Answer all questions correctly. 

EF5400 Advanced International Trade Practice Problem Set 1 1. Consider an economy in which there are two countries, i = 1,2, and a continuum of goods, indexed by & e [0, 1]. Goods are produced using labor: DI (#) = 1 (1) / m (k) . where a, (k) is the unit labor requirement for producing good & in country i, y (k) is the output of good & produced in country i and i, (k) is the amount of labor used in production. Assume that the unit labor requirement functions are a1 (k) = call-k) a2 (k) = god. The representative consumer in each country has the utility function This consumer is endowed with & units of labor where h = 12 = I. (a) Define an equilibrium of the economy. Calculate expressions for all of the equilibrium prices, p.(k), and quantities, c(k), y(), and (k). Draw a graph that illustrates the pattern of specialization in production, consumption, and trade. (b) Suppose now each country imposes an ad valorem tariff + on imports from the other country. Repeat the analysis of part (a). (c) For the model in part (b), calculate GDP in each country. 2. Consider an economy in which there is a continuum of goods, s E [0, co), which are ordered so that higher-indexed goods involve more advanced tech- nologies in the production process. An individual consumer has preferences given by u(c ) = em f tog (els.() + 1)ds at.What is the significance of having negative interest Difficulties In measuring Inflation accurately rates at times of serious economic weakness? When real interest rates are negative, there is an increased Difficulties in measuring inflation accurately are one Incentive for people to spend and borrow rather than reason not to aim for zero inflation. As discussed in the measurement blas in the Canadian CPI, the mea- save. Here's why: If you deposit $100 in a savings sured rate of inflation tends to overstate the increase account, it may earn you 2 per cent interest over one in the true cost of living by an estimated 0.5 per cent year; but if inflation is running at 4 per cent, your cash per year. This means that if the Bank targeted zero will be buying you less at the end of the year than it Inflation (no change in the measured CPI), It would does now. The real rate of interest on your Invest- in reality be targeting a systematic, even if relatively ment is a negative 2 per cent. So, in this case, you amall, year-after-year decrease in the true cost of may choose to spend more now rather than save and living." have to fork out more money to buy later. Similarly. if you are a business owner looking to finance your Downward nominal wage rigidity purchases of machinery, and the real cost of bor- Some analysts believe that there is a psychological rowing today is negative, you may find it less costly to floor' to nominal (money) wages, such that wages purchase the equipment now and pay later, than pur- are unlikely to decline even when there is consider- chase when you have the money to pay for it. In times able slack in the labour market. So they argue that of severe economic weakness, this extra spending a positive rate of inflation-preferably higher than can prove helpful to the economy 2 per cent-is needed to "grease the wheels" of the economy and encourage workers in struggling But with an inflation target of zero, the monetary industries to accept a cut in "real" (inflation-adjusted) authorities lose the option of stimulating the economy wages, rather than lose their jobs." through negative real interest rates because, in this case, real interest rates too cannot fall below zero While there is evidence of limited downward wage Preserving the policy option of negative real interest rigidity in Canada, this does not appear to have pre- rates is often cited as the main reason for having a vented labour market adjustment and to have raised positive inflation target.' the unemployment rate. In addition to the risks associated with the 2LB, the following two arguments are frequently made for not 2 Tha does not necessarily mean that observed proct would be facing, bad targeting an inflation rate closer to zero, Fot Pry would be increasing less rapidly fan Fe improvement in quaallyOverall, the massurement error In the CPI and down- ward wage rigkililes would not, by thomasives, pro- Why not a higher inflation target of 4 or 5 per cent? vide a strong argument against an Inflation target lower than 2 per cant, although they could have Impli Many of the costs of inflation stem from its unpredict- cations for how much lower the target could be. ability. If Inflation could be kept at 4 or 5 per cent. these costs might not be as great. But experience On the other hand, the recent experience in many shows that the higher inflation is, the more uncertain advanced countries, Including Canada, has made and volatile it tends to be, and the less anchored are It clear that the risks and costs associated with the people's inflation expectations. ZLB must now be taken more seriously. ZLB consid In this regard, one important question is: What would erations have shaped the Bank's perspective on the happen to the credibility that the central bank has main issues studied for the 2011 renewal of the infla- worked hard to build by keeping inflation and inflation tion-control target, including the potential net benefits expectations around 2 per cent, if the target was to the economy from an inflation target lower than raised to 4 or 5 per cent? Experience shows that 2 per cent. moderate inflation can easily creep up to become high inflation if people are afraid that if the central bank can On this score, the Bank's Latest findings suggest go from 2 to 4 per cent, why not from 4 to 6 per cent that such benefits may be greater than previously and so on. estimated, strengthening the case for a lower infla- Furthermore, if money loses 4 to 5 per cent (or more) tion target. However, research and the International of its purchasing power every year, it may become experience have also highlighted the sizable risks less effective as a unit of measurement for goods associated with the ZLB. Accordingly, the Bank has and services and as a store of value. Besides, history concluded that before the benefits of a lower infla- shows that higher inflation does not yield any lasting tion target can be confidently pursued, ways must be gains in terms of output and employment. So why not found to limit the probability of hitting the ZLB and to him for a lower inflation rate that better preserves the deal with it more effectively when this happens." value of money over time? Concerns about the ZLB have also renewed calls Finally, given the costs of inflation, it makes little from some analysts for a target higher than the 2 per sense to aim for a higher inflation rate year after year cent the Bank of Canada and other major central just so monetary policy has greater scope to use banks are currently pursuing. However, there are negative interest rates to prop the economy in case important arguments against a higher inflation target of a severe crisis, which is a rare event. This is a very costly proposition, especially since monetary policy can use other. non-baditional tools to provide stimulus in exceptional circumstances December 2011(20 points) A consumer allocates her income m = 10 between goods 1 and 2, and she considers them to be perfect substitutes: 711331.562) = 3:1 + 3:2. The price of good 2 is $1 per unit, and but the price of good 1 is 2371 per unit. That is, good 1 becomes more expensive if more of good 1 is purchased. (a) Write down an equation expressing the consumer's budget constraint. (b) Draw the budget constraint, labeling the horizontal and vertical intercepts. (0) Draw an indifference curve that passes through the budget constraint. ) ((1 Compute the optimal bundle (1:35:73) demanded by the consumer