Download Examiners` commentaries 2015

Examiners’ commentaries 2015
Examiners’ commentaries 2015
EC3016 International economics
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
• discuss and explain specific policy issues such as ‘environmentalism as
protectionism’; international dumping; the choice of an exchange rate
regime; the desirability of free capital flows
• apply a specific framework to illlustrate the connection between a
variety of models and approaches. Explain the connections between
Ricardian, Heckscher-Ohlin and the specific factors models in trade
theory or between the ‘monetary approach’ and the ‘asset approach’ in
exchange rate theory
• explain how international economic theory has been shaped by real
world events.
Planning your time in the examination
Both Zone A and Zone B papers of the EC3016 International
economics have followed the same format in recent years, namely an
eight-part compulsory question consisting of statements which you are
required to identify as true, false or uncertain and to justify your answers
briefly; and a second section of essay-type questions where you are
required to choose three questions from nine.
Question 1 carries 25 marks and each essay carries 25 marks. In the three
hours available, you should aim to spend around ten minutes on each subquestion of Question 1 and around forty minutes for each essay question.
This leaves a few minutes to read the questions carefully and make a
selection.
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EC3016 International economics
You will waste time if you start a question and then abandon it for one
in which you believe you will perform better. It is worth taking the time
to read through all the questions carefully and to think carefully before
making a selection. Once you have started your essay, it usually makes
sense to persevere and complete it, rather than switching to a new
question halfway through.
What are the examiners looking for?
Examiners are looking for a sound grasp of the economic theory
in the subject guide and associated Essential reading, as well as a sense of
the empirical validity of the models. Moreover, candidates should
make use of examples and discuss theories through these examples. For
example, when discussing exchange rate regimes, you need to show some
familiarity with the Bretton Woods system, the exchange rate mechanism
(ERM) or other systems. A working knowledge of current debates in the
area of international economics, through reading of The Economist or
quality newspapers will also be rewarded, particularly when addressed
with reference to economic theory.
A breadth of knowledge is important. You must have a good grasp of
most, if not all, of the subject guide in order to perform well in Question 1.
The choice offered in the essays allows you to focus on areas that interest
you and for which you’ve explored the Further reading. The level of
depth of analysis expected is similar to that shown in the subject guide
and suggested readings. You are expected to make use of diagrams and
relevant equations to support your explanations and arguments.
It cannot be overstressed that comments on the questions in the 2013
Examiners’ commentaries do not constitute model answers or sketches of
model answers. The Examiners are always looking to reward
candidates who take an original approach to a question.
Key steps to improvement
• You are urged to consider the allocation of marks to each question and
sub-question and to practise answering questions from past papers
under timed conditions.
• You are advised to spend a few minutes reading the questions carefully
before selecting the questions to be attempted.
• You should not answer more than two questions from Section B and
more than one question from Section C. If more than three questions
are attempted, the first three will be marked. Extra credit is not
awarded for attempting more questions than required.
• You would benefit from reading the question more carefully to ensure
you are answering the question asked. In Section A, you should ensure
that you do not forget to conclude whether the statements are true,
false or uncertain after you offer your explanations.
• It is important that you tailor your answers to address the specific
questions asked by picking and choosing the relevant and important
points in order to build a line of argument. You would benefit from
spending a few minutes organising your answers so that the flow of the
argument is clear.
• You would benefit from ensuring that the appropriate level of depth of
analysis is employed when answering the questions.
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Examiners’ commentaries 2015
• You are advised to be patient, and not leave the examination until
you are satisfied that you have thought as hard as possible about each
question.
Examination revision strategy
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This may be due to a
number of reasons. The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One
particular failing is ‘question spotting’, that is, confining your
examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious
consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the
section of the VLE dedicated to each course. You should read the
syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and
questions from year to year and may well set questions that have not
appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be
helpful during your revision, you cannot assume that topics or specific
questions that have come up in past examinations will occur again.
If you rely on a question-spotting strategy, it is likely
you will find yourself in difficulties when you sit the
examination. We strongly advise you not to adopt this
strategy.
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EC3016 International economics
Examiners’ commentaries 2015
EC3016 International economics – Zone A
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
Comments on specific questions
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). Candidates are strongly advised to
divide their time accordingly.
If more questions are answered than requested, only the first answers
attempted will be counted.
Section A
Answer Question 1 from this section.
