International Economics - 9 Edition Instructor's Manual

International Economics 9th Edition Instructors Manual
CHAPTER 1+2+3+4+5+6+7+8+9+10+11+12+13+14+15+20+21
CHAPTER 1
*(Core Chapter)
Answer to Problems
1. a) International economic problems reported in our daily newspapers are likely to

include:
trade controversies between the United States, Europe, Japan, and China;
great volatility of exchange rates;
Increasing international competition from China and fear of job losses in the United
States and other advanced countries.
structural unemployment and slow growth in Europe, and stagnation in Japan;
financial crises in emerging market economies;
restructuring problems of transition economies;
deep poverty in many developing nations in the world.
b) Can result in trade restrictions or even a trade war, which reduce the volume and the
gains from trade;
discourage foreign trade and investments, and thus reduce the benefits from trade;
Can result in trade restrictions or even a trade war, which reduce the volume and the
gains from trade;
reduces European and Japanese imports and the volume and the benefits from trade;
financial crises in emerging market economies could spread to the United States;
can lead to political instability, which will adversely affect the United States;
can lead to political instability in these countries - which also adversely affect the
United States.
c) Can result in your paying higher prices for imported products;

lead to great fluctuations in the price of imported products and cost of foreign travel;
Can lead higher prices for imported products and increases the chances that you will
have to change jobs;
can lead you to support demands for trade protection in the United States;
can reduce the value of your investments (such as a stocks) in the United States;
can lead to your paying higher taxes for the United States to respond to these threats;
can result in your paying higher taxes to help these nations.
2. a) Five industrial nations not mentioned are: Italy, France, Canada, Austria, and
Ireland.
(353085526.doc) 3-1 Dominick Salvatore

b) See Table 1A.
c) Smaller nations, such as Ireland and Austria, are more interdependent than the larger
ones. Note that interdependence was measured by the percentage of the value of imports and
exports (line 98c and 90c, respectively in IFS) to GDP (line 99b).
Table 1A
Economic Interdependence as
Measured by Imports and Exports
as a Percentage of GDP, 2004
Imports as Exports as
Natio a percent of a percent
n GDP of GDP
Italy 25.8 26.6
Franc
e 25.7 25.9
Cana
da 34 38.2
Austri
a 46.1 51
Irelan
d 63.7 79
*Source: International Financial Statistics
(Washington, D.C., IMF, March 2006).
3. a) Five developing nations not mentioned in the text are: Brazil, Pakistan, Colombia,
Nepal, and Tunisia.
b) See Table 1B.
c) In general, the smaller the nation, the greater is its economic interdependence. Note
that interdependence was measured by the percentage of the value of imports and exports
(line 98c and 90c, respectively in IFS) to GDP (line 99b).
Table 1B
Economic Interdependence as

Measured by Imports and Exports as

a Percentage of GDP, 2004
Imports as Exports as
a percent a percent
Nation of GDP of GDP
Brazil 13.4 18
Pakistan 16.7 16
Columbia 20.7 19.4
Nepal 31.7 17.3
Tunisia 49.6 46.7
*Source: International Financial Statistics

(Washington, D.C., IMF, March 2006).
4. Trade between the United States and Brazil is much larger than trade between the United
States and Argentina. Since Brazil is larger and closer than Argentina, this trade does follow the
predictions of the gravity model.
5. a) Mankiws Economics (4th., 2007) includes the following microeconomics topics:

The market forces of demand and supply;
elasticity and its application;
the theory of consumer choice;
consumers, producers, and the efficiency of markets;
the costs of production;
firms in competitive markets;
monopoly;
oligopoly;
monopolistic competition;
markets for the factors of production;
the demand for resources;
b) Just as the microeconomics parts of your principles text deal with individual
consumers and firms, and with the price of individual commodities and factors of
production, so do Parts One and Two of this text deal with production and consumption
of individual nations with nations with and without trade, and with the relative price of
individual commodities and factors of production.
c) Mankiws Economics (4th., 2007) includes the following microeconomics topics:

measuring a nations income and the cost of living;
production and growth;
savings investment and the financial system;
unemployment and its natural rate;

the monetary system, growth and inflation;
money growth and inflation;
open-economy macroeconomics: basic concepts;
a macroeconomic theory of the open economy;
aggregate demand and aggregate supply;
the influence of monetary and fiscal policy on aggregate demand;
the short-run trade off between inflation and unemployment
five debates over macroeconomic policy.
d) Just as the macroeconomics parts of your principles text deal with the aggregate level
of savings, consumption, investment, and national income, the general price level, and
monetary and fiscal policies, so do Parts Three and Four of this text deal with the
aggregate amount of imports, exports, the total international flow of resources, and the
policies to affect these broad aggregates.
6. a) Consumer demand theory predicts than when the price of a commodity rises (cet.
par.), the quantity demanded of the commodity declines.
When the price of imports rises to domestic consumers, the quantity demanded of exports
can be expected to decline (if everything else remains constant).
7. a) A government can reduce a budget deficit by reducing government expenditures

and/or increasing taxes.
b) A nation can reduce or eliminate a balance of payments deficit by taxing

imports and/or subsidizing exports, by borrowing more abroad or lending less to other
nations, as well as by reducing the level of its national income.
8. a) Nations usually impose restrictions on the free international flow of goods,

services, and factors. Differences in language, customs, and laws also hamper these
international flows. In addition, international flows may involve receipts and payments in
different currencies, which may change in value in relation to one another through time. This is
to be contrasted with the interregional flow of goods, services, and factors, which face no
such restrictions as tariffs and are conducted in terms of the same currency, usually in the
same language, and under basically the same set of customs and laws.
b) Both international and interregional economic relations involve the overcoming

of space or distance. Indeed, they both arise from the problems created by distance. This
distinguishes them from the rest of economics, which abstracts from space and treats the
economy as a single point in space, in which production, exchange, and consumption take
place.

9. We can deduce that nations benefit from voluntarily engaging in international trade
because if they did not gain or if they lost they could avoid those losses by simply refusing to
trade. Disagreement usually arises regarding the relative distribution of the gains from
specialization in production and trade, but this does not mean that each nation does not gain
from trade.
10. International trade results in lower prices for consumers but harms domestic
producers of products, which compete with imports. Often those domestic producers that
stand to lose a great deal from imports band together to pressure the government to restrict
imports. Since consumers are many and unorganized and each individually stands to lose only
very little from the import restrictions, governments often give in to the demands of producers
and impose some import restrictions. These topics are discussed in detail in Chapter 9.
11. A nation can subsidize exports of the commodity to other nations until it drives the
competing nation's industry out of business, after which it can raise its price and benefit from its
newly acquired monopoly power.
Some economists and politicians in the United States have accused Japan of doing
just that (i.e., of engaging in strategic trade and industrial policy at the expense of U.S.
industries), but this is a very complex and controversial aspect of trade policy and will be
examined in detail in Chapter 9.
12. a) When the value of the U.S. dollar falls in relation to the currencies of other
nations, imports become more expensive for Americans and so they would
purchase a smaller quantity of imports.
b) When the value of the U.S. dollar falls in relation to the currencies of other
nations, U.S. exports become chapter for foreigners and so they would purchase a greater
quantity of U.S. exports.

CHAPTER 2
*(Core Chapter)
Answer to Problems
In case A, the United States has an absolute advantage in wheat and the United Kingdom in
cloth.
In case B, the United States has an absolute advantage (so that the United Kingdom has an
absolute disadvantage) in both commodities.
In case C, the United States has an absolute advantage in wheat but has neither an
absolute advantage nor disadvantage in cloth.
In case D, the United States has an absolute advantage over the United Kingdom in both
commodities.
In case A, the United States has a comparative advantage in wheat and the United
Kingdom in cloth.
In case B, the United States has a comparative advantage in wheat and the United
Kingdom in cloth.
In case C, the United States has a comparative advantage in wheat and the United
Kingdom in cloth.
In case D, the United States and the United Kingdom have a comparative advantage in
neither commodities.
In case A, trade is possible based on absolute advantage.
In case B, trade is possible based on comparative advantage.
In case C, trade is possible based on comparative advantage.
In case D, no trade is possible because the absolute advantage that the United States has
over the United Kingdom is the same in both commodities.
4. a) The United States gains 1C.
b) The United Kingdom gains 4C.
c) 3C < 4W < 8C.

d) The United States would gain 3C while the United Kingdom would gain 2C.
5) a) The cost in terms of labor content of producing wheat is 1/4 in the United States aand 1
in the United Kingdom, while the cost in terms of labor content of producing
cloth is 1/3 in the United States and 1/2 in the United Kingdom.
b) In the United States, Pw=$1.50 and Pc=$2.00.
c) In the United Kingdom, Pw=1.00 and Pc=0.50.
6) a) With the exchange rate of 1=$2, Pw=2.00 and Pc=$1.00 in the United Kingdom, so
that the United States would be able to export wheat to the United Kingdom and the
United Kingdom would be able to export cloth to the United States.
b) With the exchange rate of 1=$4, Pw=$4.00 and Pc=$2.00 in the United
Kingdom, so that the United States would be able to export wheat to the United
Kingdom, but the United Kingdom would be unable to export any cloth to the United
States.
c) With 1=$1, Pw=$1.00 and Pc=$0.50 in the United Kingdom, so that the United
Kingdom would be able to export both commodities to the United States.
d) $1.50 < 1.00 < $4.00.
7. a) See Figure 1.
b) In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.
c) In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.
8. See Figure 2.
The autarky points are A and A' in the United States and the United Kingdom,
respectively. The points of production with trade are B and B' in the United States and the
United Kingdom, respectively. The points of consumption are E and E' in the United States and
the United Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E' >
A' for the U.K.
9. a) If DW(US+UK) shifted up in Figure 2.3, the equilibrium relative commodity price of

wheat would also rise by 1/3 to PW/PC=4/3. Since the higher DW(US+UK) would still intersect the
vertical portion of the SW(US+UK) curve, the United States would continue to specialize
completely in the production of wheat and produce 180W, while the United kingdom would
continue to specialize completely in the production of cloth and produce 120C.

b) Since the equilibrium relative commodity price of cloth is the inverse of the relative
commodity price of wheat, if the latter rises to 4/3, then the former falls to .. This means that
DC(UK+US) shifts down by 1/3 in the right panel of Figure 2.3.

