homework2f09ans - Econ 434 Professor Ickes Fall 2009...

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Econ 434 Professor Ickes Fall 2009 Homework Assignment #2 This assignment is due on Thursday, October 15 at the beginning of class (or sooner) . 1. Consider a small economy so the country is a price taker in traded goods. Then we can treat foreign and domestic traded goods as a composite good, T . Suppose that if all resources in the economy are devoted to producing non-traded goods then NT =22 . Theeconomycan produce traded goods as well, according to T =100 . 2 2 What does the production possibilities set look like for this economy? Draw it. brief answer Here is the production frontier. The black line is the initial production frontier. 0 2 4 6 8 10 12 14 16 18 20 22 0 20 40 60 80 100 Non-traded goods traded goods Figure 1: Production Frontier with T . 2 2 (a) Suppose that preferences in this economy are such that optimal consumption occurs where traded and non-traded goods are consumed in equal proportions. What will be the initial levels of consumption of T and in this economy? brief answer By assumption consumption will be where the 45 degree line intersects the production frontier. This is the green line in f gure 1 (notice the axes are not equally scaled. You can roughly see that the optimal point is at ( 20 , 20) . If I grind out the equation I get the same answer:so the answer must be = T =20 . 1
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NT T 1 99.8 2 99.2 3 98.2 4 96.8 59 5 6 92.8 7 90.2 8 87.2 9 83.8 10 80 11 75.8 12 71.2 13 66.2 14 60.8 15 55 16 48.8 17 42.2 18 35.2 19 27.8 20 21 11.8 22 3.2 Figure 2: 2
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(b) Suppose that the country received a transfer from abroad of 10 units of the traded good. What will the optimal consumption bundle be in this economy? What will happen to the real exchange rate in this economy as a result of this transfer? Explain. brief answer The transfer shifts the frontier upwards by 10 units, to the red curve in f gure 1 . You can see that the new consumption point is to the northeast of the initial one. So the relative price of traded goods must fall. This makes sense — we are receiving a transfer constituted entirely of T , so this creates an excess supply of T , so its relative price must fall to clear the market. The new optimum is at about (21,21). (c) Suppose instead that the transformation curve is given by T =44 2 NT . How do your answers to parts a and b change? Explain. Does the transfer cause the real exchange rate to change in this case? brief answer Now the frontier is linear. The real exchange rate will not change. Con- sumption increases from about ( 15 , 15) to about ( 18 , 18) . Although the transfer ini- tially causes excess demand for production can shift without a change in the real exchange rate. 0 2 4 6 8 10 12 14 16 18 20 22 0 10 20 30 40 50 Non-Traded Goods Traded Goods Production Frontier with 44 2 2. A robust empirical fact is that price levels for services (or more generally, nontradable goods) are generally lower in poor countries. Can you explain why this might be the case?
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homework2f09ans - Econ 434 Professor Ickes Fall 2009...

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