International Economics

East Asian countries have accumulated very large stocks of foreign exchange reserves in the past decade. Explain why, in a first generation model of currency crises, countries would like to have a large stock of foreign exchange reserves.

A large stock of foreign exchange gives more room for the central bank in expanding domestic credit during economic downturns. In other words, a large stock of foreign reserves makes it more difficult that the shadow exchange rate equals the peg and so that a currency crisis occurs. Thus the central bank can use domestic credit to mitigate the cycle, expanding it in economic downturns and contracting it during expansions. Importantly, if the central bank expands domestic credit at a steady pace, a currency crisis will occur no matter how big the stock of foreign reserves is. The stock of foreign reserves will just determine when the attack takes place. There are at least two other reasons why a country may want to hold a large stock of foreign reserves. Firstly, in the second generation models of currency crises, holding a large stock of foreign reserves may be a way to coordinate expectations on the good equilibrium and avoid self-fulfilling currency crises. Secondly, accumulating foreign reserves may also be a way to keep a depreciated exchange rate and boost exports.

IS-LM-BP - Devaluation (graph)

BP IS shift out

IS-LM-BP - Capital inflow flexible (graph)

BP out, IS down, BP back

IS-LM-BP - Capital inflow fixed (graph)

BP shift out

'Trade eliminates cross-country inequality in income.' Is this statement true in the context of the Ricardian model? Explain.

False. Wage rates remain equal to the marginal productivity of labour. Hence wage rates are not equalised in terms of wage rate.

Why might countries engage in preferential trade agreements?

First step to further integration. Better than no policy if the trade creating is more than trade diversion.

Lerner Diagram - Increase price of y

Flatter

Lerner Diagram - decrease price of x

Flatter

Lerner Diagram - technology change improvement in y

Flatter

IS-LM-BP - Fiscal Stimulus fixed (graph)

IS shifts out

IS-LM-BP - Fiscal Stimulus flexible (graph)

IS shifts out and back, BP shifts out

IS-LM-BP - Monetary Stimulus flexible (graph)

LM IS BP shift

IS-LM-BP - Monetary Stimulus fixed (graph)

LM shifts out

Explain, in the small country case, why it is possible that removing tariffs against one trading partner can make a country worse off, while removing all tariffs will make a country better off. If the theory says that this is the case, how can you explain that many countries have bilateral trade agreements?

Removing tariffs against a single trading partner may lead to trade diversion. This happens when the lifting of the tariff induces imports from a country which is not the most efficient in producing the good. In this case the country can be worse off because it loses the revenue from the tariff and it pays a price for the good higher than the world price. The existence of bilateral trade agreement can be explained through contracting costs, that it may be significantly easier to reach an agreement with a single partner, rather than reaching an agreement among a large number of countries.

Use a general equilibrium diagram to show the combined effect of introducing a consumption tax and a production subsidy in an import-competing industry in a small trading country. What are the effects on production, consumption, welfare and international trade? Explain your answer.

Same effect as an import tariff. Assume the small country case. An import tariff is a tax levied when a good is imported. It has the effect of raising the domestic price of the good by the amount of the tariff (from Pw to Pw + t), while leaving the world price unchanged. In terms of the welfare effect, the tariff reduces welfare effect is a loss that arises because the tariff distorts incentives to consume and produce.

'A country should not impose an import tariff because it reduces national welfare.' Is this statement true? Explain.

Statement is not true it depends on the size of the country. If the country is big then the introduction of trade barriers may improve national welfare. On the other hand if the country is small the policy is certainly welfare reducing. Full grades when the candidate also draws graphs.

Lerner Diagram - Increase price of x

Taller

Consider the standard trade model with two goods and two factors, labour and capital. Suppose that a country experiences an increase in its capital stock. How would the Production Possibilities Frontier change as a result?

The PPF will shift outward: the Y intercept shifts upwards and the X intercept shifts to the right. The relative size of these two movements will depend on the relative capital intensity of each good. Here we assume that good X is labour intensive and good Y capital intensive. As Y is assumed to be K-intensive relative to X, the economy produces proportionally more of Y than X: the Y intercept shifts up by a greater percentage than the X-intercept shifts right (i.e. a skewed shift of the PPF).

In a monopolistic competition model of trade, explain why opening to trade causes consumers to consume less of each good.

The opening up to trade corresponds to an increase in the number of products that consumers can purchase. Due to the assumption of love of variety, consumers will react to this increase in consumption possibilities by expanding the number of goods they consume. This in turn translates into a decrease in the amount spent on each good and hence consumers will consume less of each good.

Rybczynski Theorem

The property of the H-O Model that, at constant prices, an increase in the endowment of one factor increases the output of the industry that uses that factor intensively and reduces the output of the other (or some other) industry. Due to Rybczynski (1955). Illustrated with Edgeworth production box

The real exchange rates of fast-growing economies tend to appreciate over time. For example the Baltic countries, Poland, the Czech Republic, have appreciated their currencies relative to the dollar between the beginning of the 90s and end 2007. Propose a model that rationalizes this pattern of the real exchange rates.

To address the empirical regularity we should refer to the Balassa- Samuelson model characterised by difference in productivity among rich and poor countries. We will assume that there are two countries and they produce two goods: a tradeable (T) and non-tradeable (NT). The key assumptions are that: • Labour is the only factor of production and is perfectly mobile within countries but completely immobile between countries • Countries are equally productive in the N sector, but Foreign (*), the rich country, is more productive in the T sector: • The law of one price holds for tradeable. Low wages in poor countries (due to low productivity in the tradeable sectors) result in relatively low prices in non-tradeable sectors, as productivity in these sectors is approximately the same as in rich countries. It is plausible to assume that international productivity differences are sharper in traded than in non-tradeable goods. Note that a key assumption is that labour is perfectly mobile within a country. As transition economies are catching up their productivity in the tradeable sectors may well increase at a higher rate compared both to the developed world and to the productivity in their own non-tradeable sectors. This would imply that PN/PT increases over time, which in turn implies real appreciation in these countries. This appreciation will not last forever. It will stop when the productivity levels in the transition economies become closer to the levels of developed countries.

Rybczynski Theorem - Less capital (graph)

flatter

Rybczynski Theorem - More capital (graph)

taller

Rybczynski Theorem - Less labour (graph)

thinner

Trade and Transformation Curve Diagram - Expansion small country import biased

trade declines

Trade and Transformation Curve Diagram - Expansion small country export biased

trade expands

Explain who a tariff will help, and who it will hurt. Is it possible that everybody is better off with a tariff? How would you design a policy which uses tariffs to increase the welfare of all members of your country? (Describe any information you would need to collect.)