*CHAPTER 3
(Core Chapter)
Answer to Problems
1. a) See Figure 1.
b) The slope of the transformation curve increases as the nation produces more of X and
decreases as the nation produces more of Y. These reflect increasing opportunity costs as
the nation produces more of X or Y.
2. a) See Figure 2.
We have drawn community indifference curves as downward or negatively sloped because
as the community consumes more of X it will have to give up some of Y to remain on
the same indifference curve.
b)The slope measures how much of Y the nation can give up by consuming one more unit
of X and still remain at the same level of satisfaction; the slope declines because the more
of X and the less of Y the nation is left with, the less satisfaction it receives from
additional units of X and the more satisfaction it receives from each retained unit of Y.

c) III > II to the right of the intersection, while II > III to the left.
This is inconsistent because an indifference curve should show a given level of satisfaction.
Thus, indifference curves cannot cross.
3. a) See Figure 3 on page 22.
b) Nation 1 has a comparative advantage in X and Nation 2 in Y.
c) If the relative commodity price line has equal slope in both nations.
4. a) See Figure 4.
b) Nation 1 gains by the amount by which point E is to the right and above point A and
Nation 2 by the excess of E' over A'. Nation 1 gains more from trade because the relative
price of X with trade differs more from its pretrade price than for Nation 2.
5. a) See Figure 5. In Figure 5, S refers to Nation 1's supply curve of exports of commodity X,
while D refers to Nation 2's demand curve for Nation 1's exports of commodity X. D and S
intersect at point E, determining the equilibrium PB=Px/Py=1 and the equilibrium quantity
of exports of 60X.
b) At Px/Py=1 1/2 there is an excess supply of exports of R'R=30X and Px/Py falls toward
equilibrium Px/Py=1.
c) At Px/Py=1/2, there is an excess demand of exports of HH'=80X and Px/Py rises

toward Px/Py=1.
6. The Figure in Problem 5 is consistent with Figure 3-4 in the text. From the left panel of
Figure 3-4, we see that Nation 1 supplies no exports of commodity X at Px/Py=1/4 (point
A). This corresponds with the vertical or price intercept of Nation 1's supply curve of
exports of commodity X (point A).
The left panel of Figure 3-4 also shows that at Px/Py=1, Nation 1 is willing to export 60X
(point E). The same is shown by Nation 1's supply curve of exports of commodity X.
The other points on Nation 1's supply curve of exports in the figure of Problem 5 can also
be derived from the left panel of Figure 3-4, but this is shown in Chapter 4 with offer
curves.

Nation 2's demand curve for Nation 1's exports of commodity X could be derived from the
right panel of Figure 3-4, as shown in Chapter 4. What is important is that we can use the
D and S figure in Problem 5 to explain why the equilibrium relative commodity price with
trade is Px/Py=1 and why the equilibrium quantity traded of commodity X is 60 units in
Figure 3-4.
7. See Figure 6 on page 24.
The small nation will move from A to B in production, exports X in exchange for Y so as
to reach point E > A.
8. a) The small nation specializes in the production of commodity X only until its opportunity
cost and relative price of X equals PW. This usually occurs before the small nation has
become completely specialized in production.
b) Under constant costs, specialization is always complete for the small nation.
9. a) See Figure 7.
b) See Figure 8.
10. If the two community indifference curves had also been identical in Problem 9 the relative
commodity prices would also have been the same in both nations in the absence of trade and
no mutually beneficial trade would be possible
11. If production frontiers are identical and the community indifference curves different in the
two nations, but we have constant opportunity costs, there would be no mutually beneficial
trade possible between the two nations
12. See Figure 11
13. It is true that Mexico's wages are much lower than U.S. wages (about one fifth), but labor
productivity is much higher in the United States and so labor costs are not necessarily
higher than in Mexico. In any event, trade can still be based on comparative advantage.
App. 1. See Figure 12

Commodity X is the L-intensive commodity in Nation 2 (as in
Nation 1) because the production contract curve bulges
toward the L- axis or is everywhere to the left of the diagonal.
App. 2. Since L and K are released from the production of X in a higher

ratio than are absorbed in the production of Y, wages fall in Nation 2.
This leads to the substitution of L for K in the production of X and Y, so
that the K/L ratio falls in the production of both commodities.

353085526.doc) 6-14 Dominick Salvatore


*CHAPTER 4
(Core Chapter)
Answer to Problems
1. See Figure 1.
The equilibrium Py/Px=P'2=1/P2.
2. See Figure 2.
3. See Figure 3.
5. a) A nation's offer curve is similar to a demand curve because it shows the nation's
demand for imports.
b) A nation's offer curve is similar to a supply curve because it shows the nation's supply for
exports.
c) An offer curve shows how much of its import commodity a nation demands in order to
supply various amounts of its export commodity. The usual demand and supply curves
measure the quantity demanded and supplied, respectively.
6. a) See Figure 5.
b.) The quantity of imports demanded by Nation 1 at PF' exceeds the quantity of exports of Y
supplied by Nation 2. Therefore, Px/Py declines (Py/Px rises) until the quantity
demanded of imports of Y by Nation 1 equals the quantity of exports of Y supplied by
Nation 2 at PB=PB'.
c.) The backward bending (i.e., negatively sloped) segment of Nation 1's offer curve indicate
that nation 1 is willing to give up less of X for larger amounts of Y.



7. a) See Figure 6 on page 34.
b) The nation with the offer curve with the greater curvature gains more from trade.
c) The nation with the offer curve with the greater curvature gains more from trade because the
greater curvature of the offer curve reflects the nation's weaker or less intense demand for the
other nation's export commodity.
8. See Figure 7.
From the left panel of Figure 4.4, we see that Nation 2 does not export any amount of
commodity Y at Px/Py=4, or Py/Px=1/4. This gives point A on Nation 2's supply curve of the
exports of commodity Y (S). From the left panel of Figure 4.4, we also see that at Px/Py=2 or
Py/Px=1/2, Nation 2 exports 40Y. This gives point H on S. Other point on S could similarly be
derived. Note that S in Figure 7 is identical to S in Figure 4.6 in the text showing Nation 1's
exports of commodity X.
From the left panel of Figure 4.3, we see that Nation 1 demands 60Y of Nation 2's e exports
at Px/Py=Py/Px=1. This gives point E on Nation 1's demand curve of Nation 2's exports of
commodity Y (D). From the left panel of Figure 4.3, we can estimate that Nation 1 demands 40Y at
Py/Px=3/2 (point H on D in Figure 7) and 120Y at Py/Px=2 (point H' on D).
The equilibrium relative commodity price of commodity Y is Py/Px=1. This is

determined at the intersection of D and S in Figure 7. At Py/Px=3/2, there is an excess
supply of R'R=30Y and Py/Px falls to Py/Px=1. On the other hand, at Py/Px=1/2, there is an
excess demand of HH'=80Y and Py/Px rises to Py/Px=1. Note also that Figure 7 is
symmetrical with Figure 4.6 in the text.
9. a) The analysis in the answer to Problem 8 refers to partial equilibrium analysis because
it makes use of the traditional demand and supply curves. These refer to the market for
commodity Y and abstract from all the interconnections that exist between the market for
commodity Y and the market for all the other commodities in the e economy. As such, it provides
only an approximation to the answer sought.
b) The analysis of Figure 4.5 relies on offer curves. These incorporate demand and supply
information in both nations and for both commodities (in our two-nation, two-commodity
world). As such, they allow us to trace a change in demand or supply, for either commodity,
in either nation, on the demand and supply of the other commodity and in the other nation,
as well as the repercussions from the original change on the demand and supply for both
commodities in both nations. Thus, Figure 4-5 refers to general equilibrium analysis. This
is admittedly more difficult than partial equilibrium analysis, but it also provides a
complete and explicit answer to the problem.


c) The partial equilibrium analysis shown in Figure 7 here and in Figure 4.6 in the text and the
general equilibrium analysis provided by Figure 4.5 are related because both are derived
from the same basic information (the production frontier and the indifference map of each
nation). Partial equilibrium analysis, however, utilizes only part, not all, of the information
provided by the production frontier and the indifference maps, as general
equilibrium analysis does.
In Figure 8, Nation 2 is the small nation and we magnified the portion of the offer curve
of Nation 1 (the large nation) near the origin (where Nation 1's offer curve coincides with
PA=1/4, Nation 1's pretrade relative commodity price with trade). This means that Nation 2
can import a sufficiently small quantity of commodity X without perceptibly affecting Px/Py in
Nation 1. Thus, Nation 2 is a price taker and captures all of the benefits from its trade with Nation
1. The same would be true even if Nation 2 were not a small nation, as long as Nation 1 faced
constant opportunity costs and did not specialize completely in the production of commodity X
with trade.
11. See Figure 9 on page 36. Figure 9 shows that in the unlikely event that both nations faced
constant costs, the offer curves of both would be straight lines until both nations became
completely specialized in production. Afterwards, offer curves would assume their normal
shape and determine the equilibrium Px/Py=PE at their intersection at point E.
12. a) If the terms of trade of a nation improved from 100 to 110 over a given period of time,
the terms of trade of the trade partner would deteriorate by about 9 percent over the same
period of time.
b) A deterioration in the terms of trade of the trade partner can be said to be unfavorable
because the trade partner must pay a higher price for its imports in terms of its
exports. This does not necessarily mean that the welfare of the trade partner has
decreased because the deterioration in its terms of trade may have resulted from an
increase in productivity that is shared with the other nation.
13. Under the conditions of tight supply that prevailed during the 1970s, OPEC was given
credit for the sharp increase in petroleum prices; but when excess supplies arose from the
second half of the 1980s to most of the 1990s, OPEC was unable to prevent almost equally
sharp price declines. Thus, OPEC does not seem able to set petroleum prices.
App. 3. See Figures 10 and 11.

App. 4. See Figure 12.
App. 5. See Figure 13. At P', Nation 1 wants to import and export more than
Nation 2 is willing to trade. As P' falls, Nation 1 will want to trade less and
Nation 2 more, until Pc, where the amounts traded are in equilibrium. The
opposite is true at P*.

