE TB/E
(iii) If TB < 0, dTB/dE < E dTB*/dE
(iv) If TB > 0, dTB/dE > E dTB*/dE
(v) If TB 0, dTB/dE E dTB*/dE
(d) (i) Using the answer to c (iii), its possible that the trade balance can improve in terms of foreign
currency while worsening in terms of domestic currency.
(ii) The contradiction can be reconciled by the fact that
d(E TB*)/dE dTB*/dE TB*
Therefore, although dTB/dE and dTB*/dE are of opposite signs, it will be the case that
dTB/dE and d(E TB*)/dE are the same sign. If the country is initially in a deficit, and a
devaluation restores balanced trade, then dTB/dE is negative, and TB* is negative, therefore,
although dTB*/dE will be positive, the overall effect d(E TB*)/dE will also be negative.
6. (a) [m x(1 m x) m x(1m x)]/[( m m)(x x)] > 0 [x(m x m(1 m) x m)

(1 m) m x]/[( m m)( x x)] > 0
The denominator of the above expression is unambiguously positive. Therefore, the

Bickerdickie-Robinson-Metzler condition requires that
x(m x m(1 m) x m) (1 m) m x > 0
This can be rearranged to get
m(x (1 m x) mx) mx(1 x) > 0
Taking the limit as m x goes to infinity will yield
[mx(1 m x)]/[ m x] > 0
This simplifies easily to the Marshall-Lerner condition.
(b) This condition is less stringent than the Marshall-Lerner condition. If the Marshall-Lerner
condition is satisfied, then the above is always satisfied, whereas there may be situations where
the above is satisfied and the Marshall-Lerner condition is not.

1. The exchange rate is
(a) price of exports measured in terms of foreign currency.
(b) the ratio of prices across countries.
(c) the ratio of productivity across countries.
(d) the price of foreign exchange.
(e) not related to trade in goods.
Answer: (d)
2. An appreciation
(a) increases the value of domestic currency and the exchange rate.
(b) increases the value of domestic currency and decreases the exchange rate.
(c) decreases the value of domestic currency and the exchange rate.
(d) decreases the value of domestic currency and increases the exchange rate.
(e) increases the value of domestic currency and leaves the exchange rate unchanged.
Answer: (b)
3. Under a fixed exchange rate regime, the official exchange rate

(a) must equate private supply and demand for a currency.
(b) must collapse if the central bank no longer has foreign currency reserves.
(c) is maintained by the central banks willingness to buy and sell currency at the official rate.
(d) will lead to a balance of payments deficit.
Answer: (c)
4. Under fixed exchange rates

(a) the rate will always be equal to the intersection of supply and demand for foreign
exchange.
(b) central bank intervention in foreign exchange markets is not required.
(c) the central bank must sell domestic currency to prevent a depreciation.
(d) exchange rates will be highly volatile.
Answer: (e)
5. A devaluation occurs when

(a) a new, higher fixed exchange rate is set.
(b) the exchange rate is permanently reduced.
(c) the central bank sells large amounts of domestic currency.
(d) there is a switch from fixed rates to floating rates.
(e) the central bank accumulates too much foreign exchange.
Answer: (a)
6. One US dollar can be traded for 200 Japanese yen. The dollar/yen exchange rate is then
(a) 100.
(b) 200.
(c) 0.5.
(d) 0.05.
(e) 0.005.
Answer: (e)
7. If the supply of goods is infinitely elastic, then

(a) output levels are determined by supply.
(b) prices are volatile.
(c) output is determined by demand.
(d) there is a fixed quantity of some goods.
(e) supply curves are vertical.
Answer: (c)
8. A devaluation
(a) lowers the price paid by foreigners for domestic exports and raises the price of imports.
(b) raises the price paid by foreigners for domestic exports and raises the price of imports.
(c) raises the price paid by foreigners for domestic exports and lowers the price of imports.
(d) lowers the price paid by foreigners for domestic exports and lowers the price of imports.
(e) does not change the price paid by foreigners for domestic exports and lowers the price of
imports.
Answer: (a)
9. Which of the following were problems with the early low estimates of demand elasticities?
(a) measurement errors of the variables due to misreporting to avoid paying customs or turning
foreign exchange to local governments
(b) changes in elasticities over time
(c) existence of an upward-sloping supply relationship
(d) problems aggregating the data
Answer: (e)
10. The supply of foreign exchange

(a) is the trade balance.
(b) is determined by the quantity of exports supplied.
(c) is the quantity of imports purchased.
(d) is export revenue.
(e) is import spending.
Answer: (d)
11. The net supply of foreign exchange

(a) is the trade balance in domestic currency.
(b) is determined by the quantity of exports supplied.
(c) is the trade balance in foreign currency.
(d) is export revenue.
(e) is import spending.
Answer: (c)
12. A devaluation
(a) always improves the trade balance.
(b) increases the real quantity of imports.
(c) reduces the real quantity of exports.
(d) always increases export revenue.
Answer: (e)
13. If the elasticity of export demand is 1, then a devaluation

(a) must lead to a worsening of the trade balance.
(b) will leave exports unchanged.
(c) will leave export revenue unchanged.
(d) must improve the balance of payments.
Answer: (c)
14. If the elasticity of export demand is 0.3, and the elasticity of import demand is 0.6,
then a devaluation will
(a) increase export revenue.
(b) lead to a trade deficit.
(c) reduce the real quantity of exports.
(d) increase import spending.
Answer: (b)
15. If the elasticity of export and import demands are 0.9 and 0.2 respectively, and the country initially
has balanced trade, a devaluation will lead to
(a) a trade surplus.
(b) a trade deficit.
(c) export revenue could rise.
(d) export revenue could fall more than import revenue.
Answer: (a)
16. If we observe several countries and note that exchange rates are highly volatile and that following a
devaluation the countries observe their trade balances worsening in the long-term, we might suspect
(a) the J-curve holds.
(b) the Marshall-Lerner condition is violated.
(c) the Marshall-Lerner condition is satisfied.
(d) the countries are on a fixed exchange rate regime.
Answer: (b)
17. Demand elasticities rise over time as a result of

(a) production and delivery lags.
(b) information lags.
(c) ordering lags.
(d) shifts in production.
Answer: (e)
18. A devaluation may result in producers

(a) ceasing production.
(b) moving production to a country with a lower-valued currency.
(c) purchasing more imported inputs.
(d) producing less.
(e) moving production to a country with a higher-valued currency.
Answer: (b)
19. If the J-curve is a relevant phenomenon, then a devaluation will lead to

(a) an initial worsening of the trade balance and a greater worsening in the long-run.
(b) large short-run demand responses.
(c) an initial worsening of the trade balance and an improvement in the long-run.
(d) an initial improvement in the trade balance and a worsening in the long-run.
(e) an initial improvement in the trade balance and a greater improvement in the long-run.
Answer: (c)
20. The J-curve relies upon

(a) lags in demand response to devaluation.
(b) larger demand elasticities in the short-run than long-run.
(c) firms operating at full capacity.
(d) the Marshall-Lerner condition always being satisfied.
Answer: (a)
Chapter 17
National Income and the Trade Balance
17.1 The Small-Country Keynesian Model
The Determination of Income
17.2 The National Saving-Investment Identity
17.3 Multipliers
The Multiplier Effect of a Fiscal Expansion
The Multiplier Effect of an Increase in Exports
17.4 The Transfer Problem
17.5 For a Large Country: The Two-Country Keynesian Model

Repercussion Effects
The Solution to the Two-Country Model
Empirical Evidence on Growth and Import Elasticities
17.6 Summary
Chapter Summary
Chapter 16 introduced a simple version of exchange rate determination involving several simplifying
assumptions. Chapter 17 begins the process of relaxing some of these assumptions by considering the
addition of the effects of income on foreign exchange markets. The analysis is conducted in a Keynesian
framework in the sense that all changes in demand are assumed to be reflected in output changes and not
in price changes. The material in this chapter is presented in a somewhat formal, mathematical manner,
supplemented by graphs.
Sections 17.1 allows import demand to be a function of income as well as prices. The marginal propensity
to import is the change in import demand resulting from a one unit change in income. Similarly, export
demand is a function of foreign income. The Keynesian small-economy assumption is that foreign
income is exogenous, and thus under fixed exchange rates, foreign export demand is exogenous. Equation
17.6 then shows that as domestic income increases, the trade balance deteriorates under a fixed exchange
rate regime. At the equilibrium level of income, output supplied equals output demanded. This analysis
extends the standard Keynesian macroeconomic model with which students should have some familiarity.
The addition of the marginal propensity to import reduces the multiplier from the closed-economy level,
because as each round of spending occurs, there is leakage resulting from saving and import purchases,
which send money abroad.
Section 17.2 considers the relationship between total national saving and the trade balance. Recall that
in the Keynesian closed-economy model, the equilibrium output was where savings equaled investment.
Chapter 17 National Income and the Trade Balance 119
In the open-economy model, net savings must equal the trade balance. Higher income means increased
savings and worsening of the trade balance. These two forces determine the equilibrium output level. The
graphical approach shown in figure 17.1 is useful since it allows for the effects of changes in exogenous
variables to be easily analyzed. In addition, changes in the marginal propensity to import or consume can
be examined by altering the slopes of the curves.
The effects of a fiscal expansion, currency devaluation or other factors affecting the trade balance can also
be examined in this simple model through a shift in the net export line in Figure 17.2. An improvement in
the trade balance as a result of a devaluation (assuming the Marshall-Lerner condition holds) leads to an
increase in equilibrium income, and thus leads to an increase in imports that partially offsets the initial
improvement in the trade balance. The net effect on the trade balance is unambiguously positive, however.
The transfer problem, introduced in chapter 4, is considered once again in the simple Keynesian model in
Section 17.4. A transfer tends to harm the receiving country to the extent that they will spend some of this
income on imports, resulting in a trade balance deficit. The financial transfer therefore leads to a transfer of
real goods. The deterioration of the trade balance is less than the initial transfer amount given that consumers
will save some fraction of the income. Figure 17.3 demonstrates this point graphically. The analysis here can
be related to that in chapter 4 by considering the analysis in chapter 16. The transfer leads to increased import
demand, which is also increased demand for foreign exchange. This results in a higher price of foreign
exchange, and thus foreign goods cost more in terms of domestic goods (a deterioration in the terms of
trade). This line of reasoning can be used to emphasize some of the links between the monetary analysis
in the second half of the book and the real analysis at the beginning of the text.
Section 17.5 relaxes the assumption of exogenous export demand. This results in foreign income being a
determinant of domestic equilibrium income as illustrated by Figure 17.5 Thus growth in one country leads
to growth among its trading partners. In addition, the multiplier with respect to changes in exogenous
variables is larger than in the small country case. While some of the income that previously leaked out as
imports reappears as exports, as long as any foreign income is saved, the multiplier will be smaller than the
closed-economy multiplier. Note also that an increase in income in any country still results in a trade deficit
if foreigners save. Furthermore, since both imports and exports have increased, the volume of trade rises.
Interestingly, if all countries have the same marginal propensity to import, the trade balance will deteriorate
only if a country is growing faster than its trading partners. Therefore, a country growing at approximately
the same rate as its trading partners will experience only minimal changes in its trade balance.

in a Keynesian open-economy model, an increase in income will lead to a trade deficit
transfers from abroad may also lead to a trade deficit
the Keynesian multiplier is determined in part by the marginal propensity to import
income growth across countries may be linked by international trade

1. The total effect on income is not infinite as only a fraction of spending is passed on in each round.
Savings and the purchase of goods from abroad reduce the amount of spending that occurs in each
successive round of spending. Therefore, the total amount is finite.
2. m is likely to be less than c (and thus M < C) since the portion of income used to consume imported
goods will be less than the portion used to consume goods in general (both domestically produced
and imported goods). Since s c 1, if c > m, s m < 1.
3. (a) G/Y0C is the slope of the new national savings line or s. Thus, Y0C/G 1/s which is the
multiplier for a closed economy.
(b) D2D/Y is the slope of the national savings line (s) while D1D/Y is the slope of the XM line
(m). Therefore, Y/G 1/(s m) which is the multiplier for an open economy. The open
economy multiplier is smaller than that of a closed economy since s m > s. This is to be
expected because spending leaks out through higher imports rather than only higher saving.
4. Singapore is generally characterized as having a high savings rate, and Australia generally imports
a large fraction of their products. These conditions imply that there will be high amounts of leakage
of spending in these economies. One would then expect that Belgium will have the highest multiplier
of the three countries.
5. (a) According to the national savings identity, an increase in the government deficit will reduce
national savings (for a given level of private saving). Thus, investment and/or the current account
balance must fall.
(b) In the Keynesian model, a tax cut will result in increased income. As a result, imports will
increase thus reducing the current account balance. This can be seen from a downward shift
in the national savings line in figure 17.1. If investment is affected by interest rates, investment
will fall due to the increased interest rate caused by the increased budget deficit. In this case, both
investment and the current account balance will decline.
(c) A recession will cause the budget deficit to increase as the government collects less revenue to
a decline in national income. However, the fall in exogenous consumption will increase private
saving. The likely result will be an increase in the current account due to declining imports
resulting from the decline in national income.
(d) A decrease in exports will result in the net exports line shifting downwards in figure 17.1.
This will lead to a decline in income, a decline in national savings and a trade deficit.
(e) The answers to questions a and b are consistent since both indicate that changes in national
savings may affect either investment, the current account or a combination of the two.
6. (a) Substitute A, TB and Yd into the equilibrium equation (Y A TB) to obtain:

Y (A X M)/(s m) (c m)TP/(s m)
(b) Y/TP (c m)/(s m)
Government spending is assumed to be exogenous and part of A, so:
Y/G 1/(s m)
Since c m is less than 1, the government spending multiplier is greater than the tax cut
multiplier. This occurs in this model since government spending is assumed to have a direct
impact on spending and is spent domestically while the tax cut has an indirect effect by
increasing disposable income and thus consumer spending; consumers do not spend the entire tax
cut and part of what they do spend goes towards imported goods.
(c) Using the answer to b and noting that Japanese consumers tend to have a relatively high savings
rate, one would expect the tax cut multiplier to be relatively low.
7. (a) Yd (A X M T)/(s m). Therefore, Yd (T)/(s m)

(b) TB (T) (m/(s m))
(c) CA (T) (s/(s m))
8. (a) From(17.12): (s m)Y A X M M Y From (17.13): (s m)Y A M mY X

Substituting in for Y in 17.12
(s m) Y A X M (m/(s m))(A M X mY)
(s m (mm)/(s m)) Y A X M (m/(s m))(A M X)
Y [A X M (m/(s m))(A M X)]/[(s m (mm)/(s m))]
(b) TB/Y ms/(s m)and Y/A 1/(s m ((mm)/(s m)))
Therefore TB/A [ms/(s m)]/[1/(s m ((mm)/(s m)))] ms /[(s m m) mm]
ms /[ss ms ms mm mm ] ms /[ss ms ms]
(c) In the small country model,
TB/A m/(s m)
In this large country model, the numerator is smaller and the denominator is larger. There is then
less leakage than in the small country model.
9. (a) TB/T TB/Y TB/Y ms/[ss ms ms] ms/[ss ms ms]

(ms ms)/[ss ms ms]
(b) If ss is positive, then the ratio must be necessarily less than 1. If m 0, then TB/T
ms/(ss ms) m/(s m)
(c) CA/T ss/[ss ms ms] The current account therefore worsens.

1. In the Keynesian model of foreign exchange,
(a) income is fixed.
(b) imports do not vary with income.
(c) consumption does not vary with income.
(d) exports increase as domestic income increases.
(e) prices are fixed.
Answer: (e)
2. If an increase in income of $100 leads to an increase in imports of $30, then the marginal propensity
to import out of income is
(a) 3.
(b) 30.
(c) 0.3.
(d) 0.7.
(e) 70.
Answer: (c)
3. If the marginal propensities to save and to import are 0.3 and 0.2 respectively, then the multiplier
on government spending is
(a) 1.
(b) 1.5.
(c) 2.
(d) 3.5.
(e) 4.
Answer: (c)
4. If an increase in income of $100 leads to an increase in savings of $10, then the marginal propensity
to consume is
(a) 1.
(b) 0.1.
(c) 10.
(d) 10.
(e) 0.9
Answer: (e)
5. In the Keynesian balance of payments model

(a) the trade balance is not affected by income changes.
(b) an increase in income will increase exports.
(c) an increase in income will increase imports.
(d) an increase in income will increase the trade balance.
(e) an increase in income will increase both imports and exports.
Answer: (c)
6. Assume the Marshall-Lerner condition is satisfied and we are looking at the small country model.
Which of the following events produces changes in exports similar to those produced by a
devaluation?
(a) A shift in tastes away from foreign goods.
(b) A shift in tastes towards foreign goods.
(c) An exogenous decrease in foreign income.
(d) All sources of a worsening of the trade balance.
Answer: (a)
7. If the marginal propensity to save is 0.2 and the marginal propensity to import is 0.3, then a $200
million dollar increase in government spending will increase equilibrium income by what amount
in the Keynesian model?
(a) $400 million
(b) $200 million
(c) $100 million
(d) $60 million
(e) $40 million
Answer: (a)
8. In the open-economy Keynesian model, there are leakages from the spending stream as a result of
(a) saving.
(b) imports.
(c) exports.
(e) (a) and (b) only.
Answer: (e)
million dollar increase in government spending will change the trade balance by what amount in the
Keynesian model?
(a) $400 million
(b) $200 million
(c) $120 million
(d) $120 million
(e) $400 million
Answer: (c)
10. In the Keynesian open-economy model, the trade balance is equal to

(a) investment.
(b) national savings.
(c) private savings minus investment.
(d) national savings minus investment.
(e) income minus consumption.
Answer: (d)
11. If the marginal propensity to import is 0.2, then a $200 million dollar increase in income will change
the trade balance by what amount in the Keynesian model?
(a) $400 million
(b) $200 million
(c) $40 million
(d) $40 million
(e) $120 million
Answer: (c)
12. The effect of a fiscal expansion in the two country model is

(a) smaller than in the small country model because more spending leaks out.
(b) larger than in the small country model because some of the spending that leaks out of the
economy through imports leaks back into the economy through exports.
(c) larger than in the small country model because some of the spending that leaks out of the
economy through exports leaks back into the economy through imports.
(d) larger than in the small country model because of more leakage through the trade deficit.
(e) smaller than in the small country model because less spending leaks out through the trade deficit.
Answer: (b)
million dollar increase in exports (as a result of devaluation) will change the trade balance by what
amount in the Keynesian model?
(a) $200 million
(b) $60 million
(c) $40 million
(d) $40 million
(e) $20 million
Answer: (c)
14. It is generally found that a devaluation increases exports. However, the increase in the trade balance
is usually less than the increase in exports as a result of increased imports. In the Keynesian open-
economy model, devaluation increases imports by
(a) increasing income.
(b) reducing savings.
(c) making imports more expensive.
(d) increasing the marginal propensity to import.
Answer: (a)
15. If a country is expanding more rapidly than its trading partner, it is most likely to run a large trade
deficit if
(a) the two countries have the same marginal propensity to import.
(b) it has a smaller marginal propensity to import than its trading partner.
(c) it has a larger marginal propensity to import that its trading partner.
(d) the two counties have the same marginal propensity to import and the expansion is not much
larger than its partner.
Answer: (c)
16. In the Keynesian open-economy model

(a) a transfer will always be undereffected.
(b) a transfer may be fully effected.
(c) a transfer will never be undereffected.
(d) the recipients trade balance always improves.
(e) a transfer will be either undereffected or fully effected.
Answer: (a)
17. In the Keynesian open-economy model, the recipients trade balance falls by less than the amount
of the transfer as a result of
(a) increased exports.
(b) increased private saving.
(c) decreased imports.
(d) increased government spending.
(e) increased investment.
Answer: (b)
18. In the Keynesian open-economy model, a transfer of income results in

(a) an improvement in the recipients trade balance.
(b) decreased trade volume.
(c) decreases in recipients private savings.
(d) a fall in the recipients current account.
Answer: (d)
19. Consider a Keynesian two-country, open-economy model, where both countries have a marginal
propensity to import of 0.2 and a marginal propensity to save of 0.1. An increase in government
spending by $100 million in country A leads to an increase in income of
(a) $1000 million.
(b) $600 million.
(c) $300 million.
(d) $200 million.
(e) $60 million.
Answer: (b)
20. Developing countries tend to have low income elasticities of import demand, yet face highly income-
elastic demand for their exports. This implies that
(a) their income is highly procyclical.
(b) demand for their goods falls more than demand for goods from other countries when the world
is in recession.
(c) demand for their goods rises more than demand for goods from other countries when the world
is in an economic boom.
(d) their income is highly counter-cyclical.
(e) (a), (b) and (c).
Answer: (e)
Chapter 18
Spending and the Exchange Rate
in the Keynesian Model
18.1 Transmission of Disturbances
Transmission Under Fixed Exchange Rates
Transmission Under Floating Exchange Rates
18.2 Expenditure-Switching and Expenditure-Reducing Policies

