Examiners commentaries 2011

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1 Examiners commentaries 2011 Examiners commentaries International economics Zone A Important note This commentary reflects the examination and assessment arrangements for this course in the academic year In 2012 the format of the examination will change to: Candidates should answer FOUR of the following TEN questions: QUESTION 1 of Section A (40 marks) and THREE questions from Section B (20 marks each). The format and structure of the examination may change again in future years, and any such changes will be publicised on the virtual learning environment (VLE). Comments on specific questions Candidates should answer QUESTION 1 of Section A (25 marks), TWO questions from Section B (25 marks each) and ONE question from Section C (25 marks). Candidates are strongly advised to divide their time accordingly. Recommended reading KO = Krugman and Obstfeld International economics, eighth edition. C = Copeland, Exchange rates and international finance, fifth edition. Section A Answer all parts of Question 1 (25 marks in total). Question 1 For (a) to (d) below, is the statement true or false? Explain your answers, making use of diagrams where relevant. Unsupported answers will receive no marks. a. Trade can only be mutually beneficial between countries which either have different technologies, different supplies of factors, or different preferences. (6 marks) Monopolistic competition: subject guide Chapter 5; KO Chapter 6 Reciprocal dumping (pp ). FALSE: Trade can be mutually beneficial even between identical countries if there are increasing returns to scale as highlighted by the Krugman model. In presence of increasing returns to scale, international trade expands the number of goods or varieties that consumers can purchase, thus increasing their welfare. Very good answers could also mention that increasing returns have been used to justify the existence of intra-industry trade or elaborate on the sources of welfare gains in the Ricardian and Heckscher-Ohlin model (respectively differences in technology and in factor endowment). 1

2 16 International economics b. Suppose that we use a Heckscher-Ohlin model to describe the economy of New Zealand, where the two factors are capital and labour, and the two products are manufacturing (capital intensive) and agriculture (labour intensive). In February 2011, an earthquake destroyed many of the buildings in Christchurch, New Zealand. The Heckscher-Ohlin model predicts that if the earthquake reduced the total stock of capital, then more capital will be used in the agricultural sector. (Assume that the world prices for manufacturing and agriculture are unaffected). (7 marks) Rybczynski Theorem: subject guide Chapter 2; KO Chapter 4, especially Figure 4.9. TRUE: The Rybczynski Theorem states that if the endowment of a factor increases, and goods prices are held constant, then the output of the good which uses that factor intensively will increase and the output of the other good will decrease. The earthquake causes a decrease in the stock of capital and, by the Rybczynski Theorem, this generates an increase in the production of the labour intensive good (agriculture) and a decrease in the production of the capital intensive good (manufacturing). For this to happen, capital has to flow from manufacturing to agriculture and hence more capital will be used in the agricultural sector. Good answers include a clearly labelled Edgeworth box diagram. Excellent answers note that the result depends on assumption of unchanged terms of trade (unchanged relative prices), and discuss what would change if goods prices were allowed to change: the price of the capital-intensive good would increase, so the price of capital would increase, and both industries would become less capital intensive; the effect on production in each industry would then be ambiguous. c. If people suddenly expect currency A to depreciate relative to currency B, then the difference between their interest rates (ia-ib) will fall (holding everything else equal). (6 marks) Uncovered interest parity: subject guide Chapter 12, especially equation 12.1; C pp.86 93; KO pp FALSE: By the uncovered interest parity condition (UIP) investors will have to be compensated for the expected depreciation with an increase in the interest rate paid on assets denominated in currency A. This will increase the differential ia-ib. Good answers add that formally, UIP says that (E e E)/E= ia ib, where E is the exchange rate (units of currency A for one unit of currency B) and E e is the future expected exchange rate. So if A is expected to depreciate, E e E increases, so ia ib increases, so the difference increases. Excellent answers note that this may not be true if the UIP fails to hold, as it seems to be the case empirically. d. In a country with a fixed exchange rate, imperfections in capital mobility make fiscal policy more effective (compared to a case with perfect capital mobility). (6 marks) Mundell-Fleming: subject guide Chapter 16; C (pp ). 2

