ECON 3500 Final Exam

Curtis Miller 00693330

I. Compare and contrast (5 points each.)

1. Labor intensity and Labor abundance (explain with help of an example) Labor intensity is the amount of a labor a production process uses relative to other inputs. Labor abundance is the amount of a resource available in a country relative to other factors of production. Both intensity and abundance are considered relatively, meaning that they are considered in comparison to other relevant factors. However, intensity relates to how much of a resource is required for a unit of output, whereas abundance relates to how much of a resource is available for production. For example, consider the following table of unit requirements: Labor Capital Autos 20 30 Cloth 4 5 In this example, cloth is relatively labor intensive, whereas autos are relatively capital intensive. This is because the ratio of units of labor to capital in cloth production ( ) is greater than the ratio of units of labor to capital in auto production ( ; so , making cloth labor intensive).

Consider the following table of available inputs for production in two countries: Labor Capital Homeland 2000 3000 Foreign Republic 400 500 In this example, the Foreign Republic is relatively labor abundant, whereas Homeland is relatively capital abundant. This is because the ratio of available units of labor to available units of capital in the Foreign Republic ( ) is greater than the ratio of available units of labor to units of capital in Homeland ( ; so , making the Foreign Republic labor abundant).

2. Depreciation and Appreciation of exchange rate Depreciation of an exchange rate is when the home currency weakens against the foreign currency, and buys less of the foreign currency. Appreciation is when the home currency strengthens against the foreign currency, and buys more foreign currency. For example, if one USD goes from buying two CAD to one CAD, the dollar has depreciated. Likewise, one CAD goes from buying half a USD to one USD, so CAD has appreciated. Both depreciation and appreciation involve fluctuation of currency exchange rates, but they differ in direction.

3. Expected Exchange rate and Interest Rates Expected exchange rate is the anticipated future rate of exchange between currencies by currency traders. An interest rate is the income a lender in a particular currency makes from loaning out her money to a borrower. Both expected exchange rate and interest rates are in the interest parity condition:

and

represent interest rates, and

is the expected exchange rate.) However,

whereas interest rates are tangible and are not in the least ambiguous, representing a legallybinding contract, expectations are intangible and change on whim.

4. Current account and Balance of Payment account The current account ( ) is the difference between an economys exports and imports:

The balance of payment account tracks an economys payments to and receipts from foreigners. For example, if Homeland imports clothing from the Foreign Republic, Homelands balance of payment may look something like this: Credit Debit -50,000

Clothing Purchase (Current account, Homeland Import) Sale of bank deposits by Homeland First National +50,000 Bank (Financial account, Homeland asset sale) Both the current account and balance of payment account are useful for determining trade flows. However, the current account can sum to a number other than zero, whereas the balance of

payment account must have all credits offset by a debit, and vice versa, and thus must always sum to zero.

II. Numerical problem (15 points)

Unit Labor Requirement

Home 20 30

Foreign 40 50

Wheat Cloth

and A. What is the opportunity cost of wheat in terms of cloth for Home and Foreign? The opportunity costs of wheat in terms of cloth for Home and Foreign are given by and , respectively, where represents the unit labor requirement of wheat for Home ( likewise

likewise for Foreign) and represents the unit labor requirement of cloth for Home ( for Foreign). Inserting the given numbers results in the following math:

B. Which country has a comparative advantage in cloth and why? Home has a comparative advantage in cloth if (in English, the opportunity cost of

producing cloth in Home is less than the opportunity cost of producing cloth in Foreign). Numerically, this works out to be:

This translates to Foreign having the comparative advantage in cloth, since the opportunity cost for producing cloth in Foreign is less than the opportunity cost of producing cloth in Home.

C. What is Relative Price? What is the condition for each country to specialize and trade (use opportunity cost of wheat and relative price here)? Relative price of wheat in terms of cloth is given by the equation problem: , and so, in this

If

, Home will specialize in producing wheat. The reason why is because wages for ) are higher than wages for producing cloth ( ):

producing wheat in Home (

If

, workers are indifferent between producing cloth and producing wheat, and , then Home will specialize in ).

thus it cannot be said that Home will specialize. If

producing cloth (for similar reasons Home would specialize in producing wheat if Foreign faces an analogous situation.

D. Find the quantities of wheat and cloth produced in each country after specialization, that is, Qw, Qc, Qw*,Qc*, if L = 5400 and L* = 10000 (L and L* are labor hours in home and foreign respectively). Because because , Home will specialize and produce only wheat. Likewise, , Foreign will specialize and produce only cloth. The quantity of wheat

Home produces is thus given by:

The quantity of cloth Foreign produces is, likewise, given by:

I then proceed to calculate the quantities of wheat and cloth Home and Foreign produce:

Wheat Home

Cloth (Home specialized in wheat; no cloth is produced)

Foreign

(Foreign specialized in cloth; no wheat is produced)

E 1. Draw the production possibility frontier for each country. Also sh ow the consumption possibility frontier for each country in the same graph if they engage in trade. Label the graph.