Adjustment to a Current Account Deficit
Types of Expenditure-Switching Policies
The Swan Diagram
18.3 Monetary Factors

Monetary Expansion
Fiscal Expansion and Crowding Out
The Liquidity Trap and Japan in the 1990s
Devaluation and Crowding Out
18.4 Summary
Appendix A: The Laursen-Metzler-Harberger Effect

Expenditure and the Terms of Trade
The Condition for a Devaluation to Improve the Trade Balance
Implications for Transmission Under Floating Rates
Temporary Versus Permanent Shifts in the Terms of Trade
Appendix B: The Assignment Problem
Chapter Summary
Chapter 18 expands the material in the previous chapter by considering how government policy can be
used to meet trade balance and income objectives. Throughout the chapter, the central point of the analysis
is that changes in policy variables affect the exchange rate. The analysis also allows for exchange rates to
vary with changes in the supply and demand for foreign exchange, which was ruled out by assumption in
Chapter 17.
Section 18.1 considers the transmission of disturbances across countries under both fixed and floating
exchange rate regimes. Under fixed exchange rates, the analysis proceeds as in the previous chapter.
The key point is that disturbances are transmitted across countries via the trade balance. The assumption
of fixed exchange rates is then relaxed, leading to a situation where the exchange rate adjusts such that the
Chapter 18 Spending and the Exchange Rate in the Keynesian Model 127
trade balance will be zero. Therefore, before and after any change, the trade balance must be zero, and thus
disturbances cannot be transmitted cross countries via the trade balance. Figure 18.1 illustrates the basic
point that the effects of domestic disturbances are confined to the home country and that floating exchange
rates insulate the home country from foreign disturbances. The exchange rate adjusts to account for
changes in the foreign country, leaving domestic real variables unchanged. Under fixed rates, this
adjustment in the exchange rate is prevented from occurring, and thus real quantities will change. Note
that the choice of exchange rate regime is then one of choosing between movements in real quantities
or exchange rate uncertainty.
A country that is running a trade deficit then has several policy alternatives to eliminate this deficit. These
can be classified into two basic groups, expenditure-switching policies and expenditure-reducing policies.
The first of these is any policy that switches spending from foreign to domestic goods, for example,
devaluation. Tariffs and other trade restrictions are also examples of expenditure switching policies.
Expenditure-reducing policies are those that reduce aggregate expenditure, and thus reduce imports.
The effects of these two policies on employment differ greatly, as the former will result in an employment
increase and the latter an employment decline. This suggests that there may be tradeoffs involved in
achieving both internal balance (full employment) and external balance (balanced trade). Figure 18.2
illustrates the nature of this trade-off. Note that although at first glance, a policy of devaluation appears
desirable as it improves the trade balance and raises output, there is a cost associated with having excess
demand. Figures 18.3 and 18.4 show that the combinations of exchange rates and government spending that
give external balance can be represented on an upward sloping line, whereas internal balance requires a
downward sloping line. Figure 18.5, the Swan diagram combines these two to illustrate how the exchange
rate and government spending determine employment and the trade balance. Note that a movement to both
internal and external balance can only be achieved by using both expenditure-reducing and expenditure-
switching policies. Also note that the correct policies may not be obvious from an examination of the
economies current position. For example, an economy with a trade deficit and unemployment will need
to devalue their currency, but the correct change in government spending is ambiguous.
The analysis in section 18.3 is conducted in the standard IS-LM framework, which will also be used in
subsequent chapters. A further extension of the model is the addition of monetary factors to the model.
Changes in the money supply will change the interest rate via liquidity effects, and thus lead to changes in
income. Figures 18.7 and 18.8 show the effects of monetary and fiscal expansion respectively. Both fiscal
and monetary expansion will result in a worsening of the trade balance. The effects of fiscal expansion
on output are somewhat limited in that there will be a reduction in investment spending. In the special case
of a liquidity trap, the LM curve becomes horizontal, reflecting the ineffectiveness of monetary policy.
However, fiscal policy becomes more effective as the crowding out effect is eliminated.
The Appendix to Chapter 18 examines the Laursen-Metzler-Harberger effect and the Assignment Problem.
Appendix A discusses the fact that a devaluation may have real consequences beyond a worsening of the
terms of trade. The deterioration in international purchasing power may have repercussions on savings
behavior in that consumers may reduce savings to maintain their standard of living. This is the Laursen-
Metzler-Harberger effect. Thus the trade balance could go into deficit as a result of the devaluation, even
if the Marshall-Lerner condition is satisfied. The second main implication is that there will be international
transmission of disturbances, even with floating exchange rates, but the disturbance will be transmitted
in reverse (an increase in income at home may lead to a fall abroad). Appendix B considers the assignment
problem: which government agency should be responsible for monitoring the external balance the
treasury or the central bank?
Key concepts in this chapter include

floating exchange rates may prevent the international transmission of disturbances
external and internal balance can be achieved simultaneously only with both expenditure-shifting and
expenditure-reducing policies
monetary disturbances may also affect the exchange rate and the trade balance
1. (a) (i) Y (C I G X M)/[1 (1 s m)(1 t)]
(ii) Y/G 1/[1 (1 s m)(1 t)]
This is smaller than 1/s as in each round of spending there are losses due to imports and
taxation as well as to savings.
(iii) This multiplier is also smaller than the open-economy Keynesian multiplier in section 17.1
as a result of leakage due to taxation.
(iv) TB/G m/[1 (1 s m)(1 t)]
(b) (i) Y/X 1/[1 (1 s m)(1 t)]
(ii) TB/X (1 m)/[1 (1 s m)(1 t)]
(iii) Y/G m/[1 s(1 t)] To keep trade balanced, we require a change in exports equal
to X mG/[1(1 s m)(1 t)], which then requires an exchange rate movement
of E mG/[(1 (1 s m)(1 t))]
2. (a) (i) Recall that Y/A 1/(s m) and Y/X 1/(s m). Therefore,
Var(Y) (1/(s m))2 (Var(A) Var(X))
(ii) Under floating exchange rates, the TB 0. Therefore,
Var(Y) (1/(s m))2 (Var(A))
(b) (i) If the variance of foreign disturbances is very large, then the economy would be best
off under floating rates.
(ii) If the marginal propensity to import is large, then fixed rates should be used. The country
with the higher marginal propensity to import would then be the best candidate for fixed
rates.
3. Y/G 1/(s m) and Y/E /(s m). Therefore, the slope of the numerator is given by 1/.
TB/G m/(s m) and Y/G ((s m) m)/(s m). The slope of the numerator is then
given by m/(s).
The ratio of these two slopes is s/m.
4. Student reads articles about the macroeconomy of a particular country and applies it to the Swan
diagram.
5. (a) Y [C I G X M bi]/(s m). This equation gives the IS curve, as Y is an inverse

function of i.
(b) Y [C I G X M bM/ph]/(s m bK/h)
(c) Y/G 1/(s m bK/h) This is smaller than the previous multiplier. This is a result of the fact
that an increase in government spending increases money demand, and thus there is some
leakage from each round of spending increases as a result of increased money holdings.
If h is very high, then the multiplier is large.
(d) Y/ (M/ P) (b/ h)/(s m bK/ h) As h increases, the multiplier falls (the numerator falls at
a rate faster than the denominator).

1. In a closed-economy Keynesian model, a countrys multiplier is estimated to be 4. Which of the
following are possible values for the same country in an Keynesian open-economy model?
(a) 5
(b) 4.5
(c) 2
(d) 0.8
(e) 3
Answer: (c)
2. Under floating exchange rates, the exchange rate adjusts such that
(a) the central bank has met all excess demand or foreign exchange.
(b) there is a balance of payments deficit after a devaluation.
(c) the economy is at a full employment output level.
(d) the central bank must exhaust its foreign exchange reserves.
(e) the balance of payments is zero.
Answer: (e)
3. Which of the following are expenditure-switching policies?

(a) Price deflation.
(b) Import tariffs.
(c) Direct barriers to trade.
Answer: (d)
4. In a Keynesian open-economy model with floating exchange rates, if the marginal propensity
to import is 0.3 and the marginal propensity to save is 0.2, then an increase in government spending
of $200 million will increase equilibrium income by
(a) $1000 million.
(b) $666 million.
(c) $400 million.
(d) $200 million.
(e) $100 million.
Answer: (a)
5. In a Keynesian open-economy model with floating exchange rates, if the marginal propensity
to import is 0.3 and the marginal propensity to save is 0.2, then an increase in government spending
of $200 million will increase the value of net exports by
(a) $400 million.
(b) $300 million.
(c) $200 million.
(d) $100 million.
(e) $0.
Answer: (b)
6. Expenditure-reducing policies can be used to reduce the trade deficit. In doing so, they will
(a) reduce income and employment.
(b) increase income and employment.
(c) increase income and reduce employment.
(d) reduce income and increase employment.
(e) have the same effect on income as expenditure-switching policies.
Answer: (a)
7. Expenditure-reducing policies reduce trade deficits in Keynesian models to the extent that they
(a) reduce income.
(b) reduce savings.
(c) increase exports.
(d) reduce imports.
Answer: (d)
8. In the Keynesian open-economy model with trade initially balanced, a monetary expansion will
(a) lower the interest rate, increase income and cause the trade balance to go into deficit.
(b) raise the interest rate, increase income and cause the trade balance to go into deficit.
(c) lower the interest rate, decrease income and cause the trade balance to go into surplus.
(d) raise the interest rate, increase income, and cause the trade balance to go into surplus.
(e) raise the interest rate, decrease income, and cause the trade balance to go into surplus.
Answer: (a)
9. A tariff is a policy that

(a) has the same effects on personal income as a quota.
(b) is expenditure-switching only.
(c) is expenditure-reducing only.
(d) is both expenditure-switching and expenditure-reducing.
Answer: (d)
10. Internal balance is a situation where

(b) output exceeds potential output
(c) national savings is zero.
(d) output is at the full-employment level.
Answer: (d)
11. In the Keynesian open-economy model with trade initially balanced, a fiscal expansion will
(a) increases the interest rate, encourages private investment and causes the trade balance to go into
surplus.
(b) decreases the interest rate, encourages private investment and causes the trade balance to go into
surplus.
(c) decreases the interest rate, discourages private investment and causes the trade balance to go into
deficit.
(d) increases the interest rate, discourages private investment and causes the trade balance to go into
deficit.
(e) increases the interest rate, discourages private investment and causes the trade balance to go into
surplus.
Answer: (d)
12. A devaluation
(a) is an expenditure-switching policy.
(b) will increase interest rates, reduce investment and push initially balanced trade into a surplus.
(c) leads to crowding-out of investment.
(d) reduces output because demand from the foreign sector decreases.
(e) (a)(c).
Answer: (e)
13. Start from a point of both internal and external balance. In order to remain balanced externally,
a devaluation must be accompanied by
(a) decreased government expenditure.
(b) increased income taxes.
(c) contractionary monetary policy.
(d) increases in government spending.
Answer: (d)
14. Start from a point of both internal and external balance. In order to remain balanced internally,
an increase in government spending must be accompanied by
(a) depreciation.
(b) appreciation.
(c) export taxes.
(d) import subsidies.
Answer: (b)
15. A country observes that it has a trade deficit and unemployment. A correct combination of policies
may be
(a) devalue and cut government spending.
(b) raise the exchange rate and cut government spending.
(c) raise the exchange rate and provide incentives for decreased investment.
(d) raise the exchange rate and government spending.
(e) raise the exchange rate and not change government spending.
Answer: (a)
16. Fiscal policy should be used to achieve internal balance and exchange rate policy external balance if
(a) the country has large foreign exchange reserves.
(b) the marginal propensity to save is high.
(c) the country is initially in a trade deficit.
(d) the country has a large money supply.
(e) the economy is not very open to imports.
Answer: (e)
17. If monetary policy reduces the interest rate, then

(a) real incomes may be lower.
(b) the demand for money will increase.
(c) the return on assets increases.
(d) the opportunity cost of holding money rises.
(e) net savings minus investment will increase.
Answer: (b)
18. The assignment problem refers to the

(a) the problem determining whether a policy is expenditure-switching or expenditure
reducing.
(b) the problem determining whether more output leaks out of an economy through savings or the
trade deficit.
(c) the problem determining which part of government, the central bank (with control over the
exchange rate) or the treasury (with control over fiscal policy), is responsible for internal balance.
(d) the problem assigning the cause of a trade deficit as crowding-out or a devaluation.
Answer: (c)
19. In an economy where income is related to interest rates, the effects of expansionary fiscal policy will
be less than in the standard Keynesian open-economy model as a result of
(a) higher imports relative to the standard model.
(b) higher taxes relative to the standard model.
(c) higher private savings relative to the standard model.
(d) lower investment relative to the standard model.
(e) higher consumption relative to the standard model.
Answer: (d)
20. The Laursen-Metzler-Harberger effect refers to the phenomenon whereby

(a) devaluation improves a countrys terms of trade.
(b) devaluation changes government spending.
(c) devaluation reduces consumers levels of savings in order to maintain their previous
standard of living.
(d) devaluation leads to an increase in the real quantity of imports.
Answer: (c)
Chapter 19
The Money Supply, the Price Level,
and the Balance of Payments
19.1 The Nonsterilization Assumption
The Definition of Sterilization Operations
Humes Price Specie-Flow Mechanism
Mundells Income Reserve-Flow Mechanism
19.2 The Purchasing Power Parity Assumption

PPP: Definitions
Arbitrage and the Law of One Price
Reasons for Failure of PPP
Empirical Evidence on PPP
19.3 Purchasing Power Parity in a Hyperinflation
19.4 PPP in the Model of the Balance of Payments

The Aggregation of Traded Goods for Small Open Economies
The Real Balance Effect
19.5 Summary
Appendix A: The Gold Standard

The Idealized Gold Standard
The Ups and Downs of the Gold Standard
Appendix B: Fiscal Expansion Under Mundells Reserve Flow Mechanism
Appendix C: The Determinants of the Balance of Payments in the Monetarist Model

The Effect of a Monetary Expansion in the Monetarist Model
The Real Balance Effect of a Devaluation
Chapter Summary
Chapter 19 introduces variations in the price level and the central banks holdings of international reserves
to the determination of the balance of payments. The model presented here is referred to as the monetary
approach to the balance of payments, and results in the conclusion that the balance of payments is a
monetary phenomenon.
The link between the money supply and the balance of payments is established in Section 19.1. Recall
from Chapter 15 that the balance of payments is equal to the change in the central banks international
reserves. A balance of payments deficit must then be accompanied by the central bank selling international
reserves. The monetary base then falls when there is a trade deficit. This can be prevented by the central
bank creating money at the same time that they sell their reserves. The nonsterilization assumption rules
out this behavior. The fact that trade deficits and surpluses change with the monetary base is the central
point of the monetary approach to the balance of payments. Figure 19.1 considers the effects of a monetary
expansion under the assumption of nonsterilization of reserve flows in the Keynesian model of the last
chapter. Note that in the long run, real variables are not affected under these assumptions. Monetary policy
than has long-run real consequences only in situations where the central bank sterilizes reserve flows.
A devaluation, however, leads to a significant long-run increase in income with no long-run effect on the
trade balance. An interesting feature of the above material is that although it represents the monetary
approach to the balance of payments, it is should not be described as a monetarist model. Prices are held
fixed throughout, which is one of the cornerstones of Keynesian economics.
The assumption that prices are fixed is relaxed beginning in Section 19.2. If prices are flexible then
in equilibrium, the supply of and demand for all goods will have adjusted such that there will be no
arbitrage opportunities. This yields the Purchasing Power Parity (PPP) condition and the Law of One
Price. This can be used to define and introduce the concept of the real exchange rate. This is the rate at
which goods can be traded (as opposed to the nominal exchange rate which is the rate at which currencies
can be traded), and was known as the terms of trade earlier in the text. In practice, however, it is fairly
obvious that PPP fails to hold for all goods, a fact that is documented empirically in the text.
Section 19.3 discusses PPP in the context of a hyperinflation. PPP works well in the long run and,
in a hyperinflation, the long run arrives quickly. However, there are large short-run errors that push both
the exchange rate and price level away from PPP. During a hyperinflation, PPP tends to explain nominal
exchange rates quite well, though not real exchange rates.
Section 19.4 explores the relationship between PPP and the balance of payments assuming that prices are
flexible and therefore PPP must hold. An additional assumption is that exports and imports can be
represented by aggregate goods, which is motivated by considering only small open economies. The final
assumption is that exchange rates are fixed (floating rates are considered in Chapter 27). The real balance
effect is introduced. A devaluation leads to a proportionate increase in the price level resulting in a decline
in the real money supply. The result is an excess demand for money causing consumers to reduce their
purchases of internationally traded goods thus improving the trade balance. This balance of payments
surplus sets in motion developments that are self-correcting until the balance of payments return to zero.
Appendix A considers the gold standard system of exchange rates in light of the monetarist model
of exchange rates. This material serves two basic purposes. First, it provides an introduction to the
exchange rate regime that prevailed for a large part of the last hundred years. Second, and more
importantly, many of the implications and results from the monetarist model can be examined by looking
at the time period over which exchange rates were fixed. This helps in understanding the workings of the
monetarist model, as well as some of its shortcomings. Appendix B considers the effects of fiscal
expansion under the Mundells Reserve Flow Mechanism. Under the assumption of nonsterilization, fiscal
expansion is found to raise income and worsen the trade deficit in the short run, but it has no effect on
either in the long run. Appendix C explores the material covered in section 19.4 in more detail along with
more applications.
The supplement to Chapter 19 discusses the monetarist approach to the balance of payments as it considers
a two-country version of the model. The key result of this section is that persistent deficits or surpluses
in the balance of payments can only result from persistent excess supply or demand for money.
Chapter 19 The Money Supply, the Price Level, and the Balance of Payments 135

monetary disturbances have real effects in the Keynesian model only to the extent that the central bank
does not sterilize changes in reserves
with flexible prices, there will be no arbitrage opportunities in equilibrium
under PPP with flexible prices and fixed exchange rates, the balance of payments tends towards zero.
1. (a)
The appreciation of the currency shifts the IS curve downwards. This leads to a short-run
deterioration in the trade balance, and a reduction in income. As a consequence, reserves are
decreasing over time. Under non-sterilization, the money supply falls over time, shifting the
LM curve inwards. This leads to an improvement in the trade balance, and a further drop in
income in the long-run.
(b)
The appreciation will lead to a proportionate fall in the price level. This will then lead to an initial
balance of payments deficit (A to B). Over time, money flows out of the country, returning the
balance of payments to zero (at C). Income is fixed at the full employment level.
2. (a) (i) the CPI will grow at 3 percent per year

(ii) the CPI will grow at 10 percent per year
(iii) the CPI will not change
(b) (i) the balance of payments will increase by billion dollars

(ii) the balance of payments will increase by KP billion dollars
(iii) the balance of payments will increase by 100K billion dollars
(c) The real exchange rate is equal to
E[(Pn/ Pt)Pt]/(Pn/ Pt)Pt]
(d) (i) Pn/Pt will increase at 3 percent per year. The real exchange rate then falls at 2 percent
per year.
(ii) There will be no change in the real exchange rate.
(iii) The real exchange rate will be increasing at 3 percent per year.
3. (a) A gold discovery will increase prices. The real exchange rate will increase, resulting in a trade
deficit. The world price level will also increase.
(b) Washington, DC
4. The solution for income in the model is Y [C I G X M bM/hP]/[s (1 s) t

m(1 t) bK/h]
(a) TB/G [m(1 t)]/[s (1 s) t m(1 t) bK/h] Over time, the effect diminishes.
(b) TB/ (M/P) [(b/h) (1 t)]/[s (1 s) t m(1 t) bK/h]
5. (a) The balance of payments is equal to

BP (M (1/)PY)
An increase in the money supply will then lead to a balance of payments deficit. This occurs
because there is an excess supply of money, some of which is spent abroad.
(b) The effects are consistent in that the difference between nominal and real variables matter when
prices are flexible.
(c) BP (M(1/)EP*Y)
In the short run, BP/E (/)P*Y > 0, thus a devaluation results in an increase in BP. In the
long run, the balance-of-payments surplus means that the money supply is increasing. Since
BP/M M < 0, this increase in the money supply reduces BP until BP 0.

