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Summary International Economics (MAN-BCU2021) (Grade; 7.0)
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Monetary approach (long-run model of the exchange rate based on PPP);- Make predictions about the relative price
- It is about how participants might form their expectations (what they may expect what the exchange
rate will do). It is NOT an explanation of how the exchange rate would move in the long-run
- Long-run theory the monetary approach proceeds as if prices can adjust right away to maintain full
employment as well as PPP.
Assumption;
1) Absolute PPP; 𝐸$/€ = 𝑃$% /𝑃& (Assume a world where there are no market rigidities)
%
2) Real money demand = liquidity preference; 𝑀' /𝑃 = 𝐿(𝑅, 𝑌) (𝑃$% = 𝑀$% /𝐿(𝑅$ , 𝑌$% ))
3) Money market in equilibrium; 𝑀 ( = 𝑀'
Predictions;
1) A permanent rise in the domestic money supply causes (𝑴𝒔𝑼𝑺 ↑);
- Causes a proportional increase in the domestic price level (long-run money neutrality)
- Causes a proportional nominal deprecation of the domestic currency (through PPP)
Mechanism;
(
Increase 𝑀$%
----> (proportional) increase in prices (if money demand remains constant) 𝑃$% ↑
----> domestic products more expensive
----> competitiveness worsens (more import, less export)
----> more demand for foreign currency (less supply of foreign currency)
----> (proportional) deprecation of the dollar against the euro (𝐸$/€ ↑)
2) A permanent rise in the domestic interest rate causes (𝑹$ ↑);
- Lowers domestic real money demand (liquidity preference)
- Increase in the domestic price level
- Causes a proportional nominal depreciation of the domestic currency (through PPP)
Mechanism;
Increase 𝑅$
----> decrease in the real money demand (𝐿(𝑅$ , 𝑌$% ) ↓)
----> increase in prices (if money supply remains constant) 𝑃$% ↑
----> domestic products more expensive
----> competitiveness worsens (more import, less export)
----> more demand for foreign currency (less supply of foreign currency)
----> (proportional) deprecation of the dollar against the euro (𝐸$/€ ↑)
3) Permanent rise in the domestic output level (𝒀𝑼𝑺 ↑)
- Raises domestic real money demand (liquidity preference)
- Decrease in the domestic price level
- A proportional nominal appreciation of the domestic currency (through PPP)
Mechanism;
Increase 𝑌$(
----> increase in the real money demand (𝐿(𝑅$ , 𝑌$% ) ↑)
----> decrease in prices (if money supply remains constant) 𝑃$% ↓
----> domestic products cheaper
----> competitiveness improves (less import, more export)
----> less demand for foreign currency (more supply of foreign currency)
----> appreciation of the dollar against the euro (𝐸$/€ ↓)
All 3 changes affect money supply or money demand. Thereby causing prices to adjust to maintain
equilibrium in the money market. And causing that relative prices, the exchange rate to adjust to PPP
,Specific factors model; better or worse off? (effect of a change in the price of only one good) (trade)
• The factor specific to the sector whose relative price increases is definitely better off
• The factor specific to the sector whose relative price decreases is definitely worse off
• The change in welfare for the mobile factor is ambiguous
Example;
7% increase in Pc
- Increases labor demand curve for labor in the cloth sector increases by 7% (MPLc x Pc increases by 7%)
- As result of this shift;
- The wage rate rises (w) BUT by less than the increase in Pc
- Labor shifts from the food sector to the cloth sector and the output of cloth rises while that of food
falls
Workers; we cannot say (labor is a mobile factor; ambiguous)
- Workers find that their wage rate has risen, but less than in proportion to the rise in Pc
- Their real wage in terms of cloth (the amount of cloth they can buy with their wage income) w/Pc falls
- Their real wage in terms of food (the amount of food they can buy with their wage income) w/PF rises
- We cannot say whether workers are better or worse off; this depends on the workers’ preferences
Capital owners; better off (capital is specific factor for the cloth sector)
- Their real wage in terms of cloth (the amount of cloth they can buy with their wage income) w/Pc falls
- So the profits of capital owners in terms of what they produce (cloth) rises; the income of capital owners
will rise more than proportional with the rise in Pc
Land owners; worse off (land is specific factor for the food sector)
- Their real wage in terms of food (the amount of food they can buy with their wage income) w/PF rises; this
squeezes their income. And the rise in cloth prices reduces the purchasing power of any given income
Everyone can benefit from trade as we redistribute income in such a way that everyone gains from trade. That
everyone could gain from trade (expands the economy’s choices) does not mean that everyone actually does.