*CHAPTER 5 (Core Chapter)
Answer to Problems
1. a) See Figure 1.
b) The slope of the lines measuring K/L of each commodity in Nation 2 fall if w/r rises in
Nation 2 as a result of international trade.
c) The slope of the lines measuring K/L of each commodity in Nation 1 rise if w/r falls in
Nation 1 as a result of international trade.
d) Given the results in parts (a) and (b), international trade reduces the difference in the
K/L in the production of each commodity in the two nations as compared with the
pretrade situation.
2. a) See Figure 2.
b) The comparative advantage of each nation is determined by differences in production

conditions only since tastes are identical.
c) The two nations consume different amounts of the two commodities in the absence of
trade but the same amounts with trade because internal prices differ without trade but are
identical with trade.
3. See Figure 3.
5. See Figure 5.
3. a) Besides a difference in factor endowments, the production frontier of two nations could
differ also because of a difference in technology.
b) A difference in the production frontier of two nations due to a difference in the

technology is prevented by assumption by the H-O model.
c) Another possible cause (besides a difference in production frontiers) of a difference in

relative commodity prices between two nations in the absence of trade is a difference in
tastes.
7. See Figure 6.
8. People in developing countries consume very different goods and services than U.S.
consumers not because tastes are very different from the tastes of U.S. consumers but
because incomes are so different (much lower) than in the United States.



9. a) If tastes change in favor of commodity Y (the commodity of its comparative

disadvantage) in Figure 5-4 for Nation 1, Px/Py will be lower in Nation 1 because point
A will move up and to the left.
b) The effect of the change in tastes examined in part (a) for Nation 1 will cause r/w to rise
in Nation 1.
c) The effect of the changes examined in parts (a) and (b) will be to increase the volume
of trade. These changes will improve the partner's terms of trade.
10. The statement was made by Gottfried Haberler in his Survey of International Trade Theory,
Special Papers in International Economics, No.1 (Princeton, N.J.: Princeton University
Press, International Finance Section, July 1961), p. 18.
While the statement is true, it does not detract from Samuelson's great contribution in
rigorously showing the conditions under which trade would bring about the complete
equality in the returns to homogeneous factors among nations.
11. Internatioal trade with developing economies, especially newly industrializing economies
(NIEs), contributed in two ways to increased wage inequalities between skilled and
unskilled workers in the United States during the past two decades. Directly, by reducing
the demand for unskilled workers as a result of increased U.S. imports of labor-intensive
manufactures and, indirectly, by speeding up the introduction of labor-saving innovations,
which further reduced the U.S. demand for unskilled workers. International trade, however,
was only a small cause of increased wage inequalities in the United States. The most
important cause was technological change.
12. a) Leontief found that U.S. import substitutes were more K-intensive than U.S. exports
even though the United States was the most K-rich nation. This implied factor-intensity
reversal and rejection of the H-O trade model.
b) Kravis found that wages in U.S. export industries were higher than in U.S. import-
competing industries, reflecting the greater productivity of labor in U.S. exports than
in U.S. import substitutes. This was confirmed by Keesing who found that U.S. exports
were more skill intensive than the exports of 9 other industrial nations. By adding human to
physical capital, Kenen succeed in eliminating the paradox. Baldwin found that including
human capital and excluding natural-resource industries eliminated the paradox.
c) The paradox was seemingly resolved by Leamer, Stern and Maskus, and Salvatore and
Barazesh by comparing the K/L ratio in U.S. production vs. U.S. consumption, rather
than in exports vs. imports when natural-resource-based industries are excluded.
d) Factor-intensity reversal seems to be rather rare in the real world.
13. a) See Figure 7.
b) Factor-intensity reversal could occur if the substitutability of K for L in the production

of X was much greater than for Y and r/w was lower in Nation 2 than in Nation 1.
c) Minhas found factor-intensity reversal to be fairly frequent. However, by correcting an

important source of bias in the Minhas study, Leontief showed that factor-intensity
reversal was much less frequent. Ball tested another aspect of Minhas' conclusion and
confirmed Leontief's results that factor-intensity reversal was rare in the real world.
14. With factor-intensity reversal, a commodity is L-intensive in one nation and K-intensive in
the other. The H-O model would then predict that both nations would export the same
commodity. Since this is impossible, both nations must export the commodity intensive in
the same factor.
If this is the K-intensive commodity, the demand for K will increase in both nations. If it
is the L-intensive commodity, the demand for K will fall in both nations. Thus, the price
of K will either rise or fall in both nations, and international differences in the price of K
will decrease, increase or remain unchanged depending on the rate of change in the price
of K in the two nations.
15. a) By allowing for different technologies and factor prices across countries, nontraded
goods, transportation costs, and by using better and more disaggregated data.
b) Factor endowments broadly defined seem to explain comparative advantage well.
c) We retain a qualified factor-endowments H-O model of international trade.
App. 4. The effect of the opening of trade on the real income of labor and capital in
Nation 2 (the K-abundant nation) if L is mobile between the two industries in
Nation 2 but K is not is to increase Py/Px and to cause more L to be used in the production
of Y.
Wages then fall in terms of Y but rise in terms of X. On the other hand, the return on
capital increases in the production of Y but falls in the production of X.


At P1 commodity Y is K-intensive (compare point C to point A).
At P2 commodity Y is still K-intensive (compare point D to point B).
App. 6. For the X isoquant e = (K/L)/(K/L) = (3/3-2/4)/(2/4) = 1

slope/slope (2-1)/1
For the Y isoquant e = (4/2-2.5/3)/(2.5/3) = 1.4

(2-1)/1


CHAPTER 6
Answer to Problems:
1. See Figure 1.
2. See Figure 2.
3. See Figure 3.
4. a) T = 1 - /1000-1000/ = 1 - 0 = 1.
1000+1000 2000
b) T = 1 - /1000-750/ = 1 - 250 = 0.86.

1000+750 1750
c) T = 1 - /1000-500/ = 1 - 500 = 0.67.

1000+500 1500
d) T = 1 - /1000-250/ = 1 - 750 = 0.4.

1000+250 1250
e) T = 1 - /1000-0/ = 1 - 1000 = 0.
1000+0 1000


5. a) T = 1 - /1000-1000/ = 1 - 0 = 1.
1000+1000 2000
b) T = 1 - /750-1000/ = 1 - 250 = 0.86.

750+1000 1750
c) T = 1 - /500-1000/ = 1 - 500 = 0.67.

500+1000 1500
d) T = 1 - /250-1000/ = 1 - 750 = 0.4.

250+1000 1250
e) T = 1 - /0-1000/ = 1 - 1000 = 0.
0+1000 1000
Note that the results are identical to those in Problem 4 because we take the absolute
value of exports minus imports or imports minus exports.
6. See Figure 4.
The AC and the MC curves in Figure 4 are the same as in Figure 6-2. However, D and the
corresponding MR curve are higher on the assumption that other firms have not yet imitated
this firm's product, reduced its market share, or competed this firm's profits away. In Figure
4, MR=MC at point E, so that the best level of output of the firm is 5 units and price is
$4.50. Since at Q=5, AC=$3.00, the firm earns a profit of AB=$2.00 per unit and $10.00
in total.
7. a) Monopolistic competition resembles monopoly because under both forms of market

organization the firm produces a product that is unique (i.e., no other firm produces an
identical product).
b) Monopolistic competition is different from monopoly because under monopolistic

competition there are many other firms that produce a similar product. On the other hand,
there is no close substitute for the product sold by a monopolist.
Furthermore, under monopolistic competition, entry into the industry is easy. As a result,
attracted by this firm's profits, more firms enter the industry to produce similar
products. This reduces the monopolistically competitive firm's market share (i.e., its
demand and corresponding MR curves shift down) until we get to the situation
depicted by Figure 6-2 in the text, where P=AC and our firm breaks even. On the other
hand, under monopoly, entry into the industry is blocked, so that the monopolist can
continue to earn profits in the long run.

c) The difference between monopoly and monopolistic competition is important for

consumer welfare because consumers get a greater variety of the commodity at a lower
price with monopolistic competition than with monopoly.
8. A perfectly competitive firm faces an infinitely elastic or horizontal demand curve. This
means that the firm is a price taker and can sell any quantity of the homogenous product at
the price determined at the intersection of the market demand and supply curves for the
commodity.
Both the demand curves faced by the monopolistic competitive firm and the monopolist are
downward sloping, indicating that each can sell more units of the commodity by
lowering its price. However, the demand curve facing the monopolistically competitive firm
generally has a smaller inclination (i.e., it is more elastic) than the demand curve facing
the monopolist because the former sells a commodity for which many good substitute are
available.
9. If the C curve had shifted down only half as much as curve C' in Figure 6-3, the new
equilibrium point would be at P=AC=$2.50 and N=350.
10. See Figure 5 on the previous page.
11. The increased pirating or production and sale of counterfeit American goods without paying
royalties by foreign producers shorten the U.S. product cycle or the time during which the
U.S. firm can reap the benefits from the new product or technology it introduced and thus
reduces the ability of U.S. firms to engage in research and development (R & D) new
product cycles.
With transportation costs specialization would proceed to point C in Nation 1 and point C
in Nation 2. Pc in nation 1 (the nation exporting commodity X) is smaller than Pc' in Nation
2 (the country importing commodity X) by the relative cost of transporting each unit of
commodity X from Nation 1 to Nation 2. Trade does not seem to be in
equilibrium because transportation costs are expressed in terms of commodity X.
13. See Figure 7 on the next page.
P2 exceeds P1 by the relative cost of transporting one unit of commodity X from Nation 1
to Nation 2.
14. See Figure 8.



The firm's AC=AF without and BC with external economies. Thus, at a
given level of output of the firm, the firm's AC are lower (i.e., the
firm's AC curve shifts down) as cumulative industry output expands.

App. 2. Parameter "a" refers to the starting AC (i.e., the AC when output or Q is
zero). Parameter "b" refers to the rate of decline in AC as cumulative
industry output
increases. Thus, "b" should be negative. Furthermore, the larger the absolute value
of b, the more rapid is the decline in AC as cumulative industry expands over time.

CHAPTER 7
Answer to Problems
1. a) See Figure 1.
b) See Figure 2
c) See Figure 3.
2. See Figure 4.
3. a) See Figure 5.
b) See Figure 6.
c) See Figure 7.
4. Compare Figure 5 to Figure 1.

Compare Figure 6 to Figure 3. Note that the two production frontiers have the same vertical
or Y intercept in Figure 6 but a different vertical or Y intercept in Figure 3.
Compare Figure 7 to Figure 2. Note that the two production frontiers have the same
horizontal or X intercept in Figure 7 but a different horizontal or X intercept in Figure 2.