3 Examiners commentaries 2011 FALSE: In the IS-LM-BP diagram, if capital mobility is imperfect then the BP curve will slope upwards. This means that for a given rightward shift in the IS curve, the new equilibrium output will move relatively less. Intuitively, with imperfect capital mobility, interest rates can rise without the exchange rate changing, so there will be some crowding out of investment when government expenditure increases. Good answers illustrate this point using a diagram. Section B Answer TWO questions from this section (25 marks each). Question 2 Subject guide, Chapter 4; KO appendix to Chapter 5 Representing international equilibrium with offer curves (pp ). Answer all parts (a) to (e), providing clear explanations. a. Draw side by side a PPF diagram and an offer curve diagram. Let the PPF be curved as usual. Indicate where on the offer curve diagram corresponds to the world price being equal to the autarky price. The slope of the autarky price line is found by drawing the line tangent to the point on the PPF corresponding to the autarky equilibrium (the point such that the country consumes only its own production of the two goods). The intersection with the offer curve is found by drawing a line starting from the origin with the same slope as the autarky price line on the offer curve diagram. b. Show on both diagrams how an increase in the world price of your export goods can lead to a decrease in the quantity of exports. To show this change the slope of the price line on both graphs. Intuitively, after an improvement in the terms of trade the country needs to export a smaller quantity of its exported good to attain the same quantity of imports. c. Can a decrease in the price of your exports also lead to a decrease in the quantity of goods you import? Yes. This can be answered as part b, just changing the slope of the price curve in the other direction. d. Draw a PPF for a country with Ricardian production functions, described by qa = La, qb = Lb, with La+Lb = 1. Draw the offer curve for this country, assuming their utility function is Leontief (i.e., U(xa,xb) = min{xa,xb}). The PPF will be a straight line with slope qa/qb that intersect the axis at points qa and qb. With Leontief utility function the indifference curves will be L-shaped. The offer curve is drawn as in the standard case. 3

4 16 International economics e. Show on both diagrams how a tariff can increase welfare (you don t need to use the same production and utility functions). A tariff can increase welfare by manipulating the terms of trade in favour of the home economy. Question 3 Brazil produces 1/3 of the world supply of coffee beans. Suppose we divide Brazil s economy into two factors, land and labour, which produce two goods, coffee and other goods. The payment to land we will call the rent, the payment to labour is the wage. Finally, assume coffee production is land-intensive relative to the production of other goods. Explain all your answers clearly. a. Suppose a boom in world demand for coffee raises the price of coffee. What do you expect to happen to the ratio between the wage and rate of rent? (i.e., what happens to the relative return to these two factors?) (3 marks) Stolper Samuelson Theorem: subject guide Chapter 2; KO Resources and output (pp.61 64). By the Stolper Samuelson theorem the ratio will decrease (i.e. the rental rate of land will increase relative to wages). Good answers include a graph to show this. b. Does the increase in the price of coffee help Brazilian workers who buy a lot of coffee? (3 marks) Stolper Samuelson Theorem: subject guide Chapter 2; KO Resources and output (pp.61 64). No because their wage decreases, while the price of coffee increases. Hence, the wage expressed in terms of the price of coffee will decrease and Brazilian workers will be able to afford a smaller quantity of coffee than before. c. Is the increase in price of coffee good for Brazilian land-owners? (3 marks) Stolper Samuelson Theorem: subject guide Chapter 2; KO Resources and output (pp.61 64). Yes because their rental rent of land will increase both in terms of coffee and in terms of other goods. d. Colombia is the second-largest producer of coffee beans. If Brazil has a higher ratio of land to labour than in Colombia, will the wage be higher in Brazil? (4 marks) Factor price equalisation: subject guide Chapter 2; KO Factor price equalisation and trade and income distribution in the short run (pp.68 72). By the factor price equalisation theorem we know that the ratio of wages to rental rate of land will be the same in the two countries. This implies 4

