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Economics Q&A Bank
References
Dominick Salvatore
Paul Krugman

Unit 3
(2 Markers)
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(8 Markers)
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International competition forces firms and plants in industrial countries only
one or a few, varieties and style of the same product rather than different varieties and
styles
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 Under this theory, all factors can gain
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 The level of intra-industry trade can be measured using the foll formula:
T = 1 – l X-M l / X+M
The value of T ranges from 0 to 1
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If T=1, when exports are equal to imports
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The broader the definition, greater the T
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What is absolute advantage?
 According to Adam Smith, trade between two nations is based on absolute advantage
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 By this process, resources are utilized in the most efficient way and the output of both
commodities will rise
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Free trade would cause world
resources to be utilized most efficiently and would maximize world welfare
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S
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K
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Similarly, the 6W that the United Kingdom
receives from the United States is equivalent to or would require six man-hours of labor time to
produce in the United Kingdom
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By being able to exchange 6C (requiring
a little over one hour to produce in the United Kingdom) for 6W with the United States, the
United Kingdom gains 24C, or saves almost five man-hours
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What is the Law of Comparative Advantage
 According to the law of comparative advantage, even if one nation has an absolute disadvantage
or is less efficient than the other nation in the production of both commodities, there is still a
basis for mutually beneficial trade
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U
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U
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Wheat (bushels/man-hour)

6

1

Cloth (yards/man-hour)

4

2

 Since U
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labor is half as productive in cloth but six times less
productive in wheat with respect to the United States, the United Kingdom has a
comparative advantage in cloth
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In short, the United States’ absolute advantage is
greater in wheat, and so the United States has a comparative advantage in wheat
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According to the law of comparative advantage, both nations
can gain if the United States specializes in the production of wheat and exports some of
it in exchange for British cloth
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1
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2
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3
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5
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6
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8
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9
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All resources are fully employed in both nations
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International trade between the two nations is balanced
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The Heckscher—Ohlin theorem can be stated as follows: A nation will export the commodity
whose production requires the intensive use of the nation’s relatively abundant and cheap
factor and import the commodity whose production requires the intensive use of the nation’s
relatively scarce and expensive factor
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This means that Nation 1 exports commodity X because commodity X is the L-intensive
commodity and L is the relatively abundant and cheap factor in Nation 1
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e
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Unit 4
2 Markers
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2
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It tax or duty levied on a traded commodity as it
crosses national boundary
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

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Types of Tariffs
Ad Valorem: Expressed as a fixed percentage of the value of the traded commodity
Specific: Expressed as a fixed sum per physical unit of he traded commodity
Compound: Combination of ad valorem and specific tariff
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What is the partial equilibrium analysis of a tariff?
Introduction of a tariff increases the price of the traded commodity
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8 Markers
1
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The various types of import tariffs are:
 Ad Valorem: The phrase ad valorem is Latin for "according to value"
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For example, 10% ad valorem tax levied by India
on German automobiles
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This tax protects domestic producers and also keeps prices artificially high for Indian
consumers
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This tariff is specific to
the respective commodity being traded
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30 on each pair of shoes imported
and Rs
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 Compound: Combination of ad valorem and specific tariff
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800 and Rs
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2
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Consumer surplus is the difference between what the consumer is willing to pay for each unit of a
commodity and what the consumer actually pays it
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(Figure 1)
At the 30th unit of the commodity, consumers are willing to pay Rs
...
1, thus the
difference accounts for the surplus
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When the
price rises to Rs
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With tariff, consumers pay Rs
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The consumer surplus thus shrinks from ARB = 112
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50

(Figure 2)
The producer surplus is given by the shaded region AGJC = Rs
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At Px=2, they produce 20X
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40 (OGJU),
but VCJU is the cost of production
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15)
This increase in producer surplus because of tariff, is sometimes referred to as the subsidy effect of the
tariff
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Explain ad valorem, specific, and compound tariffs
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16 Markers
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It is a direct quantitative
restriction on the amount of a commodity allowed to be imported or exported
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
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

