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Question 1 (25 %)
a) Home has an absolute advantage in the production of both goods since its efficiency is the
highest. To determine comparative advantage, we can look at relative prices under autarky or we
can look at relative efficiency. Relative prices are the ratio of labour hours in production, or the
inverse of the ratio of number produced per hour. This gives:
PX / PY Home = 4 / 8  0.50
PX / PY B = 2 / 4  0.50
PX / PY C = 2 / 6  0.33
Comparative advantage is found where the relative prices or the opportunity cost is the lowest.
We see that relative prices are the same in Home and Nation B, hence no pattern of comparative
advantage exists and trade based on comparative advantage will not materialise. We also see
that Nation C has a comparative advantage in Good X since the relative price is the lowest, giving
Home a comparative advantage in good Y.
b) Either 800 X or 400 Y or some combination.
c) Home will export good Y to nation C and import good X.
d)
The world relative price PX/PY = 0.4 with trade falls between the autarky prices, hence both
nations will gain from trade. Home will produce 400 Y. Since the relative price is PX/PY = 0.4, in
principle these could be exported for 400/0.4 = 1000 X in return. There will be gains from trade
as shown below. Other representations may also be possible.
e) The real wage at home is 4 Y or 4 * 2.5 = 10X. If employed in the Good X sector, real wage would
be 8 X; equivalent to 8 * 0.4 = 3.2Y. Real wage in C is 6 X or 6 * 0.4 = 2.4Y. Real wages are higher
in Home because the labour force is more efficient. Wage rates are determined by absolute and
not comparative advantage.
f)
We have complete specialisation because the real wage is highest in the sector where a nation
enjoys a comparative advantage. For example, Home can produce either 8 X or 4 Y per hour.
With the given relative price PX/PY = 0.4, good Y should be produced and one hour is worth 4 *
2.5 = 10X.
Question 2 (25 %)
a) The Ricardian model is discussed in chapter 2 in Feenstra/Taylor, the specific factors model in
chapter 3 and Heckscher-Ohlin in chapter 4. Some points which should be mentioned are that in
the Ricardo model, there is only one factor or production (labour) and comparative advantage is
driven by productivity differences. Since there is only one factor of production, we cannot look at
income distribution in the Ricardo model since all income is earned by labour. In the specific
factor model we have factors of production which in the short run is linked to a given industry,
and we can determine how trade and changing goods prices affect factor returns. The HeckscherOhlin model is a long term model and all factors of production are mobile nationally. We
therefore need to modify some of the conclusions reached in the specific factors model
regarding trade and distribution of income. The Heckscher-Ohlin models also attempts to explain
the pattern of comparative advantage; by supply of real resources.
b) We have that:
RT (PB / P B )  PB  QB  (W / W )  W  LB

RT
RT  T
RT 10%  150  5%  70

 14.4%
RT
80
c) We have that:
0  QC  W  LC
K
RK
W  W  LC 



RK
W  RK  K 
RK 
RK
 75 
 5%    5%
RK
 75 
d) The impact of the increase in the price of barley on the welfare of labour is ambigious because
labour gains in terms of computers since the price of computers remained constant, while wages
increased by 5 %, but lost in terms of barley because the percentage increase in barley is higher
than the percentage change in the wage.
e) Similar to the situation above, capital owners would be worse off because the rental on the
capital would fall by more than the decrease in the computer price. Landowners would be better
off as the rental on land rises even without the increase in the price of barley. The effect on
labour is ambiguous. Wages fall so workers are worse off in terms of barley, but because the
drop in wage is less than the percentage decrease in the manufactured good, labour gains in
terms of that commodity.
Question 3 (25 %)
D = 45 – 3P
S = 3P – 9
a) S = D when 45 – 3P = 3P – 9. P = 9 and Q = 18.
b) With free trade the border price determines the domestic market price, i.e. price = 6. D = 45 – (3
* 6) = 27, S = (3*6) – 9 = 9. Imports are 27 – 9 = 18.
c) Domestic marked price increases by 1 to 7. D = 45 – (3 * 7) = 24, S = (3*7) – 9 = 12. Imports are 24
– 12 = 12.
d) CS is (15 – 6) * 27/2 = 121.50 with free trade and falls to (15 – 7) * 24/2 = 96 with a tariff. PS with
free trade is (6 – 3) * 9/2 = 13.5, increasing to (7 – 3) * 12/2 = 24 with a tariff. Government
revenue with the tariff is 12 * 1 = 12. DWL = 121.50 + 13.5 – 96 – 24 – 12 = 3. It may be
advantage to use a figure to show this also.
e) A quota of 12 is the same import volume we obtained in c). Quantity demanded is 24, domestic
supply 12, imports are 12 and price is 7.
f)
Same as in d). Only difference is that the quota rent of 12 is now captured by domestic producers
and not the government.
g) With a tariff the market power of the monopoly is broken down since the nation can import all it
wishes at a given price, and this price + the tariff determine the domestic market price. With an
absolute quantitative restriction on imports through a quota, the monopolist will monopolise the
market net of the quota, giving a higher market price and a higher DWL.
Question 4 (25 %)
a) This is discussed in chapter 9 in Baldwin/Wyplosz.
b) This is also discussed in chapter 9 in Baldwin/Wyplosz. It is important to stress that in the short
run, money is not neutral. Monetary policy will therefore have an impact on real variables in the
economy. In the long run money is neutral as the increased money supply is absorbed in the
economy through higher prices, and in the long run money will only have an impact on nominal
variables such as inflation and interest rates.
c) There will be depreciation in the short run as capital leaves the country pressing the currency to
depreciate. In the long run, the neutrality of money applies to the exchange rate as well.
Following an increase in the price level, the nominal exchange rate will depreciate, leaving in
principle the real exchange rate unchanged.
Question 5 (25 %)
a) This is discussed in details in chapter 11 in Baldwin/Wyplosz. It is important to stress that if a real
exchange rate is good on average, it may still be incorrect for both nations.
a) If the shock is symmetric, there will be no disagreement or conflicting interest as to how to deal
with the shock.
b) This is also discussed in chapter 11 in the text. It is important to focus at least on the 3 economic
OCA criteria; labour mobility, diversified production structure and open economies.
Question 6 (25 %)
a) We know that there is a deficit bias in the conduct of fiscal policy inside the EU. This is discussed
in detail in chapter 11 in Baldwin/Wyplosz. With recurrent deficits public debt grows, and it is
feared that this growth in debt could eventually lead one country to default. The effect on the
country in question and all other members of the monetary union would be devastating. In order
to maintain a robust system, the SGP limits deficits and debts.
EU public debt (% of GDP)
80
70
60
50
40
30
20
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
b) If the structural budget is in balance or perhaps even in surplus, a nation has sufficient room for
action if the business cycle situation demands it. This is discussed in detail in chapter 11 in
Baldwin/Wyplosz. The rule of thumb is that if GDP falls by 1 %, the deficit increases by 0.5 %
mostly due to automatic stabilizers. If a country almost is reaching the limit of 3 % deficit, there is
no room for a countercyclical fiscal policy to be enacted. Students may wish to discuss the
following setup:
c) What speaks in favour of harmonizing fiscal policy is when policy has substantial external
effects. For example, a fiscal stimulus in a given nation also benefits other countries
through trade channels, and if all nations act independently the measures may be too
large. Some macroeconomic policies also exhibit economies of scale, indicating they
should be carried out on a large scale. What speaks against is primarily that there will be
information asymmetries and heterogeneous preferences among a central authority and
an individual nation, and whoever is closest to the problem may be best suited to solving
it.