Christian Bjørnskov

Basics of International Economics
- Exercises
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Problems for Basics of International Economics - Exercises
© 2006 Christian Bjørnskov and Ventus Publishing ApS
ISBN 87-7681-054-2
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Basics of International Economics – Exercises

4
Table of Contents
Problems to Chapter 1 5
Solutions to problems to chapter 1 8
Problems to Chapter 2 11
Solutions to problems to chapter 2 12
Problems to Chapter 3 14
Solutions to problems to chapter 3 16
Problems to Chapter 4 22
Solutions to problems to chapter 4 23
Problems to Chapter 5 24
Solutions to problems to chapter 5 25
Problems to Chapter 6 27
Solutions to problems to chapter 6 29
Problems to Chapter 7 30
Solutions to problems to chapter 7 31
Table of Contents
Problems to Chapter 8 33
Solutions to problems to chapter 8 35
Problems to Chapter 9 41
Solutions to problems to chapter 9 42
Problems to Chapter 10 47
Solutions to problems to chapter 10 49
Problems to Chapter 11 53
Solutions to problems to chapter 11 54
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Basics of International Economics – Exercises

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Problems to Chapter 1
1. Imagine a world with only two countries, Denmark and England, and two products, chips and
cell phones. The prices in the two countries are given in Table 1.1 below.
1.1. Does any country have an absolute or comparative advantage in a product?
1.2. What are the relative prices?
1.3. Which country specializes in which product?
2. Continue with the same world but with different prices as given by Table 1.2.
2.1 Does any country have an absolute or comparative advantage in a product?
2.2 What are the relative prices?
2.3 Which country specializes in which product?
3. Continue with the same world but with different prices as given by Table 1.3. The parameter
a takes the value 1 with probability ¼ (about every four years), the value -1 with probability
¼, and takes the value 0 with the probability ½.
Denmark
England
2
8
Cell phones
6
4
Potato chips
Table 1.1
Problems to Chapter 1
Denmark
England
2
8
Cell phones
2
4
Potato chips
Table 1.2
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Basics of International Economics – Exercises

6
3.1 Does any country on average have an absolute or comparative advantage in a product? Will
there be trade in this example?
3.2 Which country specializes in which product in years with a=1? Who exports which product?
3.3 Which country specializes in which product in years with a=-1? Who exports which product?
3.4 If it is costly and takes at least a year to set up a firm, what is likely to happen?
4. Continue with the same world but with different prices as given by Table 1.4. Imagine that
Denmark places a tariff t on imports of chips, such that imported chips are going to cost t
percent more than those produced in Denmark.
Denmark
England
4
8
Cell phones
2+a
4
Potato chips
Table 1.3
Problems to Chapter 1
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4.1. How large does the tariff need to be to prevent imports of chips from England?
5. Comparative advantages often arise from differences in factor endowments. Assume that all
goods are produced using only two inputs: labour and capital. There are two countries in the
world, one which is well endowed with labour, the other well endowed with capital.
5.1. If the production of cell phones requires a large capital stock, which country will have a
comparative advantage in producing cell phones?
5.2. As the labour-abundant country grows richer and builds a larger capital stock, what happens to
its comparative advantage?
Denmark
England
2
8
Cell phones
4
4
Potato chips
Table 1.4
Problems to Chapter 1
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Basics of International Economics – Exercises

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Solutions to problems to chapter 1
1. Denmark produces cell phones absolutely cheaper than England while England produces chips
absolutely cheaper than Denmark. The relative prices are 2/6=1/3 in Denmark, i.e. you get one
cell phone for three units of chips. In England, the relative price is 8/4=2. Hence, England has
an absolute advantage in producing chips and therefore specializes in this product while
Denmark has an absolute advantage in producing cell phones, which it specializes in.
2. In this example, Denmark can produce both products absolutely cheaper than England and
therefore has an absolute advantage in both products. The relative prices, however, are 2/2=1
in Denmark, but 8/4=2 in England. In relative terms, English cell phones are hence more
expensive than Danish cell phones. Thus, Denmark has a comparative advantage in producing
cell phones and England has a comparative advantage in producing chips. The countries will
therefore specialize in these products.
Alternatively, on can note that there is a profit opportunity: 1) buy a cell phone in Denmark
for 2 and sell it in England for 8, which gives you a profit of 6; 2) buy chips for the profit,
which gives you 1.5 units of chips; 3) bring the chips to Denmark and sell them for 2·1.5=3,
which is pure profit.
3. The first thing to note is that the average value of a is 0. Hence, on average the prices are given
by Table S1.3. Here, the countries have the same relative prices, as 4/2=2 and 8/4=2. Thus,
even if Denmark has an absolute advantage in both products, there are no comparative
advantages. As a consequence, there will be no trade.
With a=1, Danish potato chips are more expensive, implying that the Danish relative price
on cell phones becomes 4/3. Danish cell phones have thus become relatively cheaper than
English phones, meaning that Denmark specializes in the production of cell phones, exporting
them to England.
Denmark
England
4
8
Cell phones
2
4
Potato chips
Table S1.3
Solutions to problems to chapter 1
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When a=-1, the Danish relative price on cell phones becomes 4/1=4. Hence, England gets
a comparative advantage in the production of cell phones. The opposite comparative advantages
thus appear. Finally, if it is costly to set up a firm and takes time, the point of the example is
that a completely arbitrary value of a at the beginning can make countries specialize
in a product.
4. To find the tariff that prevents trade, note that the profit that an arbitrageur can make from
trading depends on the relative prices. To make those equal, the relative price in Denmark must
be 2 (as in England). To do so, the tariff must necessarily be 300%, since 2·(1+3)/4=2. That
way, traders will get a profit of zero.
5. The country with the large endowment of labour (depicted to the left) will quite naturally
have a larger supply of labour too. As Figure S1.1 shows, this will lead to a lower wage in the
labour-abundant country. All other things being equal, this means that the production of chips
will be cheaper in that country, giving it a comparative advantage over the capital-abundant
country. The same argument can be made for the supply of capital.
As such, when the labour-abundant country grows richer and builds a larger capital stock,
the price of capital will decline. Hence, in the course of development its comparative advantage
in producing chips will erode.