A tariff benefits producers of the imported goods and the government, who collects the revenue from the tariff. It hurts consumers. Good answers show this using a partial equilibrium graph. The tariff can increase welfare if the country is large and thus if its consumption and production decisions influence the terms of trade. In this case the tariff leads to a decrease in the world demand and to an increase in the world supply of the imported good and to a decrease in its world price. This represents an improvement in the country's terms of trade which is welfare enhancing for the country as a whole. On the other hand, the tariff introduces distortions in the consumption and production decisions, which are welfare decreasing for the country as a whole. To check which one of the two effects prevail, policy-makers need detailed information about the domestic and world economy. For example, the price elasticity of demand and supply for the good determine the impact of the tariff on the world price of the good and hence the size of the improvement in terms of trade.

In the context of a fixed exchange rate regime, under which circumstances will a country accumulate foreign exchange reserves? Discuss why a country might want to sterilise the accumulation of foreign reserves and to what extent sterilisation is effective.

Accumulation of foreign reserve in a context of a fixed exchange rate occurs when in the foreign exchange rate market there is a pressure for an appreciation of the currency. The central bank would intervene by selling domestic currency and buying foreign currency. Sterilisation on the forex markets are interventions aimed at influencing the exchange rate by changing the composition of the assets of the central bank without affecting the total money supply. To offset the increase in forex reserves and keep total money supply unchanged the central bank would sell domestic bonds in exchange for money. Sterilisation would maintain the total money supply unchanged, while changing the composition of the central banks' assets because domestic credit has decreased, while forex reserves have increased. If domestic and foreign assets are perfect substitute only their aggregate matters, while how money supply is split between the two components has no real effects. Hence for sterilisation to be successful domestic and foreign assets must be imperfect substitute, so that a change in the composition of money supply can influence the exchange rate.

Find a combination of domestic policies reproducing the effects of an export subsidy in a small open economy. First derive the welfare implications of the export subsidy. Second, find the fiscal policy that replicates the welfare outcome by introducing a combination of consumption and production subsidies/taxes.

Again we assume a small country for simplicity (large country case is a simple extension; see Krugman and Obstfeld as well). An export subsidy is a payment to a firm that exports a good. Consider the diagram below. With the subsidy, when a firm exports the good, it receives a higher price for that good than when it sells it domestically. Hence the firm's incentive is to export more of its output, leaving a smaller quantity for domestic consumers. Thus at the given world free trade price, from the initial equilibrium condition at home, there is now an excess demand for the good, so the domestic price of the good will rise. In the diagram, the export subsidy increases exports from (Q0 - X0) to (Q1 - X1). This raises domestic price from Pw to Pw + s. As a result of this price increase, domestic demand for the good falls (from X0 to X1) while production rises (from Q0 to Q1). Welfare effects: There will be a loss of consumer surplus equal to (a + b), and a gain in producer surplus equal to (a + b + c). The cost of the subsidy is (b + c + d), total exports times perunit subsidy. Hence the net welfare effect is a loss of (b + d). To reproduce the effects of this export subsidy using domestic policies, the government should subsidise producers of the good and tax consumers of the good. The producer subsidy again raises the price received by producers, hence they will raise production from Q0 to Q1. The tax on consumption of the good will reduce consumption from X0 to X1. In terms of the welfare effect, the producer subsidy raises producer surplus by (a + b + c), at the cost of the subsidy of (a + b + c + d). The consumption tax reduces consumer surplus by (a + b), and raises a tax revenue (a). Therefore the net welfare effect of combining these two policies is a loss of (b + d), which is the same as the welfare loss from the export subsidy.

Effects of a Price Change

All of this can be combined to determine the effects of changes in variables that are exogenous to the Lerner diagram, such as prices. The case shown is an increase in the price of good X. The price increase pulls the unit-value isoquant for X in toward the origin. This causes the common tangent to rotate clockwise, becoming steeper and representing a higher relative price of labor compared to capital. In nominal terms, the wage rises and rental falls. These changes cause both industries to substitute toward using less labor and more capital, moving up and to the left along their isoquants to higher ratios of capital to labor. This increase in the capital-labor ratios of diversification means that the diversification cone rotates counterclockwise. Some factor endowments that previously would have involved specialization in the more capital-intensive industry now will accommodate both industries, while other factor endowments that were inside the cone but closer to its bottom edge are now below it, switching from producing both goods to producing only X. For endowments that remain within the cone, factors must be re-allocated in order to keep them fully employed at the new higher capital-labor ratios. The more labor-intensive industry, even though it now employs a higher ratio of capital to labor, also must expand, employing a larger amount of both factors. The capital-intensive industry Y, on the other hand, employs less of both factors and contracts. Thus, for a country within the cone, the output of X rises and the output of Y falls.

Explain why fiscal policy is more effective under fixed exchange rates than floating, and explain why monetary policy is more effective under floating exchange rates than fixed. (Use the Mundell-Fleming model. You should explain the intuition, as well as providing a graphical analysis.)

An increase in fiscal expenditure (IS shifts right) causes an increase in the interest rate that partly counteracts its positive impact on output (graphically, this is captured by the slope of the LM curve). Under a fixed exchange rate arrangement the central bank has to take action to guarantee that the domestic and the world interest rate are equal in order to defend the peg. To offset the increase in the interest rate the central bank will thus engineer an increase in money supply (LM shifts right) so as to equalise the domestic and world interest rate. The monetary expansion has a positive impact on output, thus magnifying the initial impact of the increase in government expenditure. Under a flexible exchange rate the central bank doesn't have to offset the interest rate differential and hence only the direct impact of fiscal policy on output is present. To see why monetary policy is more effective under a flexible exchange rate regime suppose that the exchange rate is fixed and that the monetary authority wants to stimulate output by running an expansionary monetary policy (LM shifts right). The expansion in money supply will lead to a decrease in the domestic interest rate and to a negative spread between the domestic and world interest rate. To maintain the peg the central bank will have to shrink the money supply to its initial level (LM shifts left) until the interest rate differential is eliminated. In the end there will be no impact on equilibrium output. Hence, under a fixed exchange rate, monetary policy cannot be used as an independent tool to affect output (though it has to be used if the economy is hit by a shock that opens a differential between home and foreign interest rates). Conversely, under a flexible exchange rate regime the central bank is free to use monetary policy to affect output.