1. The term sterilization in the monetary approach to the balance of payments refers to
(a) changes in the price level.
(b) changes in the money supply.
(c) the effects of money supply changes on the exchange rate.
(d) central bank actions that prevent reserve changes from altering the monetary base.
Answer: (d)
2. The monetary base is defined as

(a) international reserves plus net domestic assets.
(b) international reserves.
(c) international reserves minus net domestic assets.
(d) currency minus liabilities issued by the central bank.
(e) net domestic assets minus international reserves.
Answer: (a)
3. If a countrys international reserves fall by $200 million, and their net domestic assets increases
by $100 million, then there will be a change in the balance of payments of
(a) $100 million.
(b) $200 million.
(c) 0.
(d) $100 million.
(e) $200 million.
Answer: (e)
4. If a countrys international reserves fall by $200 million, and their net domestic assets increases
by $100 million then there will be a change in the monetary base of
(a) $100 million.
(b) $200 million.
(c) 0.
(d) $100 million.
(e) $200 million.
Answer: (d)
5. A central bank wishes to sterilize a reserve outflow. Which of the following achieve this goal?
(a) Expand net domestic assets at the same rate as the reserve outflow is contracting the money
supply.
(b) Reduce net domestic assets at the same rate as the reserve outflow is expanding the money
supply.
(c) Use open market operations to sell treasury securities on the private market.
(d) Use open market operations to reduce domestic money supply.
(e) Enlist the help of the fiscal branch to create expenditure-switching activities.
Answer: (a)
6. Under the monetary approach to the balance of payments, a monetary expansion may lead to
(a) decreased income, a worsened trade balance and reserves declining over time.
(b) increased income, a worsened trade balance and reserves increasing over time.
(c) increased income, an improved trade balance and reserves increasing over time.
(d) increased income, an improved trade balance and reserves declining over time.
(e) increased income, an worsened trade balance and reserves declining over time.
Answer: (e)
7. The Law of One Price should hold theoretically because of

(a) Humes price specie-flow mechanism.
(b) sterilization of reserve outflows.
(c) international arbitrage.
(d) expenditure-reducing fiscal policies.
(e) currency devaluations.
Answer: (c)
8. Under the monetary approach to the balance of payments, in the long-run, if the central bank chooses
not to sterilize reserve flows, a devaluation may lead to
(a) no change in income, a worsened trade balance and constant reserves.
(b) increased income, a worsened trade balance and constant reserves.
(c) increased income and no change in the trade balance.
(d) no change in income and no change in the trade balance.
(e) a decline in prices.
Answer: (c)
9. Under the monetary approach to the balance of payments, a devaluation that leads to a $50 million
increase in exports will lead to what permanent increase in income? Assume that the central bank
does not sterilize reserve flows, the marginal propensity to import is 0.2 and the marginal propensity
to save is 0.3.
(a) $50 million
(b) $100 million
(c) $200 million
(d) $250 million
(e) 0
Answer: (d)
10. If the US CPI is 1.20 and the Japanese CPI is 180 then if PPP holds, the dollar/yen exchange rate
must be
(a) 1.5.
(b) 15.
(c) 150.
(d) 0.0067.
(e) 0.067.
Answer: (d)
11. Purchasing Power Parity may fail to hold because of the presence of
(a) imperfect information, contracts and momentum in consumer buying habits.
(b) tariffs and transportation costs.
(c) non-traded goods and services in price indices.
(d) permanent shifts in the terms of trade between traded goods.
Answer: (e)
12. The US CPI is growing at 4 percent per year and the German CPI is growing at 3 percent per year. If
PPP holds, then one would expect the nominal exchange rate to be
(a) depreciating at 4 percent per year.
(b) constant.
(c) depreciating at 3 percent per year.
(d) depreciating at 1 percent per year.
(e) appreciating at 7 percent per year.
Answer: (d)
13. The US CPI is growing at 4 percent per year and the German CPI is growing at 3 percent per year.
If PPP holds, then one would expect the real exchange rate to be
(a) depreciating at 4 percent per year.
(b) constant.
(c) depreciating at 3 percent per year.
(d) depreciating at 1 percent per year.
(e) appreciating at 7 percent per year.
Answer: (b)
14. If there are non-traded goods in each country, then PPP will still hold if
(a) non-traded goods are less than 50 percent of consumption.
(b) the prices of non-traded goods move in proportion to prices of traded goods.
(c) the prices of non-traded goods are constant.
(d) there are shifts in the relative prices of traded and non-traded goods.
(e) PPP can never hold in this situation.
Answer: (b)
15. The general empirical evidence on PPP shows

(a) real exchange rates have shown little difference in variability over periods of fixed and flexible
exchange rates.
(b) real exchange rates have been especially variable in the flexible exchange rate period since 1973.
(c) real exchange rates have been much less variable during periods of flexible exchange rates than
during periods of fixed exchange rates.
(d) conflicting results between flexible exchange rate regimes after 1973 and flexible exchange rate
regimes before 1973.
Answer: (b)
16. The Keynesian model and the monetarist model of the balance of payments differ in that
(a) in the Keynesian model an increase in income leads to trade deficit, whereas it leads to a trade
surplus in the monetarist model.
(b) prices are fixed under the Keynesian model and flexible under the monetarist model.
(c) income increases result primarily from increases in demand in the Keynesian model and
increases in supply in the monetarist model.
Answer: (d)
17. In the monetarist small-country model, an exogenous increase in the world price level
(a) leads to a higher domestic price level, an increase in domestic money demand and a temporary
balance-of-payments surplus.
(b) leads to changes in the domestic economy through changes in relative prices as in the elasticity
approach.
(c) leads to a lower domestic price level, a decrease in domestic money demand and a temporary
balance-of-payments surplus.
(d) leads to a higher domestic price level, an decrease in domestic money demand and a temporary
balance-of-payments deficit.
(e) (a) and (b).
Answer: (a)
18. Under the monetarist model of the balance of payments (with fixed exchange rates) a monetary
expansion will initially lead to
(a) excess demand for money and a trade deficit.
(b) excess demand for money and a trade surplus.
(c) excess supply of money and a trade surplus.
(d) excess demand for money and a trade deficit.
(e) excess demand for money and balanced trade.
Answer: (d)
19. Under PPP and flexible prices, the balance of payments (with fixed exchange rates) a devaluation will
initially lead to
(a) excess demand for money and a trade deficit.
(b) excess demand for money and a trade surplus.
(c) excess supply of money and a trade surplus.
(d) excess demand for money and a trade deficit.
(e) excess demand for money and balanced trade.
Answer: (b)
20. Under the gold standard

(a) exchange rates are volatile.
(b) the central bank would sell gold if there were excess demand for foreign exchange.
(c) the world price level is determined by the world supply of gold.
(d) the central bank can easily sterilize reserve flows.
(e) wages and goods prices must be fixed.
Answer: (c)
Chapter 20
Developing Countries and Other Small Open
Economies with Nontraded Goods
20.1 Non-Traded Goods
Output of Traded and Non-Traded Goods
Consumption of Traded and Non-Traded Goods
20.2 Expenditure and the Relative Price of Non-Traded Goods

Maintaining Equilibrium in the Traded Goods Market
Maintaining Market Equilibrium for Non-Traded Goods
20.3 The Monetary Approach with Non-Traded Goods

Reserve Flows
The Dutch Disease
The Effects of an Increase in the Money Supply in the Non-Traded Goods Model
The Effects of a Devaluation
20.4 Summary
Chapter Summary
Chapter 20 explores the implications of the preceding theory for economies that are open to trade and too
small to influence world prices. This is the situation in many developing countries. In the simplest case,
a devaluation in these economies cannot affect the trade balance other than via the real money balance
effect. This leads to a very pessimistic outlook regarding exchange rate policy in developing countries.
The purpose of this chapter is to explore other channels by which exchange rate policy can affect real
balances in small, open economies.
The idea that some goods are not traded internationally was introduced in chapter 4. Section 20.1 discusses
how output and consumption are allocated between traded and non-traded goods. This analysis is similar
to that in the early parts of the text. The relative price of non-traded goods determined the location
of production along a PPF for traded and non-traded goods. If trade is balanced, then consumption must
correspond to production. Note that this analysis has nothing to say about the actual levels of exports and
imports, but is instead concerned only with the difference between them. Figure 20.1 illustrates the case
where there is balanced trade. Note that this is not a necessary consequence of the model, but is instead
a special case where the indifference curve that maximizes utility along the budget line happens to
correspond exactly to production. If the optimal consumption choice were above and to the left of S,
then the country would be running a trade surplus. They would be exporting more traded goods than they
import, and using the excess revenues to consume more non-traded goods.
Section 20.2 analyzes the effects of changes in expenditure and the relative price of traded and non-traded
goods. An increase in expenditure will lead to a trade deficit (starting from an initial situation of balanced
trade), as spending on traded goods will increase. Note that this may involve either an increase in imports
or an increase in the amount of the export good consumed domestically. Unlike changes in spending,
changing the relative price of non-traded goods will affect both production and consumption. An increase
in the relative price of traded goods will lead to greater production of traded goods. This is the movement
along the PPF from S to X in Figure 20.2. The effects on consumption involve both a substitution and
income effect. If expenditure is held constant, then the income effect will be small, and thus an increase
in the relative price of traded goods will lead to a decrease in consumption. Combined with the effect on
production, this means that there will then be a trade surplus (starting from initially balanced trade).
Figures 20.3 and 20.4 combine the effects of expenditure changes and changes in the relative price.
Starting from a point of balanced trade, an increase in expenditure must be accompanied by a decrease
in the relative price of non-traded goods in order for trade to remain balanced. The effects of these changes
will also be felt in the non-traded goods market. Figure 20.5 illustrates the idea that an increase in
expenditure will create excess demand for non-traded goods (distance XB in figure 20.2), which can only
be eliminated by an increase in the relative price of non-traded goods. Figure 20.5 is then the Swan
Diagram that was introduced in Chapter 18 (with the curves flipped as increases in the exchange rate are
now movements down the vertical axis).
The Swan diagram suggests that policy intervention is needed to maintain internal and external balance.
However, there may be automatic adjustment mechanisms that aid in restoring balance. Internal balance
may be maintained if producers of non-traded goods are able to adjust prices in response to excess supply
and demand for their goods. External balance may be assured to some degree by international reserve
flows. These reserve flows may affect expenditures in the direction that will help in removing external
imbalances. There is no assurance that these tendencies will restore both external and internal balance,
leading to a need for policy intervention, the effects of which is the subject of section 20.3.
Monetary policy can be used to change the level of expenditure in the economy, and exchange rate policy
can be used to change the relative price of traded goods. The analysis requires the assumptions that reserve
flows are not sterilized and that goods prices are perfectly flexible. Another important point to consider is
the discussion relating to devaluation and stickiness of some variables. If all prices and quantities were
perfectly flexible, then devaluation would have no real effects in any of the models studied. In the long
run, all variables have been permitted to adjust, and thus there are no long-run real effects of the
devaluation.

non-traded goods allow devaluations to have effects in small open economies
there may be automatic tendencies for internal and external balance to be maintained

1. The good is not a non-traded good. Non-traded goods are goods that cannot be traded. It is possible
that grain can be traded, but trade in grain happens to be balanced in this country.
2. Policies should be designed to increase expenditure, and not change the money supply. A reduction
in taxes or an increase in government spending would do this; the country needs a policy that will
increase expenditure and eliminate the balance of payments surplus.
3. The country has a large trade deficit, unemployment and low non-traded goods prices. This country
would be in Quadrant I of figure 20.5.
Chapter 20 Developing Countries and Other Small Open Economies with Nontraded Goods 143
4. A devaluation would reduce the trade deficit and lead to a decline in the relative price of non-traded
goods. If worried about inflation (producing beyond full employment output), this policy may be a
problem, as the devaluation will increase output.
5. Cutting off cotton imports will increase the price of cotton. Since cotton is used as an input in the
textile industry, this will reduce output and employment in the industry. Since this is a large portion
of the countrys output, this policy will not be good.
6. (a) For every 1 percent nominal devaluation, wages and the price of non-traded goods will rise by
0.5 percent.
(b) For a 10 percent increase in the output of traded goods, a 10 percent increase in the P/ W
is required.
(c) Given the ansers to (a) and (b), a 20% devaluation is necessary to get a 10% increase in the
output of traded goods. This will lead to a 10% increase in W and the price of non-traded goods.
As a result, the CPI will rise by 15% (since W rises by 2/3 of the increase in the CPI).

1. In small open economies where all goods are traded, a devaluation affects the trade balance
(a) not at all.
(b) via the real money balance effect.
(c) via the income effect.
(d) via the effect on relative prices.
(e) via intertemporal substitution.
Answer: (b)
2. Which of the following goods is most likely to be non-traded?

(a) housing
(b) clothing
(c) canned food
(d) tourism
(e) computers
Answer: (a)
3. In the monetary approach with non-traded goods, a devaluation improves the trade balance by
(a) reducing the real money supply and reducing the relative price of non-tradables.
(b) reducing the real money supply only.
(c) reducing the relative price of non-tradables only.
(d) reducing the real money supply and increasing the relative price of non-tradables.
(e) increasing the real money supply and increasing the relative price of non-tradables.
Answer: (a)
4. Which of the following are potential contractionary effects of a devaluation?

(a) The domestic currency value of dollar denominated debt decreases.
(b) The real balance effect, which results when households cut expenditure to restore their real
money balances to pre-devaluation levels.
(c) The decrease in the price of imported raw materials and inputs.

Answer (b)
5. The economys total output of traded goods is

(a) exports plus imports.
(b) exports minus imports.
(c) production in the export sector plus imports.
(d) production of all goods that can be exported plus domestic production of all goods that can be
imported.
(e) domestic consumption of the export good plus production of all goods that could be imported.
Answer: (d)
6. The trade balance is the difference between the production and consumption of
(a) both traded and non-traded goods.
(b) non-traded goods only.
(c) traded goods only.
(d) exports of traded goods and production of traded and non-traded goods.
(e) non-traded goods and imports of traded goods.
Answer: (c)
7. An exogenous increase in expenditure will create a trade deficit as a result of

(a) decreased exports.
(b) decreased export production.
(c) an increase in the demand for non-traded goods.
(d) decreased production of importables.
(e) increased consumption of exportables.
Answer: (e)
8. A devaluation will lead to

(a) an decrease in the price of non-traded goods.
(b) an increase in the relative price of non-traded goods.
(c) a more than proportionate increase in the price of traded goods.
(d) a more than proportionate increase in the price of non-traded goods.
(e) a proportionate increase in the price of traded goods.
Answer: (e)
9. In the monetary approach, the Dutch disease can be caused by

(a) a real appreciation of currency.
(b) a large inflow of reserves and a fixed exchange rate.
(c) a real depreciation of the currency.
(d) a large outflow of reserves and a fixed exchange rate.
(e) (a) and (b).
Answer: (e)
10. Starting from balanced trade and excess demand for non-traded goods, what should be done in order
to attain both internal and external balance?
(a) devaluation alone
(b) devaluation and increased expenditure
(c) devaluation and decreased expenditure
(d) appreciation and decreased expenditure
(e) appreciation and increased expenditure
Answer: (c)
11. A higher relative price for non-traded goods, without a change in overall expenditure, will lead to
(a) increased production and consumption of non-traded goods.
(b) decreased production of traded goods.
(c) decreased production and consumption of non-traded goods.
(d) decreased production and increased consumption of non-traded goods.
Answer: (b)
12. A higher relative price for non-traded goods, without a change in overall expenditure, will lead to
(a) a substitution effect that reduces non-traded goods consumption and an income effect that
increases non-traded goods consumption.
(b) an ambiguous change in non-traded goods consumption.
(c) reduced non-traded goods production.
(d) a substitution effect that reduces non-traded goods consumption and an income effect that
reduces non-traded goods consumption.
Answer: (d)
13. In the non-traded goods model with a fixed exchange rate, an increase in the money supply leads
initially to
(a) an increase in the relative price of non-tradables, a trade deficit and a decrease in
international reserves.
(b) an increase in the relative price of non-tradables, a trade deficit and an increase in
(c) a decrease in the relative price of non-tradables, a trade deficit and an increase in
(d) a decrease in the relative price of non-tradables, a trade surplus and an increase in
Answer: (a)
14. A balance of payments deficit may lead to a contractionary effect on output if

(a) it is accompanied by government spending increases.
(b) it is accompanied by tax cuts.
(c) prices are fixed.
(d) it results in a movement from fixed to flexible exchange rates.
(e) it creates a loss in central bank reserves.
Answer: (e)
15. Reserve inflows can lead to real currency appreciation via

(a) increases in wages and the prices of non-traded goods.
(b) deflation.
(c) reductions in the money supply.
(d) appreciation of the nominal exchange rate.
Answer: (a)
16. Assume that prices of non-traded goods adjust rapidly and that reserve flows are not sterilized. A
monetary contraction will lead to
(b) a trade surplus and excess demand for non-traded goods.
(c) a trade deficit and excess demand for non-traded goods.
(d) excess demand for non-traded goods.
(e) a trade surplus and excess supply of non-traded goods.
Answer: (a)
17. Assume that prices of non-traded goods adjust rapidly and that reserve flows are not sterilized. In the
long run, a monetary contraction will lead to
(a) a trade deficit.
(b) excess demand for non-traded goods.
(c) both (a) and (b).
(d) a decrease in the countrys reserves.
Answer: (e)
18. A devaluation will lead to

(a) a trade surplus and increased spending on both traded and non-traded goods.
(b) a trade deficit and increased spending on both traded and non-traded goods.
(c) a trade surplus, increased spending on traded goods and decreased spending on
non-traded goods.
(d) a trade surplus, decreased spending on traded goods and increased spending on
non-traded goods.
(e) a trade surplus and decreased spending on both traded and non-traded goods.
Answer: (e)
19. Assume that prices of non-traded goods adjust rapidly and that reserve flows are not sterilized. In the
long run, a devaluation will lead to
(b) excess demand for non-traded goods.
(c) both (a) and (b).
(d) a decrease in the countrys reserves.
Answer: (d)
20. In the monetary approach to the balance of payments, which of the following is sticky?
(a) the stock of foreign reserves in the short run.
(b) the stock of foreign reserves in the long run.
(c) the trade balance.
(d) the relative price of traded to non-traded goods.
(e) the real money supply.
Answer: (a)
Chapter 21
The Globalization of Financial Markets
21.1 The Postwar Financial System (19441973)
The Euromarkets
21.2 The Foreign Exchange Market

Bid-Ask Spreads and Arbitrage in the Spot Market
Interbank Trading of Foreign Exchange
Vehicle Currencies
The Dollar and Its Rivals for International Currency Status
Is Most Foreign Exchange Trading Speculation?
21.3 Liberalization
Liberalization by Countries Controlling Inflows
Liberalization by Countries Controlling Outflows
Changes in Tax Laws
Liberalization of Domestic Financial Markets
Liberalization of Trade in Financial Services and Direct Investment
The Optimal Order of Liberalization
21.4 Innovation
The Forward Exchange Market
Covered Interest Arbitrage
Other Ways of Managing Risk in Exchange Rates and Interest Rates
Securitization
21.5 Advantages of Financial Integration

Some Disadvantages in Practice
The Theory of International Capital Flows as Intertemporal Optimization
21.6 Summary
Appendix: The Effect of a Budget Deficit Under Intertemporal Optimization

