Fisher Equating

𝑟𝑡 = 𝑖𝑡 − 𝜋𝑡+1 ;

𝑃𝑡+1 − 𝑃𝑡
𝜋𝑡+1 =
𝑃𝑡

𝑃𝑡 is either CPI or GDP Deflator

National Income Identity:

𝑟 𝑌 𝑟 𝑝 𝑝 𝑌
𝑌 = 𝐶 ( , ) + 𝐼 ( ) + 𝐺 + 𝑋 ( ) − 𝑀( , )
−+ − + −+
𝑟 𝑌 𝑟 𝑌 𝑟
𝐴( , ) = 𝐶( , )+𝐼( )+𝐺
−+ −+ −

Gordon Growth Model:

Stock price is the present discounted value of future Dividend.

𝐷𝑡+1 𝐷𝑡+2
𝑃𝑆𝑡 = + + ⋯ ..
1 + 𝑟 (1 + 𝑟)2

𝐷𝑡+1 = (1 + 𝑔)𝐷𝑡 ; 𝑔 < 𝑟

1+𝑔
𝑃𝑆𝑡 = 𝐷
𝑟−𝑔 𝑡

Nominal Exchange Rate: It is denoted by 𝑆, and defined as the amount of domestic currency
that can fetch one unit of foreign currency. It is the rate at which currencies are exchanged in
the foreign exchange market. It is also the price of foreign currency in terms of the domestic
currency. We will consider the foreign country is the US and the domestic country is India.
𝑅𝑠
The unit of the nominal exchange rate in our analysis is . When nominal exchange rate
$
rises, it means you have to spend more domestic currency to obtain one unit of foreign
currency. It implies a reduction in value of domestic currency. It is known as depreciation of
domestic currency. It also implies a depreciation of nominal exchange rate. Hence, a rise in
nominal exchange rate is known as the depreciation of exchange rate.

Real Exchange Rate: It is the rate at which goods are exchanged between two countries. It is
𝑆𝑃 ∗
denoted by 𝑝 in our analysis. By definition, 𝑝 = , where, 𝑃∗ is the price of foreign good
𝑃
produced in foreign country and priced in foreign currency (USD), and 𝑃 is the price of the
same good produced in the domestic country and denominated in domestic currency (INR). It
is a unit free measure. It represents the relative price of good produced in the foreign country
and the good produced in the domestic country after converting in same domestic currency
unit.

𝑝 > 1 implies foreign good is costly compared to the domestic good. This induces higher
export of the domestic good and lower import of foreign good. Hence, it implies a rise in net
export (𝑁𝑋 = 𝑋 − 𝑀)
𝑝 𝑌 𝑝 𝑝 𝑌
𝑁𝑋 ( , ) = 𝑋 ( ) − 𝑀( , )
+− + −+

𝜕𝑀
0< <1
𝜕𝑌

𝐴 = 𝑎0 − 𝑎1 𝑟 + 𝑎2 𝑌
𝑝 𝑌 𝑝 𝑝 𝑌
𝑁𝑋 ( , ) = 𝑋 ( ) − 𝑀( , )
+− + −+

𝑁𝑋 = 𝑓0 + 𝑓1 𝑝 − 𝑓2 𝑌

𝑟 is real interest rate, 𝑝 is the real exchange rate

Data Shows:

𝜕𝐶
0< <1
𝜕𝑌
𝜕𝐶
Marginal propensity to consumption: 𝜕𝑌

𝑟 𝑌 𝑟 𝑌 𝑟 𝑝 𝑝 𝑌
Savings: 𝑆 ( , ) = 𝑌 − 𝐶 ( , ) = 𝐼 ( ) + 𝐺 + 𝑋 ( ) − 𝑀( , )
++ −+ − + −+

National Income Identity

Y=C+I+G+X-M

Y-T+interest income from net foreign assets=C+I+G-T+X-M+interest income from net

foreign assets

GNP=C+I+G-T+CA;

CA=∆𝑁𝐹𝐴 or NIIP

S – I = G – T + CA
 S – I = G - T + ∆𝑁𝐹𝐴 or NIIP
Current Account (CA) surplus allows to accumulate higher foreign assets ( ∆𝑁𝐹𝐴 positive)
and improves Net International Investment Position (NIIP) of a Country
𝐶𝐴 = 𝑇𝑟𝑎𝑑𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 (𝑇𝐵) + Interest Income from Net Foreign Assets
𝑇𝑟𝑎𝑑𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 (𝑇𝐵) = 𝐸𝑥𝑝𝑜𝑟𝑡 (𝑋) − 𝐼𝑚𝑝𝑜𝑟𝑡 (𝑀)
Note,
𝐶𝐴 − 𝑇𝑟𝑎𝑑𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 (𝑇𝐵) > 0 ⇒ Interest Income from Net Foreign Assets > 0
𝐶𝐴 − 𝑇𝑟𝑎𝑑𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 (𝑇𝐵) < 0 ⇒ Interest Income from Net Foreign Assets < 0
Countries with Interest Income from Net Foreign Assets > 0 are international
creditor/lenders
Countries with Interest Income from Net Foreign Assets < 0 are international
debtor/borrower

Nominal Exchange Rate: It is denoted by 𝑆, and defined as the amount of domestic currency
that can fetch one unit of foreign currency. It is the rate at which currencies are exchanged in
the foreign exchange market. It is also the price of foreign currency in terms of the domestic
currency. We will consider the foreign country is the US and the domestic country is India.
𝑅𝑠
The unit of the nominal exchange rate in our analysis is . When nominal exchange rate
$
rises, it means you have to spend more domestic currency to obtain one unit of foreign
currency. It implies a reduction in value of domestic currency. It is known as depreciation of
domestic currency. It also implies a depreciation of nominal exchange rate. Hence, a rise in
nominal exchange rate is known as the depreciation of exchange rate.