Explain why fiscal policy is more effective under fixed exchange rates than floating, and explain why monetary policy is more effective under floating exchange rates than fixed. (Use the Mundell-Fleming model. You should explain the intuition, as well as giving diagrams.)

An increase in fiscal expenditure (IS shifts right) causes an increase in the interest rate that partly counteracts its positive impact on output (graphically, this is captured by the slope of the LM curve). Under a fixed exchange rate arrangement the central bank has to take action to guarantee that the domestic and the world interest rate are equal in order to defend the peg. To offset the increase in the interest rate, the central bank will thus engineer an increase in money supply (LM shifts right) so as to equalise the domestic and world interest rate. The monetary expansion has a positive impact on output, thus magnifying the initial impact of the increase in government expenditure. Under a flexible exchange rate the central bank doesn't have to offset the interest rate differential and hence only the direct impact of fiscal policy on output is present. To see why monetary policy is more effective under a flexible exchange rate regime suppose that the exchange rate is fixed and that the monetary authority wants to stimulate output by running an expansionary monetary policy (LM shifts right). The expansion in money supply will lead to a decrease in the domestic interest rate and to a negative spread between the domestic and world interest rate. To maintain the peg the central bank will have to shrink the money supply to its initial level (LM shifts left) until the interest rate differential is eliminated. In the end there will be no impact on equilibrium output. Hence, under a fixed exchange rate monetary policy cannot be used as an independent tool to affect output (though it has to be used in case a shock that opens an interest rate differential hits the economy). Conversely, under a flexible exchange rate regime the central bank is free to use monetary policy to affect output.

In the coming months, the Federal Reserve is expected to increase the Fed fund rate. What would be the impact of the increase in the Fed fund rate for a small open economy? (Hint: you could use the IS-LM model and interpret the foreign interest rate as the Fed fund rate.)

An increase in the fed fund rate, interpreted as an increase in the foreign interest rate, will affect the capital account of the balance of payment creating a situation of capital outflows. Depending on the degree of capital mobility (and also on the exchange rate regime), this will translate into pressure for the exchange rate to depreciate. If international capital flows are perfectly mobile and there is a floating exchange rate regime, a depreciation of the currency will be needed to restore the equilibrium. As the currency depreciate, the IS curve shifts to the right and in the new equilibrium the economy will have a higher interest rate and a crowding out effect on domestic investment in favour of the net exports. Under a fixed exchange rate regime, there will be a reduction in international foreign reserve to maintain the peg and the LM curve will shift to the left with a higher equilibrium domestic interest rate as well.

Briefly describe the flexible price monetary approach to exchange rate determination. Explain what happens when there is an exogenous decrease in income from y0 to y1 (i.e. y1< y0) under a floating and a fixed exchange rate regime in the context of this model. In the floating exchange regime case, is it possible for monetary authorities to use monetary policy to restore the initial equilibrium in the domestic price level? If so, how?

An increase in the fed fund rate, interpreted as an increase in the foreign interest rate, will affect the capital account of the balance of payment creating a situation of capital outflows. Depending on the degree of capital mobility (and also on the exchange rate regime), this will translate into pressure for the exchange rate to depreciate. If international capital flows are perfectly mobile and there is a floating exchange rate regime, a depreciation of the currency will be needed to restore the equilibrium. As the currency depreciate, the IS curve shifts to the right and in the new equilibrium the economy will have a higher interest rate and a crowding out effect on domestic investment in favour of the net exports. Under a fixed exchange rate regime, there will be a reduction in international foreign reserve to maintain the peg and the LM curve will shift to the left with a higher equilibrium domestic interest rate as well. (more at 2015 za 8)

Consider two countries (E and I) that can produce two goods (cloth and machinery) using two factors (labour and capital). The technology to produce the two goods is the same in the two countries and allows for substitution among inputs. Cloth production is labour intensive, while machinery production is capital intensive. E is relatively capital abundant while I is relatively labour intensive. Suppose that the two countries trade freely, but because of a natural disaster, country E's endowments of labour and capital are halved. What are the effects on the observed trade pattern?

As both E L and K are halved, E is still capital abundant. This means that it will specialise in the sector that requires the inputs in which the country is rich. So it will still specialise in the machinery production.

Find a combination of domestic policies reproducing the effects of an import tariff in a small open economy. First derive the welfare implications of the import tariff. Second, find the fiscal policy that replicates the same welfare outcome by introducing a combination of consumption and production subsidies/taxes.

Assume the small country case. An import tariff is a tax levied when a good is imported. It has the effect of raising the domestic price of the good by the amount of the tariff (from Pw to Pw + t), while leaving the world price unchanged. In terms of the welfare effect, the tariff reduces consumer surplus by (a + b + c + d), and increases producer surplus by (a). Government revenue is (c), so the net welfare effect is a loss of (b + d), an efficiency loss or a deadweight loss that arises because the tariff distorts incentives to consume and produce. Triangle (b) is the production distortion loss, while triangle (d) is the consumption distortion loss. One combination of domestic policies that reproduces the effects of an import tariff is a combination of a subsidy to producers in that industry and a tax on consumers for consuming that good. First consider the producer subsidy. This has the effect of raising the price received by the producers of that good (from Pw to Pw + t), thus inducing them to increase production from Q0 to Q1. Similarly, the tax on consumption of the good raises the price faced by consumers (again from Pw to Pw+t), thus inducing them to reduce consumption, from X0 to X1. The gain in producer surplus from the subsidy is (a), while the cost of the subsidy is (a+b). The loss in consumer surplus from the tax is (a + b + c + d), while the tax revenue is (a + b + c). Summing these, the net welfare effect is a loss of (b + d), exactly the same as the welfare loss from the import tariff. N.B. It is straightforward to extend this to the large country case. All you need to be careful of is the effect that home policies have on the world price.

Let LDC be a developing country characterized by a segmented economy. A traditional sector coexists with a modern sector. Segmentation is reflected in a persisting differential in wages between the two sectors. Mr. B., president of LDC, suggests the introduction of trade tariffs to protect the modern sector. He claims that this policy will increase LDC production as the modern sector will expand creating new jobs at the expenses of the traditional sector. Is he right? Suppose you are the Secretary of State for work. What type of concern would you express about this policy?