6. See Figure 9.
7. See Figure 10.
8. See Figure 11.
9. See Figure 12.
11. See Figure 14.
12. See Figure 15.
13. The United States has become the most competitive economy in the world since the early
1990s while the data in Table 7.3 refers to the 1965-1990 period.



14. The data in Table 7.4 seem to indicate that China had a comparative advantage in capital-
intensive commodities and a comparative disadvantage in unskilled-labor intensive
commodities in 1973. This was very likely due to the many trade restrictions and
subsidies, which distorted the comparative advantage of China. Its true comparative
advantage became evident by 1993 after China had started to liberalize its economy.
App. 1a. See Figure 16.
1b. For production and consumption to actually occur at the new

equilibrium point after the doubling of K in Nation 2, we must
assume either than commodity X is inferior or that Nation 2 is too
small to affect the relative commodity prices at which it trades.
1c. Px/Py must rise (i.e., Py/Px must fall) as a result of growth only.
Px/Py will fall even more with trade.
1. If the supply of capital increases in Nation 1 in the production of commodity Y

only, the VMPLy curve shifts up, and w rises in both industries. Some labor shifts
to the production of Y, the output of Y rises and the output of X falls, r falls, and
Px/Py is likely to rise.
2. Capital investments tend to increase real wages because they raise the K/L ratio
and the productivity of labor. Technical progress tends to increase K/L and real wages
if it is L-saving and to reduce K/L and real wages if it is K-saving.

*CHAPTER 8 (Core Chapter)
Answer to Problems
1. a) Consumption is 70Y, production is 10Y and imports are 60Y (see Figure 1 on the
next page).
b) Consumption is 60Y, production is 20Y and imports are 40Y (see Figure 1).
c) The consumption effect is -10Y, the production effect is +10Y, the trade effect
is -20Y and the revenue effect is $40 (see Figure 1).
2. a) The consumer surplus is $245 without and $l80 with the tariff (see Figure 1).
b) Of the increase in the revenue of producers with the tariff (as compared with their
revenues under free trade), $l5 represents the increase in production costs and another
$15 represents the increase in rent or producer surplus (see Figure 1).
c) The dollar value or the protection cost of the tariff is $l0 (see Figure 1).
3. This will increase the rate of effective protection in the nation.
4. a) g = 0.4 - (0.5)(0.4) = 0.4 - 0.2 = 0.2 = 40%

1.0 - 0.5 0.5 0.5
5. a) g=60%
b) g=80%
c) g=0
d) g=20%
6. a) g=70%
b) See the first paragraph of section 8.3b.
7. See Figure 2.
8. When Nation 1 (assumed to be a small nation) imposes an import tariff on commodity Y,

the real income of labor falls and that of capital rises.
9. Py/Px rises for domestic producers and consumers. As production of Y (the K-

intensive commodity) rises and that of X falls, the demand and income of K rises and
that of L falls. Therefore, r rises and w falls.
10. If Nation 1 were instead a large nation, then Nation 1's terms of trade rise and the real
income of L may also rise.


India is more likely to restrict imports of K-intensive commodities in which India has a
comparative disadvantage and this is likely to increase the return to capital and reduce the
return to labor according to the Stolper-Samuelson theorem.
13. See Figure 4.
14. a) The volume of trade may shrink to zero (the origin of offer curves).
App. 1. The more elastic SH and SF are, the lower is the free trade price
of the commodity and the lower is the increase in the domestic
price of the commodity as a result of the tariff.
App. 2a. The supply curve of the nation for the commodity shifts up
and to the left (as with the imposition of any tax); this does not affect
the consumption of the commodity with free trade, but it reduces
domestic production and increases imports of the commodity; it
also increases the revenue effect and reduces producers' surplus.
b) The imposition of a tariff on imported inputs going into the domestic production of the
commodity will have no effect on the size of the protection cost or deadweight loss.
App. 3. See Figure 5 (on the next page).
App. 5. Real w will fall in terms of Y and rise in terms of X. On the

other hand, real r will rise in terms of Y and fall in terms of X. This
can be seen by drawing a figure similar to Figure 8-10, but with the
VMPLy curve shifting upward.
App. 6a. See Figure 7.
c) After Nation 1 has imposed an optimum tariff and Nation 2 has retaliated with an
optimum tariff of its own, the approximate terms of trade for Nation 1 is 0.8, while the
approximate terms of trade of Nation 2 is 1.25.
d) Nation 1's welfare declines from the reduction in the volume and in the terms of
trade. Although nation 2's terms of trade are higher than under free trade, the volume of trade
has shrunk so much that nation 2's welfare is also likely to be lower than under free trade.


*CHAPTER 9
(Core Chapter)
NONTARIFF TRADE BARRIERS AND THE NEW PROTECTIONISM
Answer to Problems:
1. Nations restrict trade either in response to lobbying by the producers of a

commodity in which the nation has a comparative disadvantage or to gain a
strategic advantage in relation to other nations. The first leads to a welfare loss for
he nation as a whole. The second is very difficult to achieve.
2. The partial equilibrium effects of the import quota are:

Px=$1.50; consumption is 45X, of which 15X are produced
domestically;
by auctioning off import licenses, the revenue effect would be $15.
3. The partial equilibrium effects of the import quota are:

Px=$2.50; consumption is 40X, of which 10X are produced
domestically;
the revenue effect is $45.
4. The partial equilibrium effects of the quota are:

Px=$2; domestic production and consumption are 50X; The revenue is
zero.
5. The partial equilibrium effects of the quota are:

Px=$1; consumption is 70X, production is 30X, and revenue is zero.
6. The partial equilibrium effects of a negotiated export quota of 30X are:

Px=$4; domestic production is 40X, of which 10X are consumed at
home.
1. An export tariff or quota, as an import tariff or quota, affects the price

of the commodity and domestic consumption and production. But the
effects are the opposite.
8. See Figure 1.
The equilibrium price of the commodity is Px=OC and the equilibrium
quantity is Qx=OB in Figure 1.

9. If the supply curve of the commodity in Figure 1 referred to a cartel of

exporters acting as a monopolist, Px=OF and Qx=OA (see Figure 1).
10. Px is higher and Qx smaller when exporters behave as a monopolist.
11. a) The monopolist should charge P1=$4 in the domestic market and
P2=$3 in Figure 9-5 in Appendix A9.2.

b) This represents the best, or optimal distribution of sales between the

two markets because any other distribution of sales in the two markets
gives less revenue.
12. See Figure 2. To the left of point A, the domestic firm faces higher long-
run average costs of production (LACD) than the foreign firm (LACF). To the right of
point A the opposite is the case.
12. a) If the entries in the top left-hand corner of Table 9-5 were changed
to +10, +10, then both Boeing and Airbus would produce the aircraft
without any subsidy, and so no strategic trade and industrial policy
would be needed in the U.S. or Europe.
b) If the entries in the top left-hand corner of Table 9-5 were changed to +5, +0,
then both Boeing and Airbus would produce the aircraft without any
subsidy, and so no strategic trade and industrial policy would be
needed in the U.S. or Europe.
*Note that even though Airbus only breaks even, in economics
we include a normal return on investment as part of costs. Thus,
Airbus would remain in business because it would earn a normal
return on investment.
c) If the entries in the top left-hand corner of Table 9-5 were changed to +5, -10, then
both Boeing produces and Airbus does not produce without any subsidy. With a
subsidy of at least $10 million per year, however, Airbus would enter the market and
lead to a loss of $100 million for Boeing unless the U.S. government would provide a
subsidy of at least $5 million per year to Boeing.
14. The answer to part (a) and (b) are presented in Appendix A9.3.
App. 1. See Figure 3 on page 90.
App. 2. In order to maximize to maximize total profits the

domestic monopolist practicing international price discrimination
should sell at the price of Pd=$20 in the domestic market and at
the price of Pf=$15 in the foreign market.
App. 3. By imposing a 100% tax on the production of commodity

X and giving it as a subsidy to producers of commodity Y.

CHAPTER 10
Answers to Problems:
1. If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X from

Nation B and Nation C, Nation A will produce commodity X domestically because the
domestic price of commodity X is $10 as compared with the tariff-inclusive price of
$16 if Nation A imported commodity X from Nation B and $12 if Nation A imported
commodity X from nation C.
2. a) If Nation A forms a customs union with Nation B, Nation A will import commodity
X from Nation B at the price of $8 instead of producing it itself at $10 or importing it
from Nation C at the tariff-inclusive price of $12.
b) When Nation A forms a customs union with Nation B this would be a trade-creating
customs union because it replaces domestic production of commodity X at Px=$10
with tariff-free imports of commodity X from Nation B at Px=$8.
3. If Nation A imposes a 50 percent ad valorem tariff on imports of commodity X from

Nation B and Nation C, Nation A will import commodity X from nation C at the tariff-
inclusive price of $9 instead of producing commodity X itself or importing it from
Nation B at the tariff-inclusive price of $12.
4. a) If Nation A forms a customs union with Nation B, Nation A will import commodity
X from Nation B at the price of $8 instead of importing it from Nation C at the tariff-
inclusive price of $9.
b) When Nation A forms a customs union with Nation B this would be a trade-diverting
customs union because it replaces lower-price imports of commodity X of $6 (from
the point of view of Nation A as a whole) with higher priced imports of commodity
X from Nation B at $8.
Specifically, Nation A's importers do not import commodity X from Nation C

because the tariff-inclusive price of commodity X from Nation C is $9 as compared
with the no-tariff price of $8 for imports of commodity X from Nation B. However,
since the government of Nation A collects the $3 tariff per unit on imports of
commodity X from Nation C, the net effective price for imports of commodity X
from Nation C is really $6 for Nation A as a whole.
5. See Figure 10-1 in the text. Any figure similar to Figure 10-1 in the text would do.
6. The welfare gains that Nation 2 receives from joining Nation 1 to form a customs union
is given by the sum of the areas of triangles CJM and BHN in Figure 10-1 in the text.
Any similar figure and sum of corresponding triangles would, of course, be adequate.
7. See Figure 10-2 in the text. Any figure similar to Figure 10-2 in the text would do.
8. The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union
is given by C'JJ'+B'HH'- MNH'J'=$11.25 in Figure 10-2 in the text.
Any similar figure and sum of corresponding triangles minus the area of corresponding
rectangle would, of course, be adequate.
9. See Figure 1 and compare it to Figure 10-2.
10. The net gain from the trade-diverting customs union shown in Figure 1 is given by
C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 10-2, however, the sum
of the areas of the two triangles (measuring gains) is greater than the area the rectangle
(measuring the loss). Thus, the nation would now gain from the formation of a custom
union. Had we drawn the figure on graph paper, we would have been able to measure
the net gain in monetary terms also.
11. A trade-diverting customs union is more likely to lead to a welfare gain of a member
nation (1) the smaller is the relative inefficiency of nation 3 with respect to nation 1,
(2) the higher is the level of the tariff, and (3) the more elastic are Dx and Sx in nation
2. These can seen by comparing Figure 10-2 in the text with Figure 1 on the next page.
12. See Figure 2. The formation of the customs union has no effect.
13. NAFTA created much more controversy because the very low wages in Mexico led to
great fears of large job losses in the U. S.
14. The possible cost to the U.S. from EU92 arose from the increased efficiency and
competitiveness of the E.U. The benefit arose because a more rapid growth in the EU
spills into a greater demand for American products, which benefits the U. S.
App. Compare points B' and H' in Figure 10-3 with the corresponding points in
Figure 3.