A
Wheat

D B

E Cloth
Line

represents the production frontier of Home. Line

represents the production

frontier of Foreign. The curve represents the consumption frontier of Home and Foreign if the two nations trade; without trade, their consumption frontiers are simply their production frontiers. Point A represents the amount of wheat Home could produce if Home produces no cloth, which is:

This is labeled C in the test. Im assuming it was incorrectly labeled.

Likewise, point E represents the amount of wheat Foreign could produce if Foreign produces no cloth, equaling 250. Point C represents the amount of cloth Foreign could produce if Foreign produces no wheat, which is:

Likewise, point E represents the amount of cloth Home could produce if Home produces no wheat, and is equal to 180.

III. Case Study: 20 points

Use the following video: [Link] markets-protest-too-muchand this article: [Link] and [the] article attached at the end of exam paper and the material we cove red in last chapter of the book to answer [the] following question. (You can use the video and article to give examples or any other research you may find relevant) (Please see there are 3 pieces a video, one article attached at the end an d one link to another article) 1. What is original sin? How does it affect developing countries? Original sin is the inability of developing countries to borrow in their domestic currencies. As a result of original sin, developing countries are subject to the dangers of exchange rate fluctuations. If their domestic currency appreciates, foreign debts become less expensive; but if the foreign currency appreciates, foreign debts become more expensive. Furthermore, developing countries cannot use monetary policy to reduce their real debt.

2. What is [sic] currency wars? Write [a] few lines on tension between developing countries and US based on the examples of exchange rate mentioned in these resources. A currency war is when countries pursue competing policies to attempt to control the currency exchange rate, policies intended to favor the country implementing them. In the three articles I read, developing nations claim that the United States is attempting to depreciate the USD with its QE measures. The QE measures, according to the developing countries, damaged exports, increased liquidity that made domestic currencies more volatile, and made inflation more volatile. This prompted some countries, such as Brazil, to retaliate by increasing taxes on borrowing from overseas and on foreign investment. Colombia and Peru sought to control their currencies by purchasing dollars on foreign exchange markets.

3. What are the host of problems developing countries face while de aling with macro variables like interest rates? For example, if Brazil wants to increase interest rates, what is the restricting consideration for the country?

Developing countries struggle to control their domestic money supplies, must keep foreign reserves, and cannot borrow in their own currency. Interest rates are difficult to control because of the decreased ability of developing countries to control their domestic money supply, making monetary policy difficult. If they wanted to use fiscal policy to control their domestic interest rates, they would have difficulty borrowing money if they needed to do so, since they must borrow in a foreign currency. If Brazil wanted to increase interest rates, they could decrease the domestic money supply, increase government spending, or reduce taxes (and likely run a deficit). However, if they decrease the domestic money supply, causing interest rates to rise, foreign investors, noticing the increase in the interest rates in Brazil, would be drawn to invest in Brazil and purchase Brazilian financial assets, pumping liquidity into the Brazilian economy and countering the attempt by the central bank to reduce the money supply. If they run a government deficit, they must borrow in a currency that is not the domestic currency, and thus run into the problems of original sin, and should Brazil be unable to pay their debts, the only option available to them is default; they cant print money to pay off the debt, since they cant print the currency in which their debts are denominated.

4. How is [sic] [the] US been able to keep its export growing throu gh exchange rate management and use of monetary policy? Exports increase when the domestic currency depreciates; depreciation makes domestic goods cheaper in international markets, increasing exports. Thus, its in the interest of the US to devalue the USD. The Feds QE measures increase the amount of dollars circulating, decreasing the value of the dollar, which decreases the price of domestic goods, increasing exports.

5. Why are emerging economies protesting against devaluation? Devaluation of the USD has many negative effects on emerging economies. Emerging economies depend on exports for growth, but devaluation of the USD makes their goods relatively more expensive, decreasing their exports. The price of commodities in particular, with prices denominated in USD (oil and food are notable commodities for which this is the case), rises, making those essential resources more expensive for emerging economies. Liquidity pours into developing economies with a devaluation of the USD, damaging price stability, undermining the stability of their domestic currencies, increases credit, and generally creates instability in domestic markets. Its thus in the interest of developing economies to resist USD depreciation.

IV. Numerical (15 points)

The exchange rate between US and Britain is $ 1.25 per G BP. Suppose the GBP depreciates by 10%. What is the new value of dollar/pound exchange rate? How much a mobile phone worth 300 that costs $ 375 earlier will cost now in US dollars? Is depreciation of pound favorable for US customers? Explain the logic. I first note the present exchange rate:

I then modify the exchange rate. If the GBP depreciates by 10% (implying a fall in value of GBP), then it will now take 1.1 to purchase $1.25, so I replace 1 with 1.1, and calculate the new exchange rate:

After I have calculated the new exchange rate, I determine the price of the 300 phone by multiplying the price of the phone (in GBP) with the exchange rate (which is dollars per pound): Because the price of the phone in dollars is less than it was prior to the depreciation, the depreciation of the GBP was beneficial to American consumers. Therefore, depreciation of the GBP is generally beneficial to US customers, since the price of imports drops, and goods become cheaper for the consumers.