Candidates are expected to explain here the Harris-Todaro argument. Harris-Todaro main points: 1. Difference in wages not only reflects differences in productivity; it also reflects the possibility of remaining unemployed when moving form the traditional sector to the modern one. 2. When the unemployment salary is positive, the creation of an additional job in the modern sector might actually reduce output, by increasing unemployment.

Let LDC be a developing country characterized by a segmented economy. A traditional sector coexists with a modern sector. Segmentation is reflected in persisting differential in wages and marginal productivity of labour in the two sectors. Mr. B, president of LDC, suggests the introduction of trade tariffs to protect the modern sector. He claims that this policy will increase LDC production as the modern sector will expand creating new jobs at the expenses of the traditional sector. Is he right? Suppose you are the Secretary of State for work. What type of concern would you express about this policy?

Candidates are expected to explain here the Harris-Todaro argument. Harris-Todaro main points: 1. Difference in wages not only reflects differences in productivity; it also reflects the possibility of remaining unemployed when moving form the traditional sector to the modern one. 2. When the unemployment salary is positive, the creation of an additional job in the modern sector might actually reduce output, by increasing unemployment.

Compare the currency board regime with a fixed exchange rate regime. Describe the main characteristics of the two emphasizing the costs and benefits of adopting the two regimes.

Currency board: a monetary institution that only issues domestic currency that is fully backed by foreign assets. The domestic currency is convertible into a foreign anchor currency at a fixed rate and on demand. Anchor currency: a currency chosen for its expected stability and international acceptability. Convertibility: a currency board maintains full and unlimited convertibility between its notes and coins and the anchor currency at a fixed rate. Foreign reserves are composed by low-risk, interest bearing bonds and other assets denominated in the anchor currency. Currency board reserves are equal to 100 per cent or more of its notes and coins in circulations, as set by law. A currency board generates profits (seignorage) from the difference between interest earned on its reserve assets and expense in maintaining its liabilities (notes and coins in circulation). A currency board does not act as a lender of last resort to protect domestic banks from losses. No discretion in monetary policy ⇒ market forces determine money supply. The only function of a currency board is to exchange notes and coins for the anchor currency at the fixed rate. The currency board does not lend to domestic banks or to the government. A fixed rate between the domestic currency and foreign anchor currency tends to keep interest rates and inflation in the currency board country roughly the same as those in the anchor currency country. Fixed exchange rate: similar implications but can issue money (more discretion in monetary policy).

'A large country has a greater incentive than a small country to use export subsidies.' True or false. Evaluate this statement in a partial equilibrium framework.

False. In both a large and small country an export subsidy has a negative welfare effect. Nevertheless, in the large country case the negative effect is bigger. The subsidy raises the domestic price of the exported good. This has the effect of reducing domestic demand and raising domestic supply of the good, thus increasing Home Export Supply and resulting in a fall in the world price for the good. The difference between the new world price (Pw1) and the new domestic price (Pd1) is the size of the subsidy. As to welfare effects, there is a fall in Consumer Surplus equal to (ab), an increase in Producer Surplus equal to (abc), and a subsidy cost equal to (bcdefg) (exports times per-unit subsidy). Therefore the net welfare effect is (bdefg), which is negative. b and d represent the deadweight losses (consumption and production inefficiencies) while the area efg represent the loss due to the worsening of the terms of trade. For a small country the world price is given, so when the export subsidy is imposed there is no effect on the world price efg=0. The welfare effect is still unambiguously negative (bd); but the overall effect is in general smaller because the loss due to the terms of trade effect disappears and only the inefficiency losses remain. Thus, a large country has a smaller incentive to use export subsidies than a small country. The reason is that, by subsidizing its exports, a large country increases the world supply for the exported good, hence reducing its price and worsening the country's terms of trade.

Lerner Diagram - The Diversification Cone

If factor prices are those given by the common tangent, as they must be for both goods to be produced, then the cost-minimizing techniques of production in the two industries are at the two points of tangency. Therefore, the factor ratios at these points of tangency, and the rays with these slopes labeled kX and kY above, represent these techniques. The diversification cone is the set of all factor endowments lying on or between these rays.

Trade and Transformation Curve Diagram - Tariff small country

If the country is small, so that the world price remains unchanged with the tariff, then the tariff faces producers with a flatter price line, to which they respond by producing less of good X and more of good Y, at a tangency of the transformation curve with this flatter price line. The budget line of the country as a whole is still given by world prices, however, now passing through this new production point, P1. To have balanced trade, consumption must be on this line, at a point of tangency between an indifference curve and another domestic price line parallel to that facing producers. The effects of the tariff in the small country include a drop in welfare compared to free trade, and a reduction in the quantities traded.

Suppose you were an import competing producer in a perfectly competitive setup. Which policy instrument would you prefer: an import tariff or an import quota? Would your answer change in a monopolistic setup?

If the firm is perfectly competitive, then a tariff and an import quota have identical effects on the firm. See Figure 1. A tariff will raise domestic price to Pw+t, resulting in a gain to Producer Surplus equal to area (a). An equivalent quota (which raises domestic price to Pw+t as well) will also result in an identical gain in Producer Surplus. So, for a perfectly competitive firm, a tariff, a quota, and a production subsidy are equivalent. But suppose that the firm is a monopoly. Now a quota will be better for the firm. Under free trade, the monopoly must charge a price equal to the world price, Pw, since if it sets a higher price, it will not be able to sell its product (goods are homogeneous!). For a monopoly, a tariff of size t raises the domestic price of the good from Pw to Pw+t. This reduces demand from X0 to X1, and raises domestic production from Q0 to Q1. Producer Surplus rises by area (a). With the tariff, the monopoly will set a price equal to the world price plus the tariff, Pw+t, since it cannot sell any units if it sets a higher price. A quota on the other hand limits the quantity of imports to (Q1−Q0). This is equivalent to shifting the demand curve faced by the monopoly inwards, from D to D' (the actual demand curve remains at D). There is a Marginal Revenue curve MR associated with D'. Given the new demand curve, with the quota the firm can set price to maximise its profit (MC=MR), and sell output Q0. The gain in Producer Surplus is the area bounded by Pd, Q0, MC, and Pw. This gain will be greater than the gain in Producer Surplus under the tariff, as long as the new domestic price as a result of the tariff is lower than Pd. The intuition behind this result is that, with a quota, the monopoly can raise its price without losing the entire market to import competition, since there is a maximum limit to the number of units that can be imported. Thus, after taking into account the loss of demand due to imports, the monopoly can charge a price that maximises profits. Result: If the domestic import-competing firm is a monopoly, then it will prefer a quota to a tariff.

