Question 3

(b) Derive an expression for the world's relative demand Qworld,2/ Qworld,l and for world's relative supply onrld,2/onrld,l as functions of price p where Qworldj : QNJ- + Qsj is the total world consumption of good j : 1,2 and onrld,j : YNj + Ysj is its total world supply. (c) Plot the world's relative demand and supply curves derived in part (b). Put p in the yaxis, and supply and demand on the xaxis as done in class. (d) Derive the conditions under which the North and the South both specialize in the production of only one good. Interpret it economically. (e) Derive conditions under which the North has higher real wages than the South. Interpret economically. 3. Fixed vs. oating exchange rates (25 points) The recent increase in interest rate by the US Federal Reserve System sparked currency and sovereign debt crises in several developing countries. This exercise aims to describe the mechanism linking the USA policy to the crises. (a) (7 points) A developing country that pegs its currency to the US dollar. Illus trate the effect of the increase in US$ interest rate on the money and foreign exchange markets. Label the axes and curves clearly. (b) (4 points) Still in the peg, in what direction does the increase in US$ interest rate move the following variables: (i) central bank's foreign reserves, (ii) capital, (iii) output. Briey explain b.(iii) (Do not use the AA, DD curves. Just tell me what you think would happen in one or two sentences.) (c) (5 points) Use your answers to parts (a) and (b) to explain how the increase in interest rate in the USA affects the ability of the government in the devel- oping country to pay its debt. That is, indicate which variables inuence the payment of debt and in what direction. I do not need an explanation, only a list of the variables and the direction of change. (d) (4 points) Now suppose that the country does not have a peg in what direc- tion does the increase in US$ interest rate move the following variables: (i) capital, (ii) exchange rate. Specify whether capital ows into or out of the country and whether the exchange rate appreciates or depreciates. (Do not use up or down which are ambiguous terms for these variables.) (e) (5 points) How may your answer to part (d) affect the ability of the develop ing country to pay its debt? Does your answer help explain the tendency of many countries to heavily manage their currency even though they are not formally in a peg? Explain briey. 2