Solutions to problems to chapter 1
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Figure S1.1
The demand for labour

W
1

Wage Wage
S
S
D
D
Quantity Quantity
W
0
W
1
Solutions to problems to chapter 1
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Basics of International Economics – Exercises

11
Problems to Chapter 2
1. Competitive advantages often arise due to the existence of economies of scale.
1.1. How can firms achieve internal economies of scale?
1.2. How can firms achieve external economies of scale?
2. At the outset, two countries trade with each other. There is only one firm in each country.
Imagine now that a strongly protectionist government comes to power in one of the countries.
The new government imposes an import tariff that effectively prevents imports.
2.1. What happens to the market structure in the two countries?
2.2. What are the welfare consequences of preventing imports in this situation?
3. Two different types of models are often used to explain trade in similar goods.
3.1 How do the Lancaster model and the Dixit-Stiglitz models differ?
3.2. Are there fundamental differences between the implications of the two models?
4. Quality differences often matter for trade, as rich consumers tend to demand higher quality
goods.
4.1. If poor countries produce goods of lower quality, what are the implications for trade patterns
between countries? Who trades with whom?
4.2. For a poor country like Ghana, does trade protections vis-à-vis other poor countries or vis-à-
vis rich countries matter more when quality differences are important for traded goods?
4.3. What is the situation like for rich countries?
4.4. What is the situation like for middle-income countries, i.e. countries in between?
Problems to Chapter 2
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Solutions to problems to chapter 2
1. The answers are given in Basics of International Economics, pages 17-18.
2. When the new government imposes an import tariff that effectively prevents imports, there
will be only one producer left in each country. As such, the market structure changes to a
monopoly. The welfare consequences in this situation are simple, as monopolies supply smaller
quantities at higher prices, which leaves consumers and the country as such worse off.
3. The Lancaster model and the Dixit-Stiglitz models differ on one point. The Lancaster model
assumes that people only have preferences for one type of the good and therefore buy the
product that is closest to their true preference so as to maximize their utility. The Dixit-Stiglitz
model, on the other hand, assumes that people buy a variety of types – one day, they may buy
a Coca-Cola, the other day a Sprite. Hence, they maximize their utility by consuming a range
of goods.
However, there are no real fundamental differences between the implications of the two
models. In the Lancaster model, consumers are better off when trade is free because is gives
them a possibility to get closer to their true preference while in the Dixit-Stiglitz model, it
gives them a larger variety of goods to choose from.
Solutions to problems to chapter 2
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Basics of International Economics – Exercises

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4. When quality differences matter for trade and rich consumers tend to demand higher quality
goods, the situation can be depicted as in Figure S2.1 below. This indicates that similar
countries will trade more with each other as a larger share of their products can be sold in other
similar countries. As such, poor countries ought to trade mostly with other poor countries and
rich countries ought to trade more with other rich countries.
This also has the implication that for poor countries such as Ghana, trade protections vis-à-vis
other poor countries matters more because their prospective markets are substantially larger
in other poor countries. The same is the situation for rich countries, as their prospective markets
are in other rich countries. For rich countries, the trade policies of other rich countries therefore
matter relatively more.
However, for middle-income countries that are at a stage of development in between, part of
their products can be sold in poor countries and part in rich countries (for example, place
a country exactly in between Ghana and Denmark in the figure to see this point). It will
therefore depend on other factors what matters most.

Figure S2.1
Trade with quality differences

Y = Imcome
b
c
a
Quality
e
f
Y
Denmark
Y
Portugal
Y
Gihana
Products trade
between Denmark
and Portugal
d
Solutions to problems to chapter 2
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Basics of International Economics – Exercises

14
Problems to Chapter 3
1. Imagine a small open economy with an initial tariff on a product. Now remove the tariff.
1.1. Outline the welfare consequences of the tariff liberalization.
1.2. Who would argue for keeping the tariff in place? Who would argue for removing it?
2. Imagine a small open economy with an import quota on a product. Now remove the quota.
2.1 Outline the welfare consequences of removing the quota.
2.2 Who would argue for keeping the quota in place? Who would argue for removing it?
3. Imagine a small open economy with an initial tariff on a product. Now suppose that the
domestic producers experience a supply shock, for example due to the introduction of a new
an more efficient technology that reduces their production costs.
3.1. Outline the welfare consequences of this supply shock.
3.2. What happens to imports?
4. Imagine that an economy has a tariff rate quota (TRQ) in place for imports from a number of
developing countries.
4.1. What is the difference between binding and non-binding TRQ?
4.2. Illustrate the effects of a non-binding TRQ.
4.3. Illustrate the effects of a binding TRQ.
5. Imagine a large economy like the EU, which provides export subsidies to certain products.
5.1. What is the cost to the government of providing the export subsidy?
5.2. Illustrate what happens to exports if the export subsidy is cut in half?
5.3. What are the welfare consequences of this cut?
6. Imagine again a large economy that chooses to protect a sector of its economy by imposing
a tariff on imports.
6.1. What are the welfare consequences of imposing a tariff in a large economy?
6.2. How do tariffs in large economies differ from tariffs in small economies?
6.3. What are the arguments against a small positive tariff in large economies?
Problems to Chapter 3
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15
7. Governments are often concerned about standards, for example food security. Such standards
can be imposed in two difference ways: 1) either as standards that imports have to conform
to, which requires paper work that is costly when importing; or 2) standards on how products
are produced, which increases the costs for foreign firms of producing the goods. Both types
of standards can work as non-tariff barriers.
7.1. Analyze both cases for a small open economy. How do they differ?
Problems to Chapter 3
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Solutions to problems to chapter 3
1. The effects of removing the tariff can be illustrated by the demand-supply diagram below
where pw is the (inelastic) world supply. Removing the tariff first means that producers lose
area A, which is the change of the producers’ surplus. The change occurs because a number
of producers – the ones supplying quantities q
f
to q
t
– can no longer compete with producers
in the world market at the price without the tariff t. Secondly, the government loses the tariff
revenue, which is necessarily equal to the tariff t times the import quantity, d
t
-q
t
, or the area
C. However, consumers win areas A, B, C and D as they pay a lower price and are able to
consume more (d
f
-d
t
). As such, the tariff liberalization has the effect of transferring areas
A and C from the producers and the government, respectively, to consumers, but also the effect
of removing the two deadweight losses B and D.
Therefore, producers will always prefer to keep the tariff in place while consumers will prefer
to remove the tariff. All other things being equal, the government will also prefer to keep the
tariff in place due to the revenue it generates. Yet, if it also collects an income tax, this
conclusion will not be unambiguous since consumers have become richer due to the lower price.
This will tend to increase the government’s revenue from the income tax, which could
theoretically make the government willing to remove the tariff.