Real Exchange Rate: It is the rate at which goods are exchanged between two countries. It is
𝑆𝑃 ∗
denoted by 𝑝 in our analysis. By definition, 𝑝 = , where, 𝑃∗ is the price of foreign good
𝑃
produced in foreign country and priced in foreign currency (USD), and 𝑃 is the price of the
same good produced in the domestic country and denominated in domestic currency (INR). It
is a unit free measure. It represents the relative price of good produced in the foreign country
and the good produced in the domestic country after converting in same domestic currency
unit.

𝑝 > 1 implies foreign good is costly compared to the domestic good. This induces higher
export of the domestic good and lower import of foreign good. Hence, it implies a rise in net
export (𝑁𝑋 = 𝑋 − 𝑀)
𝑝 𝑌 𝑝 𝑝 𝑌
𝑁𝑋 ( , ) = 𝑋 ( ) − 𝑀( , )
+− + −+

Purchasing Power Parity (PPP): Satisfaction of PPP implies same good is priced
identically across the worlds. PPP implies, 𝑝 = 1 . PPP does not hold for non-tradable goods.
PPP also does not hold in the presence of trade barriers, e.g., tariff, quota, etc.

Demand for USD: $𝑑 = 𝑑0 − 𝑑1 𝑆

Supply of USD: $𝑠 = 𝜎0 + 𝜎1 𝑆
𝑑 −𝜎
At equilibrium, $𝑑 = $𝑠 . This implies, market clearing exchange rate, 𝑆 ∗ = 𝑑0 +𝜎0; and market
1 1
clearing USD obtained by submitting 𝑆 ∗ to demand curve or supply curve. I substitute, 𝑆 ∗ to
𝑑 −𝜎
the demand curve to obtain the market clearing USD. It gives, $∗ = 𝑑0 − 𝑑1 𝑑0 +𝜎0
1 1

Suppose, the demand for USD rises. The new demand curve becomes, $𝑑 = 𝑑0′ − 𝑑1 𝑆; 𝑑0′ >
𝑑0 . This causes the demand for USD curve shifts up. The new market clearing nominal
𝑑′ −𝜎 𝑑′ −𝜎
exchange rate, and USD become, 𝑆 ∗∗ = 𝑑0 +𝜎0 ; $∗∗ = 𝑑0′ − 𝑑1 𝑑0 +𝜎0. This is the case under
1 1 1 1
flexible exchange rate.
Now, suppose government follows a fixed exchange rate regime. In this case, government
won’t allow nominal exchange rate to change even if demand for USD rises. Government
increases supply of USD to such a level so that, the nominal exchange rate remains fixed at
𝑆 ∗.

Mathematically, government sets, 𝜎0′ = 𝑑0′ − (𝑑1 + 𝜎1 )𝑆 ∗. In this case the demand for USD
𝑑 −𝜎
will be, $∗∗∗ = 𝑑0′ − 𝑑1 𝑆 ∗ = 𝑑0′ − 𝑑1 𝑑0 +𝜎0
1 1

The description given above is graphically explained below.

 S

𝑑0′
𝑑1

𝑑0
𝑑1

𝑆 ∗∗

𝑆∗

$∗ $∗∗ 𝑑0 $∗∗∗ 𝑑0′ $

𝜎0
𝜎1

𝜎0′
𝜎1
Numerical Example:

$𝑑 = 10 − 0.4𝑆

$𝑠 = 5 + 0.6𝑆

Here, 𝑑0 = 10, 𝑑1 = 0.4; 𝜎0 = 5, 𝜎1 = 0.6

𝑑0 − 𝜎0 𝑑0 − 𝜎0
𝑆∗ = = 5; $∗ = 𝑑0 − 𝑑1 = 10 − 2 = 8
𝑑1 + 𝜎1 𝑑1 + 𝜎1

New demand for USD,

$𝑑 = 20 − 0.4𝑆

𝑑0′ = 20

Flexible Exchange Rate:

𝑑′ −𝜎 𝑑′ −𝜎
𝑆 ∗∗ = 𝑑0 +𝜎0 =15; $∗∗ = 𝑑0′ − 𝑑1 𝑑0 +𝜎0 = 20 − 0.4 ∗ 15 = 14
1 1 1 1

Fixed Exchange Rate:

𝑑0 − 𝜎0
𝑆∗ = =5
𝑑1 + 𝜎1

𝜎0′ = 𝑑0′ − (𝑑1 + 𝜎1 )𝑆 ∗ = 20 − 5 = 15

$∗∗∗ = 𝑑0′ − 𝑑1 𝑆 ∗ = 20 − 0.4 ∗ 5 = 20 − 2 = 18

Demand for USD: $𝑑 = 𝑑0 − 𝑑1 𝑆 , when $𝑑 ≤ $̅𝑑

= $̅𝑑 , 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒

Supply of USD: $𝑠 = 𝜎0 + 𝜎1 𝑆

In equilibrium,

$̅𝑑 = 𝜎0 + 𝜎1 𝑆

$̅ 𝑑 − 𝜎0
or, 𝑆̅ = 𝜎1

𝑑0 − 𝜎0
𝑆∗ =
𝑑1 + 𝜎1

𝑑0 − 𝜎0
$∗ = 𝑑0 − 𝑑1
𝑑1 + 𝜎1

Excess demand for USD:

$∗ − $̅𝑑

Here, 𝑑0 = 10, 𝑑1 = 0.4; 𝜎0 = 5, 𝜎1 = 0.6; $̅𝑑 = 6

𝑑0 − 𝜎0 𝑑0 − 𝜎0
𝑆∗ = = 5; $∗ = 𝑑0 − 𝑑1 = 10 − 2 = 8
𝑑1 + 𝜎1 𝑑1 + 𝜎1

$̅𝑑 − 𝜎0
𝑆̅ = = 1.67
𝜎1

Excess demand for USD:

$∗ − $̅𝑑 = 8 − 6 = 2
 S

𝑑0
𝑑1

𝑆∗

𝑆̅

$̅̅̅
𝑑
$𝑑 , $ 𝑠

𝜎0
-
𝜎1
Interest Rate Parirty: This implies capital/investment should have identical return internally

𝑖 ∗ is the return of 1 USD deposit to a US bank after one year. The total return after one year is
USD (1 + 𝑖 ∗ ).

𝑖 is the return of 1 INR deposit to an Indian bank after one year. The total return after one
year is INR (1 + 𝑖).

A deposit of USD 1 to the Indian bank yields return INR 𝑆(1 + 𝑖) after one year.

Suppose, the nominal exchange has changed from 𝑆 to 𝑆 ′ after one year. So, the return after
𝑆(1+𝑖)
one year is USD .
𝑆′

Interest rate parity implies,

𝑆(1 + 𝑖)
(1 + 𝑖 ∗ ) =
𝑆′
Covered Interest Rate Parity: When 𝑆 ′ = 𝐹, where F is a forward exchange rate on which
the individual is at a forward contract. It safeguards the individual from the uncertainty of
future exchange rate fluctuations.

𝑆(1 + 𝑖)
(1 + 𝑖 ∗ ) =
𝐹
Covered Interest Rate Differential:

𝐹
(1 + 𝑖) − (1 + 𝑖 ∗ )
𝑆
Domestic interest rate (𝑖) rises. Demand for INR rises and demand for USD falls. Indian
currency appreciates. As a result exchange rate (𝑆) also appreciates. Note, an appreciation of
exchange implies a reduction in exchange rate. This dynamics is possible under open market
and flexible exchange rate.

When capital market is open and exchange rate is fixed (𝑆 = 𝐹) implies 𝑖 = 𝑖 ∗ . This also
implies the domestic country does not have monetary policy independence. In this case, when
domestic interest rate (𝑖) rises, there a pressure on the domestic currency to appreciate. Since,
the exchange rate is fixed, central bank to intervene in the foreign exchange market to keep
the exchange rate unchanged. The central purchase USD and sells INR. The rise in foreign
exchange reserves increases money supply and reduces interest rate so that 𝑖 = 𝑖 ∗ is
maintained.

Fixed exchange rate and monetary policy independence can be maintained when capital
market is closed and the interest rate parity condition is not relevant.

This implies fixed exchange rate, monetary policy independence and open capital market
cannot be maintained simultaneously. This is known as the “impossible trinity” in
international finance.
Basic Concepts

Opportunity Cost: Opportunity cost of good X is the amount of Good Y one receives by
foregoing 1 unit of X. Suppose, we have 2 goods – Cheese and Wheat with unit of
measurement kg. Then, the Opportunity cost of Cheese is the amount of Wheat one receives
in kg by foregoing 1 kg of Cheese.

Suppose, 1 labour-hour is needed to produce 10 kgs of Cheese, and 100 kgs of Wheat. What
is the opportunity cost of Cheese?

Foregoing 10 kg of Cheese releases 1 labour-hour. This implies, foregoing 1 kg Cheese

1 1
releases 10 labour hour. Using this extra 10 labour hour, how much wheat can be produced?

1 1 100
1 labour-hour produces 100 kg Wheat. Then, 10 labour hour produces, 100 10 = = 10 kg
10
Wheat. Therefore, the opportunity Cost of Cheese is 10 kg of Wheat.

Generalizing the Concept:

Suppose, amount of labour-hour required to produce 1 unit of Cheese is 𝑎𝐿𝐶 ; and the amount
of labour-hour required to produce 1 unit of Wheat is 𝑎𝐿𝑊 . What is the opportunity Cost of
Cheese?

Foregoing 1 unit of Cheese releases 𝑎𝐿𝐶 labour-hour. How much Wheat can be produced by
using 𝑎𝐿𝐶 labour-hour?
1
Note, 𝑎𝐿𝑊 labour-hour produces 1 unit of Wheat. This implies, 1 labour-hour produces 𝑎
𝐿𝑊
𝑎
units of Wheat. This further implies, 𝑎𝐿𝐶 labour-hour produces, 𝑎 𝐿𝐶 units of Wheat. So, the
𝐿𝑊
𝑎𝐿𝐶
opportunity Cost of Cheese is, 𝑎
𝐿𝑊

Production Possibility Frontier:

Suppose, the total labour endowment of a country is 𝐿. Also assume, that the country
produces both Cheese and Wheat. Suppose, amount of labour-hour required to produce 1 unit
of Cheese is 𝑎𝐿𝐶 ; and the amount of labour-hour required to produce 1 unit of Wheat is 𝑎𝐿𝑊
for the country. Suppose, the country produces C units of Cheese, and W units of Wheat.
Then, the labour market equilibrium of the country suggests.