- The Debt-Neutrality Proposition
- Feldstein-Horioka and Measures of International Capital Mobility
Chapter 21 The Globalization of Financial Markets 149
Chapter Summary
Section V of the text explores some issues relating to international capital markets. Since World War II
there has been an extreme movement towards more developed international capital markets. This has led
to a dramatic increase in international capital flows. The development of these markets and their effects is
the subject of chapter 21.
In the 1960s, the trend towards fully international capital markets began with the development of the
Euromarkets. This occurred largely in response to the severe restrictions on international financial flows
that were in place at the time. These markets create a disparity between the location of the deposit and the
currency in which it is held, which creates transactions not subject to many international banking
regulations. Note that in considering Eurodollar transactions effects on balance of payments accounts,
it is the nationality of the parties involved that determines where credits and debits are registered, not the
currency used.
A second important international financial market is the market for foreign exchange. This market is
characterized by large trading volumes, much of it involving trades among banks, and low transactions
costs. As can be seen by examining the financial pages of any newspaper, there is no single foreign
exchange market, but instead a large number of financial institutions trading currencies. The discussion
relating to arbitrage opportunities illustrates how some of the diversity in the market is accounted for, in
the sense that each institution must offer similar rates and that bilateral cross-rates must be consistent with
a lack of triangular arbitrage. A large fraction of exchange rate trading occurs in a few currencies,
illustrating the concept of vehicle currencies. Vehicle currencies are used in order to simplify many of the
trades and to account for some of the risk associated with foreign exchange markets. The dollar is the clear
choice for leading international currency, though some speculate that the euro may gain more stature in the
years to come.
Over the last 40 years there has been a strong tendency towards the removal of restrictions on international
capital flows. This liberalization is the subject of section 21.3. Restrictions on inflows of capital were
usually concerned with issues relating to domestic control over exchange rates and monetary policy. The
removal of many of these restrictions has led to an increase in the volume of capital flows and the
reduction of international interest rate differentials. There were also restrictions on capital outflows,
usually in regards to concerns over exchange rates and balance of payments deficits. The text documents
the fact that the removal of this type of foreign exchange control has been a relevant phenomenon for a
large variety of countries over the last 20 years. There has also been a liberalization of tax policies towards
foreign investors, and a removal of many direct restrictions on financial markets. The removal of trade
barriers (as discussed in chapter 10) also impacts upon foreign exchange markets, largely in the sense that
trade controls affect foreign direct investment and multinational enterprises. The final issue addressed in
this section is whether there is an upper bound to the degree of international capital liberalization that
should be permitted. For economies with poorly developed capital markets, there may be large costs
associated with maintaining open international financial markets.
Section 21.4 discusses innovation in domestic financial markets. Much of this innovation has been in
response to the risk associated with foreign exchange markets. The most important of these innovations
is the development of forward exchange markets, which allow investors to secure against adverse
exchange rate movements. The covered interest parity condition ensures that on average there cannot be
gains from forward exchange markets. This condition links forward prices to spot prices, thus removing
any systematic arbitrage opportunities from trading foreign exchange across time. Other markets that can
be used to deal with exchange rate uncertainty are also introduced, including futures markets, options,
currency swaps, interest rate swaps and derivatives. Many of these will be familiar to students. Another
issue addressed here that has recently received a large amount of media attention is that of the emerging
financial markets of Latin America, Asia and Eastern Europe, which will be examined in more detail in
chapter 24.
Section 21.5 explores the pros and cons of financial integration as well as developing providing a more
formal model of international capital flows based on intertemporal optimization. Borrowing and saving
represent the allocation of income and consumption across time, and the development of international
capital markets aids in this process, leading to gains in utility. These gains result from increased ability to
receive higher returns on savings. In addition, international capital flows will occur in a world where
interest rates are equal across countries if consumers differ in their savings behavior.
The material in the Appendix to chapter 21 concerns the effect of budget deficit under intertemporal
optimization.Empirical evidence regarding the neutrality of budget deficits as proposed by Robert Barro is
explored.The savings-retention coefficient is introduced as a measure of international capital mobility.It
is shown thatno matter how integrated financial markets are, national savings can still influence domestic
real interest rates.

characteristics of foreign exchange markets
covered interest parity
the microeconomic foundations of international capital flows

1. (a) Maybe-If the spot rate went higher than 0.70, then it would be profitable to exercise the option.
(b) Yes-you can purchase the Swiss francs at 0.7 dollars per franc and then resell them on the spot
market at 0.8 dollars per franc.
(c) Maybe-Although you can profit from exercising the option immediately, if the spot rate rises
further then profits will be larger than if the option were exercised immediately.
(d) The option would be more valuable if the Swiss franc spot rate were very volatile, as the option
insures against some of the risk in that you are ensured that the most you will have to pay to
obtain Swiss francs is 0.7 dollars per Swiss franc.
2. (a) F [(1.20)(1.06)]/(1.04) 1.223

(b) You are getting 100 euro 1 year from now. You can either
(i) sell them forward and get 100 F dollars
or
(ii) borrow 100S/(1 i) dollars and invest them in the US. This will yield (1 i) S/(1 i) dollars,
which by covered interest parity is equal to the 100 F dollars that could be obtained above.
(c) F (1.20)(1.03)/(1.01) 1.224
(d) (a) and (c) imply that the dollar will depreciate against the euro.
(e) 1 Swedish Krona will be worth 0.091 euro in one year (one euro will be worth SK 11).
According to interest parity,interest rates on SK deposits to rise, resulting in a forward rate on
Swedish Krona equal to 0.091 euro per krona.

1. Eurodollar markets are unique in the sense that
(a) all transactions take place in European countries.
(b) all transactions involve US dollars.
(c) transactions are not denominated in the currency of the country where they take place.
(d) very few of the transactions are by banks.
(e) they are highly regulated.
Answer: (c)
2. A US citizen sells Eurodollars to a Canadian. In the US, this is recorded as

(a) a short-term capital outflow.
(b) a short-term capital inflow.
(c) a long-term capital outflow.
(d) a flow of investment income.
(e) it depends on the currency used in the transaction.
Answer: (a)
3. Bid-ask spreads are likely to be larger for currencies that

(a) are vehicle currencies.
(b) have large trade volumes.
(c) are purchased by large firms.
(d) have highly volatile exchange rates.
Answer: (d)
4. The dollar/yen exchange rate is 0.006 and the dollar/euro exchange rate is 0.6. If there are no
arbitrage opportunities, then the euro/yen exchange rate will be
(a) 100.
(b) 60.
(c) 10.
(d) 0.001.
(e) 0.0166.
Answer: (d)
5. The dollar/euro exchange rate is 0.05, the euro/yen exchange rate is 20 and the dollar/yen exchange
rate is 0.002. US investors have an arbitrage opportunity in that they could
(a) sell dollars for yen, convert these to euro and then back to dollars.
(b) sell dollars for euro, convert these to yen and then back to dollars.
(c) sell dollars for yen and then immediately convert them back to dollars.
(d) sell dollars for euro and then immediately convert them back to dollars.
(c) There are no arbitrage opportunities.
Answer: (a)
6. The daily volume of the foreign exchange market worldwide is

(a) $10 $15 million.
(b) $100 $150 million.
(c) $10 15 billion.
(d) $100 $150 billion.
(e) over $1 trillion.
Answer: (e)
7. Assume that initially there are no arbitrage opportunities nor transaction costs of trading foreign
exchange. If the dollar/euro exchange rate appreciates 4 percent in one year, and the dollar/yen rate
depreciates 2 percent in one year what must the change in the euro/yen rate be such that there will be
no arbitrage opportunities at the end of the year
(a) appreciation of 6 percent.
(b) appreciation of 2 percent.
(c) depreciation of 2 percent.
(d) depreciation of 6 percent.
(e) depreciation of 8 percent.
Answer: (d)
8. The major disadvantage of a country having its currency used as a vehicle currency is
(a) loss of seigniorage.
(b) large fluctuations in demand for the currency.
(c) large fluctuations in supply of the currency.
(d) high transactions costs.
(e) ineffectiveness of monetary policy.
Answer: (b)
9. The removal of controls on international capital flows has led to

(a) a fall in foreign direct investment.
(b) a reduction in interest rate differentials across countries.
(c) an increase in restrictions on international goods flows.
(d) increased labor movement across countries.
Answer: (b)
10. A speculator expects that the yen will appreciate to a value higher than the current forward rate in the
next year. They will then
(a) sell yen forward one year.
(b) buy yen forward one year.
(c) buy yen at the spot rate now.
(d) sell yen at the spot rate now.
Answer: (b)
11. A vehicle currency is

(a) subject to fewer fluctuations in demand than other currencies.
(b) a leading currency used as a focal point for trading.
(c) a currency commonly used to invoice trade in goods and services.
(e) (b) and (c).
Answer: (e)
12. The interest rate on dollar deposits is 10 percent per year and the interest rate on yen deposits is
6 percent per year. The dollar/yen spot rate is 0.005 and the one year forward rate is 0.0052. US
investors will then tend to
(a) invest in dollars and make no foreign exchange transactions.
(b) sell yen at the spot rate and buy yen forward.
(c) sell yen at the spot rate, invest in the US and buy yen forward.
(d) buy yen at the spot rate, invest in Japan and sell yen forward.
(e) buy yen at the spot rate, invest in dollars and sell yen forward.
Answer: (d)
13. The interest rate on dollar deposits is 6 percent per year and the interest rate on mark deposits is
4 percent per year. The dollar/mark spot rate is 0.005. If covered interest parity holds, what must be
the one-year forward dollar/mark exchange rate?
(a) 0.005
(b) 0.0052
(c) 0.00509
(d) 0.00491
(e) 0.00526
Answer: (c)
14. The interest rate on dollar deposits is 5 percent per year and the dollar/yen spot rate is 0.005. The
one-year forward dollar/yen exchange rate is 0.0052. If covered interest parity holds, what must be
the interest rate on yen deposits?
(a) 0.1 percent
(b) 1.0 percent
(c) 4.0 percent
(d) 9.0 percent
(e) 9.2 percent
Answer: (b)
15. In practice covered interest parity actually holds because of

(a) governmental regulation of capital markets.
(b) restrictions on international capital flows.
(c) transportation and transaction costs.
(d) arbitrage.
(e) (a) and (b).
Answer: (d)
16. Futures contracts differ from forward contracts since

(a) futures mature on specific dates, the third Wednesday of March, June, September, and December.
(b) forward contracts do not require a deposit.
(c) futures contracts are marked to market daily.
Answer: (d)
17. A currency trader purchased an option to buy Canadian dollars at 0.74 US dollars. The current US
dollar/Canadian dollar exchange rate is approximately 0.725. The option expires in six months.
The trader should
(a) exercise the option immediately.
(b) allow the option to expire.
(c) wait and exercise the option if the US dollar appreciates.
(d) wait and see how much the US dollar depreciates.
Answer: (d)
18. The term securitization refers to

(a) increased trading of international securities.
(b) the trend towards more secure assets.
(c) the decline in the use of financial intermediaries.
(d) Federal Reserve actions to stabilize international financial markets.
(e) issuing of securities by developing countries.
Answer: (c)
19. The debt-neutrality proposition, or Ricardian equivalence, states that

(a) changes in the government deficit have no effect on the economy since lower taxes and higher
government borrowing lead individuals to save now for higher taxes in the future.
(b) capital inflows should be restricted by the country of origin and hence be neutral to the type
of capital.
(c) the effect of debt is the same whether debt is denominated in the domestic currency or in dollars
on the Euromarket.
(d) borrowing to finance futures and forward contracts leads to the same risk exposure.
Answer: (a)
20. Currently, the leading international currency is the

(a) euro
(b) Japanese yen
(c) US dollar
(d) British pound sterling
(e) there is no one leading international currency anymore
Answer: (c)
Chapter 22
The Mundell-Fleming Model with Partial
International Capital Mobility
22.1 The Model
The Balance of Payments Relationship
22.2 Fiscal Policy and the Degree of Capital Mobility Under Fixed Rates
22.3 Monetary Policy and the Degree of Capital Mobility Under Fixed Rates
22.4 When Money Flows are Not Sterilized

Monetary Expansion and the Capital Account Offset
Fiscal Expansion and Capital Mobility
Are Capital Flows and Money Flows the Same Thing?
22.5 Other Automatic Mechanisms of Adjustment
22.6 The Pursuit of Internal and External Balance

Difficulties of Policy-Making
22.7 Summary
Appendix: Zones of Internal and External Balance

Combinations of Monetary and Fiscal Policy
The Assignment Problem
Chapter Summary
Chapter 21 illustrated the trend towards increased international capital mobility in the last 20 years.
Chapter 22 adds these capital flows to the open economy IS-LM model developed in chapter 18. The main
difference is that the balance of payments is no longer equal to the trade balance, as there are international
capital flows. The effects of changes in monetary and fiscal policy are examined in this framework.
Several basic assumptions are maintained throughout this chapter, among them the Keynesian assumption
of fixed prices, and the assumption of fixed exchange rates (which is relaxed in Chapter 27).
The basic motivation for international capital flows is assumed to be differences in rates of return across
countries. The degree to which capital responds is assumed to be an exogenous parameter of the model.
Much of the analysis in this chapter maintains the assumption that capital flows are not perfect, and thus
some capital remains in the low interest rate country. The IS and LM curves are the same as those in
chapter 18. The TB curve of chapter 18 is replaced by an upward sloping BP curve, reflecting the fact that
as income increases, interest rates must also increase to maintain a zero balance of payments. As income
increases, imports will increase, leading to a worsened trade balance. This can be balanced in the balance
of payments by higher interest rates, which will create a larger capital account. The slope of the balance
of payments line is then a decreasing function of the responsiveness of capital to interest rates, a flatter line
means that a smaller interest rate change can offset a given income change. Note that equilibrium output
and interest rates are determined by the goods and money markets, and not by a zero balance of payments.
A fiscal expansion will have offsetting effects on the balance of payments. Higher income will increase
imports and higher interest rates will attract capital. In contrast to chapter 18, where fiscal expansion
always led to a balance of payments deficit, the addition of capital flows makes the result ambiguous. The
relative slopes of the LM and BP curves determine whether the expansion leads to a balance of payments
surplus or deficit. Note that even with a small degree of capital mobility, the balance of payments deficit
created is less than in the case with no capital mobility. Therefore, there is one unambiguous result worth
stressing from this section in that the addition of capital mobility to the open-economy Keynesian model
results in a smaller balance of payments deficit as a result of a fiscal expansion.
Section 22.3 examines the effects of a monetary expansion when international capital flows are permitted.
The unambiguous result here is that the addition of capital outflows exaggerates the effect of monetary
expansion upon the trade balance. This occurs because the expansion lowers equilibrium interest rates,
creating a capital outflow. Note that this outflow cannot continue indefinitely, as the country will run out
of international reserves if the central bank chooses not to sterilize reserve flows. Monetary expansion may
then be followed by devaluation or depreciation of the exchange rate. In the long run, monetary policy
cannot create changes in real variables, a result that remains the same as in earlier analysis.
The long-run effects of fiscal policy are sensitive to assumptions about international capital mobility.
In the long run, the money supply will adjust such that there will be zero balance of payments. Therefore,
long-run equilibrium will occur at the intersection of all of the IS-LM-BP curves. There will then be no
long-run effects on the balance of payments. However, to the extent that the BP curve slopes upwards,
there will be a long-run increase in income. This results from the increased quantity of capital in the
economy, which exactly offsets the increased level of imports.
The final section of the chapter examines the question of whether both internal and external balance can
be attained simultaneously using both monetary and fiscal policy. The analysis here proceeds in much the
same manner as chapter 18. The general result here is that both internal and external balance can be
attained if both policy instruments can be used simultaneously, and if capital is internationally mobile.
Therefore, the addition of internationally mobile capital means that exchange rate policy is no longer
required to attain internal and external balance simultaneously. Some of the problems of implementing
these policies, as well as more in-depth coverage of the topic, are covered in the appendix.

with international capital flows, fiscal expansion can lead to a short-run balance of payments surplus
the addition of capital flows magnifies the effect of monetary expansion on the balance of payments
in the short-run
fiscal policy will lead to long-run effects on real income with internationally mobile capital
it may be possible to use a combination of monetary and fiscal policy to achieve internal and external
balance simultaneously
Chapter 22 The Mundell-Fleming Model with Partial International Capital Mobility 157

1. A country that has a deficit and unemployment is in quadrant I of figure 22.5. The appropriate
combination of policies is then expansionary fiscal policy accompanied by contractionary monetary
policy.
2. Equilibrium output is given by Y [A X M bM/hP]/[s m bK/h].

The slope of the YY line is then {1/[s m bK/h]}/{(b/h)/[s m bK/h]} h/b.
The slope of the BB line is then
{m/[s m bK/h]}/{[(mb/h)/(s m bK/h)] K/h}
{1/[s m bK/h]}/{[(b/h)/(s m
bK/h)] K/mh}.
The ratio of the two slopes is given by
{(b/h)/[s m bK/h]}/{{(b/h)/[s m bK/h]} K/mh} Since K, m and h are all positive, this ratio
is greater than one.

1. International capital flows result primarily from
(a) interest rate differentials across countries.
(b) income differentials across countries.
(c) the desire to avoid portfolio risk.
(d) technology differences across countries.
(e) differences in capital stocks across countries.
Answer: (a)
2. If there are no international capital flows, interest rates are determined by

(a) the supply and demand for money.
(b) savings only.
(c) investment demand only.
(d) the supply and demand for final goods.
(e) the supply and demand for bonds versus money.
Answer: (e)
3. Investors would be willing to hold assets in a low interest country as a result of

(a) risk aversion.
(b) high transactions costs in asset trading.
(c) information costs.
(d) capital controls.
Answer: (e)
4. An increase in income will lead to

(a) decreased exports and increased imports.
(b) increased exports and increased imports.
(c) increased exports and decreased imports.
(d) decreased exports and decreased imports.
(e) increased imports and no change in exports.
Answer: (e)
5. The balance of payments will necessarily increase when

(a) the trade balance increases.
(b) interest rates decrease and income decreases.
(c) interest rates increase and income decreases.
(d) there is a large capital inflow.
(e) the marginal propensity to import falls by 50 percent.
Answer: (c)
6. An increase in the exchange rate leads to an increase in exports of $100 million. The marginal
propensity to import is 0.2. This will shift the BP curve
(a) right by $20 million.
(b) left by $500 million.
(c) left by $20 million.
(d) left by $100 million.
(e) right by $100 million.
Answer: (e)
7. Along the BP schedule, higher income leads to

(a) a trade deficit, a higher interest rate and a capital inflow which leaves the overall balance of
payments below zero.
(b) a trade deficit, a higher interest rate and a capital inflow which leaves the overall balance of
payments at zero.
(c) a trade surplus, a higher interest rate and a capital inflow which leaves the overall balance of
payments above zero.
(d) a trade surplus, a lower interest rate and a capital outflow which leaves the overall balance of
payments at zero.
Answer: (b)
8. In the Keynesian model with international capital flows, in the short-run, a fiscal expansion will lead to
(a) increased income, higher interest rates and a balance of payments deficit.
(b) increased income, higher interest rates and a balance of payments surplus.
(c) increased income, higher interest rates and an ambiguous effect on the balance of payments.
(d) increased income, lower interest rates and an ambiguous effect on the balance of payments.
(e) decreased income, higher interest rates and an ambiguous effect on the balance of payments.
Answer: (c)
9. What role does the degree of capital mobility play in the short-run effects of a monetary expansion
under fixed exchange rates?
(a) When capital is less mobile, the interest rate falls less and income increases more.
(b) When capital is more mobile, the interest rate falls less and income increases more.
(c) When capital is less mobile, reserves flow out of the country faster and the balance of payments
deteriorates more.
(d) When capital is more mobile, reserves flow out of the country faster and the balance of payments
deteriorates more.
(e) The effects are roughly the same for all degrees of capital mobility.
Answer: (d)
10. In the Keynesian model with international capital flows, in the long run, a fiscal expansion will lead to
(a) increased income, lower interest rates and no change in the balance of payments.
(b) increased income, lower interest rates and a balance of payments surplus.
(c) increased income, higher interest rates and no change in the balance of payments.
(d) increased income, lower interest rates and an ambiguous effect on the balance of payments if the
central bank does not sterilize reserve flows.
(e) decreased income, higher interest rates and no change in the balance of payments.
Answer: (c)
11. Liberalization of financial markets can be represented as