CHAPTER 11
INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT
Answer to Problems:
1. International trade could retard development by:

keeping the nation in primary production;
leading the nation to adopt excessive capital-intensive production techniques;
increasing the propensity to consume, thus reducing the nation's savings rate;
leading to foreign exploitation of natural resources;
2. Each of the criticisms that international trade can retard development given in the
answer to problem 1 can by countered as follows:
As the availability of capital and technology increases, the nation can begin to export
manufactured goods;
through appropriate taxes and subsidies the nation can avoid the use of excessive
capital-intensive production techniques;
increased taxation can increase the rate of public savings;
taxation and regulation can reduce or eliminate foreign exploitation;
3. An improvement in the technology of primary production results in a shift in the nation's

transformation curve from Y1X1 to Y1X2 in Figure 1.
4. An improvement in the technology of primary production is likely to lead to deterioration

in the terms of trade as the developing nation exports more primary commodities.
5. A vent for surplus can be shown by a movement from point A inside the nation's
production frontier without trade to point A' on the higher production frontier with
growth and trade in Figure 2 on the previous page.


6. a) The nation's commodity terms of trade would be 91.7.
b) The nation's income terms of trade would be 119.2.
c) The nation's single factoral terms of trade would be 128.4.
7. The nation of problem 6 will be better off in 2000 as compared with 1980 because
its
income and single factoral terms of trade rose.
8. Figure 7-6 in the text shows how deteriorating terms of trade resulting from
growth can
make a nation worse off after trade than before. This was called immiserizing
growth in
Chapter 7.
9. Figure 3 on the previous page shows that when the supply of a commodity
increases, its
equilibrium price will fall by a greater amount, the more price inelastic is the
demand
curve for the commodity.
10. Figure 4 on the next page shows that with a negatively inclined demand curve and
a
positively inclined supply curve, producers' earnings fluctuate more with a shift in
demand (Panel a) than with a shift in supply (Panel b).
11. Figure 5 shows how a buffer stock could either lead to an unmanageable stock of
the
commodity or to the running out of the commodity. Specifically, if the buffer
stock
authority sets price above the long-run equilibrium price of the commodity, it will
face
an unmanageable stock of the commodity. On the other hand, if the buffer stock
authority sets price below the long-run equilibrium level, then the buffer stock
authority
will run out of the commodity.
12. A New International Economic Order (NIEO) has not been established because
industrial
countries did not want to give up control over the present system and pay the
economic
costs of reforming it along the lines demanded by developing countries. The
establishment of a NIEO is no longer a hotly debated topic because developed
countries faced serious problems of their own during the 1980s and early 1990s in

the form of slow growth and high unemployment. The NIEO was replaced by
concerns about globalization in the 1990s.
13. The Uruguay Round benefited developing countries by the reduction in trade
protectionism on agricultural products and labor-intensive commodities. Although
protectionism will be reduced, it will still remain relatively high in these products.
14. Immiserizing growth does not seem to have occurred in most globalizing
developing countries despite some deterioration in their terms of trade because the
volume of trade
and their income terms of trade have increased substantially over the past three
decades.
15. Rich nations should forgive all of the foreign debt of the poorest developing
countries
because it is impossible for them to repay it or even service it. This, however,
might
encourage the poorest nations to continue to borrow and even use borrowed funds
unwisely knowing that eventually their foreign debt might be forgiven.


CHAPTER 12
INTERNATIONAL RESOURCE MOVEMENTS AND

MULTINATIONAL CORPORATIONS
Answer to Problems:
1. See Figure 1.
In Figure 1, the outflow of capital is shown by the leftward and upward shift of the
SK curve to S'K. This increases the return on capital until it is equal to that in the host
or receiving country.
2. See Figure 2.
In Figure 2, the outflow of capital is shown by the rightward and downward shift of
the SK curve to S'K. This reduces the return on capital until it is equal to that in the
investing country.
3. The data to update Table 12-1 is found in the July issue of the most recent year of
the Survey of Current Business.
7. The Statement is true.
The profitability of a portfolio is equal to the weighted average of the yield of the
securities included in the portfolio. Therefore, the profitability of a portfolio of many
securities can never exceed the yield of the highest-yield security in the portfolio.
The second part of the statement is also true if the portfolio includes securities for
which yields are inversely correlated over time.
8. See Figure 3. The gain of the investing country is EGR.
9. See Figure 4. The gain of the host or receiving country is ERM.
10. The general principle that can be deduced from the answers to the previous two
problems and from Figure 12-1 is that the nation with the more rapidly

declining VMPK curve gains more. With the VMPK curves declining at equal rates,
both nations gain equal amounts.

The rate of return on U.S. direct investment in developing nations often exceeds the
rate of return on investment on it investments in developed nations because of
relative scarcity of capital and technology and lower wage rates in developing than
in developed nations.
11. U.S. labor generally opposes U.S. investments abroad because they reduce the K/L
ratio and the productivity and wages of labor in the United States.
An inflow of foreign capital leads to an increase in the K/L ratio and in the
productivity and wages of labor or employment in developing nations.
12. The data to update Table 12-6 are found in the World Investment Report published
yearly by the United Nations for the most recent year.
App. See Table 1.
Table 1
(a) (b) (c) (d)
US Petroleum
Year Petroleum Price OPEC Exports OPEC Imports Imports
(US $/barrel) (bill. $) (bill. $) (bill. $)
1973 2.7 39 20.1 7.6
1974 9.76 119.3 32.1 26.1
1975 10.72 109.8 51.3 26.5
1976 11.51 133 62.2 34.1
1977 12.4 146 83.8 44.2
1978 12.7 141.9 94.9 41.6
1979 16.97 208 101.6 58.6
1980 28.67 294.2 133.2 76.9
Source: International Financial Statistics, 1981 Yearbook.

Petroleum prices refer to Saudi Arabian prices

*CHAPTER 13
(Core Chapter)
BALANCE OF PAYMENTS
1. a. The U.S. debits its current account by $500 (for the merchandise imports) and
credits capital by the same amount (for the increase in foreign assets in the U.S.).
The U.S. credits capital by $500 (the drawing down of its bank balances in
London, a capital inflow) and debits capital by an equal amount (to balance the
capital credit that the U.S. importer received when the U.K. exporter accepted to
be paid in three months).
The U.S. is left with a $500 debit in its current account and a net credit balance of
$500 in its capital account.
2. a). The U.S. debits unilateral transfers by $100 and credits capital by the same
amount.
b). The U.S. credits its current account by $100 and debits capital by the same
amount.
c). The debit of $100 in unilateral transfers and the credit of $100 in current account.
3. a). The same as 2a.
The net result is the same, but the transaction in part a of this problem refers to
"tied" aid while transactions a and b in problem 2 do not.
4. The U.S. debits capital account by $1,000 (for the purchase of the foreign stock
by the U.S. resident) and also credits the capital account (for the drawing down
of the U.S. resident bank balances abroad) by the same amount.
5. The U.S. credits its current account by $100 and debits its capital account by the
same amount.
6. The U.S. credits its capital account by $400 (for the purchase of the U.S. treasury
bills by the foreign resident) and debits its capital account (for the drawing down
of the foreign resident's bank balances in the United States) for the by the same
amount.
7. The U.S. debits its current account by $40 for the interest paid, debits its capital
account by $400 (for the capital outflow for the repayment of the repayment of

the principal to the foreign investors by the U.S. borrower), and then credits its
capital account by $440 (the increase in foreign holdings of U.S. assets, a credit).
8. a). The U.S. credits its capital account by $800 and debits its official reserves
account by the same amount.
b). The official settlements balance of the U.S. will improve (i.e., the U.S. deficit will
fall or its surplus will rise) by $800.
a.
Bal. Pay. Bal. Pay. Bal. Pay. Bal. Pay.
Year $ Year $ Year $ Year $
1965 -1 1975 -6 1985 5 1995 ($100)
1966 0 1976 -15 1986 -36 1996 -134
1967 -3 1977 -37 1987 -54 1997 -18
1968 2 1978 -35 1988 -36 1998 27
1969 2 1979 14 1989 16 1999 -53
1970 -10 1980 -8 1990 -32 2000 -42
1971 -30 1981 -1 1991 -23 2001 -23
1972 -11 1982 1 1992 -44 2002 -112
1973 -6 1983 -5 1993 -71 2003 -280
1974 -10 1984 0 1994 -45 2004 -398
where values are in billions of dollars and a negative balance represents a deficit
while a
positive balance a surplus in the balance of payments.
b. Because until 1972, we had a fixed exchange rate system, but from 1973 we had a
managed floating exchange rate system. Under the latter, the balance of payments
only measures the amount of official intervention in foreign exchange markets.
9. See the July Issue of the Survey of Current Business for the most recent year.
12. See the July and November Issues of the Survey of Current Business for the most
recent year.
13. See the Balance of Payments Statistics Yearbook for the most recent year.
App. 1. The major difference between the way the United States keeps its balance
of payments and the International Monetary Fund method is in the way they deal
with international capital movements. The United States records international

capital movements as increases in U.S.-owned assets abroad and foreign-owned

assets in the United States, subdivided into government and private. The
International Monetary Fund includes international capital flows into a financial
account, which is subdivided into direct investments, portfolio investments assets
and liabilities, and other investment assets and liabilities.
2. See the table in April and October issue of the IMF's World Economic Outlook
for the most recent year.