𝑎𝐿𝐶 𝐶 + 𝑎𝐿𝑊 𝑊 = 𝐿
 The above equation is the Production Possibility Frontier (PPF) of the country.
Wheat

𝐿
𝑎𝐿𝑊

𝐿 Cheese
𝑎𝐿𝐶

𝑎
Slope of the PPF is, − 𝑎 𝐿𝐶 , which is the negative of the Opportunity cost of Cheese. Here, the
𝐿𝑊
negative sign implies, one has to forego Cheese to obtain Wheat.

Numerical Example:
Suppose, a country produces Cheese and Wheat. The country uses 2 labour-hour to produce 1
kg of Cheese, and 5 labour hour to produce 1 kg of Wheat. The total endowment of labour-
hour of the country is 12,000. Suppose, the country produces 100 kg of Cheese. How much
Wheat is produced using full endowment of labour-hour. Answer by writing down the PPF of
the country. What is the opportunity cost of Cheese?
Suppose, the country produces W kg of Wheat. Here, 𝑎𝐿𝐶 = 2 and 𝑎𝐿𝑊 = 5. The PPF is,
2 ∗ 100 + 5 ∗ 𝑊 = 12000
𝑊 = 2360
2
The country produces 2360 kg Wheat. The opportunity Cost of Cheese is, 5
 Supply Function of Cheese:

Suppose, the price of Cheese in the country is, 𝑝𝐶 , and the same for Wheat is 𝑝𝑊 . Suppose,
the wage given is factories producing Cheese is 𝑊𝐶 , and the same in factories producing
Wheat is 𝑊𝑊 . The revenue earned by factories by producing 1 unit of Cheese is, 𝑝𝐶 . Since,
𝑎𝐿𝐶 is the amount of labour-hour required to produce 1 unit of Cheese, the cost of producing
1 unit of Cheese is, 𝑊𝐶 𝑎𝐿𝐶 . If, the entire revenue is devoted to hire labour-hour we get,
𝑝𝐶
𝑝𝐶 = 𝑊𝐶 𝑎𝐿𝐶 ⇒ 𝑊𝐶 =
𝑎𝐿𝐶
𝑝
Similarly, for factories producing Wheat we get, 𝑊𝑊 = 𝑎 𝑊
𝐿𝑊

𝑝 𝑝 𝑝 𝑎
The country will produce only Cheese if, 𝑊𝐶 > 𝑊𝑊 ⇒ 𝑎 𝐶 > 𝑎 𝑊 ⇒ 𝑝 𝐶 > 𝑎 𝐿𝐶 . In this case,
𝐿𝐶 𝐿𝑊 𝑊 𝐿𝑊
𝐿
PPF gives the total production of Cheese is, 𝑎
𝐿𝐶

𝑝 𝑝 𝑝 𝑎
The country will produce only Wheat if, 𝑊𝑊 > 𝑊𝐶 ⇒ 𝑎 𝑊 > 𝑎 𝐶 ⇒ 𝑝 𝐶 < 𝑎 𝐿𝐶 . In this case,
𝐿𝑊 𝐿𝐶 𝑊 𝐿𝑊
𝐿
PPF gives the total production of Wheat is, 𝑎
𝐿𝑊

𝑝 𝑝 𝑝 𝑎
The country will produce both Cheese and Wheat if, 𝑊𝐶 = 𝑊𝑊 ⇒ 𝑎 𝐶 = 𝑎 𝑊 ⇒ 𝑝 𝐶 = 𝑎 𝐿𝐶 . In
𝐿𝐶 𝐿𝑊 𝑊 𝐿𝑊
this case, the country produces anywhere on the PPF.

Supply function of Cheese relative is drawn below

𝑝𝐶ℎ𝑒𝑒𝑠𝑒
𝑝𝑊ℎ𝑒𝑎𝑡

𝑎𝐿𝐶
𝑎𝐿𝑊

𝐿 𝐶ℎ𝑒𝑒𝑠𝑒
𝑎𝐿𝐶
Numerical Example:
Suppose, a country produces Cheese and Wheat. The country uses 2 labour-hour to produce 1
kg of Cheese, and 5 labour hour to produce 1 kg of Wheat. Suppose, the price of Cheese is
Rs. 20 per kg and that of Wheat is, Rs. 10 per kg. What is the wage rate given in Cheese
factories and Wheat factories? Which good be produced by the country and what is the
amount? Assume, that the total endowment of labour-hour of the country is, 12000.
Here, 𝑎𝐿𝐶 = 2, 𝑎𝐿𝑊 = 5; and 𝑝𝐶 = 20, 𝑝𝑊 = 10
𝑝 20
Wage in the Cheese factories is, 𝑊𝐶 = 𝑎 𝐶 = = 10
𝐿𝐶 2

𝑝 10
Wage in the Wheat factories is, 𝑊𝑊 = 𝑎 𝑊 = =2
𝐿𝑊 5

Note, 𝑊𝐶 = 10 > 𝑊𝑊 = 2. This implies that, the country produces only Cheese. The total
12000
production of Cheese is, = 6000 kg.
2

Technological Difference (difference in labour productivity) as a Basis of Trade: The