The exchange rate between US and Britain is $ 1.25 pe r GBP and the expected exchange rate is $ 1.1 per GBP. What does this expectation mean (Hint: are the agents expecting appreciation or depreciation in future and by how much %)? Expected exchange rate is the anticipated future rate of exchange between GBP and USD by currency traders. Because GBP buys fewer USD (implying GBP has lost value), GBP has depreciated. To determine the percentage by which GBP is expected to depreciate, I use:

The expected exchange rate the numbers and calculate:

, and the current exchange rate

, so I plug in

I conclude that the markets expect GBP to depreciate by 12% against the dollar.

The interest rate on dollar is 6% and interest rate on pound is 5%. Does the interest parity condition holds? If not, which currency gives higher expected rate of return? The interest parity condition is held when the expected rate of return from investments in two different currencies is equal. If the interest parity condition is held, the following equation is true:

In this problem, the pound interest rate , and the dollar interest rate (the other variables have already been given). I find that the interest parity condition does not hold because:

This also shows that the expected rate of return of the dollar is greater than the expected rate of return of the pound, since the left side of the equation is greater than the right.

Suppose todays exchange rate depreciates to $ 1.3 per GBP. What will be new expected rate of return? As before, the expected rate of return on GBP interest-baring investments is given by:

The only difference is that now, because the dollar depreciated, the equation yields:

. Substituting this into

To find the expected rate of return on USD interest-baring loans, I use:

I calculate this out:

V. Exchange rate model (20 points)

Derive the short run economic equilibrium (please derive the mechanisms in both the asset and product market and then the relationship between exchange rates and output in the 2 markets). Hint: remember one of the markets has 2 markets in it. So total we have 3 markets to consider. First, I notice the channel of the money market. An increase in GNP ( ) leads to an increase in money demand ( ), causing the money demand curve to shift outward. Assuming the money supply remains constant, this results in a subsequent rise in interest rates.
M
S

Interest Rates

R'

R Y

M '
M
s d

M P

Money Supply
Next, I note how these changes play a role in the forex markets. The guiding relation of the forex markets is the interest parity condition (discussed earlier). This relation is given by:

is the interest rate of foreign currencies, is the expected exchange rate, and is the current exchange rate. The motivation for using this relation is that if this relationship did not hold, then one currency is more valuable than the other, and investors will flock to the more valuable currency, pushing the exchange rate down until the parity condition is restored (this is the process

of arbitrage). Interest rates and the exchange rate have an inverse relationship, implying that a rise in the interest rate prompts a fall in the exchange rate, and vice versa. This gives the following graph:

R'

Exchange Rate

E'
Inte rest Pa rity Con d

ition

R'

Interest Rate
Because the exchange rate fell with a rise in GNP, this suggests:

This is the asset market relation, and from this derivation, I can show the asset market relation AA, in which GNP has a negative relation with the exchange rate:

Exchange Rate

AA

Output
Next to derive is the goods market. Aggregate demand is given by the equation:

In words, demand is defined as the aggregation of domestic consumption, investment, government spending, and the current account balance (exports less imports). The condition:

states that output equals demand, motivating the output equation:

These are then related together in the goods market:

Y =D

Aggregate Demand

AD ' D'
AD E D

Y'

Output
The identity is a one-for-one line, and represents output, having a smaller slope since not all income is spent (Y also represents income). A depreciation of exchange rate (an increase in E) increases exports (domestic goods are cheaper in foreign markets) and decreases imports (foreign goods are more expensive in the domestic market), increasing the current account balance and shifting AD up to AD. This leads to output Y increasing. This suggests:

In words, a depreciation of the domestic currency leads to exports increasing and imports decreasing, increasing the current account balance, which increases output. This suggests a positive relation between E and Y. The DD curve (representing equilibrium in the goods market) has an increasing slope:

DD

Exchange Rate

AA Y Output
The intersection of AA and DD represents the equilibrium of all markets.

Suppose an external shock like reduction in world demand for this economys goods reduces the level of output to less than full employ ment level. How would the central bank use monetary policy to restore full employment level? What is the main drawback of using an expansionary monetary policy in this case?

DD'
E3

C B A

DD

Exchange Rate

E2
E1

AA' AA
Yu Yf

Output
The global demand shock manifests first through a drop in exports (X). This drop in exports reduces the current account, pushing the DD schedule upward to DD. The economy moves away from operating at point A to point B, with a depreciating exchange rate and reduced output, and thus reduced employment. The central banks response would be to increase the money supply, pushing the AA curve outward to AA, and the economy moves away from point B to point C. Interest rates drop in the money market, which results in the currency depreciating in the forex market. While the central bank has managed to once again restore full employment, it comes at the cost of the further depreciation of the currency. Imports will be more expensive. As discussed in earlier questions, there could also be effects on other nations from this course of action by the central bank.