*CHAPTER 14
(Core Chapter)
FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES
1. a. With supply curve of pounds S, the equilibrium exchange rate is R=$2/1 and
the equilibrium quantity is Q=40 million (point E in Figure 1 on the next page)
under a flexible exchange rate system. On the other hand with supply curve of
pounds S, the equilibrium exchange rate would be R=$3/1 and the equilibrium
quantity would be Q=20 million (point B in Figure 1).
b. If the United States wanted to maintain the exchange rate fixed at R=3 in Figure 1
with supply curve S, the U.S. central bank would gain 40 million in reserves
per day.
2. a. See Figure 2 on the next page.
b. With supply curve of pounds S*, the equilibrium exchange rate would be
R=$1/1 and Q=70 million under a flexible exchange rate system (see Figure 2).
c. If the United States wanted to maintain a fixed exchange rate of R=1 in Figure 2
with S*, the U.S. central bank would lose 50 million of reserves per day.
3. Use $2 to purchase 1 in New York, use the 1 to purchase 410 yens in London,
and use the 410 yens to purchase $2.05 in Tokyo, thus earning $0.05 in profit for
each pound so transferred.
4. a. The forces at work that will make the cross exchange rates consistent in currency
arbitrage in the previous problem are as follows. The selling of pounds for yens in
London will reduce the yen price of the pound in London until it is 400 yens to 1.
b. The consistent cross rates in Problem 3 are: $2=1=400 yens.
5. a. The pound is at a three-month forward premium of 1c or 0.5% (or 2%/year) with

respect to the dollar.
b. The pound is at a three-month forward discount of 4c or 2% (or 8%/year) with

respect to the dollar.
6. a. The euro is at three-month forward premium of 1% (or 4%/year) with respect to

the Swiss franc.

b. The dollar is at three-month forward discount of 5% (or 20%/year) with respect to

the yen.


7. The importer would have to purchase forward 10,000 pounds for delivery in
three months at today's FR=$1.96/1.
After three months (and regardless of what the spot rate is at that time), the
importer would pay $19,600 and obtain the 10,000 he needs to make the
payment.
8. The exporter would have to sell forward 10,000 pounds for delivery in three
months at today's FR=$1.96/1.
After three months, the exporter will deliver the 10,000 and receive $19,600.
9. The speculator can speculate in the forward exchange market by purchasing

pounds forward for delivery in three months at FR=$2/1.
If the speculator is correct, he will earn 5c per pound purchased.
10. The speculator can speculate in the forward exchange market by selling pounds
forward.
If the speculator is right, he will earn 5c per pound transferred.
If, on the other hand, SR=$2.05/1, the speculator will lose 5c per pound.
11. The interest arbitrageur will earn 2% per year from the purchase of foreign three-
month treasury bills if he covers the foreign exchange risk.
12. a. If the foreign currency was instead at a forward premium of 1 percent per year,
the interest arbitrageur would earn 5% per year.
b. If the foreign currency was at a forward discount of 6 percent per year, it would
pay for investors to transfer funds from the higher- to the lower-interest center
and lose 4% interest but gain 6% from the foreign exchange transaction, for a net
gain of 2% per year.
13. a. At point B, the loss of 1% per year from the forward premium on the foreign
exchange transaction on the part of the foreign investor is more than made up by
the 2% per year gain from the higher interest rate in our nation.
At point B', the 1% interest loss per year on arbitrage inflow into our nation is less
than the 2% per year gain on the forward discount on currency transaction.

b. As arbitrage inflow continues from point B, the positive interest differential in

favor of our nation declines and the forward premium on the foreign currency
increases.
From B', the interest differential in favor of the foreign country increases and the
forward discount on the foreign currency decreases.
14. a. At CIAP, there is no further possibility from increasing returns over and above
those that investors can achieve in their own country, but this does not mean that
returns in the two countries are equalized.
As proof of this, we can see that in the example given at the end of Section 14.6d,
annualized returns remain at 8 percent in London for British investors and are
increased from 6 percent to 6.852 for American investors without considering
transaction costs and 6.602 percent if we consider transaction costs of 1/4 of 1
percent investing in London. Thus, returns become less unequal as a result of
CIA, but are not equalized!
App.1a. a. The U.S. investor will get back ($200,000)(1.015)=$203,000.
b. The U.S. investor will get back $203,000+($200,000)(0.00213)=

$203,000+$426=$203,426.
c. The U.S. investor will get back $205,000+($200,000)(0.0025)=

$203,000+$500=$203,500, an overestimation of $74.

*CHAPTER 15
EXCHANGE RATE DETERMINATION
Answer to Problems
1. a. The rate of inflation in Switzerland from 1973 to 1998 was:
101.3 - 46.6 = 54.7 = 0.739 or 73.9%

(101.3+46.6)/2 74
On the other hand, the rate of inflation in the United States from 1973 to 1998
was:
107.0 29.2 = 77.8 = 1.142 or 114.2%
(107.0+29.2)/2 68.1
Thus, the inflation rate in Switzerland minus the inflation rate in the United
States from 1973 to 1998 was:
73.9% - 114.2% = -40.3%
From 1973 to 1998, the Swiss franc appreciated with respect to the U.S. dollar
from 3.1648 Swiss francs per dollar in 1973 to 1.4898 Swiss francs per dollar in
1998 or by
1.4898 - 3.1648 = -1.675 = -0.720 or -72.0%

(1.4898+3.1648)/2 2.3273
b. The relative PPP theory did hold only to the extent that since the rate of inflation
was lower in Switzerland than in the United States the Swiss franc appreciated
with respect to the U.S. dollar between 1973 and 1998. But the percent
appreciation of the Swiss franc with respect to the dollar was much greater than
that predicted by the relative PPP.
Note that in the above calculations, percentage changes were obtained by the
average of the beginning and end values. You may want to ask the class to do the
same when assigning this and the next problem so as to get the same answer.
2. The rate of inflation in Spain from 1973 and 1998 was:
107.5 10.1 = 97.4 = 1.656 or 165.6%

(107.5+10.1)/2 58.8

Thus the rate of inflation in Spain minus the rate of inflation in the United States
(found in Problem 1a) is:
165.6% - 114.2% = 51.4%
From 1973 to 1998, the Spanish peseta depreciated from 58.26 pesetas per dollar
in 1973 to 149.40 pesetas to the dollar in 1998 or by:
149.40 - 58.26 = 91.14 = 0.878 or 87.8%

(149.40+58.26)/2 103.83
Since Spain had an inflation rate 51.4 percent higher than the U.S. inflation rate
and the Spanish peseta depreciated by 87.8 percent from 1973 and 1998, we can
say that the relative PPP theory worked reasonably well between the United States
and Spain during this period.
3. a. Md=kPY=(1/V)(PY)=(1/5)(200)=$40 billion.
b. If the nation's nominal GDP rises to $220 billion, Md=220/5=$44 billion.
c. If the nation's nominal GNP increases by 10 percent each year, Md increases also
by 10 per cent each year.
4. a. Monetary base of the nation is,

D+F=8+2=$10 billion.
b. The value of the money multiplier is,

m=1/LLR=1/0.25=4.
c. The value of the nation's total money supply is

Ms=m(D+F)=4(8+2)=$40 billion
5. a. Md=Ms and the nation is in balance of payments equilibrium.
b. Md of $44 billion exceeds Ms of $40 by $4 billion.
With m=4, there will be an inflow of money or international reserves from abroad
of $1 billion to equate Ms to Md. Thus, the nation's balance of payments surplus
will be equal to $1.
6. The nation will face a continuous inflow of money or international reserves and
balance of payments surplus of $1 billion, year in and year out.

a. If monetary authorities do not change the domestic component of the nation's

monetary base, the nation's balance of payments disequilibrium is corrected by a
once-and-for-all inflow of money or international reserves of $1 billion.
b. If monetary authorities do not change the domestic component of the nation's

monetary base, the nation's balance of payments disequilibrium is corrected by a
once-and-for-all inflow of money or international reserves of $1 billion.
c. If monetary authorities completely sterilize, or neutralize, the balance-of-

payments disequilibrium with a change in the domestic component of the nation's
monetary base, the domestic component of the nation's monetary base will fall by
an amount equal to the increase in the foreign component of the nation's monetary
base so as to leave the monetary base unchanged. This could only go on until the
domestic component of the nation's monetary base has dropped to zero.
7. Md=100/4=25 falls short of Ms=30 and there will be an outflow of international

reserves (a deficit in the nation's balance of payments).
8. According to the monetary approach, inflation in the second nation is caused by

excessive money creation there. As a result, either the first nation's exchange rate
has to appreciate to keep its balance of payments in equilibrium or its monetary
base will rise (so that inflation will spread to nation 1).
9.(a) The condition for uncovered interest parity is given by i-i*=EA, where EA is the
expected appreciation of the pound. That is, since the spot rate of SR=$2.02/1 in
three months is 1% (4% on an annual basis) higher than SR=$2.00/1 today, the
condition for UIA is satisfied because 6%-10% = 4% (with all percentage rates
expressed on an annual basis).
(b) If the spot rate is expected to be SR=$2.04/1 in three months, the pound would
be expected to appreciate by 2% for the three months (8% on an annual basis).
Investors would now earn more by investing in London than by investing in New
York and the condition for UIA would no longer be satisfied. As more dollars are
exchanged for pounds to increase investments in London, the actual spot rate will
increase from SR=$2.00/1 to SR=$2.02/1. This will leave only an expected
appreciation of the pound of about 4% per year (the same as before the change in
expectations). This is obtained by comparing the new higher spot rate of
SR=$2.02/1 today with the new expected spot rate of SR=$2.04/1 in three
months, so as to return to UIA parity.
10. (a) The expected change in the exchange rate is part of the uncovered interest parity
(UIP) condition (see Equation 15-8). Here investors face a foreign exchange risk
in purchasing foreign bonds. On the other hand, the forward discount or premium
is part of covered interest arbitrage condition (see Equation 14-1) and investors do
not face any foreign exchange risk in purchasing foreign bonds.