Explain why in a duopolistic market, it may be welfare improving for an economy to introduce export subsidy. When would be the introduction of a export tax the optimal policy intervention?

In a monopolistic market with Cournot competition, it might be optimal to introduce an export subsidy to guarantee greater market shares to the domestic firm. The subsidy lowers the marginal cost of firm A and this implies an increase of production of firm A. The best reaction of firm B is to reduce its production and let the price increase. Hence the profits of firm A benefit as both quantities and prices increase.

Consider the case of Thailand, a small open economy that faces constant goods prices. Assume that there are two sectors, manufacturing and farming. There are three productive factors. Labour is employed in both sectors and is freely mobile between them. Capital is used only in manufacturing and land only in farming. After the recent floods a relevant part of arable land has been destroyed: discuss the effect on wages and the incomes of capital and land owners.

In a small open economy factor prices and labour allocation are determined as follows: • In each sector i (with i=m, f), labour is demanded up to the point where the value marginal product of labour equals the wage rate: VMPLi = pi MPLi= pi ∂Fp(K, Li)/∂Li = w. • Labour is mobile so the wage must be the same in both sectors: pm MPLm = w = pf MPLf. • Labour is fully employed, Lm + Lf = L Because of the floods the land endowment of the economy decreases. The fall in T decreases the marginal product of labour in the farming sector. The new equilibrium wage is lower and labour moves to the manufacturing sector. Under the small open economy assumption, the price of both sectors remains constant. Given that labour moves to manufacturing, the marginal product of capital increases (hence r rises); thus, the income of capital owners (rK= pmMPKmK) increases. As labour in farming decreases, the value marginal product of land (v) goes down, but the reduction in land has a positive effect on v so that the overall effect on the value marginal product of land is ambiguous. However, under reasonable assumptions, given that T diminishes the overall effect on the income of landowners (v×T) is negative.

Use the IS-LM model to determine how a fall in the world interest rate will influence domestic output under fixed and floating exchange rate regimes. How does your answer depend on the degree of capital mobility?

In all cases, a decrease in the world interest rate will initially trigger a capital inflow and therefore increase the demand for domestic currency. Clearly the magnitude of these capital inflows and of the increase in demand for domestic currency depends crucially on the degree of capital mobility: the greater the degree of capital mobility then the greater their magnitude. Note that with zero capital mobility there is no impact at all. The consequences of these changes on output depend on the exchange rate regime in operation. Recall the three key relationships derived from the building blocks of the Mundell-Fleming model described in your lecture notes (2012 za 7)

Use a graphical approach to describe the equilibrium of the Krugman monopolistic competition model of trade. What does the PP curve represent? What does the CC curve represent? Discuss the effects of free trade on equilibrium price and product variety compared to autarky.

In the Krugman model consumers love variety and n firms produce n differentiated varieties of a horizontally differentiated good. Consider the average variety. Call F and c its fixed and marginal cost, P its price, Q its output, n the number of firms, S the size of the industry's market, b a constant term representing the responsiveness of a firm's sales to its price. The key equilibrium relationships of the model are the average cost condition (CC curve): AC = Fn/S + c and the profit maximising pricing condition (PP curve): P = c +1 (bn) In autarky the two curves can be represented as CC1 and PP in the following diagram: Consider now two identical economies. Under autarky these two economies are represented by the same CC1-PP diagram depicted above. The effect of trade liberalisation is the same as if each economy experienced a doubling of its market size. This shifts the CC curve downwards to CC2, so the equilibrium price decreases and the equilibrium number of varieties increases. However, considering firm heterogeneity, there is a further effect due to firm selection. As P falls and n rises, the cut-off cost falls, which, in turn reduces the average marginal cost c. Lower c drives both the CC and the PP curves downwards (from CC2 to CC' and from PP to PP') and, as a result, P falls further while the final effect on the number of varieties is ambiguous

Suppose that there is perfect capital mobility and a fixed exchange rate regime. The government increases public spending permanently. What are the implications for output and the current account if you use the IS-LM model? How does your answer change in the case in which there is imperfect capital mobility?

In the Mundell-Fleming model the increase in G induces a higher level of output and a current account deficit. In Figure 5, IS shifts to IS' when G rises permanently. This induces large capital inflows which push the BOP into surplus. The central bank intervenes to maintain e by increasing the money supply which shifts LM to LM'. The result is an increase in Y and a current account deficit. When capital mobility is imperfect the BP line becomes steeper and the effects on output and current account will be smaller.

East Asian countries have accumulated very large stocks of foreign exchange reserves in the past decade. Explain why, in the context of a first generation model of currency crises, countries would like to have a large stock of foreign exchange reserves.

In the context of the first generation currency crisis model, foreign reserves are needed in order for the central bank to intervene in the foreign exchange market to defend the initial currency parity. The bigger the stock of foreign exchange reserve, the less likely a central bank will be to face a currency crisis. More generally indeed, a large stock of foreign exchange gives more room for the central bank in expanding domestic credit during economic downturns. In other words, a large stock of foreign reserves makes it more difficult for the shadow exchange rate to equal the peg, and so a currency crisis occurs. Thus the central bank can use domestic credit to mitigate the cycle, expanding it in economic downturns and contracting it during expansions. Importantly, if the central bank expands domestic credit at a steady pace, a currency crisis will occur no matter how big the stock of foreign reserves is. The stock of foreign reserves will just determine at what point the attack takes place. There are at least two other reasons why a country may want to hold a large stock of foreign reserves. In the second generation models of currency crises holding a large stock of foreign reserves may be a way to coordinate expectations on the good equilibrium and avoid self-fulfilling currency crises. Accumulating foreign reserves may also be a way to keep a depreciated exchange rate and boost exports.

Consider the specific factor model for a small open economy. There is a mobile factor, labor, and two short-run sector-specific types of capital K1 and K2. Discuss the short run implication of an increase in labour endowment L on the allocation of the three production factors across sectors. Suppose that in the long run the two K1 and K2 are freely mobile across sectors. What is the long-run effect of the increase in L on the allocation of the three production factors?

Increase in Labour supply is represented by an extension of the horizontal dimension of the figure. Short run: The figure shows that an increase in L raises employment in both sectors. Given that the two types of capital are sector-specific, their allocation is not affected in the short run. Long run: According to the Ribczinsky Theorem, an increase in L raises (reduces) the amounts of capital and labour allocated to sector 2 (sector 1). Notice that the short-run and long-run outcomes are also contradictory here.