Question 1
Assume the world has just two competitive economies, Home and Foreign,
denoted respectively by j = H, F. There is just one homogeneous production
factor, labour (L), which is immobile across countries, but perfectly mobile across
sectors within a country. Each country has Lj = 60 units of labour. There are two
goods, denoted by i = 1,2. Each country has a representative consumer with
identical Cobb-Douglas preferences over goods:
uj = u[cj (1), cj (2)] = cj (1)1/2 cj (2)1/2.
[For the full examination question, please refer to the examination paper.]
Reading for part (a) to part (f)
Krugman, P. and M. Obstfeld International economics: theory and policy. (Boston,
MA; London: Pearson/Addison-Wesley, 2009) Pearson international edition;
eighth edition [ISBN 0321553985; 9780321553980] (hereafter KO). Chapter 3.
Subject guide, Chapter 1.
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Examiners’ commentaries 2015
Approaching the question (part (a) to part (f))
a. Home has a comparative advantage in good 1 (and Foreign necessarily
has a comparative advantage in good 2). Under free trade, Home
would therefore export good 1 to Foreign in exchange for good 2.
b. Each country specialises completely. The equilibrium relative price
solve the maximisation problem of the firm: p A j (2)/ p A j (1) = aj
(2)/ aj (1).
c. Write down the maximisation problem.
max u [cj (1), cj (2)]
pj (1) cj (1) + pj (2) cj (2) = wjLj .
The first order conditions of the problem give: cj (i) = wjLj /2pj (i).
d. c H (1) = c F (2) = 15, and c H (2) = c F (1) = 7.5.
e. Both countries specialise completely. Candidates should draw the
following graph.
aH(2)/aH(1)
YW(2)/YW(1)
pτ(2)/pτ(1) = 1
Af(2)/Af(1)
CW(2)/CW(1)
max YF(2)/max YH(1) = 30/30
f. Each of them produces 30 units of the goods. 15 consumed at home
and 15 exported
Reading for part (g) to part (k)
Subject guide, Chapter 12.
Approaching the question (part (g) to part (k))
Consider now Dornbusch’s overshooting model in which there is a small
open economy described by the following set of equations (Lowercase
variables refer to logarithms):
Aggregate Demand: yd = h(e + p * – p) + g(1)
Money Market Equilibrium: ms – p = kyd – 1r(2)
_
Aggregate Supply: ∆p = p (yd – y )
(3)
Uncovered Interest Parity: r = r* + ∆ee(4)
Expectations: ∆ee = θ (e – –e))
(5)
(Note that the last equation in the text has a typo in terms of
the sign of the term in the brackets. The correct version is
∆ee = θ (e– – e)) where e is the nominal exchange rate, –e is the long-run
value of the nominal exchange rate, p(*p) is the
_ domestic (foreign) price
s
level, m stands for nominal money balances, y is potential output, r(*r)
is the domestic (foreign) nominal interest rate, ∆ee the expected rate of
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EC3016 International economics
change in the nominal exchange rate, ∆p is the rate of change of prices
and g is the public expenditure component in the aggregate demand.
g. Dornbusch’s overshooting
(Foreign international interest rate and prices, and are taken as given)
Building blocks are:
Aggregate Demand Block: (IS-LM mechanism in open economy)
Aggregate Demand:
yd = h (e + p* – p) + g(1)
Money Demand:
m – p = k y– – lr
(2)
Aggregate Supply Block: (goods prices are sticky). The aggregate
supply curve is horizontal in the immediate impact phase, increasingly
steep in the adjustment phase and vertical in the long-run.
Δp = π(yd – y–)(3)
Uncovered Interest Parity:
r = r*+Δee
(4)
Expectations:
Δee=θ(e– – e)
(5)
In the long-run y = y–, r = –r . From (2) we get that
p = m + lr* – k y–
0
0
0
0
y −g
q0 = 0
h
From (1) we get that
And from the definition of the real exchange rate we get that
e0 =
y0 − g
*
− p0 + m0 + lr0* − ky0
h
h. Combining equation (2), (4) and (5) one should obtain
m – p = ky– – lr* – lθ (e– – e)
That can be rewritten, by taking into account the long run value for p,
as
e=e−
1
( p − p)
lθ
i. Combining equation (1) and (3) we obtain
_
Δp = π(q = q )
In equilibrium
_
_
q = q and e = p + q
j. An increase in domestic public expenditure will cause a long-run
appreciation of both real and nominal exchange rates. In the long-run
y = y–, r = –r . From (2) we get that
p = p = m + lr * – ky–
1
0
0
0
From (1) we get that
q1 =
6
y 0 − g1
< q0
h
0
Examiners’ commentaries 2015
And from the definition of the real exchange rate we get that
y −g
*
e1 = 0 1 − p0 + m0 + lr0* − ky0 < e0
h
k. The increase in domestic public expenditure will increase aggregate
demand. In the long-run for a given output capacity, goods market
equilibrium will require that external demand will be lower and as such
the real exchange rate has to appreciate.