(b) If the actual change in the exchange rate were always exactly equal to the
expected change in the exchange rate, then the expected change in the exchange
rate would be equal to the forward discount.
11. The depreciation of the foreign currency means that the domestic-currency value
of foreign bonds has decreased and the nation's residents now hold less of their
wealth in foreign bonds than they want. They will, therefore, purchase more
foreign bonds. This is stock adjustment that leads to a once-and-for-all increase in
the quantity purchased of the foreign currency (to purchase the foreign bonds),
which, in turn, leads to an appreciation of the foreign currency that neutralizes in
part the original depreciation of the foreign currency.
12. According to the portfolio balance approach, an increase in the expected rate of
inflation in the nation would lead to the expectation that the domestic currency
will depreciate and the foreign currency will appreciate under flexible exchange
rates. In terms of the extended portfolio balance model, this means that the
expected appreciation of the foreign currency (EA) increases. The rise in EA will
lead to a reduction in the demand for money balances (M) and the domestic bond
(D) and an increase in the demand for the foreign bond (F) by domestic residents
(see Equations 15-10 to 15-12). This leads to a depreciation of the domestic
currency as domestic residents exchange the domestic for the foreign currency in
order to purchase the foreign bond and to other changes in all other variables of
the model until equlibrium is reestablisehd in all the markets simultaneously.
13. The increase in the supply of the foreign bond because of a foreign government's
budget deficit increases the risk premium on holdings of foreign bonds by home-
country residents. This reduces the right-hand side of the UIP condition (Equation
remaining equal, this leads to a depreciation of the foreign currency and
appreciation of the domestic currency as investors switch from foreign to
domestic bonds. Furtheremore, if inflation expectations abroad increase because
of the budget deficit, this will reinforce the tendency of the foreign currency to
depreciate and domestic currency to appreciate. The depreciation of the foreign
currency will then make foreign bonds cheaper to home-country residents and this
induces them to buy more of them. Portfolio adjustments will continue until
equilbrium is reestablished in all markets simultaneously.
14. The unanticipated increase in the money supply by the U.K. central bank, will
lead to an immediate reduction in the British interest rate and a magnified
depreciation of the pound (appreciation of the dollar). Over time, as prices and
interest rates rise in the United Kingdom, the pound appreciates (dollar
depreciates) so as to remove its undervaluation (overvaluation) in order to reach
its new long-run equilibrium level.
App. 1.At the beginning of the period:
H=D+F=100+20=120,

and F/H=20/120 and D/H=100/120
Over the period of the analysis:
gD=(10/100)100=10%
Rewriting (19A-8) and substituting the values of the problem into it, we get:
(F/H)gF=agP+bgY+gu-cgr-gm-(D/H)gD
(20/120)gF=0.1+0.04+0-0-0-(100/120)(0.1)
(20/120)gF=0.140-0.083
(20/120)gF=0.057
gF=(120/20)(0.057)
gF=0.342
Since F=20 at the beginning of the period of the analysis and grows by 34.2%
over the period of the analysis, F=20+20(0.342)=20+6.84=26.84 at the end of the
period of the analysis.
App. 2 a. An increase in Ms increases the domestic demand for the foreign bond and
increases R (i.e., the domestic currency depreciates). This is the same result
postulated by the monetary approach.
b. A once-and-for-all depreciation of the domestic currency increases the

domestic-currency value of the foreign bond (i.e., confers a capital gain to the
nation's residents). If they previously held the desired proportion of their wealth in
foreign bonds, they would be holding more of the foreign bond than they want
after the depreciation. As a result, they would sell some of their holdings of the
foreign bond to purchase more of the domestic bonds and the domestic money.
This will cause an appreciation of the domestic currency, which will neutralize in
part the previous depreciation. The process ends when equilibrium is
simultaneously reestablished in all three markets.

CHAPTER 20
FLEXIBLE VERSUS FIXED EXCHANGE RATES, THE EUROPEAN MONETARY

SYSTEM, AND MACROECONOMIC POLICY COORDINATION
1. a. The U.S. will export the commodity because at R=2, P=$7 in the U.S. and P=$8
in the U.K.
b. The U.S. has a comparative disadvantage in this commodity at the equilibrium

exchange rate.
2. Under a fixed exchange rate system and perfectly elastic international capital
flows, the attempt on the part of the nation to reduce its money supply (tight
monetary policy) tends to increase interest rates in the nation and attract capital
inflows. This frustrates the attempt on the part of the nation's monetary authorities
to reduce the nation's money supply. On the other hand, the attempt of the nation's
monetary authorities to increase the money supply of the nation will be frustrated
by the tendency of the nation's interest rate to fall, resulting in a capital outflow
that would leave the nation's money supply unchanged (see section 17.4c).
3. See Figure 1.
Figure 1 shows that for a shift in the supply of pounds from S to S' and S*, the
exchange rate fluctuate more when the demand curve for pounds is more inelastic
(D*) then when it is more elastic (D).
4. See Figure 2.
Curve A shows the fluctuation in the exchange rate over the business cycle
without speculation; curve B shows the fluctuation in the exchange over the
business cycle with stabilizing speculation, while curve C shows the fluctuation in
the exchange rate over the business cycle with destabilizing speculation.


6. An optimum currency area involves permanently fixed exchange rates as well as

common monetary and fiscal policies among its members. Thus, an optimum
currency area resemble a single economic entity and monetary union. There are
no such implications for countries which are connected only by fixed exchange
rates.
7. (a) With a single central bank and currency the member nations of the European
Union can no longer print money and thus each member no longer has the
wherewithal to conduct monetary policy. The original central bank of each
member nation now assumes functions similar to that of the federal reserve banks
in the Federal Reserve System in the United States. That is, they affect the
community-wide monetary policy only through their participation in central bank
deliberations and decisions.
(b) With a single currency, of course, there are no such things and exchange rates
among the member nations' currencies, just as there are no exchange rates for the
dollar among the states of the United States. Or better, the exchange rate is
permanently fixed at 1:1.
8. The benefits that the EU would get from establishing a single currency are:
eliminating the costs involved in exchanging currencies, eliminating the risk of
exchange fluctuations and currency crises, inducing nations to adopt more
appropriate economic policies and being able, as a community, to withstand better
external shocks. The costs results from the inability of nations to change their
exchange rate and to tailor monetary and fiscal policies to their specific national
needs.
9. See Figure 4.
10. See the dashed curve in Figure 5.
11. It is true that flexible exchange rates tend to insulate the economy from
international disturbances. For example, the tendency of a nation to follow
inflationary policies will result in a depreciation of its currency. This means that
the trade partner's currency will appreciate, making its imports cheaper and thus
preventing the importation of inflation from abroad.
In an integrated world capital market, however, inflationary policies by one nation

will lower its interest rates in the nation and will lead to capital outflows. Unless
the trade partner is able to continuously sterilize these capital inflows, inflationary
pressures will spread to it also. These inflationary pressures can be avoided by
international policy coordination. Thus, international policy coordination is useful
also under a flexible exchange rate system because in a world of unrestricted

international capital flows flexible exchange rate do not insulate nations

completely from their partner's policies.


12. Game theory is a method for examining the effect of a given policy or course of
action on a nation or other economic unit for each possible response by another
nation or other economic unit. Game theory can thus be used to show that a
cooperative equilibrium can be better for (i.e., can increase the welfare of) each
nation or economic unit than if each tries to maximize its welfare independently.
13. In a noncooperative equilibrium, each nation is likely to follow a loose fiscal

policy but a tight monetary policy in order to keep its interest rates up and thereby
attract foreign capital and keep the international value of its currency high, so as
to keep import prices low. However, when all nations do this their efforts will be
self-defeating and interest rates will be higher than with a cooperative
equilibrium. High interest rates will reduce long-term growth for all nations. With
a cooperative equilibrium, on the other hand, nations will use restrictive fiscal and
easy monetary policies. This will keep interest rates low and thus stimulate long-
run growth.
14. (a) There have been four episodes of significant international macroeconomic policy
coordination among the leading industrial nations during the past three decades.
The first occurred in 1978 when Germany was induced to stimulate its economy
and play as "locomotive" and stimulate growth in other leading industrial
countries also. The effort ended when Germany, fearing inflation, stooped
stimulating its economy. The second was the Plaza Agreement in September of
1985 when the United States, Japan, Germany, France, and the United Kingdom
met at the Plaza Hotel in New York to engineer a "soft landing" for the
overvalued dollar. This effort was regarded as successful but the markets were
already lowering the value of the dollar. The third case is represented by the
Louvre Accord in February 1987, when the leading industrial nations agreed on
implicit target zones for the exchange rates among the leading currencies. This
agreement, however, became inoperative soon after it was reached. The fourth
case is evidenced by the coordinated quick monetary response on the part of the
United States, Germany, and Japan to October 1987 worldwide equity-market
crash.
(b) International macroeconomic policy coordination to date has been episodic and
limited in scope and it is unlikely that it will be very different in the future.
App. On Janaury 1, 1999, 11 of the 15 members of the European Union adopted the
euro as their common currency. Britain, Sweden, and Denmark decided not to
join from the start, but retained the option to join later. Greece was not admitted
because of its inability to meet most of the Maastricht criteria. The likelyhood,
however, is that all four will join the euro by July 2002, when the euro is to
completely replace the currencies of the participating nations. In the meantime, a
new exchange rate mechanism, the ERM II, was installed to keep the currencies
of these four countries from fluctuating to widely, in
anticipation of their joining the euro.