Uses of import quota: protect domestic industry, to protect domestic agriculture,
and for balance of payments reasons
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Since then, the uses of import quotas grew and became a trend in
economies
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This is the same effect that is seen with the creation of
import tariffs
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Starting from free trade, Px=1, imports are 60X and domestic production is 10X
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The
demand is now at 50X out of which 20X is domestically produced
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(Illustrated in the graph below)

2
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How is the rate of effective
production measured?
Nominal tariff refers to the actual duty on an imported item
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The effective rate of protection (ERP) is a measure of the total effect of the entire tariff structure on the
value added per unit of output in each industry, when both intermediate and final goods are imported
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Based on Stolper-Samuelson model, what is the effect of a tariff on the distribution of
income between nations? Use a graph to explain
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Thus, real returns will rise to the nation’s scarce factors of production
with the imposition of tariffs
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This results in the expansion of output of
commodity X and contraction of commodity Y
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Y
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 With the labour fully employed before and after imposition of the tariff, this also means
that total earnings of labour and its share of the national income is greater
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Thus, a small nation as a whole is harmed by tariff, but its scarce factors benefit at the
cost of the abundant factor
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That is why, labour unions
generally favour import tariffs on L-intensive commodities
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Discuss the issue of environment regulation for international trade
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This pollution can lead to serious trade problems because the price of traded goods and services
does not fully reflect social environment costs
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As nations grow richer, they voluntarily become more environment friendly and focus on
sustainable development
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Describe the various kinds of dumping practices
Dumping is the export of a commodity at below cost or at least the sale of a commodity at a lower price
abroad than domestically
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Sporadic: Occasional sale of commodity at below cost or lower price or a lower price abroad to
unload the temporary excess supply without having to reduce domestic prices
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Evolution of GATT/WTO
The GATT was the only multilateral instrument governing international trade from 1946 to 1995
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GATT was signed by 23 nations in Geneva on October 30, 1947 and took effect on January 1,
1948
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The Marrakesh agreement was the document that gave the legal sanction
to the establishment of the World Trade Organization on January 1, 2005
The main purpose of GATT 1947 was to reduce tariffs internationally in order to facilitate free
trade, the outcome of which is the various tariff concessions schedules created under GATT
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The
WTO expanded its scope from traded goods to include trade within the service sector and
intellectual property rights
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WTO arrangements are
generally a multilateral agreement settlement mechanism of GATT
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Arbitrage
 Arbitrage refers to purchase of a currency in the monetary center where it is cheaper,
for immediate re-sale in the monetary center where it is more expensive, in order to
make profit
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"Arbitrage" is a French word and denotes a
decision by an arbitrator or arbitration tribunal
 People who engage in arbitrage are called arbitrageurs—such as a bank or brokerage
firm
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 Suppose the dollar price of the euro is $0
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01 in Frankfurt, an
arbitrageur would purchase euros at $0
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02 per euro
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When three are involved, it is called three point arbitrage
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Speculation
 The act of trading in an asset, or conducting a financial transaction, that has a significant
risk of losing most or all of the initial investment, in expectation of a substantial gain
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 The nature of speculation involves either incurring profits or losses, both in significant
numbers
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 The speculator has to either tie up his/her own funds or has to borrow to speculate
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So if an investor believes that a spot rate of a certain foreign currency
will rise in three months than its present three month forward rate, the speculator
purchases a specified amount of foreign currency forward for delivery in three months
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 When spectators buy foreign exchange in any type of market with the expectation of
reselling it at a higher future spot rate, he/she is considered to be in a long position in
the currency
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 While it is often confused with gambling, the key difference is that speculation is
generally tantamount to taking a calculated risk and is not dependent on pure chance,
whereas gambling depends on totally random outcomes or chance
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Foreign Exchange Risk
 Foreign exchange risk is the risk to the value of one’s assets when it is valued in another
currency
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It is this change in
value of the currency that gives rise to foreign exchange risk
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 This risk usually affects businesses that export and/or import, but it can also affect
investors making international investments
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 Ownership of foreign assets, international trade, overseas remittances, foreign currency
loans, overseas payments and receipts, receipt of foreign stock dividends, pension
funds, payment to an overseas supplier and holiday expenses overseas are transactions
that are subject to foreign exchange risk
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4
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In effect, hedging is a transfer of risk
without buying insurance policies
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 It is used is used also in protecting one's capital against effects of inflation through
investing in high-yield financial instruments (bonds, notes, shares), real estate, or
precious metals
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A gain or loss in the cash position due to changes in price
levels will be countered by changes in the value of a futures position
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If
there is a fall in price, the loss in the cash market position will be countered by a gain in
futures position
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Without hedging there would be smaller international capital flows, less trade, less
specialization in products, and smaller benefits from trade
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What are foreign exchange markets? What is their most important function and how is it
performed?
 Foreign exchange markets are markets where individuals, firms, and banks, buy and sell
foreign currencies or foreign exchange
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S
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These different monetary centers are connected by a telephone
network and video screens, and are constantly in touch with one another
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The
average daily turnover in the global foreign exchange and related markets is
continuously growing
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The principal function of foreign exchange markets is the transfer of purchasing power
from one nation and currency to another
...
With it, a domestic bank instructs its
correspondent bank in a foreign monetary center to pay a specified amount of the local
currency to a person, firm, or account
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The supply for foreign currencies arises from foreign tourist expenditures in the nation,
from exporting earnings, from receiving foreign investments, and so on
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2
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 It is an economic theory that estimates the amount of adjustment needed on the exchange rate
between countries in order for the exchange to be equivalent to each currency's purchasing
power
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 Absolute purchasing power parity theory postulates that the equilibrium exchange rate between
two currencies is equal to the ratio of the price levels in the two nations
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1 in India, then the exchange
rate between dollar and rupee should be R=$1/Rs
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R0 = P1/P0 x R0
P1*/P0*
Subscript 0 refers to the base period
Subscript 1 refers to the subsequent period