Ricardian Model of Trade

Suppose, the country we have discussed above is the Home country. Now, let us introduce a
∗
Foreign country with endowment of labour-hour 𝐿∗ . The country uses 𝑎𝐿𝐶 labour-hour to
∗
produce a unit of Cheese, and 𝑎𝐿𝑊 labour-hour produce a unit of Wheat. We assume,
opportunity cost of Cheese in the Home country is less than that of the Foreign country,
𝑎𝐿𝐶 𝑎∗
< 𝑎∗𝐿𝐶 . This implies, the PPF of the Foreign country is steeper than the Home country
𝑎𝐿𝑊 𝐿𝑊
(we can assume that the Foreign country is producing 𝐶 ∗ unit of Cheese, and 𝑊 ∗ unit of
Wheat, and draw the PPF of the Foreign country). This also, implies that, the productivity of
labour in the Cheese factories of the Home country is more than the same in the Foreign
country, and the labour working in the Wheat factories of the Foreign country is more
productive than the sme in the Wheat factories in the Home country.

This implies, Home (Foreign) country has the Comparative Advantage in Cheese (Wheat)
production. When trade opens up, Home (Foreign) country specializes in the production of
Cheese (Wheat) and exports the same to the Foreign country. Foreign country on the other
hand specializes and exports Wheat to the Home country when trade opens up. This is the
Ricardian Theory of Labour Productivity and Comparative Advantage, where the basis
of trade is the technological difference among the countries.
 Supply Function of Cheese of the Foreign country:

Suppose, the price of Cheese in the Foreign country is, 𝑝𝐶∗ , and the same for Wheat is, 𝑝𝑊
∗
.
∗
Suppose, the wage given is factories producing Cheese in the Foreign country is, 𝑊𝐶 and the
∗
same in factories producing Wheat is 𝑊𝑊 . Then,
𝑝∗ 𝑎∗
The Foreign country will produce only Cheese if, 𝑊𝐶∗ > 𝑊𝑊∗ ⇒ 𝑝∗𝐶 > 𝑎∗𝐿𝐶 . In this case, PPF
𝑊 𝐿𝑊
𝐿∗
of the Foreign country gives the total production of Cheese is, 𝑎∗
𝐿𝐶

∗ ∗
𝑝𝐶 𝑎𝐿𝐶
The Foreign country will produce only Wheat if, 𝑊𝑊∗ > 𝑊𝐶∗ ⇒ ∗ < ∗ . In this case, PPF of
𝑝𝑊 𝑎𝐿𝑊
𝐿∗
the Foreign country gives the total production of Wheat is, 𝑎∗
𝐿𝑊

𝑝∗ 𝑎∗
∗
The Foreign country will produce both Cheese and Wheat if, 𝑊𝑊 = 𝑊𝐶∗ ⇒ 𝑝∗𝐶 = 𝑎∗𝐿𝐶 . In this
𝑊 𝐿𝑊
case, the country produces anywhere on her PPF.

Supply function of Cheese of the Foreign country is drawn below

𝑝𝐶ℎ𝑒𝑒𝑠𝑒
𝑝𝑊ℎ𝑒𝑎𝑡

∗
𝑎𝐿𝐶
∗
𝑎𝐿𝑊

𝐿∗ 𝐶ℎ𝑒𝑒𝑠𝑒
∗
𝑎𝐿𝐶
 Relative Supply Function of Cheese with respect to Wheat of the World:

𝑝𝐶ℎ𝑒𝑒𝑠𝑒
𝑝𝑊ℎ𝑒𝑎𝑡

𝑝𝐶∗ ∗
𝑎𝐿𝐶
∗ = ∗
𝑝𝑊 𝑎𝐿𝑊

𝐷𝐹
𝑝𝐶𝑊𝑜𝑟𝑙𝑑
𝑊𝑜𝑟𝑙𝑑
𝑝𝑊

𝐷𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎𝐿𝐶
=
𝑝𝑊 𝑎𝐿𝑊

𝐷𝐻

𝐶ℎ𝑒𝑒𝑠𝑒
𝐿
𝑎𝐿𝐶 𝑊ℎ𝑒𝑎𝑡
𝐿∗
∗
𝑎𝐿𝑊

Suppose, relative demand of Cheese with respect to Wheat in the Home country is, 𝐷𝐻 , and
the same for the Foreign country is 𝐷𝐹 . Figure above shows both countries produce both
Cheese and Wheat at autarky. The relative price of Cheese in the Home and in the Foreign
𝑝 𝑎 𝑝∗ 𝑎∗ 𝑝 𝑝∗
country is 𝑝 𝐶 = 𝑎 𝐿𝐶 and 𝑝∗𝐶 = 𝑎∗𝐿𝐶 respectively at autarky with 𝑝 𝐶 < 𝑝∗𝐶
𝑊 𝐿𝑊 𝑊 𝐿𝑊 𝑊 𝑊

Suppose, the world demand function for Cheese relative to world demand for wheat is
𝐷𝑊𝑜𝑟𝑙𝑑 . Figure above shows, once trade opens up, the new World relative price of Cheese
𝑎 𝑝𝑊𝑜𝑟𝑙𝑑 𝑎∗ 𝑝 𝑝𝑊𝑜𝑟𝑙𝑑 𝑝∗
with respect to Wheat becomes, 𝑎 𝐿𝐶 < 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 < 𝑎∗𝐿𝐶 ⇒ 𝑝 𝐶 < 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 < 𝑝∗𝐶 due to the
𝐿𝑊 𝑊 𝐿𝑊 𝑊 𝑊 𝑊
Comparative Advantage of the Home (Foreign) country in Cheese (Wheat) at autarky. It
allows the Home country to specialize and export Cheese to the Foreign country, and the
Foreign country to specialize and export Wheat to the Home country after trade opens up.
𝐿
Once trade opens up, Home country produces, 𝑎 unit of Cheese and no Wheat, and the
𝐿𝐶
𝐿∗
Foreign country produces, 𝑎∗ unit of Wheat and no Cheese (calculated from the PPF of the
𝐿𝑊
Home and the Foreign country).
Benefit of Trade:

