BA 187: International Trade Homework #2 Answers: Gains in the Standard Trade Model

1. “The greater the difference between terms of trade and autarky prices, the greater the gains from trade.” True 1. In autarky, small country produce/consume at A SC CSCCSC Y X ASCASC CLCCLC U LC Small Country = SC Large Country = LC LC consumption point in autarky & trade U’ SC SC consumption point with trade Q SC SC Imports SC Exports 2. With trade, small country specialization cannot produce enough to meet own needs plus all of large country needs. LC Exports LC Imports QLCQLC LC production point with trade 3. Terms of trade must equal LC autarky prices to induce X prod’n in LC. 4. Result is max. gain to SC from max. difference between SC autarky prices & terms of trade.

a.Euro’s fall against US$ makes EU’s relative wage lower, increases number of goods EU exports to US. Increase in EU current account surplus. b.Do not expect EU’s current account surplus to persist indefinitely. Expect inflow of specie, i.e. EU’s money supply to increase, which will increase inflation in the Euro-zone. This will increase relative wage back to initial. c.ECB has not tried to defend euro (at least not until day this problem set was handed out) because increase in exports expands output in the EU & leads to more jobs both of which are good. ECB worries about inflation as euro’s depreciation is likely to lead to increase in inflation, which is bad. 2. The euro’s recent decline, monetized Ricardo’s prediction for trade, Hume’s prediction for EU inflation, and ECB reactions. Good 1Good 2Good 3Good 4Good 5Good 6Good 7 a* L1 /a L1 >a* L2 /a L2 >a* L3 /a L3 >a* L4 /a L4 >a* L5 /a L5 >a* L6 /a L6 >a* L7 /a L7 [We 0 /W*] EU ExportsEU Imports [We 1 /W*] EU ExportsEU Imports

(P X /P Y ) * 4. Opening trade changes relative prices 1. Assuming identical utility function for Home & Foreign PPF H PPF F 2. Home & Foreign PPF’s differ due to differences in technology or factor endowments. Y X AHAH AFAF 3. Autarky Equilibrium at A H and A F 3. Explain why the ROW is becoming Americanized at the same time as the U.S. is becoming globalized. QFQF QHQH C*C* 5. New equilib. consumption at common C *. but each country has different prod’n ;point.

(P X /P Y ) 0 4. “Export-oriented growth is an undesirable event from the point of view of the home country because it reduces our terms of trade and so lowers our well-being as a nation.” False Y X PPF 0 Q0Q0 RD 0 RS 0 (P X /P Y ) 0 P X /P Y Relative Price of X (q X + q* X )/(q Y + q* Y ) Relative Quantity of X PPF 1 RS 1 (P X /P Y ) 1 C1C1 Q1Q1 C0C0