Appreciation of the real exchange rate is associated with nominal
appreciation as the price level does not change since monetary
conditions (money supply and the real interest rate) are invariant.
_
The only curve that will shift is the GG line (q = q ) since now the
real exchange rate has appreciated. The economy will jump from the
initial equilibrium to the new ones in which the nominal exchange rate
reaches immediately the new long-run value. There is no overshooting
of the nominal exchange rate.
Section B
Answer three questions from this section.
Question 2
Trade eliminates cross-country inequality in income. Is this statement true in the
context of the Ricardian model? Explain.
Reading for the question
KO, Chapter 3.
Subject guide, Chapter 1.
Approaching the question
False. Wage rates remain equal to the marginal productivity of labour.
Hence wage rates are not equalised in terms of wage rate.
Question 3
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?
Reading for the question
KO, Chapter 4.
Subject guide, Chapter 2.
Approaching the question
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.
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EC3016 International economics
Question 4
‘A country should not impose an import tariff because it reduces national
welfare.’ Is this statement true? Explain.
Reading for this question
Subject guide, Chapters 4 and 7.
KO, Chapters 6 and 9.
Approaching the question
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.
Question 5
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 computer is expected to grow in future
years. Evaluate the Minister’s argument in the context of the welfare impact of
these two trade instruments
Reading for this question
Subject guide, Chapter 4.
KO, Chapters 6 and 9.
Approaching the question
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.
Question 6
Why might countries engage in preferential trade agreements?
Reading for this question
Subject guide, Chapter 9.
KO, Chapter 9, pp.232–36.
Approaching the question
First step to further integration. Better than no policy if the trade creating
is more than trade diversion.
Question 7
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.)
Reading for this question
Subject guide, Chapter 13.
KO, Chapter 18.
Copeland, L. Exchange rates and international finance. (Harlow: FT Prentice Hall,
2008) fifth edition [ISBN 9780273710271], Chapter 6.
Approaching the question
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
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Examiners’ commentaries 2015
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.
Question 8
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?
Reading for this question
Copeland (2008), Chapter 5.
Approaching the question
The monetary approach to exchange rate determination is characterised
by flexible prices, fixed supply and money demand equation that depends
only on income through velocity of money.
Under a floating exchange rate regime changes 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. In
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). (with graphs as well)
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
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
Ms
the initial price level by decreasing money supply. P =
and the
ky
required money supply adjustment is such that
M 1s
M 0s
=
y1
y0
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EC3016 International economics
Question 9
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).
Reading for this question
Subject guide, Chapter 12.
Approaching the question
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:
YN = AN LN YN* = AN* LN*, AN=AN*,
YT = AT LT YT* =AT* LT*, AT<AT*
• the law of one price holds for tradeable.
Note that we haven’t specified anything in terms of the demand side of the
model.
Profit maximisation by firms in all sectors implies (there is perfect
competition and prices are equal to marginal costs):
WN = AN PN and WT = AT PT,
WN* = AN* PN* and WT* = AT* PT*
Labour mobility within countries ensures wage equalisation between
sectors in each countries:
WN* = WT* and WN = WT.
This implies that
By assumption we have that AT < AT* and AN = AN* so that
and if the law of one price holds for traded goods it follows
PN <ePN*
The price level of the non-tradeable is higher in the rich country and PPP
fails.
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
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Examiners’ commentaries 2015
world and to the productivity in their own non tradable 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 will
become closer to the levels of developed countries.
Question 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?
Reading for this question
Copeland (2008), Chapter 16.
Approaching the question
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.
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EC3016 International economics
Examiners’ commentaries 2015
EC3016 International economics – Zone B
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
Comments on specific questions
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). Candidates are strongly advised to
divide their time accordingly.
If more questions are answered than requested, only the first answers
attempted will be counted.
Section A
Answer Question 1 from this section.
Question 1
Assume the world has just two competitive economies, Home and Foreign,
denoted respectively by j = H, F. There is just one homogeneous production
factor, labour (L), which is immobile across countries, but perfectly mobile across
sectors within a country. Each country has Lj = 60 units of labour. There are two
goods, denoted by i = 1,2. Each country has a representative consumer with
identical Cobb-Douglas preferences over goods:
uj = u[cj(1), cj(2)] = cj(1)1/2cj(2)1/2.