2. The effects of removing the quota can be illustrated by the demand-supply diagram below
where the notation is as in the figure above. Removing the quota first means that producers
lose area A, which is the change of the producers’ surplus. The change occurs because a number
of producers – the ones supplying quantities q
f
to q
t
– can no longer compete with producers in
Figure S3.1
The effects of a removing a tariff
Price
Quantity
q
f
Tariff A B C D
q
t
d
f
d
t
p
w
+t
p
w
S
w
D
S
Solutions to problems to chapter 3
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Basics of International Economics – Exercises

17
the world market at the price without that occurs with unrestricted imports. Secondly, if the
quota has been sold the government loses the quota rent C, which equals the value of the
import quantity, d
t
-q
t
. Otherwise, the ones holding the import license will lose this area. On
the other hand, consumers win areas A, B, C and D similarly to the removal of a tariff.
Therefore, producers will always prefer to keep the quota in place while consumers will prefer
to remove it. Given that the government has sold the quota through import licenses, it will also
prefer to keep it in place due to the revenue it generates. If it has not been sold, whoever holds
the license will prefer to keep it in place.

3. The supply shock moves the supply curve, S, to the right. As can be seen in the figure below,
this has the effect of limiting imports since more domestic producers now are able to compete
with foreign firms paying the tariff t. As such, the government loses tariff revenue – area C
becomes smaller – while producers’ surplus, A, becomes larger. However, because the price in
the figure is unchanged, consumers’ welfare is unaffected. Had the new supply curve intersected
the demand curve below p
w
+t – the price paid by foreign firms – imports had seized and the
domestic price had decreased. This would cause the government surplus to entirely disappear.
Due to the lower price, consumers’ surplus would have increased while the change in producers’
surplus would become ambiguous as they would supply more, but at a lower price.

Figure S3.2
The effects of a removing an import quota
Price
Quantity
q
f
Quota
A B C D
q
t
d
f
d
t
p
quota
p
w
S
w
D
S
S+quota
Solutions to problems to chapter 3
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4. TRQs are said to be binding when the country subject to the TRQ can supply a quantity above
the TRQ larger than the quota at the preferential tariff rate. If firms in the country cannot all
compete at the price given by the preferential tariff rate, the TRQ is said to be non-binding.
The case of a non-binding TRQ is illustrated in Figure 3.4 in Basics of International Economics
while the case of a binding TRQ is illustrated in Figure 3.3.
Figure S3.2
The effects of a domestic supply shock
Price
Quantity
Tariff A B C D
q
0
d q
1
p
w
+t
p
w
S
w
D

S
1
S
0
Solutions to problems to chapter 3
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5. The effects of cutting the subsidy in half are illustrated in the Figure below; arrows indicate the
direction the changes occur. The size of the initial subsidy is b
0
-a
0
, making the value of it
(b
0
-a
0
)·q
0
as q
0
is the total export quantity. This is also equivalent to the square a
0
b
9
c
0
d
0
.
This value equals the cost for the government of providing the export subsidy. The subsidy is
now reduced to b
1
-a
1
.
Removing the subsidy will have the effect of shifting the supply curve to the left from
S
x-s
Before to S
x-s
After. The reduction of supply leads to a price increase in the world market
from a
0
to a
1
and a reduction in the price received by exporters from b
0
to b
1
, which leads to
a reduction in exports from q
0
to q
1
. As such, the cost of providing the subsidy is reduced to the
square delineated by a
1
b
1
c
1
d
1
.
The welfare consequences can also be traced in Figure S3.3. Relative to the price without
export subsidies, f, the initial welfare gains for foreign consumers – i.e. their additional
consumers’ surplus due to the export subsidy - was a
0
d
0
e f. The initial producers’ surplus in
the homeland is given by the area f b
0
c
0
e, which is the profit they receive over and above the
market price without subsidies. The triangular area d
0
e c
0
is the deadweight loss occurring
when the export subsidy makes domestic firms competitive in the world market although they
are not as efficient as foreign firms.
When cutting the export subsidy in half, foreign consumers’ surplus is reduced to a
1
d
1
e f and
domestic producers’ surplus is reduced to f b
1
c
1
e. Hence, the cost to the government is also
reduced as is deadweight loss since more production is shifted to the more efficient foreign
firms. As such, domestic consumers’ surplus is increased since they have to pay lower taxes to
finance the export subsidy.
Figure S3.3
The effects of an export subsidy
Price
Export quantity
a
0
e
d
1
d
0
q
0
q
1
f
b
1
c
0
D
M
S
x-s
After
S
x
a
1
b
0
S
x-s
Before
c
1
Solutions to problems to chapter 3
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20
6. The welfare consequences of imposing a tariff in a large economy are different from a small
economy in that demand in the former is sufficiently large to affect the world market price.
As such, tariffs imposed by large economies differ from tariffs in small economies through the
large economy ability to affect world market prices. Tariffs therefore affect their terms of
trade – the ratio of export to import prices, which under some circumstances can be beneficial
to the economy.
The welfare consequences are slightly different from those of a small economy, as the
deadweight losses are the same, but the terms of trade change – the lower import price –
generates an additional gain to consumers. A small positive tariff can therefore be optimal in
large economies.
However, the world consists of both small and large economies. It is worth noting that a large
economy tariff is a beggar-thy-neighbour policy, i.e. the terms of trade gain comes at the
expense of other countries. As other large economies have the same incentive to impose a large
tariff, the terms of trade for all economies can therefore be unchanged. All countries nevertheless
suffer deadweight losses, which leads to the conclusions that a free-trade agreement between
all countries will necessarily be globally welfare improving.
7. The effect of a process standard is to raise the costs of foreign firms, which is equivalent to
shifting the international supply curve upwards (all production has become more expensive).
This is depicted in Figure S3.4. As such, this leads to a decrease of imports.

