1a) Assume an American citizen buys a Chinese car worth $10.000 and pays the Chinese exporter by transferring $10.000 to the account of this Chinese exporter with an American Bank.Vraag 1A(5pts): Describe how these transactions are registered at the balance of payments of the US.Answer: The purchase is an import and – $10.000 at the current account. The transfer to the account of the Chinese exporter is an inflow of capital: $10.000 in the non-reserve financial account.

1b) Figure 1 (internal and external balance)Vraag 1B(10pts):

2a) Figure 2: A short term model of the exchange rateVraag 2A (6pts) Assuming international investors expect that in the future the value of the Dollar will decrease. Show in the figure how this will effect the current exchange rate. Answer: The curve moves to the right. Why? In formulas, the expected future spot rate increases, which means a higher expected return given a particular value of the sport rate. In words, the dollar

is expected to depreciate, hence in dollar terms the investor expects to obtain more dollars in the future for a given amount of Euros.

According to this model, the exchange rate is determined by the uncovered interest parity. The figure is drawn from the perspective of a US dollar investor.

2b) Often economist assume that in the long-run the exchange rate is determined by the PPP. It has two forms.Vraag 2B (8pts): give both versions of the purchasing power parity. Also indicate which of the two versions you think is the best representative of the exchange rate’s long term level. Answer: In absolute terms the PPP=E=P/P*. In relative terms the change in the exchange rate equals the difference in inflation rates (delta) E=(delta) P- (delta) P*. The absolute version is a better representation of the long term level of the exchange rate. The absolute version gives a level, whereas the relative version only provides an estimate of the change.

Vraag 2C (6pts): Mention and explain two shortcomings of the purchasing power parity.Answer: Reasons why the PPP may not be accurate: the law of one price may not hold because of:

1. Trade barriers and non-tradable products.2. Imperfect competition.3. Differences in measures of average prices for baskets of goods and services.

3a) One of the assumptions is hold that tastes are identical in both countries following out of the HO-model.Vraag 3A (6pts): explain what the Heckscher-Ohlin Theorem implies and why assuming identical tastes across countries is essential for reaching the predictions it involves:Answer: The H-O theorem predicts that a country will have a comparative advantage in those goods that make intensive use of the production factors that are relatively abundant in that country. (1) With everything being the same on the demand side in both countries, relative abundance differences will imply lower factor prices for the countries’ abundant production factors and hence a lower relative price for goods that use those production factors intensively. (2) When, however tastes are not identical across countries, this could imply that goods and factor prices will differ on that account as well. For instance, a relatively high demand for the good that a country has a comparative advantage in will increase the autarky price of that good and thereby the relative reward for the production factor used intensively in it. (2) If taste difference are strong enough, this could even imply that comparative advantage switches. (1)

3b) The income distribution effects of trade within a country depend on the particular reason for trade.Vraag 3B (8pts): Analyse and compare the income distribution effect of the H-O trade model and the monopolistic competition trade model Answer: HO-model favours the country’s abundant production factor because the factor is used intensively in the export good for that country. HO theorem namely predicts that a country will have a comparative advantage in those goods that make intensive use of the production factors that are relatively abundant in that country. (1) Trade implies that demand for the factors goes up, increasing its nominal reward. (1) Because due to this price increase producers will start substituting the abundant factor for the scarce factor, also the marginal productivity will go up. Hence, the abundant factor also gains in real terms. (1) For the scarce factor exactly the opposite holds. (1)In the monopolistic model it is not cost differences that determine trade, but economies of scale and love for variety. (1) Moreover trade is intra-industry (within sectors) and not across sectors ( inter-industry). (1) This implies a larger market size. Because there is also tougher competition, some firms will exit the market, allowing the remaining firms to reach lower average cost while charging lower prices. In the end overall employment levels are retained, though some workers will have to move to different employers in the same sector. (1) Moreover, all workers face lower prices and more choice, so there are real welfare gains for all. (1)

3c) To analyse the impact of economic shocks on welfare, the book introduces in Chapter 5 a ‘standard model’. This model uses PPF’s with increasing opportunity costs and fields of consumption indifference curves to generate world relative supply and relative demand curves.Vraag 3C (6pts): Use the standard trade model to analyse the effect on welfare of a shift in government spending towards domestic industries. Explain your answers and use appropriate graphs to illustrate your answer.Answer: This has only implications for the RD-curve, since there are no supply effect. Consequently, the welfare effects are one-to-one related to the terms of trade effects (2). It depends however on which sectors are favoured. If these are export sectors, the RD for country’s export goods will increase, improving it terms of trade. Welfare goes up. If, by contrast, the shift in government spending is towards import competing sectors, this will increase RD for the import good, deteriorating the terms of trade of the country and welfare (3). Appropriate graph would be a RS-RD diagram.

4a) A common aspect of import reducing trade policy measures is that imports are lowered and that it increases the domestic price of imported goods. The extent to which this is the case depend on whether the tariff-imposing country is a small or a large country.

Vraag 4A (7pts ): Use a standard demand and supply diagram to show how being a small ore a large country matters for the effect on domestic prices, imports and welfare if a country imposes an import tariff.Answer: See graph below. The same tariff will increase domestic prices by less in a large country since due to the tariff also the world market price drops. (2pts) Accordingly domestic production (consumption) goes up (down) by less as well , so that imports decrease by less in a large country. (2pts) A small country always loses from a tariff ( by the distortion triangles ), while a large country

might gain as the lower world market prices imply additional, uncompensated government revenue. (3pts).

4b) One of the consequences of the GATT negotiations has been a limitation on the use of import quotas. As a response, countries have pursued a new option of limiting the level of imports. This has led to a surge in the US of VER’s (voluntary export restraint).Vraag 4B(8pts): analyse that the use of VER’s instead of import quota implies for overall welfare in the country that tries to limit its imports. Use an appropriate graph to illustrate your answer.Answer: the main difference is where the quota rents go to. This is uncertain in case of an import quota, but with a VER the import licenses and hence quota rents go to the foreign country. (2) Hence, for a VER that is equivalent to a quota ( so that the price effects are the same), a VER will be worse for welfare. (3). This can be illustrated with a standard graph (3).