5 Examiners commentaries 2011 that the real wage will be lower in Brazil (thought we cannot say anything about the nominal wage). e. If you observe that the wage is higher in Brazil and Colombia, what are some possible reasons? (4 marks) Factor price equalisation: subject guide Chapter 2; KO Factor price equalization and trade and income distribution in the short run (pp.68 72). This can happen if the factor endowments are so different that one of the two countries completely specialise in the production of one good. In this case, factor price equalisation does not have to hold. This can also happen if the government puts in place policies to mitigate the inequality between workers and land owners. These policies include the imposition of subsidies or tariffs aimed at increasing the price of other goods relative to coffee. Let us now try another model to analyse Brazil. Suppose there are three factors: land, labour, and capital. Coffee is made with land and labour. Other goods are made with labour and capital. f. Does the increase in price of coffee increase the welfare of Brazilian workers who buy a lot of coffee? (4 marks) This depends on whether coffee is more labour intensive than the other goods. If this is the case the increase in the price of coffee will correspond to an increase in real wages. g. Is the increase in the price of coffee good for Brazilian land-owners?(4 marks) Yes, as in part f. Question 4 Consider France and Germany in 1990, when the countries had different currencies. Suppose Germany had an independent monetary policy, while France used their monetary policy to maintain a constant exchange rate with Germany. (Note: it may help to draw Mundell-Fleming diagrams for each country side by side). Explain all your answers clearly. a. If uncovered interest rate parity holds and the exchange rate peg is credible, what is the relation between the French and German nominal interest rates? Uncovered interest parity: subject guide Chapter 12, especially equation 12.1; C pp.86 93; KO pp By UIP they must be equal: i = i* + (Ee E)/E, because Ee = E if the exchange rate is credibly fixed. Very good answers could mention that there could be a difference between i and i* if there is a risk premium. b. When Germany reunified in 1990, they increased public expenditure (G). What is the effect on the German IS curve, and the effect on the French IS curve? (Remember that in this two-country world German imports are French exports and vice-versa). (6 marks) 5

6 16 International economics Mundell-Fleming: subject guide Chapter 16; C pp Consider just the effects without any monetary or exchange rate effects (this is considered in the next question). The increased G shifts out the German IS curve, raising r and Y. The increased German output raises demand for French products (i.e. Y*), so the French IS curve shifts out. c. Suppose Germany does not change its money supply. Use your previous answers to determine the post-reunification levels of the interest rate and output in France, if the French central bank maintains the exchange rate peg. Is it possible to determine whether German reunification will increase or decrease French output? (7 marks) Mundell-Fleming: subject guide Chapter 16; C pp The French LM curve will shift up until the interest rates are equal in France and Germany. Intuitively France will have to implement a restrictive monetary policy to maintain the peg. So in France the IS curve has increased output and the LM has decreased output. The net effect is ambiguous. d. In 1992 the German central bank adopted a tighter monetary policy due to inflationary pressures in Germany. What is the impact of this policy on the French output and interest rate if France continues to defend the exchange rate? Suggest a way to deal with the situation, imagining yourself as a French policy maker during that time. (7 marks) Mundell-Fleming: subject guide Chapter 16; C pp Now the two effects both hurt French output: lower German demand shifts the French IS left, and a higher German interest rate forces France to shift their LM left to match the interest rate (and so keep the exchange rate constant). Both effects hurt French output. The French could (i) abandon the peg, and so let monetary policy stimulate their economy. (ii) use fiscal policy, G, to shift out the IS curve and raise output (sterilise their exchange rate intervention, if assets are imperfect substitutes). Section C Answer ONE question from this section (25 marks). Candidates are encouraged to make use of suitable diagrams, formal analysis and examples, where relevant. Question 5 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, and which would be best for your employers. Trade policy: subject guide Chapter 7; KO Chapters 8 and 9. 6

7 Examiners commentaries 2011 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). Question 6 In a monopolistic competition model of trade, explain why opening to trade causes consumers to consume less of each good. Monopolistic competition: subject guide Chapter 5; KO Chapter 6. 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. Question 7 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.) Mundell-Fleming model: subject guide Chapter 16; C pp An increase in fiscal expenditure (IS shifts right) causes an increase in the interest rate that partly counteracts its positive impact on output 7

8 16 International economics (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. Question 8 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? First generation currency crisis: subject guide Chapter 14; KO Chapter 17. 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). 8