(Hecksher-Ohlin model.) Suppose the world is made of two countries: Home and Foreign. Home is a small labour-abundant, while Foreign is capital-abundant. Both Home and Foreign produce two goods: food and cloth. Food production is labour-intensive and cloth production is capital-intensive. What is the effect of the introduction of an export subsidy in the Home country on the return to each factor of production in the Home country?

Let good 1 be relatively labour intensive and good 2 be relatively capital intensive. The Heckscher-Ohlin theorem states that a country will export the good that uses relatively intensively its relatively abundant factor of production. Since H is assumed to be labour abundant it will export the labour-intensive good (good 1) and import the relatively capital-intensive good (good 2). World prices are fixed at (P1/P2)w. Calling t the subsidy, P1d and P2d the domestic prices of good 1 and 2 in country H gives: P2d = (1 - t)P2w; P1d = P1w ; (P1/ P2)d = [P1w/(1 - t)P2w] > (P1/P2)w Hence an import subsidy increases the relative domestic price of good 1. The Stolper-Samuelson theorem states that an increase in the price of a good will result in an increase in the price of the factor used intensively in its production, in relative, nominal and real terms, and a decrease in the price of the other factor, assuming both goods continue to be produced. Furthermore, the increase in the price of the factor used relatively intensively will be more than proportional to the original increase in the price of the good (magnification effect). Thus an import subsidy, which increases the domestic relative price of the exported labour-intensive good 1, will increase the relative, nominal and real wage and will decrease the relative, nominal and real rental rate.

Propose a model that rationalises the fact that richer countries tend to have higher price levels (desribe the needed assumptions and the implications of such a model.)

Low wages in poor countries (due to low productivity in the tradeable sectors) result in relatively low prices in non-tradeable sectors, as productivity in these sector is approximately the same as in rich countries. It is plausible to assume that international productivity differences are sharper in traded than in non-tradeable goods. Note that a key assumption is that labour is perfectly mobile within a country. As transition economies are catching up, their productivity in the tradeable sectors may well increase at a higher rate compared both to the developed world and to the productivity in their own non-tradeable sectors. This would imply that PN/PT increases over time which in turn implies real appreciation in these countries. This appreciation will not last forever. It will stop when the productivity levels in the transition economies become closer to the levels of developed countries. (2012 za 10)

The Swiss National Bank (SNB) introduced a pegged exchange rate between the Swiss franc and the Euro in 2011 at 1.20 Swiss francs per Euro. In January 2015, the Swiss authorities decided to abandon the peg. Which model of currency crises could be used to explain the SNB's decision?

One model that could rationalise this situation is the second generation currency crisis model. Indeed in the first generation currency crisis model, the problem is foreign reserve depletion while in the case of Switzerland the problem has been foreign reserve accumulation. In the second generation currency crisis model a crisis could occur also when there is pressure for a revaluation of the currency as long as the speculators perceive that there is a cost of defending the peg that can exceed its benefits. For the Swiss case the cost can be represented in terms of the undesirable level of foreign exchange reserve that had been accumulated by the SNB in defence of the CHF/EUR exchange rate while the benefits could be interpreted in terms of keeping the currency relatively undervalued.

Despite the depreciation of the currency (both in real and nominal terms), the trade balance and the current account fail to improve in the short-run. What could be the possible explanations for such patterns?

One of the reasons the trade balance fails to improve in the short run is the so-called J-curve effect. In the short run the depreciation of the currency will increase the price of imports but the volume of export does not adjust immediately. The Marshall-Lerner condition defines the restrictions on the trade elasticities for which the trade balance improves following a real depreciation.

State and explain the absolute purchasing power parity theory and the underlying assumptions on which it rests. Explain relative purchasing power parity and discuss the Fisher effect.

Purchasing power parity refers to an arbitrage condition that arises in goods market. Absolute purchasing power parity, states that, when there is one homogenous commodity that is traded across the country borders in a frictionless way and in a perfectly competitive environment, then the price of the commodity should be equalised across countries once converted in a common currency (by using the nominal exchange rate). Relative purchasing power parity is related to the change over time of prices and exchange rates so that the inflation differential between two countries is equal to the rate of change in the nominal exchange rate. By combining the UIP and the relative purchasing power parity, we obtain the Fisher equation which asserts that a permanent rise in inflation in a country will lead to an increase in its interest rate by the same amount.

Use the IS-LM model to determine how an increase in the foreign output will affect domestic output under fixed and floating exchange rate regimes. How does your answer depend on the degree of capital mobility?

Recall the three key relationships derived from the building blocks of the Mundell-Fleming model described in your lecture notes: Open economy IS: Y = C(Y - T) + I(r) + G + CA(Y,Y*, e). Open economy LM:M/P = L(Y, r) Balance of Payments:BP = CA(Y,Y* e) + K(r - r*) = 0 Floating exchange rate regime: Under a floating exchange rate regime an increase in foreign output will improve the current account and boost domestic production since exports increase. As the IS curve shifts to the right we will also observe higher interest rates. Under imperfect capital mobility the combination of higher foreign output and higher domestic interest rate generates a balance of payment surplus that in the context of a floating exchange rate regime determines an appreciation of the nominal exchange rate that partially offsets the initial increase in output. As capital mobility increases, the domestic interest rate is tied to the foreign interest rate and the positive impact of an increase in foreign output is offset by the appreciation of the nominal exchange rate so that output in equilibrium does not change. Fixed exchange rate regime Under a fixed exchange rate regime, an increase in foreign output will improve the current account and boost domestic production as before. The shift to the right of the IS curve will also imply higher interest rates. The balance of payment surplus is counterbalanced by an increase in foreign reserves needed to prevent the appreciation of the currency. The ensuing increase in money supply will tend to lower interest rates and mitigate the initial impact on the interest rate. Under perfect capital mobility domestic interest rates cannot move and the increase in money supply due to the increase in foreign reserve will generate a further expansion in domestic output.

People sometimes talk about 'twin deficits', where the twins are the current account and the government budget deficit. Explain how these two deficits are related economically so that changes in one are reflected in changes in the other.

