International Economics – Models and Theory
Autumn Models:
o The 3-equation model
o Closed economy
o Open economy
o Medium-run open economy
Spring Models:
o The Gravity Model
o The Ricardian Model
o The Specific factor Model
o The Heckscher-Ohlin Model
Past paper questions on Spring models:
Explain carefully why the Ricardian model of trade is consistent with the view that
small countries benefit more from trade liberalization. (PP2022)
When the EU-15 expanded towards the East of Europe, they decided to proceed in
two phases: First, they introduced free trade and then later the free movement of
labour. Using the Heckscher- Ohlin model discuss if it made sense to proceed in this
manner. Use graphs and diagrams to illustrate your answer. (PP2018)
“Countries do not in fact export the goods the Heckscher-Ohlin theory predicts.”
Explain the theory and evaluate this statement. (PP2020)
If external economies of scale are the dominant technological factor defining or
establishing comparative advantage, then the underlying factors explaining why a
particular country dominates world markets in some product may be pure chance, or
historical accident. Discuss. (IDENTIFY MODEL) (PP2019)
If scale economies represent the dominant technological factor defining or
establishing comparative advantage, then the fact that a particular country
dominates world markets in some product may be pure chance, or historical
accident. Discuss. (PP2020)
Consider an economy with two countries, Home and Foreign, and two goods, A and
B. Factors of production may move freely across sectors, but not between countries.
Both countries have access to the same technology featuring constant returns to
scale in capital and labour. For any relative factor price, Good A is the labour
intensive good. Assuming the only difference between Home and Foreign is that the
relative endowment of capital is greater in Home, would you expect the relative price
of good A in Home to increase or to fall after trade liberalization (starting from
autarky)? Explain your answer carefully. (Specific factors?) (PP2019)
Suppose monopolistically competitive industries and assume that firms have internal
economies of scale. Explain how trade may improve efficiency when firms are
,heterogeneous, and in particular when some firms have lower marginal costs than
others. (Monopolistic competition) (PP2020)
Suppose firms are identical and enjoy internal economies of scale. In particular, they
operate with a cost function that has a fixed component and a variable component.
The variable component is proportional to the quantity produced (implying constant
marginal costs). Trade integration lowers the equilibrium price in the industry. Do you
agree that, therefore, the typical firm’s profits must fall, since prices fall, and marginal
costs are constant? Explain your answer carefully. (PP2020)
Model/Theory Notes:
Autumn Term Models and Theory:
The 3-equation closed economy:
The 3-equation model in the closed economy consists of the Investment-Saving (IS)
curve taken from the IS-LM model which represents the condition that the aggregate
demand equals national product depending on the interest rate set by the Central
Bank, the Phillips curve (PC) showing the inverse and stable relationship between
inflation and unemployment, and the Monetary Rule (MR) curve. This model is used
to analyse the effects of shocks in the economy.
The curves are as follows:
IS curve: 𝑦𝑡 = 𝐴 − 𝛼𝑟𝑡−1
Where yt is output and art-1 is the real interest rate. This captures the fact that AD
responds negatively to the real interest rate with one period lag.
PC curve: 𝜋𝑡 = 𝜋𝑡−1 + 𝛼(𝑦𝑡 − 𝑦𝑒 )
Where π represents inflation in a certain time period, and y is output, e denotes the
equilibrium output level. We assume that there are adaptive expectations in this
model and there are nominal rigidities so that nominal wages and prices do not
adjust immediately to fluctuations in Aggregate Demand (AD). Firms only adjust
wages at the start of each wage round, so wages stay fixed throughout each wage
round, which is typically a year (Barattieri et al., 2010). Prices are adjusted right after
the change in wages, in line with evidence (Alvarez et al., 2005).
An AD shock will cause output and employment to change, then in the next wage
round, nominal wages will change, immediately after the wage round, prices will
change. 𝑦𝑡 − 𝑦𝑒 represents the output gap. Wage setters change wages to cover the
previous period’s inflation and to reflect the output gap caused by a shock.
[wage inflation]
Price setters set P immediately after this to keep the mark-up fixed:
[price inflation]
Substituting the wage inflation into the price inflation equations, we get the Phillips
curve:
, which is also written as:
𝜋𝑡 = 𝜋𝑡−1 + 𝛼(𝑦𝑡 − 𝑦𝑒 )
MR curve: (𝑦𝑡 − 𝑦𝑒 ) = −𝛼𝛽(𝜋𝑡 − 𝜋 𝑇 )
This is how the MR curve is derived:
The central bank’s preferences are given by a loss function, in line with Taylor
(1993):
The central bank is worse off the further inflation (πt) is away from it’s target level
(πT), and the further output (yt) is away from its equilibrium level (ye); β reflects the
relative degree of inflation aversion of the Central Bank (CB).
This loss function is constrained by the Phillips curve constraint to the CB. The PC
shows combinations of output and inflation which are attainable by the central bank,
for a given inflation expectation.
DRAW DIAGRAM PROVING WHY THE PC FORMS A CONSTRAINT FROM
LECTURE 1 SLIDE 17-19 and show how we derive MR!
The MR curve, (𝑦𝑡 − 𝑦𝑒 ) = −𝛼𝛽(𝜋𝑡 − 𝜋 𝑇 ), tells the CB the best-response output gap
to choose when inflation is away from target.
Now that the best-response output gap is chosen, y is set using the real interest rate
on the IS curve. In reality however, the CB sets the nominal interest rate to achieve
the desired real interest rate. We ignore this in this model.
The IS curve models the demand side, the PC curve models the supply side, and the
MR curve models the policy maker.
, This diagram shows the 3-equation model and the impact of a temporary positive
demand shock. As a result of the shock, the IS curve shifts right for a temporary
amount of time then returns to it’s original position. Higher AD means that the
economy moves from A to B with a higher level of output. Inflation in the current
period (π0) shifts the PC curve to PC(πE1=π0). The Central banks will return the
economy back to the MR curve to point C for preventing losses by increasing the
interest rate to r0, this leads to lower inflation. As a results, inflation expectation
causes the equilibrium to move to point D. With a higher level of output, the Central
Bank reduces the interest rate to r1, inflation expectations then causes the economy
to return back to the original equilibrium at point Z. This model demonstrates how the
Central Bank manages an economy with higher demand.