(a) a steepening of the BP curve.
(b) an increase in the marginal propensity to import.
(c) a rightward shift of the BP curve.
(d) increased sensitivity of capital to interest rate differentials.
(e) a lessening of international interest rate differentials.
Answer: (d)
12. A country is running a persistent balance of payments deficit and has a low level of international
reserves. The country would then possibly
(a) begin to sterilize reserve flows.
(b) devalue its currency.
(c) undertake a monetary contraction.
Answer: (d)
13. An increase in the sensitivity of capital flows to interest rate differentials is likely to result in
(a) a larger balance of payments deficit following a fiscal expansion.
(b) small losses in reserves following a monetary expansion.
(c) a higher speed of capital account offset following a monetary expansion.
(d) a higher long-run increase in income following a fiscal expansion.
Answer: (c)
14. In the case of high capital mobility and non-sterilization, a fiscal expansion results in the short-run in
(a) a trade deficit and a balance of payments surplus.
(b) a trade deficit and a balance of payments deficit.
(c) a trade surplus and a balance of payments deficit.
(d) a trade surplus and a balance of payments surplus.
(e) The results cannot be predicted without more information.
Answer: (a)
15. A country has a balance of payments surplus and excess demand for goods. This country may be
characterized by
(a) persistent devaluation.
(b) high unemployment.
(c) inflation.
(d) accumulation of foreign bonds by the public.
Answer: (c)
16. A country has a balance of payments deficit and unemployment. In order to achieve both internal and
external balance this country should undertake
(a) expansionary fiscal policy and expansionary monetary policy.
(b) contractionary fiscal policy and expansionary monetary policy.
(c) contractionary fiscal policy and contractionary monetary policy.
(d) expansionary fiscal policy and contractionary monetary policy.
(e) devaluation.
Answer: (d)
17. A country has a balance of payments surplus and unemployment. In order to achieve both internal
and external balance, this country definitely does not need
(a) increased government spending and lower interest rates.
(b) increased government spending and higher interest rates.
(c) decreased government spending and lower interest rates.
(d) decreased government spending and higher interest rates.
Answer: (d)
18. Monetary and fiscal policy can be used to achieve internal and external balance simultaneously only if
(b) exchange rates are fixed.
(c) the trade balance differs from the balance of payments.
(d) there is a capital account deficit.
(e) reserve flows are sterilized.
Answer: (c)
19. Under fixed exchange rates, a decrease in government spending leads to a trade surplus. What must
happen to the interest rate to maintain an overall balance of payments equilibrium?
(a) It must be raised to induce a capital outflow.
(b) It must be raised to induce a capital inflow.
(c) It must be lowered to induce a capital outflow.
(d) It must be lowered to induce a capital inflow.
(e) The interest rate cannot be changed to maintain an overall balance of payments equilibrium.
Answer: (c)
20. Which of the following challenges do policy makers face when implementing policies?
(a) political obstacles to policy changes.
(b) uncertainty about the position of economy, the correct model of the economy, and future shocks.
(c) public expectations.
(d) time lags between the time policy is implemented and when the economy responds.
Answer: (e)
Chapter 23
Fiscal and Monetary Policy Under
Modern Financial Market Conditions
23.1 Fiscal Policy Under Floating: An Effect Mitigated by Capital Mobility
Effects of U.S. Budget Deficits in Recent Decades
23.2 Monetary Policy Under Floating: An Effect Enhanced by Capital Mobility

Three Examples of Powerful Monetary Contractions
23.3 Policy Under Perfect Capital Mobility

Fixed Exchange Rates and Perfect Capital Mobility
The Impossible Trinity, and the Example of European Monetary Integration
Floating Exchange Rates and Perfect Capital Mobility
23.4 Summary
Chapter Summary
Chapter 23 expands upon previous chapters by considering the effects of monetary and fiscal policy with
international capital flows and perfectly flexible exchange rates. The assumption about exchange rates
assures that the balance of payments will be zero at all points in time. However, the analysis becomes
more interesting since there will be greater effects on income than in the fixed rate case. In addition, the
presence of capital flows means that although the balance of payments may be zero, there will be effects
on the trade balance. Note that the assumptions of flexible exchange rates and internationally mobile
capital represent two of the dominant empirical trends in the world economy over the last 20 years.
Fiscal and monetary policy changes can be easily analyzed using the same framework as in the previous
chapter. The initial effects on the IS and LM curves do not differ from those examined previously. The
additional point of interest is now that the exchange rate will adjust to maintain a zero balance of
payments. In the case of a balance of payments deficit, there will be a depreciation, and an appreciation
will result from a surplus. These exchange rate movements will have effects on income in addition to the
initial effects of the policy. The exchange rate effects can then be introduced as secondary effects of the
policies examined in the previous chapter. Figure 23.1 examines the net effects of fiscal expansion and
Figure 23.3 examines monetary expansion. A point to note is that as the degree of capital mobility
increases in the fiscal expansion case, the size of the subsequent depreciation declines, whereas in the
monetary expansion, the size of depreciation that results is an increasing function of capital mobility. This
is a direct result of the relative sizes of the trade deficits that are crated in each of the cases. As capital
mobility increases, the effect on income of a fiscal expansion will tend to be reversed, whereas they will
be magnified in the case of a monetary expansion. A result that does not depend on the degree of capital
mobility is that both fiscal and monetary expansion increase income, and only the degree of income
increase is sensitive to assumptions about capital mobility. Also note that policies that create capital
Chapter 23 Fiscal and Monetary Policy Under Modern Financial Market Conditions 163
inflows will create trade deficits. Therefore, although this analysis may be relatively uninteresting along
the dimension of the balance of payments, there will be effects on the balance of trade. Fiscal expansions
and monetary contractions therefore create trade deficits, as both will raise interest rates, creating capital
inflows.
The situation of a fiscal expansion can be compared with the increases in government spending that
occurred in the 1980s in the US. The results of that spending increase correspond to a large degree with
the predictions of the model. An alternative approach for discussing the effects of fiscal expansion under
flexible exchange rates and international capital flows is to use the national saving identity. It can then
be seen that fiscal expansion increases interest rates, crowding out investment, and raises exchange rates,
crowding out net exports. Figure 23.2 illustrates the relationship between national savings, investment and
the current account using data from 19612003. The effects of monetary policy changes can be examined
in practice by looking at the US in the late 1970s and Great Britain in the early 1980s.
Section 23.3 examines policy changes in the extreme case that capital is perfectly mobile across countries.
This has two main purposes. First, it is not a large departure from reality, and second, it provides an extreme to
the effects of policy, as no capital mobility provides the other extreme. In this case, the BP curve will be
drawn as flat, as in Figure 23.4. An immediate result of this assumption is that all interest rate differentials
across countries will be eliminated. Under fixed exchange rates, fiscal policy will have its greatest effect on
income, whereas monetary policy will be ineffective. Under floating rates, this conclusion will be reversed.
Note, however, that in the cases where there is no change in income as result of the policy, there are changes
in the exchange rate and the trade balance. An important point to consider is that although the degree of capital
mobility is very high, the case presented here is extreme. It has been shown that both monetary and fiscal
policy have effects on income under both fixed and floating exchange rates.
An application of the analysis relating to perfect capital mobility, policy and fixed exchange rates is that
a country cannot have fixed exchange rates, financial openness and monetary independence. If the first
two of these are achieved, then monetary policy has no effect on income. The experience of European
countries and the process that led to the formation of the European Union is an example that can be used
to discuss this fact.

policy changes under flexible exchange rates will create exchange rate movements that will have
additional effects on interest rates and income
under floating rates, the degree of effectiveness of fiscal policy at changing income declines as the
degree of capital mobility increases, whereas the opposite is true for monetary policy
although flexible exchange rates ensure that policy cannot affect the balance of payments, with
international capital mobility there will be effects on the trade balance
1. The increase in government spending will create a capital inflow. This will increase domestic income,
the capital inflow will benefit construction workers, and the increased spending on health care will
benefit hospital workers. With low capital mobility, there will be a depreciation of the currency, and
thus an increase in net exports. The domestic wineries are hurt as imports have increased as a result
of the increase in income. Steel workers benefit as there will be an increase in exported steel larger
than the increase in imports. If capital is highly mobile, then there will be appreciation of the
currency. Net exports will decline, and both wineries and steel workers will be hurt.
2. 1. (a) There is no leakage from imports in (a), whereas there is in (b).

2. (c) This economy has the same multiplier as the closed-economy, which is greater than that in
the open-economy.
3. (b) There will be crowding out of investment in (d) that is not present in the open-economy
model.
4. (d) With non-sterilization (model (e)), the money supply falls, causing the LM curve to shift
downwards and a fall in income.
5. (f) Floating rates will result in depreciation and a shift upwards in the IS curve, and an increase
in income as a result.
6. (g) Low capital mobility implies that the depreciation will be smaller than in (f), but it will still
be larger than in (d).
7. (f) High capital mobility dampens the effects of the initial expansion as there will only be a
small depreciation of the exchange rate, and there may in fact be an appreciation of the
exchange rate, which would lead to a secondary income loss.
8. (d) High capital mobility will lead to appreciation, and thus a secondary effect on income
resulting in a decline relative to (d).
9. (h) Model (I) will have no effect on income.
10. (j) Model (j) is that where fiscal policy has its largest effect on income.
11. (j) This will have a larger effect than (b) as there will be a reserve inflow, shifting the LM
curve outwards and raising income. (This is the movement from A to B in Figure 23.3.)
3. If you remove the reserve controls, there will be perfect capital mobility. If the foreign interest rate
is higher than the domestic, then the removal of capital controls will cause capital to flow to the
foreign country until the interest rates are equalized. This capital outflow will be accompanied by a
trade surplus, and a depreciation of the domestic currency, there will then be an increase in domestic
income.
4. Fiscal expansion causes currency appreciation if the BP curve is flatter than the LM curve. The slope
of the BP curve is m/K and the slope of the LM curve is K/h. Therefore, the condition that must be
satisfied is
k > (mh)/K

1. Floating exchange rates adjust such that
(a) the capital account balance is zero.
(b) trade is balanced.
(c) the balance of payments is zero.
(d) excess demand for foreign exchange leads to appreciation.
(e) both (c) and (d).
Answer: (c)
2. If a country is running a balance of payments deficit,

(a) the central bank is losing reserves.
(b) it is the result of a devaluation.
(c) trade is balanced.
(d) there must be a capital outflow.
(e) the central bank will eventually have to increase the money supply.
Answer: (a)
3. Under floating exchange rates, a balance of payments surplus will lead to

(a) gradual appreciation.
(b) gradual depreciation.
(c) instantaneous appreciation.
(d) instantaneous depreciation.
(e) a trade deficit.
Answer: (d)
4. A country has flexible exchange rates, a balance of payments of zero, and high interest rates.
They will most likely then have
(a) balanced trade.
(b) a negative capital account balance.
(c) a lack of international reserves.
(d) negative net exports.
Answer: (d)
5. A country has floating exchange rates. Fiscal expansion will then lead to
(a) increased income, depreciation and a trade deficit.
(b) increased income, appreciation and a trade surplus.
(c) increased income, appreciation and a trade deficit
(d) increased income, depreciation and a trade surplus.
(e) increased income and an ambiguous effect on the currency and trade balance.
Answer: (e)
6. The results of a fiscal expansion with ______________ differ under floating and fixed exchange rate
regimes because _______________.
(a) high capital mobility; floating rates allow an appreciation which discourages net exports and
leads income to increase less than it would under fixed exchange rates.
(b) zero or low capital mobility; floating rates allow a depreciation to stimulate net exports which
allows income to increase more than under fixed exchange rates.
(c) high capital mobility; floating rates allow a depreciation which encourages net exports and leads
income to increase more than it would under fixed exchange rates.
(d) zero or low capital mobility; floating rates allow an appreciation to stimulate net exports which
leads income to increase less than it would under fixed exchange rates.
(e) (a) and (b).
Answer: (e)
7. How does increasing the mobility of capital change the effectiveness of fiscal policy under fixed and
floating exchange rate regimes?
(a) It increases the effectiveness of fiscal policy under both exchange rate regimes.
(b) It decreases the effectiveness of fiscal policy under both exchange rate regimes.
(c) Under fixed exchange rates, more capital mobility leads to less effective fiscal policy. Under
floating exchange rates, more capital mobility leads to more effective fiscal policy.
(d) Under fixed exchange rates, more capital mobility leads to more effective fiscal policy. Under
floating exchange rates, more capital mobility leads to less effective fiscal policy.
(e) The effect is ambiguous.
Answer: (d)
8. Under floating exchange rates, a monetary contraction will raise interest rates and
(a) increase income.
(b) lead to a trade surplus and an appreciation.
(c) will have its effects enhanced by increasing the degree of capital mobility.
(d) must lead to capital outflows.
(e) (a)(c).
Answer: (e)
9. With floating exchange rates, a higher degree of international capital mobility implies
(a) money comes into the country faster following fiscal expansion to augment the expansion
in income.
(b) there will be large appreciations following monetary expansion.
(c) fiscal expansion may lead to a balance of payments surplus.
(d) the exchange rate will adjust to, discourage net exports following a fiscal contraction.
Answer: (d)
10. With perfect capital mobility, the BP schedule is

(a) flat (horizontal).
(b) vertical.
(c) upward sloping.
(d) downward sloping.
(e) can have parts that are upward sloping and parts that are downward sloping.
Answer: (a)
11. Following a fiscal expansion, an economy with flexible exchange rates imposes capital controls in
order to prevent capital inflows and a trade deficit. This will also
(a) lower investment.
(b) aid producers that rely on foreign consumers.
(c) keep interest rates high.
(d) hurt producers in interest rate sensitive industries.
Answer: (e)
12. As the degree of international capital mobility is increased

(a) monetary policy becomes less effective under floating exchange rates.
(b) larger currency depreciations follow monetary contraction.
(c) a larger fraction of the stimulus from monetary expansion comes from net exports than domestic
demand.
(d) monetary contractions can lead to capital outflows.
Answer: (c)
13. The marginal propensity to import in an economy is 0.3. The responsiveness of capital to
international interest rate differentials is k 0.6. The marginal propensity to save is 0.1. The slope
of the BP curve is then
(a) 2.
(b) 3.
(c) 0.3.
(d) 0.5
(e) 0.67.
Answer: (d)
14. With fixed exchange rates and perfect capital mobility, fiscal expansion will lead to
(a) no change in output.
(b) a reduction in the money supply.
(c) a change in the domestic interest rate.
(d) the central bank being forced to abandon either its exchange rate policy or its monetary policy.
(e) a large capital outflow.
Answer: (d)
15. With fixed exchange rates and perfect capital mobility, monetary expansion will lead to
(a) no change in output.
(b) increased domestic credit and reduced international reserves.
(c) a large capital outflow.
(d) the central bank being forced to abandon either its exchange rate policy or its monetary policy.
Answer: (e)
16. The impossible trinity refers to the three policies which a country cannot adopt together. They are
(a) financial openness, free trade and fixed exchange rates.
(b) financial openness, monetary independence and fixed exchange rates.
(c) free trade, floating exchange rates and financial openness.
(d) fiscal independence, financial openness and floating exchange rates.
Answer: (b)
17. Starting from a situation of zero trade balance, in an economy with flexible exchange rates and
perfect capital mobility, fiscal expansion results in
(a) increased income, depreciation and balanced trade.
(b) no change in income, depreciation and balanced trade.
(c) no change in income, appreciation and balanced trade.
(d) no change in income, appreciation and a trade deficit.
(e) no change in income, appreciation and a trade surplus.
Answer: (d)
18. Starting from a situation of zero trade balance, in an economy with flexible exchange rates and
perfect capital mobility, monetary contraction results in
(a) increased income, appreciation and balanced trade.
(b) increased income, depreciation and balanced trade.
(c) decreased income, appreciation and balanced trade.
(d) decreased income, appreciation and a trade deficit.
(e) decreased income, appreciation and a trade surplus.
Answer: (d)
19. Under which of the following conditions will monetary policy be the most effective at stimulating
income?
(a) flexible exchange rates and perfect capital mobility.
(b) flexible exchange rates and no capital mobility.
(c) fixed exchange rates and no capital mobility.
(d) fixed exchange rates and perfect capital mobility.
(e) both (a) and (c).
Answer: (a)
20. Under flexible exchange rates and perfect capital mobility, personal income taxes are cut by $100
million dollars. This will lead to
(a) an increase in income of $100 million, no change in investment, and no change in the trade
balance.
(b) no change in income, a decrease in investment and a trade deficit.
(c) no change in income, a decrease in investment of $100 million and no change in the trade
balance.
(d) no change in income, no change in investment and a fall in net exports of $100 million.
(e) no change in income, an increase in investment and a fall in net exports of more than $100
million.
Answer: (d)
Chapter 24
Crises in Emerging Markets
24.1 Inflows to Emerging Markets -Origins
Management of Capital Inflows
The Case of Chinas Balance-of-Payments Surplus
Warning Indicators and the Composition of Capital Inflows
24.2 Managing Outflows
24.3 Speculative Attacks

First Generation: Overly Expansionary Macroeconomic Policy
Second Generation: Multiple Equilibria
Third Generation: Crony Capitalism and Moral Hazard
24.4 Contagion
24.5 IMF Country Programs

Filling the Financing Gap
Policy Conditionality
24.6 Contractionary Effects of Devaluation

Negative Effects on Aggregate Demand
Negative Effects on Aggregate Supply
24.7 Capital Controls

Review of Arguments on Efficiency of Financial Markets
Four Possible Aims of Controls
The Highway Analogy
24.8 Reform of the International Financial Architecture
24.9 Summary
Chapter Summary
Chapter 24 explores the causes and responses to currency crises including factors leading to substantial
capital inflows to developing countries; reasons for speculative attacks; the role of the IMF in providing
financial assistance while requiring economic reform and currency devaluation; short-term contractionary
effects due to devaluation; and proposals for reform of the international financial architecture.
Section 24.1 examines the causes of capital inflows, which can be characterized as internal or external.
Internal reasons for capital inflows include monetary stabilization, a spending boom and capital account
liberalization. External reasons include low rates of return in industrialized economies, the Brady Plan,
financial innovations, and moral hazard. Substantial inflows of capital require nations to manage these
inflows by either allowing the inflow of money; sterilizing the inflow; allowing the currency to appreciate;
or imposing capital controls. Those concerned about the stability of inflows should pay attention to
warning indicators and the composition of the inflows distinguishing long-term inflows from more
volatile, short-term inflows.
Section 24.2 considers possible responses to capital outflows. Governments can allow the outflow
of money, sterilize the outflow, allow the currency to depreciate, or reimpose controls on outflows.
In section 24.3, alternative explanations for speculative attacks are presented. First, overly expansionary
macroeconomic policy may result in a current account deficit and loss of reserves. Second, game theoretic
models, resulting in multiple equilibria, are applied to a variety of situations. Third, models of crony
capitalism and moral hazard have been developed as a result of the Asian financial crisis.
The issue of contagion is examined in section 24.4. Contagion is distinguished from situations where
different economies are affected by common shocks. Instead, contagion is when an economy that suffers
a significant devaluation impacts other economies with which it competes. Other economies are affected,
as their exports are now relatively more expensive, resulting in current account and currency problems. In
addition, lenders may change their perception of what are considered to be comparable economies and
thus reduce their willingness to lend to them.
The role of international lending agencies, particularly the IMF, is explored in section 24.5. Causes of the
currency crisis are distinguished between liquidity -a short-term problem, as opposed to solvency, a long-
term problem. In most cases, the problem is a combination of the two, necessitating financial assistance
coupled with requirements for structural reform. This approach, commonly referred to as policy
conditionality, requires nations seeking assistance to engage in some form of macroeconomic reform along
with devaluing of their currency in order to curtail their current account deficit. Critics question whether
this type of policy is always the most appropriate. For example, many of the nations caught up in the Asian
financial crisis did not appear to have overly expansionary macroeconomic policies prior to the crisis and
thus would not seem to have needed to tighten those policies. Other criticisms include questions regarding
national sovereignty and mission creep, where the IMF may push for specific policy changes not normally
associated with their primary mission. Since tight monetary policy tends to result in severe recessions,
some have suggested a looser monetary policy coupled with steeper devaluation.
Whereas simple economic models suggest that currency devaluations result in economic expansion by
encouraging exports, section 24.6 discusses several reasons why this may not be the case. Significant
declines in a value of a currency can have a negative impact on both aggregate demand and aggregate supply.
Six reasons are cited as to how a devaluation can reduce aggregate demand. The higher cost of imports
results in a higher trade deficit initially unless the elasticity of demand for imports is quite high. Higher
prices may cause contractionary effects by reducing the real money supply and real wages. Also, an increase
in the foreign debt burden is likely since the debt is likely to be held in terms of foreign currency
and it takes more domestic currency to equal the same amount of foreign currency. Speculative buying of
durable goods in anticipation of the devaluation can also exasperate the contractionary effect. People will buy
imported durable goods in anticipation of the price increase and then curtail purchases once the devaluation
takes place. Finally, since most tariffs are based on the domestic value of imports, as the cost of imports
increases, the effective tariff also increases, having a similar impact as a tax increase.
Chapter 24 Crises in Emerging Markets 171
Negative effects on aggregate supply are also possible for several reasons, the first two as a consequence
of increases in the cost of production. Many developing nations import essential inputs, such as oil.
Devaluation causes these inputs to become more expensive. Also, nominal wages are likely to increase
in response to rising prices, particularly in nations that index wages to inflation. It is also possible that
working capital, short-term funds used to carry inventories, pay workers, etc., may become more
expensive as interest rates rise. A study by Sebastian Edwards suggests that the contractionary effects tend
to dominate in the first year following a devaluation while expansionary effects become more prominent
over time. In the long run, devaluation tends to have no real effect.
Section 24.7 considers the role of capital controls. Benefits of financial integration are reviewed: cheaper
funds available from global sources, improved efficiency due to foreign competition, the willingness of
foreigners to invest domestically due to higher potential returns, and diversification. Recent crises point
to potential problems such as sudden financial outflows in response to little apparent news, contagions
affecting nations that seem to have relatively strong economic fundamentals, and severe recessions as a
result of the crisis. Capital controls have been suggested to achieve a variety of aims: to discourage capital
outflows in the event of a balance of payments crisis; to discourage capital inflows so as to limit currency
appreciation and the accumulation of foreign debt; to modify the composition of inflows in order to
discourage short-term inflows that prove to be more volatile; and to decouple domestic from foreign
interest rates thus gaining some independence for monetary policy. International financial integration helps
countries finance investment and thus promote economic growth, but the speed of integration may need to
be considered along with the ability of the domestic economy to more fully achieve these benefits.
A proper balance and sequence of domestic reform and opening to the outside world can enhance the
positive effect of financial liberalization.
Section 24.8 reviews reforms of the international financial architecture that have been suggested in order to
minimize the likelihood of future crises. Increased transparency, by firms, governments, and international
institutions, would allow for increased accountability by making information publicly available.
Strengthening of financial institutions would reduce their vulnerability to crises. Private sector involvement
in the form of bailing in foreign investors, as opposed to bailing them out, would reduce the potential for
moral hazard. Investors must share part of the loss due to the crisis in order to properly assess risks of future
investment decisions. Reform of the IMF and World Bank has also been suggested, restoring their missions
to their core competenciesthe IMF focusing on short-term balance of payments problems and the World
Bank dealing with long-term economic development and poverty reduction. Others have suggested the
forgiveness of loans for Highly Indebted Poor Countries that satisfy certain criteria.
Key concept introduced in this chapter include:

internal and external causes of heavy capital inflows followed by problems associated with balance
of payments deficits
explanations for speculative attacks
IMF policy conditionality in return for financial assistance for countries facing financial crises
devaluations initially having a contractionary effect by reducing aggregate demand and aggregate
supply prior to their intended expansionary effects
potential reforms of the international financial architecture