Solution Current Account = CA = X-M. Y = C + I + G + CA. Y - C - G = S = I + CA. Now we decompose savings S into private and governmental savings:. S = Sp + Sg = (Y - T -C) + (T - G) Note that Sg = (T - G) = - (G - T) = - (budget deficit) So substituting we get: Sp + Sg = I + CA CA = Sp - I - Sp CA = Sp - I - (G-T). For a given level of Sp and I, an increase in the budget deficit must be accompanied by a decrease in the CA surplus (or increase in the CA deficit). For example, consider an increase in government expenditure (G) such as the building of a bridge. If imported materials etc. are employed for the construction of the bridge there is an increase in M giving rise to the twin deficits phenomenon. Empirical studies reveal a correlation between the budget deficit and the CA deficit. However, the relationship is not as simple as it looks; Sp, Sg, I and CA are jointly determined so the relationship does not give a clear theoretical causal link.

Lerner Diagram - decrease price of y

Taller

Lerner Diagram - technology change improvement in x

Taller

Show how, in the flexible-price monetary model, the exchange rate can be expressed as a function of expectations about future fundamentals. What will happen to the exchange rate if people's expectations of future income increase? What will happen to the exchange rate if people's expectations of future money supply increase? (Try to show mathematically and explain the intuition.)

The expression in terms of fundamentals is discussed on pp.115-16 of the subject guide. Higher future income causes an appreciation because it raises future money demand, thus lowers the future price level. Higher future money supply will raise future price level and cause current depreciation.

Show how, in the flexible-price monetary model, the exchange rate can be expressed as a function of expectations about future fundamentals. What will happen to the exchange rate if people's expectations of future income decrease? What will happen to the exchange rate if people's expectations of future money supply decrease? (Try to show mathematically and explain the intuition.)

The expression in terms of fundamentals is on pp.114-15 of the subject guide. Exchange rate depends on expectations about future fundamental through the uncovered interest parity condition. The subject guide provides the derivation of the equilibrium exchange rate in this setting. Higher future income causes an appreciation because it raises future money demand, thus lowers the future price level. Higher future money supply will raise future price level and cause current depreciation.

Consider the neoclassical model of trade with two countries, two goods and two factors of production. Markets are perfectly competitive. Use a general equilibrium diagram to examine whether an import subsidy can improve welfare for a large country. Explain the economic intuition of your answer.

The implementation of the import tariff by a large country will have an impact on the relative world prices (or terms of trade). In the large country case there are conflicting effects on welfare. The consumption and production distortions arising from the tariff work to lower the welfare, while the improved terms of trade that home faces as a result of the tariff is welfare-improving. The net effect is ambiguous. The implementation of the tariff shifts the world prices from (Pm/Pf)w to (Pm/Pf)'w. At the same time the introduction of the tariff introduces a wedge between the world prices and the domestic ones which results in the (Pm/Pf)h line (that is tangent in point C). When the tariff is rebated to the consumers the optimal consumption level hifts from B to D which is in this case welfare improving. It can also be the case that D is below B and the policy is welfare reducing!

Trade and Transformation Curve Diagram - Tariff large country

The large-country case differs, in that the world price of the exported good rises when less of it is supplied to the world market, and this steepens the price line, both world and domestic, as shown. The main difference from the small-country case is that the large country's welfare may rise, as shown.

Briefly describe the monetary approach to exchange rate determination. Explain what happens when there is an exogenous decrease in real income under a floating and a fixed exchange rate regime. Could monetary policy be used to restore the initial equilibrium in the price level? If so, how?

The monetary approach to exchange rate determination is characterised by flexible prices, fixed supply and a money demand equation that depends only on income through velocity of money. Under a floating exchange rate regime we have that changes in real income implies a lower demand for money other things being equal. In order to restore equilibrium in the money market, prices should be higher. On the external side this increase in the price level is matched by a depreciation of the nominal exchange rate needed in order to have PPP holding (or otherwise in order to restore competitiveness). Include graphs. In the fixed exchange rate regime instead we will observe changes in domestic price level. Consider a decrease in real income level in the fixed case. For given domestic prices, the demand of real money balances is lower; in order to have equilibrium in the domestic money market prices will be forced up; at the fixed exchange rate, the economy is now under competitive and a balance of payment deficit will arise, reserves will decrease in order to defend the parity up to the point in which overall money supply has decreased to match the new lower demand. (N.B. you should include graphs). Under a floating exchange rate regime, the monetary authority can restore the initial price level by decreasing money supply. P = Ms/ky and the required money supply adjustment is such that MS1/MS0 = y1/y0

Briefly describe the flexible price monetary approach to exchange rate determination. Explain what happens when there is an exogenous decrease in income from y0 to y1 (i.e. y1< y0) under a floating and a fixed exchange rate regime in the context of this model. In the floating exchange regime case, is it possible for monetary authorities to use monetary policy to restore the initial equilibrium in the domestic price level? How?

The monetary approach to exchange rate determination is characterized by flexible prices, fixed supply and money demand equation that depends only on income through velocity of money. Under a floating exchange rate regime change in real income implies a lower demand for money, other things being equal. In order to restore equilibrium in the money market prices should be higher. On the external side this decrease in the price level is matched by a depreciation of the nominal exchange rate needed in order to have PPP holding (or otherwise in order to restore competitiveness). Include graphs. In the fixed exchange rate regime instead we will observe changes in domestic price level. Consider an increase in real income level in the fixed case. • For given domestic prices, the demand of real money balances is lower. • In order to have equilibrium in the domestic money market prices will be forced up. • At the fixed exchange rate, the economy is now undercompetitive and a balance of payment deficit will arise. • Reserves will decrease in order to defend the parity up to the point in which overall money supply has decreased to match the new lower demand. (With graphs as well). Under a floating exchange rate regime, the monetary authority can restore the initial price level by reducing money supply. P = Ms/ky and the required money supply adjustment is such that Ms1/Ms0 = Y1/Y0

Are there any arguments in favour of trade protection? Do these arguments change for small and big countries? Do differences in competitive situations lead to different strategic policy prescriptions? If protection from trade is bad, why are trade restrictive policies so widespread?

The only real reason for trade protection is when big countries try to modify the world terms of trade to their own advantage. So in principle small countries should never implement protective policies. Still, people have argued there might be other reasons to justify the resort to trade protection. The most important is when the assumption of perfect competition is removed. It might be welfare improving to adopt protectionist policies when there is strategic interaction in oligopolistic markets. In particular: 1. Export subsidy is advisable when there is Cournot competition. 2. Import tax is advisable when there is Bertrand competition. Protectionist policies are implemented because: 1. Rentiers lobby for these policies while the median voter does not. 2. Trade restrictions are easy to set and they guarantee certain stream of government revenues.