Trade is mutually beneficial for two countries, who are different in terms of technology,
𝒑𝑪 𝒑∗ 𝒑 𝒑𝑾𝒐𝒓𝒍𝒅 𝒑∗
< 𝒑∗𝑪 𝒂𝒕 𝒂𝒖𝒕𝒂𝒓𝒌𝒚 as long as 𝒑 𝑪 < 𝒑𝑪𝑾𝒐𝒓𝒍𝒅 < 𝒑∗𝑪 ; as it expands the Consumption
𝒑𝑾 𝑾 𝑾 𝑾 𝑾
Possibilities for both the countries
1
Note, the Home country gets, 𝑎 unit of Wheat if it uses only 1 labour-hour to produce
𝐿𝑊
𝑝𝑊𝑜𝑟𝑙𝑑 1 1
Wheat. However, the Home country gets 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 𝑎 Wheat by producing 𝑎 unit of Cheese
𝑊 𝐿𝐶 𝐿𝐶

using single labour-hour and consequently trading it with the Foreign country at the relative
𝑝𝑊𝑜𝑟𝑙𝑑 𝑝𝑊𝑜𝑟𝑙𝑑 1 1 𝑝𝑊𝑜𝑟𝑙𝑑 𝑎 𝒑
price, 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 . Note, 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 𝑎 >𝑎 as long as 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 > 𝑎 𝐿𝐶 = 𝒑 𝑪 .
𝑊 𝑊 𝐿𝐶 𝐿𝑊 𝑊 𝐿𝑊 𝑾

1
Similarly, the Foreign country gets, 𝑎∗ unit of Cheese if it uses only 1 labour-hour to produce
𝐿𝐶
𝑊𝑜𝑟𝑙𝑑
𝑝𝑊 1 1
it. However, the Foreign country gets 𝑊𝑜𝑟𝑙𝑑 ∗ Cheese by producing 𝑎∗ unit of Wheat using
𝑝𝐶 𝑎𝐿𝑊 𝐿𝑊
single labour-hour and consequently trading it with the Home country at the relative price,
𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑝𝑊 𝑝𝑊 1 1 𝑝𝑊𝑜𝑟𝑙𝑑 𝑎∗ 𝒑∗
𝑊𝑜𝑟𝑙𝑑 . Note, 𝑊𝑜𝑟𝑙𝑑 ∗ > 𝑎∗ as long as 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 < 𝑎∗𝐿𝐶 = 𝒑∗𝑪 .
𝑝𝐶 𝑝𝐶 𝑎𝐿𝑊 𝐿𝐶 𝑊 𝐿𝑊 𝑾

The above argument shows that the trade is mutually beneficial for two countries, who are
𝑝 𝑝∗ 𝒑 𝒑𝑾𝒐𝒓𝒍𝒅 𝒑∗
different in terms of technology, 𝑝 𝐶 < 𝑝∗𝐶 𝑎𝑡 𝑎𝑢𝑡𝑎𝑟𝑘𝑦 as long as, 𝒑 𝑪 < 𝒑𝑪𝑾𝒐𝒓𝒍𝒅 < 𝒑∗𝑪 after trade.
𝑊 𝑊 𝑾 𝑾 𝑾
So, the intersection of the world relative demand with the relevant world relative supply
function after trade determines if the trade at all opens up between two countries, as it
determines the world relative price and mutual benefits of trade.
𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎 𝑎∗ 𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑊𝑜𝑟𝑙𝑑
𝑝𝑊
Suppose we have, 𝑊𝑜𝑟𝑙𝑑 < 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶 . This implies, ⇒ < ⇒ 𝑊𝐶 < 𝑊𝑊 . This
𝑝𝑊 𝐿𝑊 𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊
𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎 𝑝𝐶
implies, the Home country only produces Wheat when, 𝑊𝑜𝑟𝑙𝑑 < 𝑎 𝐿𝐶 . Similarly, 𝑊𝑜𝑟𝑙𝑑 <
𝑝𝑊 𝐿𝑊 𝑝𝑊
∗ 𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑎𝐿𝐶 𝑝𝐶 𝑝𝑊
∗ ⇒ ∗ < ∗ ⇒ 𝑊𝐶∗ < 𝑊𝑊
∗
. This implies, the Foreign country only produces Wheat
𝑎𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊
𝑝𝑊𝑜𝑟𝑙𝑑 𝑎∗ 𝑝𝑊𝑜𝑟𝑙𝑑 𝑎 𝑎∗
as well when, 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 < 𝑎∗𝐿𝐶 . Hence, there is no possibility of trade when , 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 < 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶
𝑊 𝐿𝑊 𝑊 𝐿𝑊 𝐿𝑊
as both countries produce identical good, Wheat.
𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎 𝑎∗
Similarly, there is no possibility of trade when 𝑊𝑜𝑟𝑙𝑑 > 𝑎 𝐿𝐶 > 𝑎∗𝐿𝐶 because both countries
𝑝𝑊 𝐿𝑊 𝐿𝑊
would produce Cheese in this case.