1. (a) Y (1/(1 m))(A(i) xE)
(b) TB xE/(1 m) mA(i)/(1 m)
(c)
The graph should have i on the horizontal axis and E on the vertical. Rearranging the equation in
(a) results in:
E (1/x)((1 m)Y A(i))
dE/di (1/x)(A/i); Since A/i < 0, dE/di > 0

Intuitively, the reduced absorption due to higher interest rates must be offset by a stimulative
effect of a higher exchange rate in order to maintain output at its potential.
(d)
Rearranging the equation in (b) results in

E (1 m)TB/x mA(i)/x
dE/di (m/x)(A/i); Since A/i <0, dE/di < 0
Intuitively, since BP 0 and KA is constant, any reduction in imports (due to the reduction in
absorption) must be accompanied by an equal reduction in exports. This reduction in exports
would result from an appreciation of the exchange rate.
(e)
A decrease in KA will result in an increase in TB if BP 0. Thus, the BP curve derived in (d)

should shift up and to the right. Both i and E should rise to preserve external balance while not
causing a recession (new intersection of curves derived in (c) and (d)).
(f) Critics think interest rates were raised too high in that they significantly reduced domestic
absorption in such a way that resulted in a recession. They would recommend a larger
devaluation that would have resulted in an increase in the trade balance (now necessary since
foreign funding had been cut off) while avoiding a domestic recession.
2. (a)
Modifying the result found in (1c) to reflect A(i, E) results in

E (1/x)((1 m)Y A(i, E))
dE/di (1/x)(A/i (A/E)(dE/di)); Rearranging and solving for dE/di yields:
dE/di (A/i)/(x A/E))
Since A/i < 0, A/E < 0 and assuming that x is small such that the magnitude of A/E > x,
dE/di < 0
The intuition is that since a devaluation reduces domestic demand, to offset the contractionary
effect of a higher interest rate, the exchange rate must appreciate in value.
(b) The model suggests that more devaluation would have failed to restore external balance without
causing a recession. The alternative is that more resources would need to be made available to the
countries in crisis, but its unclear who would provide those resources (IMF? the creditors?).

1. Internal reasons for capital inflows into developing countries include all of the following except
(a) capital account liberalization.
(b) monetary stabilization.
(c) low rates of return in industrialized countries.
(d) spending booms.
(e) all of the above are internal reasons for capital inflows.
Answer: (c)
2. External reasons for capital inflows into developing countries include all of the following except
(a) the Brady Plan.
(b) capital account liberalization.
(c) financial innovations.
(d) low rates of return in industrialized countries.
(e) all of the above are external reasons for capital inflows.
Answer: (b)
3. Governments can respond to capital outflows by all of the following except

(a) sterilize the outflow.
(b) allow the currency to appreciate.
(c) allow the outflow of money.
(d) reimpose controls on outflows.
(e) all of the above are possible government responses.
Answer: (b)
4. All of the following are mentioned as possible explanations for speculative attacks except
(a) multiple equilibria in international financial markets.
(b) crony capitalism.
(c) substantial current account surpluses.
(d) overly expansionary macroeconomic policies.
(e) all of the above are possible explanation for speculative attacks.
Answer: (c)
5. Contagion can best be described as

(a) an economy that experiences a currency crisis impacting other economies with which
it competes.
(b) nations affected by a common economic shock.
(c) similar economies experiencing common business cycles.
(d) an economic disease, like a virus, that spreads rapidly to other nations.
(e) how a currency crisis can hurt the rest of an economy.
Answer: (a)
6. A short-term financing problem for an economy is commonly referred to as problem of

(a) solvency.
(b) contagion.
(c) policy conditionality.
(d) sterilization.
(e) liquidity.
Answer: (e)
7. Policy conditionality refers to

(a) governments implementing different macroeconomic policies depending on the condition of their
economies.
(b) conditions that nations place on international lending agencies prior to agreeing to receive
financial assistance.
(c) alternative spending plans depending on how much revenue a government collects.
(d) structural and macroeconomic reforms that the IMF requires nations to implement prior
to receiving financial assistance.
(e) how economic conditions change based on what policies are implemented.
Answer: (d)
8. Criticisms of the IMF include all of the following except

(a) balance of payments problems dont cause currency crises.
(b) some IMF policies appear to impose on national sovereignty.
(c) nations that implement IMF policies tend to experience severe recessions.
(d) the IMF may suggest the same remedy without regard to the underlying economic problem
(e) all of the above are criticisms of the IMF.
Answer: (a)
9. A devaluation can reduce aggregate demand for all of the following reasons except
(a) higher prices, due to the devaluation, reduce the real money supply.
(b) a devaluation tends to increase a nations foreign debt burden.
(c) the trade deficit is likely to increase unless the elasticity of imports is quite high.
(d) exports are likely to become more expensive as the currency loses value.
(e) all of the above can reduce aggregate demand.
Answer: (d)
10. A devaluation can reduce aggregate supply for all of the following reasons except
(a) essential imported inputs become more expensive.
(b) real money supply declines as a result of higher prices.
(c) working capital may become more expensive as interest rates rise.
(d) nominal wages are likely to increase due to indexing.
(e) all of the above can reduce aggregate supply.
Answer: (b)
11. Capital controls have been suggested for all of the following reasons except
(a) the benefits from financial integration are quite small.
(b) to modify the composition of capital inflows so as to discourage more volatile, short-term
inflows.
(c) to discourage capital outflows in the case of a balance of payments crisis.
(d) to discourage capital inflows so as to minimize the accumulation of foreign debt.
(e) all of the above are reasons suggested in support of capital controls.
Answer: (a)
12. Domestic economic benefits of financial integration include all of the following except
(a) improved efficiency due to foreign competition.
(b) the availability of cheaper funds from overseas.
(c) the willingness of local citizens to invest globally.
(d) foreigners seeking to invest domestically in order to attain higher returns.
(e) all of the above represent domestic economic benefits of financial integration.
Answer: (c)
13. Increased transparency refers to

(a) the strengthening of financial institutions.
(b) private sector involvement in rescue programs.
(c) restoring the IMF and World Bank to their original missions.
(d) having firms, governments and international institutions make more information publicly
available.
(e) bailing in foreign investors as opposed to bailing them out.
Answer: (d)
14. Reforms to reduce the likelihood of moral hazard include which of the following?
(a) minimum guidelines for funds held by banks.
(b) making more information publicly available.
(c) providing assurance to private investors that they will be protected if their investments suffer.
(d) having private investors incur some of the cost of financial problems resulting from currency
crises.
(e) the elimination of crony capitalism.
Answer: (d)
15. Historically, the primary mission for the IMF has been
(a) poverty reduction.
(b) financing short-term balance of payments problems.
(c) long-term economic development.
(d) lending funds to international agencies.
(e) coordination of the activities of central banks.
Answer: (b)
16. Overly expansive macroeconomic policy can lead to a currency crisis by

(a) rapidly increasing the average standard of living.
(b) producing a high balance of payments surplus.
(c) causing the value of the currency to be artificially low.
(d) resulting in unsustainable capital account deficits.
(e) resulting in unsustainable current account deficits.
Answer: (e)
17. Evidence suggests that a currency devaluation is likely to have a

(a) contractionary economic effect in the short and long run.
(b) expansionary economic effect in the short and long run.
(c) little, if any, effect in the short or long run.
(d) contractionary effect initially followed by an expansionary effect.
(e) expansionary effect initially followed by a contractionary effect.
Answer: (d)
18. Moral hazard problems can take place in international financial markets if
(a) investors think that the risk of their investments is minimized due to the likelihood of being
bailed out in the event of a crisis.
(b) corrupt leaders direct funds to friends who run businesses.
(c) governments spend funds on projects that are not economically feasible.
(d) investors mistakenly invest in places with low rates of returns.
(e) investors fear the risk of investing in developing countries.
Answer: (a)
19. As a result of recent currency crises, most economists have concluded that
(a) nations should consider the balancing and sequencing of domestic reform and opening to the
outside world.
(b) developing countries should reimpose capital controls.
(c) international financial integration is likely to reduce economic growth.
(d) developing countries should implement a system of fixed exchange rates.
(e) governments should play a more active role in the allocation of funds.
Answer: (a)
20. All of the following are considered warning indicators of potential currency problems except
(a) ratio of short-term debt to international reserves.
(b) inflows used to finance consumption as opposed to investment.
(c) substantial amount of short-term as opposed to long-term inflows.
(d) high levels of foreign direct investment compared to bank loans.
(e) all of the above are considered warning indicators.
Answer: (d)
Chapter 25
Interdependence and Policy Coordination
25.1 International Transmission of Disturbances Under Floating Rates
Transmission via Capital Flows
Fiscal Expansion in a Large Country
Monetary Expansion in a Large Country
Transmission via (Non-Trade) Exchange Rate Effects
25.2 Econometric Models of the Interdependent World Economy

The Results for Fiscal Policy
The Results for Monetary Policy
25.3 International Macroeconomic Policy Coordination

The Institutions of International Cooperation
The Theory of Gains from International Policy Coordination
Obstacles to Successful Coordination
25.4 Summary
Chapter Summary
Chapter 25 is concerned with the fact that international capital flows lead to domestic policy changes
having real effects in foreign countries. Two basic topics are considered. First, the case of international
interdependence with capital flows under flexible exchange rates is examined. Second, the issue of
international policy coordination is considered.
The presence of international capital flows imply that under floating exchange rates, a country need not
have a zero trade balance. In addition, a trade deficit in a given country must be balanced by a trade
surplus in the rest of the world. Section 25.1 uses these facts to consider the international effects of
domestic policy changes. Note that the results derived in this section hold for any degree of international
capital flows, not just for the assumption of perfect capital flows that is used here. The results from the
discussion concerning effects involving capital flows can be best illustrated using the fact that interest
rates must be equal across countries in equilibrium. In addition, it is also useful to emphasize that capital
flows and the trade balance for the world as a whole must sum to zero. Therefore, real effects of policy
in the domestic country must be balanced by opposing effects in the rest of the world. The material
concerning effects other than capital flows can be easily summarized by considering that policy will affect
the trade balance and foreign incomes if it leads to changes in aggregate supply or aggregate demand for
goods.
Section 25.2 summarizes some of the empirical studies that have been done in order to try and determine
the international effects of policy. The main results of these are presented in Tables 25.1 and 25.2. The
results concerning fiscal policy are relatively clear. They tend to indicate that capital is very mobile
internationally and that the non-capital flow transmission mechanisms discussed at the end of Section 25.1
are not operating. The monetary policy results are more ambiguous. An interesting feature of these results
to note is that the effects of domestic monetary policy on foreign incomes appears to be relatively small.
In addition, examination of the changes in domestic and foreign interest rates shows that they tend not to
be equalized across countries, suggesting that capital is not perfectly mobile.
Given that both theory and evidence suggest that there are significant domestic real effects of foreign
policy changes, there may be gains from policy coordination. The theory of international policy
coordination is considered in the final section of the chapter. A brief introduction to game theory and the
prisoners dilemma will help students understand much of the theory of international policy
coordination. Alternative games to those considered in Tables 25.3 and 25.4 can also be easily constructed.
This material can also be related to the earlier discussion of coordination of trade policy in that the basic
structure of the games considered is similar. The section concludes with a discussion of the problems
facing the coordination of policy, such as uncertainty about the proper objectives of policy, the specific
effects of changes in policy and where the economies are relative to target levels.
The supplement to chapter 25 explores the locomotive theory of international macroeconomic

coordination to illustrate how nations can cooperate to achieve socially superior outcomes.

the effects of policy changes may be transmitted internationally under flexible exchange rates with
international capital flows
the gains from international policy coordination

1. The reduction in interest rates will result in a capital inflow. In order to keep money demand from
increasing (a reduction in interest rates is a reduction in the opportunity cost of holding money), they
will require a decrease in income. Therefore, the loss in net exports as a result of the appreciation
must exceed the stimulus from lower interest rates.
2. Fiscal expansion and monetary contraction will lead to increases in foreign incomes, and an
appreciation of the domestic currency. A trading partner that is suffering from unemployment is then
likely to be pleased, as there will be an increase in their income. A foreign country suffering from
inflation will then be displeased. A foreign country with a large debt in the domestic currency will
also be displeased, as the value of the debt in their currency will have increased.
3. (a) The sign of D depends on the degree to which capital is internationally mobile. If capital is
highly mobile, then D will be positive. If capital is not very mobile then D will be negative
(an increase in government spending will lead to depreciation). Empirical evidence suggests that
D and C are positive, and F is negative.
(b) Set p = s = O and solve the two equations simultaneously for gm and gR. This should yield
gm = (FB + DA)/(DF DC) and gR = (DA FC)/(DF DC)
Taking the difference between these expressions
gm gR = (F(A + B))/(D(F C)) which is positive. Melanzane then prefers a higher level of
government spending than Rigatoni.
(c) Taking the derivative of the objective function and setting it equal to zero yields the result that
Chapter 25 Interdependence and Policy Coordination 181
gm ={gR (wD2 CF) (AC + wBD)}/{C2+wD2}

This is the reaction function for the Melanzane government. If w and D are low, then a cut in
Rigatoni government spending will be met by an increase in Melanzane government spending.
The cut in Rigatoni spending will result in an income loss in Melanzane. In terms of the welfare
function, the Melanzane government is most concerned about p and a decrease in Rigatoni
spending will decrease p, and therefore the Melanzane government will increase spending
to bring p back to zero. If w and D are high, then the Melanzane government will match all
movements in Rigatoni spending in order to keep was close to zero as possible.
(d)
Point A represents the non-cooperative solution. Both countries could gain by agreeing to raise
their levels of government spending. They do not do so on their own as a result of the fact that
this fiscal expansion will lead to trade deficits. However, if they were to cooperate, they could
obtain higher income levels without the trade balances if they both raised their government
spending. It should be noted that the reaction curves slope upwards as it has been assumed that
w and D are sufficiently high that all spending increases in one country will be matched to some
degree in the other country.

1. The US trades with Canada and Japan in a world with capital flows and flexible exchange rates. If the
US has a trade deficit, then
(a) Canada must have a trade surplus.
(b) Japan cannot have a trade deficit.
(c) Canada cannot have a capital inflow.
(d) Japan must have a trade surplus.
Answer: (e)
2. The US trades with Japan in a world with capital flows and flexible exchange rates. If the US reduces
government spending, then
(a) the yen will appreciate against the dollar.
(b) the Japanese trade balance improves.
(c) both the US and Japanese interest rates may rise.
(d) income in Japan will rise.
Answer: (a)
3. The US increases government spending. The Laursen-Metzler-Harberger effect predicts that
(a) the dollar/mark exchange rate will depreciate.
(b) European savings will increase.
(c) European real incomes will rise.
(d) European wages will increase.
Answer: (b)
4. Econometric models of policy interdependence across countries tend to show that

(a) capital is nearly immobile.
(b) interest rate changes are identical across countries.
(c) monetary policy has large effects upon other countrys output.
(d) appreciation of the US dollar almost always follows US fiscal expansion.
Answer: (d)
5. Coordination of monetary policy can lead to

(a) all countries having trade surpluses.
(b) decreases in income for smaller countries.
(c) gains in income for all countries.
Answer: (c)
6. International policy coordination is most likely to be unsuccessful if

(a) coordination raises inflation.
(b) monitoring of the foreign country is easy.
(c) policy targets are clear.
(d) there are few countries in the agreement.
(e) full employment is a higher priority than low inflation.
Answer: (a)
7. Econometric models of policy interdependence generally show that a monetary expansion

(a) raises the interest rate, stimulates domestic income and depreciates the currency.
(b) raises the interest rate, weakens domestic income and depreciates the currency.
(c) lowers the interest rate, stimulates domestic income and depreciates the currency.
(d) (c), but mixed results on variables such as the trade balance and foreign income.
Answer: (d)
8. A fiscal expansion by the United States results is likely to results in

(a) Europes IS curve shifting to the right.
(b) Europes IS curve shifting to the left.
(c) Europes LM curve shifting to the right.
(d) Europes LM curve shifting to the left.
(e) no effect on the European economy.
Answer: (a)
9. If the Japanese government cuts government spending in order to reduce its budget deficit, the US
economy may contract as a result of
(a) an appreciation of the dollar.
(b) a depreciation of the dollar.
(c) appreciation of the yen.
(d) capital outflows.
Answer: (a)
10. When the US Federal Reserve increases the money supply, the expansionary effect will be greater if
(a) theres capital inflows.
(b) theres capital outflows.
(c) capital flows are not affected.
(d) the US was a closed economy.
Answer: (b)
11. An appreciation of the domestic currency results in

(a) LM shifting to the right.
(b) LM shifting to the left.
(c) IS shifting to the right.
(d) IS shifting to the left.
(e) Both IS and LM shifting to the right.
Answer: (c)
12. Relative to a small open economy, a monetary expansion by a large open economy results in
(a) larger depreciation.
(b) smaller depreciation.
(c) larger appreciation.
(d) smaller appreciation.
(e) the same impact.
Answer: (b)
13. A reduction in the money supply by the European Central Bank is likely to result in
(a) an increase in the US money supply.
(b) an increase in US money demand.
(c) a decrease in the US money supply.
(d) a decrease in US money demand.
(e) no effect on US money markets.
Answer: (d)
14. An increase in the European money supply can reduce US aggregate supply by
(a) decreasing US money demand.
(b) decreasing US money supply.
(c) decreasing nominal wages in the US.
(d) decreasing real wages in the US.
(e) increasing the cost of inputs imported by the US.
Answer: (e)
15. Econometric models agree that expansionary fiscal policy has a positive impact on all of the
following except
(a) output.
(b) price level.
(c) interest rates.
(d) value of the domestic currency.
(e) it has a positive impact on all of the above.
Answer: (d)
16. According to econometric models, expansionary monetary policy results in all of the following except
(a) lower interest rates.
(b) increased output.
(c) lower value of domestic currency.
(d) smaller trade deficit.
(e) it results in all of the above.
Answer: (d)
17. Brazil and Argentina choose to use fiscal policy to achieve a trade surplus. What is the likely
outcome of the game given the following information? (TB is Brazils trade balance with Argentina)
Brazil
Increase G Decrease G
Argentina Increase G Boom in both countries and TB > 0
TB = 0
Decrease G TB < 0 Recession in both countries and

TB = 0
(a) both nation increase government spending.

