ps13q&ans-1 - ECONOMICS 205 PRINICIPLES OF...

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ECONOMICS 205: PRINICIPLES OF MACROECONOMICS FALL 2008 MARK MOORE PROBLEM SET 13: QUESTIONS AND SOLUTIONS 1. Baumol and Blinder, ch. 17, Test Yourself #1. a. 4 yards/barrel b. 2 yards/barrel d. Portugal has an absolute advantage in both goods, but a comparative advantage in wine. England has a comparative advantage in cloth. e. Portugal will specialize in wine, England in cloth. f. The world relative price of wine with trade will fall between 2 yards/barrel and 4 yards/barrel. 2. Baumol and Blinder, ch. 17, Test Yourself, #2. a. U.S. price of oil is 6 bushels/barrel Mexican price of oil is 1/2 bushels/barrel b. The United States would export wheat and Mexico would export oil. c. The free trade relative price of oil is between 1/2 and 6 bushels/barrel. d. Suppose that the free trade price is 3 bushels/barrel. With trade and specialization, the United States can command up to 4 barrels of oil, which is greater than 2. Mexico can command 12 bushels of wheat, which is greater than 2. With a graph, you can show that consumption possibilities with trade lie to the right of the production possibilities curve for both countries. 3. Baumol and Blinder, ch. 17, Discussion Question # 5. Imports are what you consume (enjoy); exports are what you must give up. Country B borrowed every year (trade deficit) to enjoy extra consumption (more consumption than its income). Country A was a lender (trade surplus) and so put off consumption. Country B borrowed, and with the earthquake never paid country A back. 4. What is the nominal exchange rate? What is the real exchange rate? The nominal exchange rate (E) is the relative price of home and foreign currencies. The real exchange rate (q) is the relative price of home and foreign goods.
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Suppose we compare the United States and Germany. Define the U.S. exchange rate in units of €/$, so that an increase in E (more euros per dollars) implies an appreciation of the dollar. The U.S. real exchange rate (again relative to Germany) is defined as EP/P*, where E is defined as above, P is the price of U.S. goods (in the United States, in dollars), and P* is the price of German goods (in Germany, in euros). Essentially, the real exchange rate has units of European goods/U.S. goods. An increase in the real exchange rate (more European goods per U.S. goods) implies a real appreciation for the home country, which means that home goods become expensive relative to foreign goods. 5. How does a nominal depreciation of the home currency affect the trade balance? Using the definition of the real exchange rate, a depreciation of the home currency (decrease in E) implies a real depreciation, given price levels. In fact, prices change relatively slowly, so that in the short run the real and nominal exchange rates tend to move together (except for high inflation economies).
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