𝑝𝑊𝑜𝑟𝑙𝑑 𝑎 𝑎∗
Suppose, we have 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 = 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶 . In this case, the Home country produces both Cheese
𝑊 𝐿𝑊 𝐿𝑊
𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑝𝑊
and Wheat because both Cheese and Wheat sector gives identical wage, = if trade
𝑎𝐿𝐶 𝑎𝐿𝑊
opens up. But the Foreign country would produce only Wheat because the wheat sector gives
𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑝𝑊
more wage than the Cheese sector in the Foreign country, ∗ < ∗ .
𝑎𝐿𝐶 𝑎𝐿𝑊

𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎 𝑝𝑊𝑜𝑟𝑙𝑑 1 1
Note, 𝑊𝑜𝑟𝑙𝑑 = 𝑎 𝐿𝐶 ⇒ 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 𝑎 =𝑎 . This implies, the Home country obtains identical
𝑝𝑊 𝐿𝑊 𝑊 𝐿𝐶 𝐿𝑊

amount of Wheat through trade in exchange of Cheese (produced by using single labour-hour)
and by directly producing the Wheat using single labour-hour at hom. Hence, trade is neither
beneficial nor non-beneficial for the Home country.
𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎∗
However, 𝑊𝑜𝑟𝑙𝑑 < 𝑎∗𝐿𝐶 ⇒ trade is beneficial for the Foreign country as explained above
𝑝𝑊 𝐿𝑊
(obtaining more Cheese in exchange of Wheat via trade). So, we cannot unequivocally predict
𝑝𝑊𝑜𝑟𝑙𝑑 𝑎 𝑎∗
whether trade opens up or not when 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 = 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶 .
𝑊 𝐿𝑊 𝐿𝑊

𝑝𝑊𝑜𝑟𝑙𝑑 𝑎∗ 𝑎
Suppose, we have 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 = 𝑎∗𝐿𝐶 > 𝑎 𝐿𝐶 . In this case, Foreign country produces both Cheese and
𝑊 𝐿𝑊 𝐿𝑊
𝑊𝑜𝑟𝑙𝑑 𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑝𝑊
Wheat because both sectors give identical wage as trade opens up, ∗ = ∗ . Note,
𝑎𝐿𝐶 𝑎𝐿𝑊
𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎∗ 𝑊𝑜𝑟𝑙𝑑
𝑝𝑊 1 1
𝑊𝑜𝑟𝑙𝑑 = 𝑎∗𝐿𝐶 ⇒ 𝑊𝑜𝑟𝑙𝑑 ∗ = 𝑎∗ . In this case, the Foreign country gets identical amount of
𝑝𝑊 𝐿𝑊 𝑝𝐶 𝑎𝐿𝑊 𝐿𝐶
Cheese by trade in exchange of Wheat (produced by using single labour-hour) and by
producing it directly using single labour-hour domestically. Hence, the trade is neither
beneficial nor non-beneficial for the Foreign country in this case.
𝑊𝑜𝑟𝑙𝑑
𝑝𝐶 𝑎
However, the Home country definitely benefits from trade when 𝑊𝑜𝑟𝑙𝑑 > 𝑎 𝐿𝐶 as explained
𝑝𝑊 𝐿𝑊
𝑝𝑊𝑜𝑟𝑙𝑑
above. Hence, we cannot unequivocally predict whether trade opens up or not when 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 =
𝑊
∗
𝑎𝐿𝐶 𝑎𝐿𝐶
∗ >𝑎 .
𝑎𝐿𝑊 𝐿𝑊

Numerical Example:

Home Country: Endowment of total labour-hour is 1200. Amount of labour required to

produce a unit of Cheese and Wheat are 3 and 2 respectively.

Foreign Country: Endowment of total labour-hour is 800. Amount of labour-hour required to

produce a unit of Cheese and Wheat is 5 and 1 respectively.

Suppose, World demand of Cheese relative to the World demand of Wheat is half of the
World price of Wheat relative to the World price of Cheese. What is the equilibrium World
price of Cheese relative to the World price of Wheat? Is trade beneficial for both countries?

If trade opens up, Home country specializes in Cheese, and the Foreign country specializes in
Wheat. It gives,
 𝐿
𝑊𝑜𝑟𝑙𝑑
𝐶𝑑 1 𝑝𝑊 𝑎𝐿𝐶 𝐶𝑆
= = = ;
𝑊 𝑑 2 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 𝐿∗ 𝑊𝑆
∗
𝑎𝐿𝑊

𝐿∗ 800
2𝑝𝐶𝑊𝑜𝑟𝑙𝑑 ∗
𝑎𝐿𝑊 1 𝑝𝐶𝑊𝑜𝑟𝑙𝑑
= = = 2 ⇒ 𝑊𝑜𝑟𝑙𝑑 = 1
𝑊𝑜𝑟𝑙𝑑
𝑝𝑊 𝐿 1200 𝑝𝑊
𝑎𝐿𝐶 3

𝑝𝑊𝑜𝑟𝑙𝑑 𝒑 𝑎 𝒑∗ 𝑎∗
Since, 𝑝𝐶𝑊𝑜𝑟𝑙𝑑 = 1 < 𝒑 𝑪 = 𝑎 𝐿𝐶 = 1.5 < 𝒑∗𝑪 = 𝑎∗𝐿𝐶 = 5. In this case, both Home country and
𝑊 𝑾 𝐿𝑊 𝑾 𝐿𝑊
Foreign country produce only Wheat because Wheat sector gives higher wage than the
Cheese sector in both countries. Hence, there is no possibility of trade in this case.