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Example: If the general price level does not change in the foreign nation from the base period to
period 1 (i
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P1*/ P*0 = 1), while the general price level in the home nation increases by 50%, the
relative PPP theory postulates the exchange rate should be 50% higher
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Empirical test:
a) Frenkel (1978) found that the PPP theory collapsed during the 1970s, as did Levich
(1985) and Dornbusch (1987)
b) Frankel (1986 and 1990) suggested that researchers should utilize data over many
decades to properly test the PPP theory because deviations from purchasing-power
parity die out only very slowly
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Conclusion
a) PPP works well for highly traded individual commodities
b) PPP works well over an extensively long period of time
c) PPP works well in cases of purely monetary disturbances and very inflationary periods

3
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The equation for the demand for money is: Md= kPY …
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This is assumed to tend
towards full employment in the long run
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With V depending on institutional factors and assumed to be constant,
Md is a stable and positive function of the domestic price level and real national income
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Under fractional reserve
banking system, each new dollar of D or F deposited in any commercial bank results in an
increase in the nation’s money supply by a multiple of $1
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A deficit in the balance of balance of payments leads to an automatic depreciation of the
nation’s currency, which causes prices and therefore the deman for money to rise enough to
absorb the excess supply of money to eliminate the deficit
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Unit 7
(8 Markers)
1
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 A theory stating that a country's trade deficit will worsen initially after the depreciation
of its currency because higher prices on foreign imports will be greater than the reduced
volume of imports
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

Starting from the origin and a given trade balances, a devaluation or depreciation of the
nation’s currency will first result in deterioration of the nation’s trade balance before
showing a net improvement
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Empirical studies by Harberger (1957), Artus and Knight (1984), and Marquez (2000), to
name a few, confirm the existence of a J-Curve effect
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Explain the derivation of foreign trade multiplier
 The foreign trade multiplier, also known as the export multiplier, operates like the
investment multiplier of Keynes
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 Starting from the equilibrium point, an autonomous change in exports or investment
disturbs the nation’s equilibrium level of income
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

Equation:
The induced changes in savings and imports when income changes are given by:



Substituting these for

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At the equilibrium

3
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 The elasticity approach assumes that if the BOP is in equilibrium, devaluation can
improve the balance of payments
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The elasticity approach tries to predict the outcome policy changes will have on the
balance of payments
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The elasticity approach is helpful in understanding the different outcomes that might
arise from the short to long run
The absorption approach emphasizes changes in real domestic income as a determinant
of a nation’s balance of payments and exchange rate
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A nation’s expenditures fall into four categories, consumption (C), investment (I),
government (G), and trade balance (X-M)
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Elasticity approach stresses the demand side and implicitly assumes that slack exists in
the economy that helps additional demand for exports and import substitutes, and
absorption approach stresses the supply side and implicitly assumes an adequate
demand for the nation’s exports and import substitutes
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What is the Marshall-learner condition for a stable foreign exchange and unstable foreign
exchange rate?