Figure S3.4
The effects of a process standard
Price
Quantity
Tariff
p
w
+t
p
w
S
w
D
S
w
new
S
q
f
d
f
Imports,new
Imports
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21
If, instead, the standard is imposed as a product standard, the non-tariff barrier is equivalent to
a tariff increase, as imports simply become more expensive. This situation can then be analyzed
as a normal tariff increase. The difference can be illustrated simply as the production standard
imposes an import cost c, which raises the price level from p
w
(1+t) to p
w
(1+t+c). Hence,
the price change is pwc. The production standard, on the other hand, raises the world market
price. Assuming that the additional cost raises the price level by a percent, the new price level
becomes pw(1+a)(1+t). Here, the price change is therefore pwa(1+t). Here, it is easy to see that
the process standard is probably in general more trade distorting.
Solutions to problems to chapter 3
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Problems to Chapter 4
1.
1.1. What does Factor Price Equalization mean?
1.2. Use the Heckscher-Ohlin model to answer which groups in rich and poor countries, respectively,
that are likely to oppose free capital movements. Which groups are likely to support it?
2. The Heckscher-Ohlin Theorem is important in international economics.
2.1. What does the Theorem say?
2.2. Explain the mechanisms ensuring that the Theorem holds.
3. How does the Stolper-Samuelson Theorem connect to factor price equalization? Please explain
the mechanisms.
4. Does the Heckscher-Ohlin model imply that wages will be equalized all over the world? Please
specify what exactly is meant by wages.
Problems to Chapter 4
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23
Solutions to problems to chapter 4
1. The Factor Price Equalization states that when two countries open up for trade, the relative
prices of the factors of production will become equal.
When using the Heckscher-Ohlin model to answer which groups in rich and poor countries,
respectively, that are likely to oppose free capital movements, it is relevant to look at the
relative wages to different groups. Note first that capital moves from the rich country to the
poor country. As the supply of capital becomes scarcer in the rich country, the interest rate (the
‘wage’ paid to capital owners) increases relative to the wage paid to labour. The opposite
happens in the poor country that receives an inflow of capital. Therefore, labour in the rich
country – meaning labour unions – will tend to oppose free capital movements while capital
owners will support it. The situation is the opposite in the poor country.
2. The Heckscher-Ohlin Theorem states that countries that are capital-abundant will export
capital-intensive goods while countries that are labour-abundant will export labour-intensive
goods. Basically, the factor endowments are the causes of the comparative advantages. That
the comparative advantages will result in trade is ensured by arbitrage, i.e. by traders seeing
profit opportunities in the market.
3. The Stolper-Samuelson Theorem states that the price of the input factor that is used intensively
in the production of the good, whose price increases, will increase. The connecting mechanism
is as follows. First, trade occurs, which increases the demand for the good in which the country
has a comparative advantage. This leads to a demand for the production factors going into the
product, and in particular for the input factor that is used intensively in its production. The
increased demand will thus lead to an increase in the pride of the input factor relative to the
other input factor.
4. No, the model only states that the relative wages – the ratio of wages to interest rates
W/r - will be equalized. Furthermore, it should be noted that it is implicitly assumed that all labour is
equally productive. Hence, in the real world the model only states that the relative effective
wages are equalized. Thus, even if interest rates would become the same, the model only
implies that equally productive labour will receive the same wage.
Solutions to problems to chapter 4
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Basics of International Economics – Exercises

24
Problems to Chapter 5
1. Liberalizing capital movements entails potential benefits.
1.1. Illustrate the benefits of capital mobility.
1.2. How are the benefits distributed between capital and labour?
1.3 How does risk affect the total benefits?
2. Dunning’s so-called ‘eclectic paradigm’ states a number of conditions for firms wanting to
invest directly abroad.
2.1. What are the conditions for successful foreign direct investments?
2.2. How can firms use them in choosing between exporting to a country or investing in production
facilities within the country?
3. Markusen’s model is intended to explain why firms sometimes chose to locate production and
headquarters in different countries and sometimes in the same country.
3.1. When do firms produce the same goods in more than one country?
3.2. When do firms produce different goods in different countries?
3.3. Under which conditions do no firms invest in other countries?
Problems to Chapter 5
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Solutions to problems to chapter 5
1. The benefits of having free capital movements can be illustrated as in Figure S5.1. When
capital movements are liberalized, capital flows to wherever it receives that highest payoff, i.e.
the country with the highest interest rate.
The benefits for the rich country (with the low interest rate) come about because the amount of
capital K
0
-K
1
moves to the poor country that has a higher interest rate. Capital will flow from
the rich to the poor country until the increase supply of capital in the poor country has driven
interest rates down and the smaller supply of capital in the rich country has driven interest rates
up to a common world level. For the rich country, the additional profit is equivalent to area
CEF. For the poor country, the value of the additional capital is equivalent to area CDE.
However, the benefits are not equally distributed. In the rich country (to the left in the figure),
labour loses the area r
i
r
w
C F. This loss can be interpreted as a relative wage decrease as
capital moves to the poor country and therefore causes a lower demand for labour. On the other
hand, capital owners in the rich country get the additional benefit of r
i
r
w
E F.
In the poor country labour demand increases, which causes labour to receive the additional benefit
r
D
D C r
w
. On other hand, capital owners lose r
D
D E r
w
due to the lower interest rate.
If investments in the poor country are deemed to be more risky than in the rich country,
investors will need to take a risk premium, causing the interest rate in the poor country to be
higher than the world interest rate. Compared to the situation without risk, the world therefore
loses the area CHI, which is a deadweight loss due to the risk.
Figure S5.1
The benefits of capital mobility

r
developed
K
0
r
D
r
W
r
W
+risk
B
C
r
developing
r
W
r
I
H
D
I
E
F
G
K
1
K
total
Solutions to problems to chapyer 5
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Basics of International Economics – Exercises

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2. Dunning’s so-called ‘eclectic paradigm’ states that the following conditions all have to be
satisfied for firms to benefit from foreign direct investments:
- The firm needs to have core competences
- There must be a location advantage
- There must be an internalization advantage
If these conditions are not satisfied, the firm would be better off producing in the foreign
country, outsourcing or exporting to the foreign country. In other words, the firm needs to be
better at something than other firms, it needs to have a reason to locate production abroad and
it needs to have reason to keep production in-house.
Firms can use the conditions roughly to asses, for example, whether it would be cheaper to set
up production in another country due to lower wages or easy access to local markets (the
location advantage). If so, and if the other conditions are also satisfied, it will probably pay to
make a direct investment in the country.
3. Firms produce the same goods in more than one country when the two countries have fairly
similar endowments of production factors. In terms of Dunning’s criteria, this situation gives a
location advantage since Markusen assumes sufficiently high trade costs for trade not to take
place. The location advantage is simply that firms can overcome the trade costs/barriers.
For firms to produce different goods in different countries, i.e. to produce vertically, there need
to be differences in the factor endowments of the countries. In other words, firms may diversity
their production across countries when there are comparative advantages making it worthwhile.
These comparative advantages arise out of a different endowment of unskilled relative to
skilled labour.
Conditions making firms chose not to invest in other countries correspond to Markusen’s type
NH and NF firms that only produce one good in one country. This can be the case if one
country has a large amount of the world’s total skilled and unskilled labour; hence, the foreign
market is very small and therefore probably not sufficiently important to justify investment.
Solutions to problems to chapyer 5
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Basics of International Economics – Exercises