Lerner Diagram - Patterns of Specialization

The reason for calling it the diversification cone, aside from its shape, is that only for factor endowments lying inside the cone -- between the rays kX and kY -- will a country produce both goods. Otherwise it would not be able to employ both factors fully, since it would be using either a higher or lower ratio of factors in both industries than it has in its endowment. Outside the cone, therefore, the country completely specializes, producing only the most labor-intensive good, X, below the cone and only the most capital intensive good, Y, above it.

What is the 'policy regime trilemma'? Do you think that individual countries in the Eurozone area are facing the 'policy trilemma'?

The trilemma consists in the fact that only two of the above could be attainable. In the current Eurozone, countries belong to a fixed exchange rate regime with free capital mobility in which monetary policy to achieve domestic goals is decided by the European Central Bank. The inability to deals with single countries' domestic objectives (deflationary pressure and high unemployment in the periphery of the Eurozone) is creating strains on the system and is the symptom of the aforementioned trilemma.

Suppose a country has a fixed exchange rate, but is also pursuing expansionary monetary policy (i.e. it is expanding domestic credit). What will happen to the stock of foreign exchange reserves? If traders discover that the peg is unsustainable, will they sell the currency when they discover the unsustainability, when foreign exchange reserves run out, or at some other time?

This is the Krugman model of balance of payment crises. To keep the exchange rate fixed, while running an expansionary monetary policy the central bank has to decrease its stock of foreign exchange reserves. To keep the exchange rate fixed the money supply has to be constant. Then since money supply = domestic credit + foreign exchange reserves any movement in domestic credit has to be offset by an opposite movement in foreign reserves. The attack on the currency will happen when the shadow exchange rate (the exchange rate that would prevail absent policy interventions and when the stock of foreign reserves equals its lower bound) is equal to the pegged exchange rate. Good answers should include a graph that illustrates the time of the attack and discuss why the attack takes place when the shadow exchange rate equals the peg (i.e. otherwise investors would make losses).

Suppose a country has a fixed exchange rate, but is also pursuing expansionary monetary policy (i.e. it is expanding domestic credit). What will happen to the stock of foreign exchange reserves? Is the fixed exchange rate regime sustainable? Articulate your answer by refereeing to the Krugman's (1978) model.

This is the Krugman model of balance of payment crises. To keep the exchange rate fixed, while running an expansionary monetary policy the central bank has to decrease its stock of foreign exchange reserves. To see this consider that to keep the exchange rate fixed money supply has to be constant. Then since money supply = domestic credit + forex reserves any movement in domestic credit has to be offset by an opposite movement in foreign reserves. The attack on the currency will happen when the shadow exchange rate (the exchange rate that would prevail absent policy interventions and when the stock of foreign reserves equals its lower bound) is equal to the pegged exchange rate. Good answers should include a graph that illustrates the time of the attack and discuss why the attack takes place when the shadow exchange rate equals the peg (i.e. show that otherwise investors would make losses).

Suppose you are an economist working for a wheat farmer in a country that imports wheat. Describe three different trade policy instruments that could be used to increase the profits of domestic wheat farmers. Which would be best for your employers?

Three different trade instruments that could be used include: 1. Import tariff, i.e. the government collects a charge for every bushel of wheat that is imported. The domestic price will now be equal to the foreign price plus the tax, so raising the domestic price of wheat, thus increasing profits of domestic wheat producers. 2. Import quota, i.e. the government limits the amount that can be imported. On a diagram, the domestic demand curve will shift in by the amount of the tariff. If the tariff is smaller than the volume of imports, the domestic price will increase and domestic wheat producers will profit. Two things to consider are (a) the profits earned by selling foreign wheat at higher domestic prices could go to the government (auctioning quota), or the foreign government (voluntary export restraint), or domestic importers (import licensing); (b) if the domestic industry is monopolistic, the quota allows them to restrict output, raising price above marginal cost, allowing for even greater profitability. 3. Domestic subsidy, i.e. the government pays domestic producers a bonus for every bushel of wheat produced. The domestic price will not change, but domestic producers will produce more, and will earn higher profits. Comparing these tools it is clear that all will increase profits of domestic wheat farmers, but just differ in where the profits come from (domestic consumers for 1 and 2, and the government for 3). (It is also worth noting that if you are a large country, the tariffs and quotas will lower the world price for wheat, so could make the country as a whole better off; the domestic subsidy would not do that).

Propose a model that explains the fact that richer countries tend to have higher price levels (describe the necessary assumptions and the implications of such a model).

To address the empirical regularity we should refer to the Balassa Samuelson model characterised by difference in productivity among rich and poor countries. (2015 za 9)

In a world characterized by the presence of only two production factors, land and labour, landowners are in favour to opening up to the international trade only if their home country is rich in land. True or False? Explain with the help of a graph.

True. In the Heckscher-Ohlin model a country has a comparative advantage in a sector that uses more intensively the input factor that is more abundant in the country. Hence what is going to happen is that the country will export the good which is produced with more land and less labour and the price of this good will equalise with the world one (which is above the home one). As a result, those who own land will be able to sell their product at a higher price and they will also increase their market by selling to the new country.

B is a small country that is considering the introduction of a tariff or an equivalent quota on computers. The Education Minister argues that the government should choose a tariff rather than a quota because the education rates are rising and the demand for computers is expected to grow in future years. Evaluate the Minister's argument in the context of the welfare impact of these two trade instruments.

True. Quotas would need to be re-established every period while the tariffs being a constant markup on prices can be decided only once. However, if you are willing to re-assess quotas in every period the two instruments are in principle the same.

Consider the Specific Factor Model for a small open economy that faces constant commodity prices. There is a mobile factor (labour) and two sector-specific factors, capital (specific to manufacturing) and land (specific to agriculture). Assume that due to pollution a part of the land cannot be used any more for production. Discuss the impact of pollution on wages and on the income of capital and land owners. Which factor owner benefits or loses from pollution?

Wages fall. The income of land owners fall and the income of capital owners increase.

Trade and Transformation Curve Diagram - Expansion small country neutral

trade expands in the first two of these cases

Rybczynski Theorem - More labour (graph)

wider

Trade and Transformation Curve Diagram - Expansion large country export biased

world price of X falls and rises respectively

Trade and Transformation Curve Diagram - Expansion large country import biased

world price of X falls and rises respectively

Trade and Transformation Curve Diagram - Expansion large country neutral

world price of X falls and rises respectively