Trade Pattern between Two Countries for Multiple Goods:

Suppose at autarky, production of Cheese is costly in the Foreign country than the Home
𝑎∗ 𝑊𝐶
country. This implies, 𝑊𝐶∗ 𝑎𝐿𝐶
∗
> 𝑊𝐶 𝑎𝐿𝐶 ⇒ 𝑎𝐿𝐶 > . This implies, Home country has
𝐿𝐶 𝑊𝐶∗
productivity advantage, and hence Comparative Advantage in producing Cheese over the
Foreign country at autarky. Hence, the Home country specializes in Cheese, and exports the
same once trade opens up.

Suppose, we have multiple good, 𝑖 = 1,2, … , 𝑁. Home country will specialize and export the
∗
𝑎∗ 𝑊 𝑎𝐿𝑗
𝑖 𝑡ℎ good if 𝑎𝐿𝑖 > 𝑊 ∗𝑖 , and the Foreign country will specialize and export the 𝑗 𝑡ℎ good if, <
𝐿𝑖 𝑖 𝑎𝐿𝑗
𝑊𝑗
𝑊𝑗∗

Thumb Rule:

𝑊 𝑎∗
Foreign country specializes in the production of the 𝑗 𝑡ℎ good if, 𝑊𝑗∗ > 𝑎𝐿𝑗
𝑗 𝐿𝑗

𝑊 𝑎∗
Foreign country specializes in the production of the 𝑗 𝑡ℎ good if, 𝑊𝑗∗ < 𝑎𝐿𝑗
𝑗 𝐿𝑗
The following table offers a numerical example in which Home and Foreign both consume and
are able to produce five goods: apples, bananas, pineapples, dates, and watermelons.

Apples
Bananas
Pineapples
Dates
Watermelons

𝑾
Suppose, 𝑾∗ = 𝟑

Home country will specialize in Pineapples, Bananas, and Apples; and Foreign country will
specialize in Dates and Watermelons when trade opens up.

Determining the Relative Wage in the Multigoods Model

𝑊 𝐿
Foreign country specializes in the production of all the goods when 𝑊 ∗ ≥ 10. In this case 𝐿∗ =
0 when trade opens up. On the other hand Home country specializes in all the goods when
𝑊 𝑊
≤ 0.75 when trade opens up. Rise in makes the labour of he Home country costly relative
𝑊∗ 𝑊∗
to the foreign country; and hence its demand falls and vice-versa. Therefore, relative demand
curve of labour is negatively sloped. Suppose for simplicity, labour at home is inelatically
supplied so that the relative labour supply curve is vertical. Intersection of the two curves
𝑊 𝐿
determines market clearing 𝑊 ∗, and market clearing 𝐿∗. If the intersection of RD and RS happens
to lie on one of the flats, both countries produce the good to which the flat applies.
We can illustrate the determination of relative wages with the following diagram.

Relative Wage
𝑊
Rate,
𝑊∗
RS
Apples
10

Bananas
8

Pineapples
4
3
Dates
2 Watermelons
0.75 RD

𝑾
Till now we assume that, = 𝟑. Figure shows how it is determined. Relative Quantity of
𝑾∗
𝐿
Labour,
𝐿∗

This shows the relative quantity of labor and the relative wage rate. The world demand for
Home labor relative to its demand for Foreign labor is shown by the curve RD. The world
supply of Home labor relative to Foreign labor is shown by the line RS.

The relative supply of labor is determined by the relative sizes of Home’s and Foreign’s labor
forces. Assuming that the number of person-hours available does not vary with the wage, the
relative wage has no effect on relative labor supply and RS is a vertical line.

Our discussion of the relative demand for labor explains the “stepped” shape of RD.
Whenever we increase the wage rate of Home workers relative to that of Foreign workers, the
relative demand for goods produced in Home will decline and the demand for Home labor
will decline with it. In addition, the relative demand for Home labor will drop off abruptly
whenever an increase in the relative Home wage makes a good cheaper to produce in
Foreign. So the curve alternates between smoothly downward-sloping sections where the
pattern of specialization does not change and “flats” where the relative demand shifts
abruptly because of shifts in the pattern of specialization. As shown in the figure, these
“flats” correspond to relative wages that equal the ratio of Home to Foreign productivity for
each of the five goods.

The equilibrium relative wage is determined by the intersection of RD and RS. As drawn, the
equilibrium relative wage is 3. At this wage, Home produces apples, bananas, and pineapples
while Foreign produces dates and watermelons. The outcome depends on the relative size of
the countries (which determines the position of RS) and the relative demand for the goods
(which determines the shape and position of RD).

Productivity and wage move together.

Co-movements between productivity and export

Gravity Model:

𝑌𝑗𝑏
𝑇𝑖𝑗 = 𝐴 ∗ 𝑌𝑖𝑎 ∗ 𝑐
𝐷𝑖𝑗

where A is a constant term, 𝑇𝑖𝑗 is the value of trade between country i and country j, 𝑌𝑖 is
country i’s GDP, 𝑌𝑗 is country j’s GDP, and 𝐷𝑖𝑗 is the distance between the two countries.

Size of the countries matter in trade. Bigger countries involve in more trades than the smaller
one.
Higher distance reduces the trade flow.

Intra-national trade is higher than the inter country trade. Canada has trade with her own
states than the US states belonging to the similar distance.