27
Problems to Chapter 6
1. Madagascar has had a rather disappointing growth performance for many years as shown in
Table S6.1. Assume an ICOR of 3. Starting in 1975, to reach a GDP per capita of roughly 5000
US dollars in 2000, 6 percent annual growth is needed.
1.1. Use the two-gap model to calculate the necessary aid to reach a growth goal of 6 percent per
year.
1.2. How fast would Madagascar have grown according to the model with the actual aid number?
1.3. How well does the two-gap model fit the case (hint: plot the numbers in the table against the
prediction of the model)?
1.4. Is there a clear connection between investments and aid as supposed by the two-gap model?
Problems to Chapter 6
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2.
2.1. Explain the concept of ‘fungibility’
2.2. Can fungibility explain the poor performance of the two-gap model?
3. Dutch Disease can affect the competitiveness of an economy.
3.1. Explain what Dutch Disease is and how aid can induce it.
3.2. Through Dutch Disease, what kind of effect can development aid have on the structure of the
economy?
1975
GDP per
capita
1181,6
Growth rate for
five-year period
-1,46
Investment
rate
3,04
Savings
rate
-1,69
Aid,
% of GDP
3,66
1980
1985
1086,8
956,2
-1,63
-2,50
2,86
2,23
-5,44
-6,82
3,73
6,22
1990
1995
901,4
819,3
-,1,15
-1,88
3,19
2,54
-2,89
-5,32
13,07
12,47
2000
Total
average
835,9
952,6
,42
-1,36
2,88
2,79
-4,96
-4,40
12,96
8,52
Table 6.1
Madagascar, statistics
Problems to Chapter 6
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Solutions to problems to chapter 6
1. First, with an ICOR of 3 and using the box on page 57 in Basics of International Economics,
we reach a necessary investment rate of 18%. With an average savings rate throughout the
period of -4.4% (it was negative!), this gives the needed level of aid of 18+4.4=22.4%. With
the actual aid levels around 8.5% over the 25-year period, we get a predicted investment rate of
8.5-4.4=4.1%. This would have caused a growth rate of 4.1/3 (divide by the ICOR), or roughly
1.4% annually.
The predicted growth rates for the period are .66, -.57, -.2, 3.39, 2.38 and 2.67. It would be
difficult to argue that they fit the actual number with any precision. The numbers also point to
a potential explanation, as the investment rate according to the two-gap model ought to
increase with increasing aid levels. However, the investment rate has been fairly stable over
the period although aid has increased substantially. This therefore indicates that the aid may
not have been turned into investments.
2. The term ‘fungibility’ refers to the situation where aid inflows are not necessarily used to
finance what they were supposed to. When international donors finance improvements in a
sector of the economy, the government can withdraw resources spent on that sector and
instead use the resources to its own liking. There is therefore not necessarily a clear link
between the investment rate and foreign aid, and as such, fungibility may explain part of the
poor performance of the two-gap model.
3. Dutch Disease comes as an almost unavoidable effect on the exchange rate. When a country
receives foreign aid, it must be exchanged for the domestic currency to be put to use. As the
figure on page 61 in Basics of International Economics shows, the increased demand for
the domestic currency has the effect of increasing the value of the currency. Thereby,
domestically produced goods become more expensive abroad, which leads to a decrease in
exports and thus a decrease in GDP.
Through inducing Dutch Disease, foreign aid therefore often has the effect of increasing
governments involvement in the economy – they gain additional resources – but decreasing
the importance of the private sector. As such, the structure of the economy can tend to become
dominated by the government sector.
Solutions to problems to chapter 6
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Problems to Chapter 7
1.
1.1. Please explain what Open Market Operations (OMO) are?
1.2. What is an exchange rate?
1.3. How do central banks use OMO to regulate the exchange rate?
2. Countries use different exchange rate regimes.
2.1. What is the difference between fixed and floating exchange rate regimes?
2.2. What happens to the money supply when countries choose a fixed rate regime?
3. Suppose that aggregate demand increases by 2% each year.
3.1. What happens to the exchange rate when the currency is floating?
3.2. What happens to the exchange rate when the currency is fixed?
Problems to Chapter 7
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Solutions to problems to chapter 7
1. Open Market Operations (OMO) are the operations that the central bank performs to control
the money supply. In its simplest form, the central bank sells bonds in the open market if it
wants to limit the money supply or buy bonds if it wants to increase the supply.
Just as in any other market, the market for currency determines a price: the exchange rate,
which is simply the price of foreign currency.
2. The main difference between fixed and floating exchange rate regimes is that in the former,
the government or central bank directs part of the economic policy to maintaining a fixed
nominal exchange rate. As financial markets change rapidly, this is achieved through the
monetary policy. Hence, when countries choose a fixed rate regime the monetary policy
becomes endogenous in the sense that the money supply is set at all times to maintain a
fixed exchange rate. Countries therefore lose the ability to use monetary policy when they fix
their currency.
3. A situation in which aggregate demand increases by 2% is depicted in Figure S7.1 below.
Solutions to problems to chapter 7
Figure S7.1
Exchange rate movements
S
0
D
0
Exchange rate
D
1
E
0
E
1
S
1
Fixed regime
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Solutions to problems to chapter 7
When the currency is floating, only D (demand) moves, resulting in an appreciation from
E
0
to E
1
. This happens in the course of each year, implying that the exchange rate continues to
depreciate.
If, on the other hand, the exchange rate is fixed, the central bank has to increase the money
supply in order to keep the exchange rate fixed, which is done by increasing it from S
0
to S
1
.
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Problems to Chapter 8
1. The media often reports that countries have conducted expansionary fiscal policy, that there is
need for tightening monetary policy etc.
1.1. How do countries conduct fiscal policy?
1.2. How do countries conduct monetary policy?
1.3. What central variables can these policies affect in society?
2. Another factor often touched upon and discussed in the media is competitiveness. How is
international competitiveness most often measured?
3. What happens to the income, employment and current account of a small open economy when
it conducts contractionary monetary policy under:
3.1. A floating exchange rate regime?
3.2. A fixed exchange rate regime?
4. What happens to the income, employment and current account of a small open economy when
it conducts expansionary fiscal policy under:
4.1. A floating exchange rate regime?
4.2. A fixed exchange rate regime?
Problems to Chapter 8
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5. Imagine that the world interest rate goes up. What happens in a small open economy when:
5.1. The country has a fixed exchange rate regime?
5.2. The country has a floating exchange rate regime?
5.3. If the increase in the interest rate is anticipated by the government in a country with a fixed
exchange rate, is there something that it can do to counteract the influence?
5.4. If the increase was not anticipated but government pursues the policy anyway, what will
happen?
Problems to Chapter 8
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Solutions to problems to chapter 8
1. Countries conduct fiscal policy by either changing government expenditures, G, or taxes, T.
Monetary policy, on the other hand, is conducted by changing the money supply. This is done
by Open Market Operations.
Fiscal and monetary policy can influence most variables in society, including income,
employment, and net exports.
2. International competitiveness is most often measured simply as the real exchange rate,
R=E P
foreign
/P. This means that countries can become more competitive vis-à-vis the rest of the
world if: 1) the nominal exchange rate E depreciates, making domestic products relatively
cheaper abroad; 2) the price level of foreign goods increases, which again makes domestic
products cheaper abroad; and 3) if the domestic price level decreases.
3. The effects of contractionary monetary policy on income, employment and current account of
a small open economy under floating exchange rate regimes are illustrated in Figure S8.1
below.
Solutions to problems to chapter 8
Figure S8.1
Contractionary monetary policy under floating
exchange rates
LM
0
IS
Y
r
r
w
Y
*
Y
1
BP
0
LM
1
BP
1
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Solutions to problems to chapter 8
The monetary contraction moves the LM curve from LM
0
to LM
1
, which has the effect of
momentarily raising the interest rate. Hence, it becomes more attractive for foreigners to invest
in the country, creating an increased demand for the currency. This demand increase leads
to an appreciation of the exchange rate, which harms the competitiveness and thus lowers the
net exports. The lower net exports moves the IS curve to the left until the interest rate equals
the world interest rate.
Under a floating exchange rate regime, income therefore suffers, as does employment since