In the real world, the presence of losers and winners from trade is one of the most important reasons why
trade is not free
- The income distribution effects that arise because labor and other factors of production are immobile
represent a temporary problem.
,HO-model (2-2-2-model);
• A nation will export the commodity whose production requires the intensive use of the nation’s relatively
abundant and cheap factor.
• A nation will import the commodity whose production requires the intensive use of a nation’s relatively
scarce and expensive factor.
• Owners of a country’s abundant factors gain from trade, but owners of country’s scarce factors lose
Assumption;
- Technology/tastes/distribution of ownership of factors of production are the same between
countries (thus cannot be the reason for a different commodity prices)
- Countries have identical production technologies that are constant returns to scale (CRS)
and there is perfect competition in goods and factor markets.
- Resource differences are the only source of trade
- Full employment of resources
SS-curve;
Producers can choose different amounts of factors of production to make cloth and food. Their choice
will depend on the relative price of production factors (w/r).
- If wage rises, the price of any good whose production uses labor will also rise
There is one-to-one relationship between the factor prices (w/r) and the relative price of cloth (PC/PF)
- As the wage rate, w, increases relative to the rental cost, r, producers will use less labor services
and more kapital in the production of food and cloth.
Competition among producers in each sector will ensure that the price of each good equals the cost of
production. The cost of production depends on factor prices (w/r)
- If w goes up, the relative price of cloth (PC/PF) will go up because cloth is relative labor intensive
- If r goes up, it should affect the price of food more than the price of cloth since food is capital intensive
CC and FF (relative factor demand curves);
- Downward sloping shows the substitution effect in the producers’ factor demand
- As the wage, w, rises relative to the rental rate, r, producers substitute capital for labor in
their production decisions.
- Shows the increasing opportunity cost in HO-theory
- CC is shifted outward relative to FF; indicates that any given factor prices (w/r) the production of
cloth will always use more labor relative to capital (L/K) than will the production of food. Thus, the
production of cloth is labor-intensive and the production of food is kapital-intensive
Trade between two-factors economies;
- The only difference between the countries is their resources; home has a
higher ratio of labor to kapital than foreign does. Thus, home is labor-
abundant and foreign is kapital-abundant. Because the cloth sector is labor-
intensive, home tends to produce a higher ratio of cloth to food. Trade leads
to converge of relative prices. Because countries differ in their factor
abundance, for any given ratio of PC/PF, home will produce a higher ratio of
cloth to food than foreign will (home will have a larger relative supply of
cloth).