*CHAPTER 21
(Core Chapter)
THE INTERNATIONAL MONETARY SYSTEM: PAST, PRESENT, AND FUTURE
1. a. The primary goal of nations today is internal balance, while during the heyday of
the gold standard nations gave priority to external balance. The gold standard
days were also characterized by much greater price flexibility than today.
Furthermore, London was then the undisputed center of international trade
and finance and as a result, there were no destabilizing international capital
flows, as frequently occur today between the different International
monetary centers.
b. The reestablishment of the gold standard today would require the reestablishment
of all the conditions that made for its smooth operation from 1880 until 1914.
Nations would have to place priority on external over internal balance and give up
their use of monetary policy. They would have to eliminate domestic restrictions
on price flexibility (i.e., abolish price ceilings, minimum wages, interest
restrictions, etc.), and reestablish the supremacy of one international monetary
center (New York, Tokyo, or London) so as to avoid destabilizing capital flows
among the international monetary centers in existence today. Needless to say, this is
impossible.
2. The nation was to pay 25% of its quota ($25 million) in gold and the remainder in
the nation's currency. Under the original rules, the nation could borrow no
more than 25% of its quota ($25 million for this nation) from the Fund in any one
year.
Today, the nation would pay 25 percent of its quota in SDRs or in currencies of
other members selected by the Fund, with their approval, and the rest in their
own currency. Under the new rules in operation today, the nation can borrow a
maximum of up to 150 percent of its quota in any one year under the various
programs to facilitate borrowing that the Fund has put in place over the years.
3. In order to borrow $25 million, the nation of problem 2 would pay into the Fund
another $25 million of its currency. The nation would then receive an equal
amount of a reserve currency (usually dollars). The nation could borrow this so-called
this gold (now, the reserve or first credit) trance automatically.
4. The nation of problem 2 could continue to borrow $25 million in each of the four
subsequent years under the original rules. During each year, the nation would

deposit an additional $25 million of its currency with the Fund in exchange for an
equal amount of a reserve currency.
After 5 years, the nation will have borrowed a total of 125% of its quota under the
original rules so that the Fund would hold 200% of the nation's quota in the
nation's currency (75% deposited when the nation joined the Fund and 125% from
borrowing). With each additional amount borrowed, the Fund imposes more conditions
and supervision.
5. The nation was to repay its loan by "repurchasing" its currency from the Fund
with other convertible currencies approved by the Fund, until the Fund once again
held no more than 75% of the nation's quota in the nation's currency. The fund allows
repayment to be made in currencies of which the Fund holds no more than 75% of
the issuing nation's quota. Repayment was originally to be made within 3 to 5 years.
6. Nation A will only have to repay $15 million (for the Fund to hold no more than
75% of nation A's quota in nation A's currency).
7. a. The nation could attempt to discourage large destabilizing international capital

flows by purchasing the foreign currency forward to reduce the forward discount
or
increase the forward premium on the foreign currency.
b. The same is true today, except that today exchange rates can fluctuate much more
than
under the Bretton Woods System and capital moves much more freely
internationally than under the old Bretton Woods System, so that the
policy of intervening in the forward market is likely to be much less
effective.
8. a. The nation could attempt to discourage large destabilizing international capital

flows
by purchasing the foreign currency in the spot market. This tends to appreciate the
foreign currency and discourage international capital inflows.
b. The same is true today, except that today exchange rates can fluctuate much more
than
under the Bretton Woods System and capital moves much more freely
internationally than under the old Bretton Woods System, so that the policy of
intervening in the spot market is likely to be much less effective.
9. Under the Bretton Woods system, the dollar was truly an international currency.
From about the mid-sixties until the collapse of the system in 1971, however, foreigners
became progressively more reluctant to hold dollars as the amount of officially
foreign- held dollars became progressively higher than U.S. gold reserves. Some

other "strong" currencies such as the German mark also began to be widely held as
international reserves. But the dollar remained by far the most widely-held international
currency.
10. a. The immediate cause of the collapse of the Bretton Woods system was the
demand on the part of some European central banks to convert some of their
dollar holdings into gold. Had the United States done so, others would have
demanded gold for dollars, soon exhausting all U.S. gold reserves. Thus on
August 15, 1971, the U.S. suspended the convertibility of dollars into gold.
This put the world on a pure paper (dollar) standard.
b. The fundamental cause of the collapse of the Bretton Woods system was the lack
of an adequate adjustment mechanism as nations were very reluctant to change
their par value when in fundamental disequilibrium. They relied instead on a web
of ad hoc measures which in the end became unwieldy and inadequate for the
task.
11. The present international monetary system is a managed floating exchange rate
system with nations intervening in the foreign exchange markets to smooth out
excessive fluctuations in exchange rates. Thus, there is still a need for international
reserves. The dollar (without any backing to gold) remains the most important
international currency.
12. a. The fundamental reason for the Mexican currency crisis was that Mexico relied
on
keeping an overvalued exchange rate that would lead to a trade deficit and thus a
capital
inflow to help finance investments and growth. This worked fine until the middle
of 1994
when investors began to doubt Mexicos ability to repay foreign loans and thus
withdrew
their capital. This caused the international value of the Mexican pesos to fall
sharply
(i.e., to depreciate very heavily with respect to the dollar), inflation and interest
rates to
rise sharply, and the nation to plunge into deep recession.
b. The IMF proposed to avoid the recurrence of a Mexican-style currency crisis by
setting
up an early-warning system for developing countries to provide accurate and
timely
financial data so that investors can anticipate problems before they become crises
and by
negotiating a doubling to $47 billion of the amount that it could borrow under the
(New)
General Agreement to Borrow in order to provide financial assistance to those
nations

that do face a serious financial crisis.
13. a. The Mexican currency and financial crisis taught developing nations that they
cannot rely excessively on short-term capital inflows (which can as quickly flow in as
flow out) to finance growth and development. They should instead try to increase
domestic savings
and encourage long-term capital inflows. Second, in the face of a financial crisis,
it is better to deal with the crisis quickly and decisively.
b. Another lesson from the Mexican crisis is that when a currency and financial
crisis does
hit, it is best to nip it in the bud and take immediate and bold action to overcome
it. For
example, if Mexico had devalued the pesos in April or even September 1994
when its
international reserves were still plentiful, the crisis would probably not have been
as deep
and serious as it became.
14. a. All the economic crises in emerging market economies during the second half of
the 1990s started with a massive withdrawal of short-term liquid funds at the first
sign of
financial weakness in the nation. Foreign investors poured funds into many
emerging
markets during the 1990s in order to take advantage of high returns and to
diversify
their portfolio after these nations liberalized their capital markets, but they quickly
got
out of the country as soon as they began to fear that an economic crisis was
imminent. This was the case in each of the four emerging market crises: Mexico
in 1994- 5, South-East Asia in 1997-1999, Russia in summer 1998, and Brazil in
1999.
b. Proposed solutions to avoid future crises in emerging market economies include:

Avoid over borrowing of short-term funds (2) increased transparency in financial
relations, (3) strengthening emerging markets (4) banking and financial system,
and
(5) greater private sector involvement in rescue programs.
15. The most important international monetary problems facing the world today are:
(1) trade protectionism in advanced countries; (2) large exchange rate volatility and
disequilibria, (3) frequent economic crises in emerging market economies (4) job
insecurity and stagnant wages in the United States and other advanced countries (5) high
structural unemployment and slow growth in Europe and stagnation in Japan (6)
restructuring challenges of transition economies, and (7) deep poverty in many
developing countries..

App. a. See Table 1 below.
b. International liquidity measured by the ratio of the dollar value of international

reserves
(with gold reserves measured at market values) to the total dollar value of world
imports declined over the years from 0.80 in 1950 to 0.31 in 1970, it rose to 0.35
in
1985, and then it ranged from 0.24 in 1995 and 0.32 in 2002, and it was 0.31 in
2005.
c. While there is still a need for international reserves under the present system, it is
much
smaller than it was under the Bretton Woods system. Thus, there seems to be an
excess
of liquidity in the world today.
Table 1
International Reserves and Trade
(in billions of dollars at year-end with gold at market value)
1950 1955 1960 1965 1970 1975 1980 1985

International
1 Reserves 48 53.6 60.7 71.3 95.8 299 776.6 679.6
1999. 1935.
2 Imports 60.1 92.1 123.9 183.3 313.5 866.8 1 2
3 Reserves/Imports 0.8 0.58 0.49 0.39 0.31 0.34 0.3 0.35
1990 1995 2000 2001 2002 2003 2004 2005

International 1227. 1756. 2091. 2380. 2743. 3283.
1 Reserves 908.3 4 7 1917 5 5 3 4
3530. 5213. 6571. 6335. 6575. 7657. 9318.
2 Imports 7 9 1 7 3 9 5 10555
3 Reserves/Imports 0.26 0.24 0.27 0.3 0.32 0.31 0.29 0.31
Source: Table 21-6 in the text and IMF, International Financial Statistics, Yearbook, 1985,
2002, 2005 and April 2006.

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International Economics 9th Edition Instructors Manual

1. a) International economic problems reported in our daily newspapers are likely to

c) Can result in your paying higher prices for imported products;

(353085526.doc) 3-1 Dominick Salvatore

b) See Table 1A.

b) See Table 1B.

(353085526.doc) 3-2 Dominick Salvatore

Measured by Imports and Exports as

*Source: International Financial Statistics

5. a) Mankiws Economics (4th., 2007) includes the following microeconomics topics:

c) Mankiws Economics (4th., 2007) includes the following microeconomics topics:

unemployment and its natural rate;

7. a) A government can reduce a budget deficit by reducing government expenditures

b) A nation can reduce or eliminate a balance of payments deficit by taxing

8. a) Nations usually impose restrictions on the free international flow of goods,

b) Both international and interregional economic relations involve the overcoming

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In case A, trade is possible based on absolute advantage.

In case B, trade is possible based on comparative advantage.

In case C, trade is possible based on comparative advantage.

4. a) The United States gains 1C.

b) The United Kingdom gains 4C.

c) 3C < 4W < 8C.

b) In the United States, Pw=$1.50 and Pc=$2.00.

c) In the United Kingdom, Pw=1.00 and Pc=0.50.

d) $1.50 < 1.00 < $4.00.

b) In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.

c) In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.

9. a) If DW(US+UK) shifted up in Figure 2.3, the equilibrium relative commodity price of

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3. a) See Figure 3 on page 22.

b) Nation 1 has a comparative advantage in X and Nation 2 in Y.

c) At Px/Py=1/2, there is an excess demand of exports of HH'=80X and Px/Py rises

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7. See Figure 6 on page 24.

12. See Figure 11

App. 1. See Figure 12

App. 2. Since L and K are released from the production of X in a higher

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The equilibrium Py/Px=P'2=1/P2.

4. See Figure 4 on page 34.

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7. a) See Figure 6 on page 34.

The equilibrium relative commodity price of commodity Y is Py/Px=1. This is

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10. See Figure 8 on page 36.

App. 3. See Figures 10 and 11.

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*CHAPTER 5 (Core Chapter)

b) The comparative advantage of each nation is determined by differences in production

4. See Figure 4 on page 46.

b) A difference in the production frontier of two nations due to a difference in the

c) Another possible cause (besides a difference in production frontiers) of a difference in

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