(b) both nations decrease government spending.
(c) Argentina increases government spending while Brazil decreases government spending.
(d) Argentina decreases government spending while Brazil increases government spending.
(e) Not enough is provided.
Answer: (b)
18. All of the following are obstacles to successful international policy coordination except
(a) policymakers being aware of their precise economic objectives.
(b) policy makers being aware of where their economies are relative to their optimal levels.
(c) the effect of specific changes in policy have on the respective economies.
(d) since nations are competitors, they wouldnt want to help improve the economies of other nations
(e) all of the above are obstacles to international coordination
Answer: (d)
Make use of the following information to answer questions 19 and 20 (TB is Brazils trade balance
with Argentina):
Brazil
Increase G Decrease G
Argentina Increase M Inflation in both nations, Inflation in Argentina and
Decrease M TB = 0 Inflation in Brazil recession in Brazil, TB < 0
and recession in Argentina, Recession in both nations,
TB >0 TB = 0
19. If both nations seek a positive trade balance, what is the likely outcome?
(a) both nations increase their money supplies.
(b) both nations reduce their money supplies.
(c) Argentina reduces its money supply while Brazil increases its money supply.
(d) Argentina increases its money supply while Brazil reduces its money supply.
(e) Not enough information provided.
Answer: (b)
20. If Argentina seeks to maintain a fixed exchange rate with the US who is running a tight monetary
policy while Brazil seeks to stimulate its domestic economy, what is the likely outcome?
(a) recession in Brazil.
(b) recession in Argentina.
(c) boom in Argentina.
(d) trade surplus for Argentina.
(e) trade deficit for Brazil.
Answer: (b)
Chapter 26
Supply and Inflation
26.1 The Aggregate Supply Relationship
Frictionless Neoclassical Supply Relationship
Modified Keynesian Supply Relationship
Friedman-Phelps Supply Relationship
Lucas-Sargent-Barro Supply Relationship
26.2 Supply Relationship with Indexed-Wages

Wages Indexed to Prices of Domestic Goods
Wages Indexed to the CPI Basket
26.3 Inflation
Why is There Inflation?
Costs of Inflation
How to Achieve Credibility
26.4 Alternative Anchors for a Countrys Money

Monetarists and Gold Bugs
The Exchange Rate as a Nominal Anchor
Inflation Targeting
26.5 The Choice of Exchange Rate Regimes

Intermediate Exchange Rate Regimes
The Corners Hypothesis
Optimum Currency Areas
The Case of German Monetary Union
Is Europe an Optimum Currency Area
26.6 Summary
Chapter Summary
Chapter 26 introduces the concept of aggregate supply to our model of the economy. Results concerning
international interdependence under various supply assumptions are derived. The issue of inflation is
examined in some detail, including the consideration of possible anchors for monetary policy. Finally,
alternative exchange rate systems are presented and examined.
Throughout much of the previous analysis it has been assumed that prices are fixed. Several alternatives
to this assumption are considered in section 26.1. These can all be considered as alternative assumptions
about the elasticity of supply with respect to the price level as given in equation 26.1. Real business cycle
theories assume that the economy is always at full employment and thus all variation in output is supply
determined. Monetary policy then has no effect on this model. The other three supply relationships
considered relax the Keynesian assumption of fixed wages, and they essentially differ in the way that
wages are determined. In all of the cases, the central result is that increases in demand will result in
increased prices, which is unlike the Keynesian result that they will result only in increased output.
Therefore, the effects of policy on output will be reduced under these assumptions, relative to the
Keynesian fixed-price assumption.
Section 26.2 considers the case where wages are indexed to prices. The material in the chapter supplement
may be useful in providing insight into wage indexation. The most important result to note here is that the
effects of policy will differ greatly whether the economy is open or closed. In particular, there will be real
effects in an open economy that are not present in a closed economy.
The causes, costs and policy responses to inflation are examined in section 26.3. Reasons for central banks
engaging in policies that lead to inflation are a low discount rate, an inability to commit to enacting a non-
inflationary policy and seignorage. Some costs incurred as a result of high inflation are discussed,
including the increased difficulty of distinguishing changes in relative prices from general price increases.
Efforts to establish central bank credibility can reduce the likelihood of inflation. Policies to help achieve
credibility include central bank independence, establishing a reputation for tight monetary policy and the
adoption of rules.
Given the difficulties that many governments have had in containing inflation, economists have suggested
alternative anchors designed to constrain central banks from engaging in overly expansionary monetary
policy. Among the proposals are targeting the growth rate of the money supply, the price of gold, inflation
and the exchange rate. In recent years, inflation targeting has become the most popular choice, having
been adopted by many developed as well as developing nations. Alternative exchange rate systems are
explored in section 26.5. Intermediate exchange rate regimes include currency bands, crawling pegs,
basket pegs and adjustable pegs. Many economists cite the need for central banks to publicly express
a firm commitment to some sort of fixed exchange rate system in order to achieve the benefit of lower
expected inflation while avoiding the problems associated with speculation regarding the abandonment
of the fixed exchange rate. As a result, nations have enacted currency unions (for example, Europe),
currency boards (Hong Kong and Argentina) and dollarization (Ecuador). Advantages and disadvantages
of various exchange rates systems are considered in light of the characteristics of the respective economies
(such as the degree of openness and size of the economy). The section concludes with an explanation of
the concept of a optimum currency area with specific application to Europe.
The supplement to chapter 26 considers what happens tothe exchange rate when wages are indexed
(either fully or in part) to inflation.

alternative assumptions about aggregate supply may led to differing theoretical results
causes, costs and policy responses to inflation
proposal for anchors for monetary policy
alternative exchange rates regimes
Chapter 26 Supply and Inflation 189

1. (a) The percentage change in Y is equal to
%Y (%P) If PY increases by 1 percent then, %Y %P 1.
Therefore, %P 1/(1 ) and %Y /(1 )
If wages adjust over time, then the fraction of the change that takes the form of a change
in income falls and the fraction that takes the form of a change in prices rises.
(b) Set p s O and solve the two equations simultaneously for gm and gR. This should yield
2. (a) Y N Taking the derivative with respect to N we obtain dY/dN N 1

Rearranging the production function to solve for N as a function of YN (Y/) 1/
Substitute this in for N in the marginal product of labor expression and rearrange to obtain
dY/dN Y(1 )/
(b) Firms set the real wage W/P w dY/dN Y(1 )/. Solving for Y
dY/dN 1/(1 )(w/)/( 1)
Therefore, /( 1).
If Y N then the real wage must be w N 1
(c) If falls then there will be an excess supply of labor. The real wage must then fall in order
to maintain full employment.
3. A monetary expansion will raise Y. The real exchange rate will also rise (depreciation), the trade
balance will improve, and there will be a net capital outflow. Interest rates will have fallen, which
will result in increased investment demand (as well as the capital outflow). There is then a larger
effect on income than in the absence of indexation.

1. Which of the following is an argument against wage indexation?
(a) In the face of negative demand disturbances indexation can lead to lower output.
(b) In the face of negative supply disturbances indexation can lead to unemployment above
the natural rate.
(c) Indexation can lead to less determination to fight high inflation.
(d) In a deflationary period, indexed wages can lead high real wages and high unemployment.
(e) (b) and (c).
Answer: (e)
2. An increase in aggregate demand of 10 percent will lead to a 10 percent increase in aggregate output
if aggregate supply is
(a) perfectly inelastic.
(b) unit elastic.
(c) vertical.
(d) indexed to the CPI.
(e) horizontal.
Answer: (e)
3. If the real wage adjusts without friction so that labor is always fully employed, then a 10 percent
increase in the money supply
(a) will lead to an increase in the demand for money.
(b) will lead to increased output.
(c) will lead to a change in the full employment level of output.
(d) will lead to a 10 percent increase in nominal wages.
(e) will cause the LM curve to shift.
Answer: (d)
4. If the real wage adjusts without friction so that labor is always fully employed, a technological
improvement will
(a) increase prices.
(b) decrease output.
(c) increase the full employment level of output.
(d) increase aggregate demand.
(e) decrease the demand for labor.
Answer: (c)
5. Which of the following is the major drawback of using gold as a nominal anchor?
(a) Gold is expensive and it is difficult for the central bank to obtain enough to fully fix
the price of gold.
(b) Under a monetary system anchored to gold, the economy is excessively vulnerable
to disturbances that shift the demand for gold.
(c) Under a monetary system anchored to gold, the nominal price of gold would be
excessively volatile.
(d) Under a new gold standard, countries could not choose to fix their exchange rates.
Answer: (b)
6. If the wage rate reflects expectations about the price level, then a monetary contraction will
(a) reduce output only if it is unexpected.
(b) decrease real wages only if it is unexpected.
(c) increase prices if it is expected.
(d) increase expected inflation.
Answer: (a)
7. If the wage rate reflects expectations about the price level, then in the long run an unexpected
3 percent monetary expansion will
(a) increase output by 3 percent.
(b) decrease real wages by 3 percent.
(c) increase prices by more than 3 percent.
(d) decrease expected inflation.
(e) increase nominal wages by 3 percent.
Answer: (e)
8. If expectations about the price level are formed rationally, then

(a) on average, they are incorrect.
(b) on average, they are correct, but they will never actually be correct.
(c) price differs from expected price systematically.
(d) the difference between price and expected price will always be negative.
(e) government cannot vary policy in any useful way.
Answer: (e)
9. An area is more likely to be an optimum currency area if

(a) labor can move freely throughout the entire area.
(b) outputs in various parts of the region are negatively correlated so that negative shocks cancel
each other out.
(c) currency transaction costs are small so that trade occurs easily across the areas.
(d) the area is too small to have its own currency.
(e) (a)(c).
Answer: (a)
10. The US and Canada form a two-country trading world and have flexible exchange rates. Wages in
both countries are fully indexed to their CPIs. The US undertakes a fiscal expansion that raises output
by 5 percent. Then
(a) output in Canada rises by less than 5 percent.
(b) output in Canada does not change.
(c) output in Canada also rises by 5 percent.
(d) output in Canada falls by less than 5 percent.
(e) output in Canada falls by 5 percent.
Answer: (e)
11. In the new classical model,

(a) the variable in question can differ from its expected value only by a random error.
(b) the government cannot change policy in any useful, systematic way.
(c) people can revise and adjust their expectations in an intelligent way.
Answer (d)
12. US fiscal contraction occurs in a two-country world with flexible exchange rates where wages are
indexed to the CPI in both countries. This will
(a) lead to an appreciation of the dollar.
(b) increase German output.
(c) have no real effects on the German economy.
(d) decrease nominal wages in the US.
Answer: (b)
13. Countries A and B are considering adopting a common currency and monetary policy. Together, they
will form an optimum currency area if
(a) both A and B are small open country that would be better pegging their currencies to the US dollar.
(b) B would be better splitting into regions with 4 separate currencies.
(c) B would be better off pegging its currency to the US dollar, but A would not.
(d) the common currency and monetary policy will improve both countrys trade balances.
Answer: (e)
14. Seignorage is when

(a) a central bank has existed for a long period of time
(b) a central bank that has earned a solid reputation
(c) government spending the money it prints
(d) government financing its deficit spending by issuing bonds
(e) the policy of a more developed economy affects the economy of a developing country
Answer: (c)
15. Which of the following is a reason for a central bank to engage in inflationary monetary policy?
(a) seignorage
(b) the government has a low discount rate
(c) the government is not able to credibly commit itself to not inflate
Answer: (d)
16. Which of the following is a way for a central bank to achieve credibility?
(a) central bank independence
(b) establish a reputation for monetary rectitude
(c) publicly commit to rules
Answer: (d)
17. An argument in favor of adopting a rule for monetary policy is

(a) once one understands the rules, its easier to conduct policy
(b) a rule that reduces expected inflation can lead to lower inflation for any given level of GDP
(c) there are many rules from which to choose
(d) oncearuleisadopted, itsimpossibleto circumvent it
(e) rules are made to be broken
Answer: (b)
18. A reason for a developing country to adopt the exchange rate as a nominal anchor is
(a) it can reduce expected inflation when pegged to a nation with sound monetary policy
(b) nominal wages would increases thus improving the standard of living
(c) it can put an end to balance of payments problems
(d) it reduces the need for budget and monetary discipline
(e) it works best in coordination with wage and price controls
Answer: (a)
19. All of the following are examples of intermediate exchange rate regimes except
(a) band
(b) crawling peg
(c) adjustable peg
(d) basket peg
(e) currency board
Answer: (e)
20. Those who support a firm-fix for exchange rates suggest all of the following except
(a) currency union
(b) dollarization
(c) currency board
(d) band
(e) all of the above have been suggested
Answer: (d)
Chapter 27
Expectations, Money and the Determination
of the Exchange Rate
27.1 Interest Rate Parity Conditions
27.2 The Monetary Model of Exchange Rates with Flexible Prices

The Exchange Rate as the Price of Money
Expectations of Money Growth
Hyperinflation
When the Money Supply Follows a Random Walk
When the Money Supply is Expected to Jump in the Future
27.3 Two Examples of the Importance of Expectations

Speculative Bubbles
Target Zones and the Honeymoon Effect
27.4 Overshooting and the Real Exchange Rate

International Differences in Real Interest Rates
Regressive Expectations
The Effect of Monetary Policy on the Real Interest Rate and the Real Exchange Rate
Long-Run Equilibrium
The Path from Short-Run Overshooting to Long-Run Equilibrium
Exchange Rate Volatility
27.5 Two More Examples of The Importance of Expectations

The Example of Official Announcements of Economic Statistics
Is Speculation Stabilizing?
27.6 Summary
Chapter Summary
In previous chapters it was assumed that capital is perfectly mobile across international boundaries. The
final section of the text addresses the determination of exchange rates in such a world. This is essentially
the theory of how investors choose their asset portfolios in an international economy. The assets they
choose to hold determine the rate at which these assets can be exchanged, or the exchange rate.
Chapter 27 Expectations, Money and the Determination of the Exchange Rate 195
The notion of uncovered interest parity can be introduced in a manner similar to that used to introduce
covered interest parity in Chapter 21. It is important to note that uncovered interest parity holds only in the
absence of exchange rate risk, whereas uncovered interest parity does hold in the presence of risk (hence the
difference in terminology). In addition, it should be emphasized that this condition does not imply causality
between exchange rates and interest rates in either direction. It is simply an equilibrium condition.
The monetary model with flexible prices is introduced in Section 27.2. The discussion of the exchange rate
as the relative price of money shows that the relative supplies and demands for currencies determine the
exchange rate in this model, just as the relative supplies and demands for goods determine their relative
prices. The addition of uncovered interest parity to the model generates Equation 27.9, which illustrates
the idea that exchange rates will adjust to fulfill expectations. Inflation is introduced into the analysis by
considering real interest parity, which can easily be derived by considering the alternative choices
available to investors. Note that increases in the price level represent increased opportunity costs of
holding money. However, the price level is determined directly by the money supply, and thus
assumptions about the money supply process play a central role in this model. There are several important
differences to note between the results of this model and earlier fixed-price models. First, the effect of
changes in income on the exchange rate is opposite to the standard Mundell-Fleming model. This is a
result of the fact that the monetarist model assumes that output is always at the full employment level,
and therefore output changes are the result of aggregate supply changes. Prices then move in the opposite
direction than they do in the Mundell-Fleming model, where output changes arise form changes in
aggregate demand. Second, the effects of a change in the interest rate differential on the exchange rate are
also opposite in the two models. This occurs as a result of the effect that this differential has on future
exchange rates in the monetarist model. The effect of an increase in the money supply is the same in that
an increase will result in depreciation. The magnitude of the effects differs somewhat, as in the monetarist
model the money supply and the exchange rate will change by the same percentage. The supplement to
Chapter 27 considers the monetarist model in a more mathematical manner.
A key point of the analysis in the early part of the chapter is that expectations about exchange rate changes
are important in the determination of exchange rates. These expectations change the portfolio holdings
of investors, and thus alter the exchange rate. It has been alleged that speculative bubbles then may create
increased volatility in exchange rates. These can be counteracted to some degree by target zones and
intervention by central banks. This material provides a good introduction to speculation and the material
in Section 27.5.
The final important topic introduced in this chapter is exchange rate overshooting. This combines the
assumptions of flexible and fixed prices. The motivation for this theory is that with perfectly flexible
prices, there will be no deviations from PPP and the real exchange rate will remain constant. This is
clearly not supported by exchange rate evidence. The exchange rate overshooting theory assumes that
in the long run, the real exchange rate is constant. In the short-run, prices are fixed and there will then be
deviations from PPP. Monetary policy will then have real effects in the short run. Figures 27.5 and 27.6
illustrate the effects of a change in the money supply in the Dornbusch overshooting model. The graphical
results in Figure 27.6 are very useful in that they show the initial effects of change in the money supply,
the long-run effects and the adjustment process.

uncovered interest parity
the monetarist model of exchange rates
exchange rate overshooting
exchange rate speculation

1. The increased use of credit cards will result in a downward shift in the demand for dollars. This will
reduce the price of dollars, and thus lead to a depreciation of the dollar (an increase in the price of
foreign exchange).
2.
3. (a) If an investor can predict that a countrys currency will appreciate in the future, then this does not
necessarily imply that this investor will earn excess returns as a result of the fact that real interest
parity may still hold.
(b) If the exchange rate has already overshot its long-run rate then there will be an excess return to
holding the currency as the real interest rates on assets denominated in that currency will exceed
the real rate on assets in foreign currencies.
4. (i) False-Consider uncovered interest parity, differences in inflation rates, differences in risk,...
(ii) False-The foreign currency could have a higher interest rate, and thus investors will expect that
the currency will gain value in the future.
(iii) False-Investors may still hold the currency if it pays a high return (uncovered interest parity
holds). If uncovered interest parity holds then the value of the currency will not fall today.
5. (a) Solving for S gives
S [mY mY KA (i i)]/
(b) The nominal interest rate, i, by fiscal policy, capital controls, banking regulations, monetary
policy, etc.
(c) The signs of the changes in the exchange rate are opposite from those in Equation 27.8 as a result
of the fact that in this model, changes in income result from aggregate supply changes, whereas
in the previous model, they are aggregate expenditure changes, thus leading to opposing effects
on prices. Interest rate effects differ in that in this model, a domestic interest rate higher than the
foreign rate results in an increase in expected depreciation, reducing the demand for dollars, and
thus leading to the depreciation. In the previous model, expectations do not change, and the
interest differential results in a capital inflow, leading to an appreciation of the exchange rate
to restore zero balance of payments.

1. The interest rate in the US is 6 percent and the interest rate in Japan is 2 percent. The expected change
in the dollar/yen spot rate must then be
(a) 4 percent.
(b) 3 percent.
(c) 8 percent.
(d) 4 percent.
(e) 12 percent.
Answer: (a)
2. In the theory of target zones, what is necessary for the honeymoon effect to occur?
(a) The bands must be wide enough so they do not effectively constrain the exchange rate.
(b) The commitment to intervene must be credible.
(c) The bands must be narrow enough so the exchange rate moves very little.
(d) Foreign exchange speculation must be limited.
Answer: (b)
3. The price level in the US is 1.5 and the price level in the UK is 2. Under the PPP assumption,
the pound dollar exchange rate would then be
(a) 1.33.
(b) 0.5.
(c) 3.
(d) 0.5.
(e) 0.75.
Answer: (e)
4. If prices are perfectly flexible, then a 5 percent increase in the money supply will
(a) increase the demand for real balances by 5 percent.
(b) increase income by 5 percent.
(c) increase the price level by 5 percent.
(d) increase the interest rate by 5 percent.
Answer: (c)
5. If prices are perfectly flexible, then a 4 percent increase in the money supply will
(a) not change the demand for real balances.
(b) increase the exchange rate by 4 percent.
(c) increase the price level by 4 percent.
(d) have no effect on income.
Answer: (e)
6. Under the monetarist model of exchange rates, an increase in the foreign interest rate will
(a) lead to depreciation of the domestic currency.
(b) increase the demand for real balances.
(c) lead to a decrease in the exchange rate.
(d) lead to an increase in income.
Answer: (c)
7. There is expected depreciation of the US dollar. This will lead to

(a) actual appreciation of the dollar.
(b) investors purchasing assets denominated in US dollars.
(c) future increases in the money supply.
(d) a decrease in US interest rates.
(e) a decline in the relative demand for assets in US dollars.
Answer: (e)
8. Which of the following is an example of destabilizing speculation?