Since we don’t know the exact shape of the demand and supply curves of foreign
exchange in the real world, we use the elasticity of the demand and supply of foreign
exchange market to see whether the market is stable or unstable
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
If the sum of price elasticities of DM and DX is less than 1, the foreign exchange market is
unstable
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Empirically, it has been found that trade in goods tends to be inelastic in the short term, as
it takes time to change consuming patterns and trade contracts
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In the long term, consumers will adjust to the new prices, and trade balance will
improve
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What is foreign repercussion? What is the multiplier formula for nation 1 with foreign
repercussions?
 In a two-nation world, an autonomous increase in the exports of Nation 1 arises from
and is equal to the autonomous increase in the imports of Nation 2
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This will induce Nation 2’s import to fall, thus neutralizing the initial increase in imports
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 Foreign trade multiplier for Nation 1 with foreign repercussions is smaller than the
corresponding foreign trade multiplier without foreign repercussions, and its trade
balance will not improve as much
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For example: if MPS1 = 0
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15 for nation 1 and MPS2=0
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1
k” =



Unit 9
(2 Markers)

= 1
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Functions of World Bank with respect to reconstruction
 To assist in reconstruction and development of territories of its member governments
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Optimum Currency Areas
It is a group of nations whose national currencies are tied up by permanently fixed exchange
rate and operate under a set of conditions to make this system optimum
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What is Bretton-woods system as being a gold exchange standard?
 In 1944, representatives of USA, UK, and 42 other nations met at Bretton Woods, to
decide what international monetary system to establish after the war
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 The Fund was established to oversee that nations followed a set of agreed norms of
international trade conduct, provide borrowing facilities in case of temporary
disequilibria of the BOP of a nation
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This meant, the US was to
maintain the price of gold fixed at $35 per ounce and be ready to exchange on demand
dollars for gold at that price without limitation or restriction
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Within this range, exchange rate was determined my market forces
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 The Bretton Woods system was in the nature of an adjustable peg system, combining
general exchange rate stability with some flexibility
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What is international monetary system? What are the characteristics of a good monetary
system?
 An international monetary system refers to the rules, customs, instruments, facilities
and organizations for effecting international payments
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 A good monetary system is one which maximizes the flow of international trade and
investments and leads to an equitable distribution of the gains from trade among
nations
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 Adjustment: It refers to process in which Balance of Payments disequilibria is corrected
A good monetary system will minimize the cost of and time required for correction

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Liquidity: The amount of liquid international reserve assets available to settle temporary
balance of payments disequilibria
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Confidence: It refers to the knowledge that the adjustment mechanism is working
adequately and that international reserves will retain their absolute and relative values
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What are the two basic functions of the IMF? What is the procedure for a nation to borrow from
the IMF?
 The basic functions of the IMF are as follows:
a
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Provide borrowing facilities for nations temporary balance of payments
difficulties
 Procedure:
a
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The size determines its voting power and
ability to borrow
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b
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In borrowing, the nation would get convertible
currencies approved by the Fund in exchange for depositing equivalent amounts
of its own currency, until the Fund held no more than 200% of the nation’s
quota in the nation’s currency
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The first 25% of its quota was called gold tranche, and could be borrowed
almost automatically
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d
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It involved the
repurchase of its own currency from the Fund with other convertible currencies
approved by the Fund, until the Fund held no more than 75% of the nation’s
quota in the nation’s currency
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If the Fund’s holding of a nation’s currency fell below 75% of its quota, the
difference from the Fund could be borrowed without having to repay its loan
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f
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Paper Pattern
No
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2
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4
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Technological Gap and Product Cycle Models
Rybczynski Theorem
Trade-Creation Customs Union
The Theory of Second Best
Income determination in open and closed economy

(If you require any other questions to be answered, mail them to iti
...
com)



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