GAINS FROM TRADE (permanent):
Changes in relative prices (PC/PF) have strong effects on income distribution. It always changes it so much
that owners of one factor of production gain while owners of the other are made worse off. Owners of a
country’s abundant factors gain from trade, but owners of a country’s scarce factors lose (permanent)
- Home (𝑃! /𝑃" ↑) ---> (𝑤/𝑟 ↑) ; increase purchasing power of workers (gain from trade), decrease
purchasing power of kapital-owners (lose from trade) (andersom voor foreign)
,Ricardian model;
Changes (preferences remain the same (thus RD stays the same));
- If home’s labor force will grow, the vertical line will shift to the
right (relative more cheese, relative price cheese falls)
- If foreign’ labor force will grow, the vertical line will shift to the
left
1) No supply of cheese in both countries if the world price dropped below aLC/aLW
- Pc/Pw < aLC/aLW ----> Home specializes in wine
- Pc/Pw < a*LC/a*LW ----> Foreign specializes in wine
- There would be no world cheese production
1) Pc/Pw = aLC/aLW (international price ratio equals the home autarky price ratio (=home opp. cost of production))
- Home can earn exactly the same amount making either cheese or wine
- Home will be willing to supply any relative amount of the 2 goods (thus will not specialize)
- Home will not gain from trade
- The gains from trade will reach the maximum for foreign (the gains are highest when trade takes place
at the others country’s autarky price ratio) (foreign still specializes in wine)
1)
- Pc/Pw > aLC/aLW ----> Home specializes in cheese
- Pc/Pw < a*LC/a*LW ----> Foreign specializes in wine
- When home specializes in cheese, it produces L/aLC pounds of cheese
- When foreign specializes in wine, it produces L*/a*LW gallons of wine
1) Pc/Pw = a*LC/a*LW (international price ratio equals foreign autarky price ratio (=foreign opp. cost of production))
- Foreign can earn exactly the same amount making either cheese or wine
- Foreign will be willing to supply any relative amount of the 2 goods (thus will not specialize)
- Foreign will not gain from trade
- The gains from trade will reach the maximum for home (the gains are highest when trade takes place
at the others country’s autarky price ratio) (home still specializes in cheese)
1) No supply of wine in both countries if the world price is above a*LC/a*LW
- Pc/Pw > aLC/aLW ----> Home specializes in cheese
- Pc/Pw > a*LC/a*LW ----> Foreign specializes in cheese
- There would be no world wine production
- The relative supply of cheese becomes infinite
Gains from trade
When a large country and a small country start trading, the international price ratio that will come about
will be close to autarky price ratio of the large country. Thus the large country will not gain that much
whereas the small country will gain very much.
- The difference between the opportunity cost of producing cheese in the big country, and what they
will get for in the world market, becomes lower. Thus, per unit of export good they will have lower
gains
- Whereas for the small country, they get an international price ratio that is much further away from
the opportunity cost than before, thus they will have higher gains
Small countries will get the major share of the gains from trade in the Ricardian trade model
A larger labor force means a lower gains for big country.
Developed onderin, developing bovenin
, Temporary Permanent
Moneyary/fiscal Monetary/fiscal
policy change policy change
Short-run P fixed P fixed
Ee fixed 1 Ee adjusts 2
Long-run P adjusts
Money Market and Foreign Exchange Market Model;
Ee adjusts 3
Change in the Domestic money supply (FED increases the US money supply) (Temporary (P fixed, Ee fixed);
At the initial interest rate (R1$), there is an excess supply
of money in the US money market. The interest rate is
driven down as unwilling money holders compete to lend
their excess cash balances. Dollar interest rate falls to R2$
and the money market new equilibrium is at point 2
Given the initial exchange rate, E1, and the new lower
interest rate on dollars (R2$), the expected return on euro
deposits is higher than that of dollar deposits. Holders of
dollar deposits therefore try to sell them for euro deposits
this causes the dollar to depreciate against the euro, the
foreign exchange market new equilibrium in point 2’.
An increase in a country’s money supply causes its currency
to depreciate in the foreign exchange market.
Change in the Foreign money supply (ECB increases the EU money supply) (Temporary (P fixed, Ee fixed);
Initially, the US money market is in equilibrium at point 1 and
the foreign exchange market is in equilibrium at point 1’.
Now the ECB increases the EU money supply, which reduces
R€, this lowers the expected return on euro deposits thus
shifts the schedule to the left. The foreign exchange market
equilibrium is restored at point 2’ with exchange rate E2
The change in the EU money supply does not disturb the US
money market equilibrium, which remains at point 1.
An increase in the EU money supply causes the dollar to
appreciate against the euro
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