(a) Speculating by buying high and selling low.
(b) Speculation based on bandwagon expectations.
(c) Speculation as in the overshooting model.
(e) Only (b) and (c).
Answer: (e)
9. Expected inflation in Japan is 1 percent and expected inflation in the US is 3 percent. The interest rate
in Japan is 2 percent. If real interest parity holds then
(a) the dollar/yen exchange rate will appreciate 2 percent.
(b) the US interest rate must be 4 percent.
(c) the US interest rate must be 2 percent.
(d) US investors will begin buying Japanese assets.
(e) Japanese investors will begin buying US assets.
Answer: (b)
10. The US money supply increases by 3 percent, the British money supply increases by 4 percent and
British incomes increase by 1 percent. Under the monetary model of exchange rates, the dollar/pound
exchange rate would then
(a) increase by 8 percent.
(b) depreciate by 2 percent.
(c) not change.
(d) appreciate by 2 percent.
(e) decrease by 8 percent.
Answer: (c)
11. The US money supply grows at a constant rate of 4 percent per year. The Fed decides to decrease this
to 3 percent per year to reduce inflation. Under the monetary model of exchange rates, this will also
lead to
(a) a 1 percent increase in expected depreciation.
(b) a 1 percent increase in the interest rate.
(c) an increase in the demand for the US dollar.
(d) eventual depreciation of the dollar.
(e) a 1 percent decrease in output.
Answer: (c)
12. The money supply follows a random walk. The Fed announces that the growth rate of money has
risen by 2 percent. Under the monetary model of exchange rates, this will lead to
(a) a 2 percent increase in expected depreciation.
(b) a 2 percent increase in the interest rate.
(c) an increase in the demand for the US dollar.
(d) eventual appreciation of the dollar.
(e) a 2 percent decrease in output.
Answer: (b)
13. Why might interest rates fall after the Fed announces a smaller than expected money supply for the
previous week?
(a) Investors expect that the Fed would correct the smaller than expected money supply by
increasing the money supply in the future.
(b) Investors believe that monetary contraction raises real interest rates.
(c) Investors did not believe the Feds announced monetary targets.
(d) (a) and (b).
(e) Interest rates would not fall; they would rise.
Answer: (d)
14. The inflation in the US is 2 percent and inflation in Europe is 1 percent. If PPP holds, it must then
be true that
(a) prices are 1 percent higher in Europe than the US.
(b) the dollar/euro exchange rate will appreciate by 1 percent.
(c) the dollar/euro exchange rate is expected to depreciate by 1 percent.
(d) nominal interest rates are 1 percent higher in the US.
(e) inflation is 1 percent higher in the US.
Answer: (c)
15. Investors are assumed to have regressive expectations, and the parameter is estimated to be 0.2.
The current dollar/yen exchange rate is 0.05 and the long-run fundamental rate is 0.04. It will then
be the case that
(a) the nominal dollar/yen rate will be expected to appreciate by 0.05 in the next year.
(b) the nominal dollar/yen rate will be expected to depreciate by 0.05 in the next year.
(c) the real dollar/yen exchange rate will be expected to appreciate at a rate of 0.05 per year.
(d) the real dollar/yen exchange rate will be expected to depreciate at a rate of 0.05 per year.
(e) the nominal dollar/yen rate will be expected to appreciate by 0.01 per year.
Answer: (c)
16. In the Dornbusch overshooting model, an increase in the US money supply will lead to
(a) an initial jump in the price level equal to the increase in the money supply.
(b) a large, immediate appreciation in the nominal exchange rate.
(c) an initial increase in the real interest differential between the US and Canada.
(d) an increase in the real money supply.
(e) no change in the long-run nominal exchange rate.
Answer: (d)
17. Uncovered interest parity

(a) is a weaker hypothesis than covered interest parity.
(b) holds only if investors view domestic currency and foreign currency assets as perfect substitutes.
(c) holds when investors care about exchange rate risk.
(d) holds because risk-free arbitrage do not exist.
Answer: (b)
18. The rate at which the dollar/euro exchange rate adjusts has been found to be high. If prices are fixed
in the short run and flexible in the long run, then a 2 percent increase in the US money supply will
(a) decrease European nominal interest rates by 2 percent.
(b) increase the real interest differential between the US and Europe.
(c) lead to a large initial depreciation of the dollar/euro exchange rate.
(d) lead to a initial depreciation in the dollar/euro exchange rate that is just over 2 percent
(e) lead to a initial depreciation in the dollar/euro exchange rate that is just under 2 percent.
Answer: (d)
19. In the monetary model of exchange rates with flexible prices, real demand for money is a/an
(a) increasing function of income and decreasing function of interest rate.
(b) decreasing function of income and increasing function of interest rate.
(c) increasing function of income and increasing function of interest rate.
(d) decreasing function of income and decreasing function of interest rate.
(e) The real demand for money is a function of other variables in the economy.
Answer: (a)
20. The fact that speculation in foreign exchange markets may be stabilizing rather than destabilizing
is supported by the fact that
(a) most speculators exit the market after a short period of time.
(b) empirical evidence indicates that PPP does not hold.
(c) central banks often have target zones for exchange rates that they are willing to maintain.
(d) profitable speculation is stabilizing.
Answer: (d)
Chapter 28
Exchange Rate Forecasting and Risk
28.1 Forecasting the Spot Exchange Rate

Forecasting Methods in Actual Use and Their Performance
Does the Forward Exchange Market Give an Unbiased Predictor?
28.2 The Role of Exchange Risk

The Exchange Risk Premium
What Makes a Currency Risky?
28.3 Portfolio Balance Effects on the Exchange Rate

Sterilized Foreign Exchange Intervention
Satiation in Holdings of a Countys Debt and the Hard Landing
28.4 Summary
Chapter Summary
Chapter 28 is concerned with the behavior of individual investors that participate in foreign exchange
markets. In particular, the assumption made in the previous chapter that domestic currency and foreign
assets are perfect substitutes is generally unrealistic. Investors may then have preferences and dislikes for
certain currencies. This chapter examines briefly the process by which investors choose to diversify their
portfolios.
Section 28.1 examines the process of exchange rate forecasting. In general, most models of exchange rate
forecasting perform very poorly. Many studies have shown that some of the models discussed earlier are
outperformed by models that assume the exchange rate follows a random walk. It should be noted that this
is not evidence in support of exchange rates following a random walk process, but instead a failure to find
evidence that supports any of the theoretical models considered earlier. An interesting strand of this
forecasting literature is that concerning the efficient markets hypothesis, the rational expectations
hypothesis and the zero exchange risk premium hypothesis. These essentially all state that the forward rate
should be an unbiased predictor of the future spot exchange rate. In general, this hypothesis has been
uniformly rejected by econometric studies, with many studies finding that the spot moves opposite to the
direction implied by the forward rate. Note that a finding that movements in the spot rate and the
difference between the spot rate and the forward rate are uncorrelated would be evidence in support of the
random walk hypothesis. There have been several explanations proposed for these findings, among them
the suggestion that speculators are overly zealous, and that banks and other large investors may respond
too strongly to differences in the forward and spot rates. However, the explanation that has received the
most attention, and is covered in the greatest detail in the text is that of an exchange risk premium.
Chapter 28 Exchange Rate Forecasting and Risk 203
The concept of exchange rate risk should be readily apparent to most students; if the return to holding a
currency is riskier, then that currency must pay a higher return in order to compensate the investor for that
risk. What may not be as apparent are the characteristics of currencies that make them risky. In addition to
increased variability of the return to a currency, there are factors such as portfolio diversification and the
degree to which returns to assets are correlated. In particular, investors should try to hold diversified
portfolios and assets whose returns that are negatively correlated. A brief formal treatment of portfolio
diversification is given in the supplement to Chapter 28. A fact to note is that most empirical studies of
international portfolio diversification find that investors portfolios are biased heavily towards domestic
assets relative to the optimum. Note that it is not the absolute riskiness of a countrys currency that
determines the risk premium associated with it, but instead its relative riskiness. A simple consideration
of the US dollar illustrates this point as it bears little absolute risk but is considered risky relative to the
Japanese yen as the dollar/yen forward rate indicated throughout much of the 1980s. A final point to note
is that if exchange risk premiums are going to be used to explain the empirical evidence relating to the
exchange rate moving in a direction opposite to the forward rate (a negative estimate of B in Equation
28.1), then this implies that currencies that are expected to appreciate must be systematically riskier. This
fact casts some doubt on the ability of exchange rate risk alone to account for the movement of spot rates
away from forward rates, although it certainly can account for some of the bias in the forward rate as a
predictor of future spot rates.
The final issue addressed in the text is that of portfolio-balance effects on the exchange rate. This analysis
considers the situation whereby investors portfolios have become satiated with a particular currency, and
thus they must be compensated to hold more. Another important point of this section is the idea that
central banks and other large investors may lean against the wind in order to dampen exchange rate
movements. This idea has been proposed as a possible partial explanation for the failure of the forward
rate to be an unbiased predictor of the future spot rate. The analysis in this section operates under the
assumption that domestic and foreign bonds are not perfect substitutes in an investors portfolio. Empirical
estimates of the substitutability of these assets reveal that they are considered very similar and thus the
portfolio-balance effects on exchange rates are most likely small.

the forward exchange rate is not an unbiased predictor of the future spot rate
exchange risk premium
portfolio-balance effects

1. If you believe that the foreign exchange market is efficient and you are risk-neutral, then you will not
hedge against exchange rate risk. If you are risk-averse, or if the market is a poor forecaster, however,
then you will choose to hedge in forward markets. If your company has obligations denominated in
foreign currencies and exchange rates change, then the value of these obligations has a correlation
of 1 with the value of obligations in the domestic currency.
2. If the expected change in the spot rate is 2 percent and the dollar is selling forward at 14 percent
discount then you should be buying dollars on the forward market.
3. (a) if x 0.4, V(r) 0.52 V; if x 0.5, V(r) 0.52 V; if x 0.6, V(r) 0.52
(b) dV(r)/dx 2Vx 2V 2Vx
Therefore, x 1/2
4. r xr (1 x)xr$
Var (r) E(r2) (E(r))2 E[xr)2 ((1 x)r$)2 2x (1 x) rr$] [x2E(r)2

(1 x)2 E(r$)2 2x(1 x)E(r r$)] x2E[r E(r)] (1 x)2E[r$ E(r$)]2
2x(1 x)E[rr$ E(rr$)] x2 V(r) (1 x)2 V(r$) 2x(1 x) Cov (rr$)
5. (a) Take the derivative of W with respect to x and set equal to zero. Solving the remaining
expression for x results in
x {E(r) E(r$)}/{2[dW/dE(r)] [dW/dV(r)][V(r) V(r$) Cov(rr$)} Cov(rr$)

(b) If the dollar return is certain (at level r), then
x {E(r) r}/{2[dW/dE(r)][dW/dV(r)][V(r)}
The fraction of the portfolio held in is then increasing in the level of the expected return to
assets and decreasing in the return to US dollar assets. Also, as the variance of the assets
increases, the optimal amount of to hold falls.
(c) If the return to assets is fixed at r, then
x {r E(r$)}/{2[dW/dE(r)][dW/dV(r)][V(r$)}
(d) If the investor is infinitely risk-averse then they will choose the currency with the minimum
variance.

1. The momentum model of exchange rate forecasting calls for
(a) buying when the current price is below a price that existed some time ago.
(b) a prediction that if the spot rate went up 1 percent this week it will go up AR percent next week,
where AR is an autoregressive coefficient.
(c) buying when the short-term moving average of an exchange rate lies above the long-term moving
average.
(d) selling when the current price is below a price that existed some time ago.
(e) exchange rates follow a random walk.
Answer: (d)
2. Which of the following models has been shown to outperform a random walk in predicting future
exchange rates?
(a) The flexible-price version of the monetary model.
(b) The monetary model.
(c) The ARIMA model.
Answer: (e)
3. If the efficient market hypothesis holds

(a) the ARIMA model could be used to earn excess returns above others in the market.
(b) all of the information in the various models as well as any relevant news will be reflected in the
forward rate.
(c) transactions costs would be small.
(d) exchange rate forecasting services would increase in demand.
Answer: (b)
4. The yen is selling at a 3 percent discount on the forward markets. If the efficient markets hypothesis
holds, this will imply that
(a) the yen will depreciate 3 percent.
(b) the yen will appreciate 3 percent.
(c) the yen/dollar exchange rate will fall 3 percent.
(d) the yen is riskier than the dollar.
(e) nominal interest rates are 3 percent lower in Japan.
Answer: (a)
5. Under the efficient markets hypothesis

(a) the forward exchange rate will always predict the future spot rate correctly.
(b) investors make systematic errors in predicting future exchange rate movements.
(c) investors do not use all information available to them.
(d) the forward exchange rate will predict the future spot rate correctly on average.
Answer: (d)
6. The rational expectations hypothesis states that

(a) investors do not use all information available to them.
(b) investors predict exchange rate changes with an error that is purely random.
(c) movements in exchange rates are purely random.
(d) the forward rate will always predict the future spot rate correctly.
Answer: (b)
7. If the yen sells at a forward discount of 4 percent against the dollar and it is expected that the yen will
depreciate 2 percent against the dollar in the next year, then
(a) the exchange risk premium on the yen is 6 percent.
(b) the exchange risk premium on the yen is 8 percent
(c) the exchange risk premium on the yen is 2 percent.
(d) the exchange risk premium on the yen is 1 percent.
(e) the exchange risk premium on the yen is 9 percent.
Answer: (c)
8. If an investor cares only about the nominal return in dollars, a currency is less risky if
(a) it is more variable.
(b) its value moves together with the value of the dollar.
(c) its value tends to go up and down opposite the value of other assets that the investor also holds.
(d) covered interest parity holds.
Answer: (c)
9. Empirical evidence on exchange rate movements indicates that

(a) both the efficient markets hypothesis and the zero exchange risk hypothesis hold.
(b) the efficient markets hypothesis does not hold, but the zero exchange risk hypothesis does.
(c) the efficient markets hypothesis holds but the zero exchange risk hypothesis does not.
(d) forward rates are biased predictors of future spot rates.
(e) both (b) and (d).
Answer: (d)
10. Empirical tests indicate that movements in spot exchange rates are uncorrelated with the forward
exchange discount. This is evidence in support of
(a) exchange rates as random walks.
(b) the efficient markets hypothesis.
(c) the rational expectations hypothesis.
(d) the zero exchange risk premium hypothesis.
Answer: (a)
11. The interest rate in the US is 2 percent and the interest rate in Japan is 4 percent. Investors expect that
the dollar will appreciate 3 percent against the yen. The risk premium on the dollar is then
(a) 3 percent.
(b) 1 percent.
(c) 4 percent.
(d) 1 percent.
(e) 9 percent.
Answer: (d)
12. Assume the Fed intervenes on the dollar/yen exchange rate by buying dollars and selling yen.
The Fed can sterilize this intervention by
(a) selling dollar currency to buy up dollar bonds.
(b) buying dollar currency and selling dollar bonds.
(c) buying dollar currency by selling yen bonds.
(d) decreasing the dollars held by private agents.
Answer: (a)
13. Two currencies, A and B, have the same expected variation in their returns. If an investor wishes to
minimize the overall variance of their portfolio, then they should hold what fraction of their portfolio
as currency A?
(a) 1
(b) 2/3
(c) 1/2
(d) 1/3
(e) 0
Answer: (c)
14. Currency A is riskier than currency B, but assets denominated in currency A pay a higher return than
those in B. A risk-neutral investor will choose to hold
(a) all assets denominated in B.
(b) half their assets in each currency.
(c) one-third of their assets in currency A.
(d) all assets in currency A.
(e) some assets in currency A and some in B, but the exact fractions cannot be determined from the
information above.
Answer: (d)
15. Exchange rates are assumed to follow a random walk. The interest rate in Canada is 5 percent, and
the interest rate in Bolivia is 20 percent. Relative to the Bolivian currency, the Canadian dollar pays
a risk premium of
(a) 4 percent.
(b) 15 percent.
(c) 25 percent.
(d) 4 percent.
(e) 15 percent.
Answer: (e)
16. Assume the Fed intervenes on the dollar/yen exchange rate by buying dollars and selling yen. If agents
view domestic and foreign assets as imperfect substitutes, sterilized intervention can succeed because
(a) the supply of yen assets has gone down, which can cause an increase in the price of dollar assets,
which is a real appreciation.
(b) the supply of dollar assets has gone up, which can cause an increase in the price of dollar assets,
which is a real appreciation.
(c) the supply of dollar assets has gone up, which can cause an increase in the price of dollar assets,
which is a real depreciation.
(d) the supply of dollar assets has gone down, which can cause an increase in the price of dollar
assets, which is a real appreciation.
(e) the supply of dollar assets has gone down, which can cause an increase in the price of dollar
assets, which is a real depreciation.
Answer: (d)
17. An investor wishes to reduce the risk in their portfolio. They should then choose combinations
of assets whose returns have a correlation of
(a) 1.
(b) 1/2.
(c) 0.
(d) 1/2.
(e) 1.
Answer: (e)
18. The variance of assets denominated in dollars is 3 percent and the variance of assets denominated
in yen is 2 percent. The correlation between the returns is zero. An investor holds 60 percent of their
portfolio in dollar assets and 40 percent in yen assets. The overall variance of their portfolio is then
(a) 2.6 percent
(b) 5 percent.
(c) 1 percent.
(d) 1.4 percent.
(e) 2.5 percent.
Answer: (d)
19. Central banks have been observed selling a currency when it is appreciating and buying it when it is
depreciating. This type of behavior is an example of
(a) leaning against the wind.
(b) portfolio satiation.
(c) the effects of an exchange risk premium.
(d) destabilizing speculation.
Answer: (a)
20. The nominal value of Canadas debt is growing at about 5 percent per year. Investors do not wish
to allow Canadian debt to grow as a share of their portfolios. Then,
(a) Canadian incomes must rise at 5 percent per year.
(b) the Canadian dollar must increase in value.
(c) the Canadian dollar will depreciate at 5 percent per year.
(d) interest rates in Canada will rise 5 percent.
(e) the Canadian dollar will have a 5 percent risk premium.
Answer: (c)

Solution Manual World Trade and Payments An Introduction

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Solution Manual World Trade and Payments An Introduction

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Chapter 1

2.2 Background Behavior: Supply

2.3 Gains from Trade and Free-Trade Equilibrium

2.4 Winners and Losers: Autarky to Free Trade

Appendix A: The Box Diagram

Appendix B: Substitution and Income Effects

Appendix C: The Offer Curve Diagram

Key concepts introduced in this chapter include:

Suggested Answers to Textbook Questions

3. (a) tastes similar across countries, transformation schedules differ

The common endowment is given by E. Countries differ in their preferences as represented by

Multiple Choice Questions

1. Exports for this country are represented by

2. Imports for this country are represented by

3. If the world price of food fell, the country would generally

4. With trade, the market value of exports is

5. If this country were to lose 10 percent of its clothing endowment it would

6. Under autarky, the relative price of food will be

7. Under autarky, country B

8. With free trade between countries with equal incomes,

9. With free trade, country A will

10. If country Bs clothing endowment increases,

11. In free trade equilibrium,

Questions 1415 concern the following scenario:

17. If a country experiences an improvement in technology,

18. Efficient consumption in autarky

19. In autarky, a preference shift towards food

21. A sharply bowed-out production possibilities frontier embodies

22. A country that has a comparative advantage in clothing production

3.2 Protecting the Import-Competing Commodity

3.3 Growth and International Trade

3.4 The Transfer Problem

3.5 Wider Interpretations of the Basic Trade Model

3.6 Trade and Market Structure

Appendix: The Stability Issue

Key concepts introduced in this chapter include

Suggested Answers to Textbook Questions

Multiple Choice Questions

2. An increase in foreign demand for homes exports must

3. An increase in demand for US exports may lead to

5. Taxing imports leads to

11. Which of the following statements is incorrect?

14. A transfer of purchasing power

15. A transfer of real resources

19. The terms of trade for a country will change as a result of

20. Which of the following statements is incorrect?

4.2 Free-Trade Equilibrium

4.3 International Wage Comparisons and Productivities

4.4 A Many Commodity and Many Country World

4.5 Winners and Losers from Productivity Shocks

4.6 Non-Traded Commodities

Appendix A Transitional Unemployment

Key concepts introduced in this chapter include:

Suggested Answers to Textbook Questions

6. (a) The amount of commodity 1 to be given up to obtain 1 unit of 3 is aL3/aL1 6/5.

Multiple Choice Questions

3. The autarky home relative price of food will be

4. Home labor productivity in the food sector is

13. In the Ricardian model, equilibrium relative wages depend on

5.2 Outputs and Income Distribution in the Closed Economy

5.3 Outputs and Income Distribution with Free Trade

5.4 Growth in Factor Endowments

5.5 Consequences for Political Economy