less production requires less labour. The current account has also deteriorated due to the
exchange rate appreciation.
Under a fixed exchange rate regime, on the other hand, the interest rate increase leads to a
higher demand for the domestic currency. However, as the exchange rate is fixed, the central
bank has to increase the money supply – that is, conduct expansionary monetary policy – to
counterweigh the increased demand for the currency with increased supply. As such, the
example illustrates that when countries chose to fix their exchange rate, they automatically
renege on their ability to use monetary policy.
4. The effects of expansionary fiscal policy on income, employment and current account of a
small open economy under floating exchange rate regimes are illustrated in Figure S8.2
below.
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Solutions to problems to chapter 8
First, the fiscal expansion leads to the IS curve moving to the right. As this raises the interest
rate, it becomes more attractive for foreigners to invest in the country, which creates an
increased demand for the currency. The additional demand increase leads to an appreciation
of the exchange rate, which harms the competitiveness and thus lowers the net exports. The
lower net exports moves the IS curve to the left until the interest rate equals the world interest
rate, i.e. it moves back to its original position. Therefore, income and employment are
unchanged. However, due to the worsened competitiveness the current account has suffered
and net exports are therefore lower. What has happened is simply that government expenditure
and government employment has replaced income creation and employment in the
export sector.
Under a fixed exchange rate regime, on the other hand, the situation is equivalent to Figure 8.4
in Basics of International Economics. To counteract the increased demand for the currency
caused by the initial interest rate increase, the central bank expands the money supply, i.e.
conducts expansionary monetary policy to ensure that the exchange rate stays fixed. Therefore,
competitiveness is unchanged while income and employment have bettered. Yet, the current
account has deteriorated since the now richer inhabitants will tend to buy more imported goods
as well as domestically produced goods.
5. The case when the world interest rate goes up for a small open economy with a fixed exchange
rate regime is depicted in Figure S8.3 below.
Figure S8.2
Expansionary fiscal policy under floating exchange rates
LM
IS
Y
r
r
w
Y
*
Y
1
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38
Solutions to problems to chapter 8
In this case, the central bank counteracts the interest rate increase by raising its interest rate.
This is done by limiting money supply as the exchange rate would otherwise depreciate. As
such, the higher interest rate reduces income and hence also reduces employment; i.e. it creates
unemployment. As the international competitiveness of the economy is unchanged but people
spend less, the current account improves.
If, on the other hand, the country has a floating exchange rate regime, the situation can be
depicted as in Figure S8.4 further below. Here, the exchange rate is allowed to depreciate
following the interest rate hike, which improves the competitiveness of the economy. It therefore
sees an improvement in net exports, which moves the IS curve to the right. Income, employment
and the current account have therefore improved.
Figure S8.3
A world interest rate increase under fixed exchange rates
LM
IS
Y
r
r
0
Y
*
Y
1
r
1
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39
Solutions to problems to chapter 8
Figure S8.4
A world interest rate increase under floating exchange rates
LM
IS
Y
r
r
0
Y
*
Y
1
r
1
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Solutions to problems to chapter 8
If the increase in the interest rate is anticipated by the government in a country with a fixed
exchange rate, the government will naturally also anticipate the undesirable consequences of it.
It can therefore conduct expansionary fiscal policy to balance the monetary contraction. If
the interest rate increase was not anticipated but government pursues this policy anyway, it
can nonetheless risk running into problems because the market for goods and services – the
IS curve – tends to react much slower than the financial markets – the LM curve. If governments
therefore attempt to conduct fiscal policy to stabilize the economy without anticipating the
international movements in, for example, the interest rate, they risk destabilizing the
economy instead.
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Problems to Chapter 9
1. Suppose that a large open economy conducts contractionary monetary policy:
1.1. What happens to the income, employment, current account and exchange rate of the
economy?
1.2. What happens to these variables for the rest of the world (hint: treat the rest of the world as a
second large economy)?
2. Suppose that a large open economy conducts expansionary fiscal policy:
2.1. What happens to the income, employment, current account and exchange rate of the
economy?
2.2. What happens to these variables for the rest of the world (hint: treat the rest of the world as a
second large economy)?
3. In the early 1980s, the US government was concerned with the high unemployment figures. At
the same time, the central bank was concerned with increasing inflation (which is often a result
of a growing money supply).
3.1. Analyze what effects it had on the country when the US government conducted expansionary
fiscal policy at the same time as the central bank tightened the monetary policy.
3.2. What happened to the rest of the world (hint: treat the rest of the world as a second large
economy)?
4. Suppose that the world consists of only two countries, the US and the EU. The EU now
conducts expansionary monetary policy in order to raise employment.
4.1. What happens to the US?
4.2. What ‘countermeasures’ can the US take?
4.3. Is there a case for international policy coordination in this example?
Problems to Chapter 9
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Solutions to problems to chapter 9
1. Suppose that a large open economy conducts contractionary monetary policy:
1.1. What happens to the income, employment, current account and exchange rate of the
economy?
1.2. What happens to these variables for the rest of the world (hint: treat the rest of the world as a
second large economy)?
2. When a large open economy conducts expansionary fiscal policy, the situation as is depicted
in Figure 9.1 in Basics of International Economics. The IS curve moves to the left, leading to
an increase in the interest rate and an inflow of capital since investments in the country have
become more profitable for foreigners. This increase in capital leads to a subsequent decrease
in the interest rate, as money supply goes up. On the other hand, in the foreign country, the
outflow of capital raises the interest rate until there again is one world interest rate. The increased
demand for the currency of the homeland has, however, led to an appreciation of the exchange
rate, which causes the IS curve to move to the left again. Income and employment have therefore
improved while the exchange rate has appreciated, causing a deterioration of competitiveness
and therefore a deterioration of the current account.
For the rest of the world, the situation is simpler. As the homeland exchange rate has appreciated,
this means that the foreign exchange rate has depreciated (there are only two countries!). As
such, the foreign current account has improved, and due to the stronger export performance,
the IS curve moves to the right, improving income and the employment situation.
Solutions to problems to chapter 9
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Solutions to problems to chapter 9
3. The situation from the US in the early 1980s is depicted in Figure S9.1. The effect of combining
strongly expansionary fiscal policy with a tight monetary policy is clearly ambiguous. While
the fiscal policy would improve income and employment, the monetary policy does the
opposite, but both raise the interest rate. As the interest rate rise above the world interest rate,
the US competitiveness deteriorates as in question 2, causing lower exports and higher imports
and therefore a deterioration of the current account.
The effects on the rest of the world are depicted in Figure S9.2. Given that the rest of the world
does not react, it benefits strongly from its improved competitiveness vis-à-vis the US. Net
exports – and thus the current account - therefore increase substantially, causing the income to
increase from Y
0
to Y
1
. Likewise, employment improves.
Figure S9.1
Combining policies
LM
IS
r
r
w
Y
US
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44
Solutions to problems to chapter 9
4. When the EU conducts expansionary monetary policy in order to raise employment, the
situation is similar to the one depicted in Figure 9.2 in Basics of International Economics
with the sole difference that the EU conducts the policy instead of the US. The effects on the
US are depicted in Figure S9.3 below.
Figure S9.2
Effects on the rest of the world
LM
IS
r
r
w
Y
0
Rest of world
Y
1
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45
Solutions to problems to chapter 9
Figure S9.3
Effects on the US of EU monetary policy
LM
IS
r
r
w
Y
0
Y
1
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Basics of International Economics – Exercises