[For the full examination question, please refer to the examination paper.]
Reading for part (a) to (f) of this question
KO, Chapter 3.
Subject guide, Chapter 1.
Approaching the question (part (a) to part (f))
a. Home has a comparative advantage in good 1 (and Foreign necessarily
has a comparative advantage in good 2). Under free trade, Home
would therefore export good 1 to Foreign in exchange for good 2.
12
Examiners’ commentaries 2015
b. Each country specialises completely. The equilibrium relative price
solve the maximisation problem of the firm: p A j (2)/ p A j (1) = aj
(2)/ aj (1).
c. Write down the maximisation problem.
max u [cj (1), cj (2)]
pj (1) cj (1) + pj (2) cj (2) = wjLj .
The first order conditions of the problem give: cj (i) = wjLj /2pj (i) .
d. c H (1) = c F (2) = 15, and c H (2) = c F (1) = 7.5.
e. Both countries specialise completely. Candidates should draw the
following graph.
aH(2)/aH(1)
YW(2)/YW(1)
pτ(2)/pτ(1) = 1
Af(2)/Af(1)
CW(2)/CW(1)
max YF(2)/max YH(1) = 30/30
f. Each of them produces 30 units of the goods. 15 consumed at home
and 15 exported.
Reading for part (g) to part (k)
Subject guide, Chapter 12.
Approaching the question (part (g) to part (k))
Consider now the Dornbusch’s overshooting model in which there
is a small open economy described by the following set of equations
(Lowercase variables refer to logarithms):
Aggregate Demand: yd = h(e + p * – p) + g(1)
Money Market Equilibrium: ms – p = kyd – 1r(2)
_
Aggregate Supply: ∆p = p (yd – y )
(3)
Uncovered Interest Parity: r = r* + ∆ee(4)
Expectations: ∆ee = θ (e – –e))
(5)
(Note that the last equation in the text has a typo in terms of
the sign of the term in the brackets. The correct version is
∆ee = θ (e– – e)) where e is the nominal exchange rate, –e is the long-run
value of the nominal exchange rate, p(*p) is the
_ domestic (foreign) price
level, ms stands for nominal money balances, y is potential output, r(*r)
is the domestic (foreign) nominal interest rate, ∆ee the expected rate of
change in the nominal exchange rate, ∆p is the rate of change of prices
and g is the public expenditure component in the aggregate demand.
Please refer to Zone A for the answers for part (g) to part (k).
13
EC3016 International economics
Section B
Answer three questions from this section.
Question 2
A monopolistically competitive firm with unit costs faces the following linear
demand function:
Q(c) = a–bP(c)
Where a, b > 0 and P(c) is the price charged by the firm. Suppose opening to free
trade lowers a. Explain how international trade can provide productivity gains in
this example. Assume that fixed production costs are zero.
There was no solution to this question given by this year’s candidates.
Question 3
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?
Reading for the question
Subject guide, Chapter 3.
Approaching this question
Wages fall. The income of land owners fall and the income of capital
owners increase.
Question 4
Use a general equilibrium diagram to how 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.
Reading for the question
Subject guide, Chapters 4 and 7.
KO, Chapters 6 and 9.
Approaching this question
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.
Question 5
Why should countries engage in preferential trade agreements?
Reading for the question
Subject guide, Chapter 9.
KO, Chapter 9 pp.232–36.
Approaching this question
First step to further integration. Better than no policy if the trade creating
is more than trade diversion.
14
Examiners’ commentaries 2015
Question 6
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.
Reading for the question
Subject guide, Chapter 12, p.116.
Approaching this question
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.
Question 7
In a 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.
Approaching this question
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.
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EC3016 International economics
Question 8
What is the ‘policy regime trilemma’? Do you think that individual countries in
the Eurozone area are facing the ‘policy trilemma’?
Approaching this question
There are three desirable objectives in terms of policy regime:
a. stable (fixed) exchange rate
b. an independent monetary policy dealing with domestic objectives
c. free capital mobility.
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.
Question 9
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
Approaching this question
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)
Interpretation:
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.
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Examiners’ commentaries 2015
Question 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 rationalize the SNB’s decision?
Reading for the question
Copeland, Chapter 16 ‘Crises and Credibility’ (the second generation models).
Approaching this question
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 are 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.
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