46
As the increase EU money supply leads to a lower interest rate, it causes investors to move
capital to the US that momentarily pays a higher interest rate. The higher demand for US
dollars leads to an appreciation, which causes a deterioration of the US competitiveness. This
is what moves the IS curve to the left and causes the US income and employment situation to
worsen. The reduced competitiveness also worsens the current account.
The US basically has two different possible ‘countermeasures’: Expansionary fiscal and
expansionary monetary policy. While fiscal policy – moving the IS curve to the right – would
lead to a restoration of income and employment and moving the world interest rate upwards,
but would also lead to a worsened current account, as in question 2. Instead, conducting
expansionary monetary policy can achieve the same goal of restoring income and employment
but, as the US interest rate decreases, it will also cause an improvement of competitiveness.
Therefore the current account will improve at the cost of the EU current account.
The problem is that such a move could lead to the two large economies competing against each
other using expansionary monetary policy, which step by step would lower the world interest
rate. To avoid this situation could benefit from coordinating their economic policies. If both
need to boost employment, they could for example agree on a mix of fiscal and monetary policy,
which could leave interest rates unchanged, and therefore also leave the exchange
rate unchanged.
Solutions to problems to chapter 9
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Basics of International Economics – Exercises

47
Problems to Chapter 10
1. Draw a Phillips curve.
1.1. What happens to employment if inflation goes up by surprise?
1.2. What happens in the following years?
1.3. If people had anticipated that inflation went up, what would likely have happened?
1.4. Use the answers to explain the NAIRU.
2. The natural rate of unemployment (the NAIRU) depends among other things on the minimum
wage. Analyze what happens if the government decides to reduce the minimum
wage substantially.
3. In Figure S10.1, the economy initially is in the point A with an inflation rate higher than the
world inflation and an unemployment level higher than the natural rate (the NAIRU)
3.1. Explain how the economy over time finds the equilibrium level.
3.2. Can economic policy make the process towards equilibrium faster? Which policy would
that be?
Problems to Chapter 10
Figure S10.1
I
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f
l
a
t
i
o
n

p
w
o
r
l
d
A
NAIRU Unemployment
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48
Problems to Chapter 10
4. Draw a Phillips curve. Now imagine that export increases substantially.
4.1. What happens to inflation?
4.2. What happens to the international competitiveness of the economy?
4.3. What eventually happens to exports?
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49
Solutions to problems to chapter 10
1. Figure S10.1 depicts a standard Phillips curve.
If inflation goes up by surprise, it is easy to see in the Figure following the Phillips curve that
it leads to a reduction of unemployment. This happens because the real wage, W/P, is lower at
the new higher prices. Firms therefore pay relatively less for labour and will therefore demand
more. In the following years, however, the deterioration of the real wage will lead to labour
demanding higher wages. As the real wage therefore increases, firms’ wage costs increase
and lead to a decrease in the demand for labour. In the end, nothing has happened
to unemployment.
Moreover, if people had anticipated that inflation went up, they would likely have demanded
higher wages to outweigh the higher prices. In that case, nothing would have happened to
firms’ wage costs and therefore, unemployment would have been unchanged although inflation
had increased. This can also be seen from the equation characterizing the Phillips curve
Π
t –
Π
e
=-α (u
t
-u
N
). Here, Π
e
is the expected inflation, showing that unemployment can only
differ from the NAIRU, u
N
, if actual inflation Π differs from what people expected, Π
e
. If an
increase in inflation is fully anticipated, nothing therefore happens to the unemployment rate.
Solutions to problems to chapter 10
Figure S10.1
I
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f
l
a
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w
o
r
l
d
A
NAIRU Unemployment
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50
Solutions to problems to chapter 10
The NAIRU – the Non-Accelerating Inflation Rate of Unemployment, has been given its name
since maintaining a low rate of unemployment – as can be seen in the figure – requires a steady
increase in inflation to offset the expectations of future inflation. Otherwise, it is impossible to
keep the real wage low. Similarly, to keep a high unemployment requires steady decreasing
inflation. The NAIRU is the unemployment level with which inflation is stable in the long run,
i.e. does not accelerate.
2. The natural rate of unemployment (the NAIRU) depends on the minimum wage. If the minimum
wage is reduced, more people will find it worthwhile to work, which increases the supply of
labour. This will tend to reduce the real wage and increase employment. Hence, the NAIRU
moves to the left. However, it is unclear what happens to inflation as more employment creates
a larger demand for goods, and thus inflation, but a large supply of labour lowers firms’ labour
costs and therefore allows them to undercut prices.
3. In Figure S10.3, the economy initially is in the point A with an inflation rate higher than the
world inflation and an unemployment level higher than the natural rate (the NAIRU)
Figure S10.1
An expectations-augmented Phillips curve
Inflation
Unemployment
0
1
1
2


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51
Solutions to problems to chapter 10
The economy finds the equilibrium level in a circular adaptation process. This process is
explained in Basics of International Economics in connection with Figure 10.1, which readers
are referred to. However, the question of whether economic policy can speed up the process
towards equilibrium is not explained.
Figure S10.3
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p
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d
A
NAIRU Unemployment
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Basics of International Economics – Exercises

52
Solutions to problems to chapter 10
4. Look at the Phillips curve in Figure S10.1. If exports increase, the demand for labour increases
and unemployment decreases since export firms need more workers to meet orders. However,
as is clear in the Phillips curve, this will lead to higher wages and thus to higher prices; i.e. the
increased export demand triggers inflation.
As domestic prices enter in the real exchange rate, the higher inflation rate will tend to worsen
the international competitiveness of the economy. This quite naturally has the longer run effect
of reducing exports. Hence, because the increased exports lead to inflation, exports in the
longer run will tend to return to their initial level.
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53
Problems to Chapter 11
1. Take the simple growth accounting in Chapter 11 of Basics of International Economics.
1.1. Will a policy that increases employment, for example a reduction of the minimum wage, lead
to growth in the long run?
1.2. Will a policy that increases the investment rate lead to growth in the long run?
2. Many economists argue that education (human capital) increases the rate of technological
progress. For example, so-called endogenous growth theory often makes the claim that for
technological progress to occur, firms need highly educated employees.
2.1. Which factor in the simple growth accounting model captures technology?
2.2. Augment the model in page 88-89 to take into account that levels of human capital are
associated with the growth of technology. Does this augmentation change the policy implications
regarding education when politicians wish to increase the growth rate of the economy?
2.3. Could such an assumption explain the positive relation between investments and education?
3. Many Western European countries are worried about the ‘age burden’, which implies that
a large number of people leave the labour market in the coming years. How will this change
the European growth rates?
4. Outline the most important dynamic effects of trade on investments.
Problems to Chapter 11
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54
Solutions to Chapter 11
1. The growth accounting in Chapter 11 of Basics of International Economics is:
( ) ( ) log log log log log 1 log y A á K â ë H â N = + + + − −
This results in the insight that growth can come from a number of sources: 1) growth in
A - technological sophistication; 2) growth in the capital stock K, i.e. investments; 3) growth
in the employment rate λ or the education (human capital) of the work force, H; or 4) growth
in population, which exerts a negative effect.
A policy that increases employment will therefore lead to a higher growth rate while the
employment rate is growing. However, this is a one-off benefit as it for obvious reasons cannot
continue to do so. Hence, such a policy will in general not lead to a higher growth rate in the
long run. However, a policy that increases the investment rate can lead to growth in the long
run, as the investment rate is the growth rate of the capital stock. If some policy raises the
investment rate (and investments are sensible) the long-run growth rate will also increase.
2. Many economists argue that education (human capital) increases the rate of technological
progress. This factor is captured in the parameter A, which measures how much output is
produced with any given level of inputs. Hence, A is also a measure of total factor productivity.
The model in Basics of International Economics can for example be written as:
Solutions to Chapter 11
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Solutions to Chapter 11

{ } { }
{ } ( ){ }
2000 1970 2000 1970 2000 1970
2000 1970 2000 1970
log log log log log log
log log 1 log log
y y GRA á K K â ë
â H H â N N
λ − = + − + −
+ − − − −
where GRA is logA
2000
-logA
1970
. If we assume that levels of human capital are associated
with the growth of technology, then GRA is a function of H. With the simple model, the policy
implications regarding education when politicians wish to increase the growth rate of the
economy are that they should increase the level of education of the population. But this is
evidently not a long-run solution because not everyone can be PhDs. With the change here, the
policy implication is instead that politicians should strive for a high level of education, which
would lead to technological progress that causes growth.
Such an assumption could potentially also explain the positive relation between investments
and education. The point is to note that to benefit from technological progress, firms need to
invest in new machinery that incorporates the new technology. Hence, education enables firms
to create and use new technology, which leads them to invest more.
3. Many Western European countries are worried about the ‘age burden’, which implies that
a large number of people leave the labour market in the coming years. Using the simple model
in Chapter 11 can inform about what happens.

( ) ( ) log log log log log 1 log y A á K â ë H â N = + + + − −
Noting that λ is the share of the population that works, the age burden affects this variable.
In the years when elderly Europeans are leaving the labour market, λ will tend to decrease.
As a consequence, the growth rate will decline. Furthermore, they may have experience that
counts as human capital, which could also lead H to decrease. Hence, during the years when
this group of people retires, the growth rate can be expected to drop. Yet, when the group has
retired as a whole, the decrease in λ and H stops, and growth rates return to their long-run
levels. As such, the simple model does not predict an effect on the long-run growth rate but
only a medium-run effect.
4. The most important dynamic effects of trade on investments outlined in Basics of International
Economics all relate to the association between trade and investments. Investments increase
when trade is liberalized because:
• Firms might be able to export to other countries or alternatively invest in production
facilities within the countries
• Firms need to invest in more efficient facilities to be able to compete with foreign
firms. When trade is liberalized, such competition tends to become fierce, leading firms
to invest substantially
• As prices are lowered by international competition, consumers gain purchasing power,
which means that they will wish to buy more. The additional demand leads firms to
invest in new capacity.
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