Economics Assignment: Questions and Answers

Question

Task: Question 1
Critically distinguish between the Ricardian concept of comparative advantage and the Heckscher-Ohlin model.

Question 2
Assume a two-country, two-good, two-input model. Let the countries in the model be the United States and the Rest of the World and the goods be steel and wheat. The two factors of production are capital and land. Further, the United States is capital-abundant and steel production is capital-intensive. Suppose, in the absence of trade, the United States operates at a point on its productionpossibility curve where it produces and consumes 20 units of wheat and 20 units of steel. Once it engages in free trade, the international price of one unit of steel is two units of wheat. In response to the opening of trade, the United States moves along its production-possibility curve to a new point where it produces 30 units of steel and 10 units of wheat. Is the United States better off following the opening of trade? Illustrate with a diagram and provide a clear explanation for your answer. (25 marks)

Question 3
Using the UK as an example, explain how a country that is running a deficit in its current account must ‘finance’ this deficit by borrowing from foreigners. (25 marks)

Question 4
Suppose that the three-months interest rate in New York is 5 percent and the three-months interest rate in London is 4 percent, and that the spot rate is £0.50/$ (e=d/f ) and the threemonths forward rate is £0.47/$ (eF =d/f). If UK is the domestic country, calculate the covered interest differential. On the basis of this result, which country would you expect to face capital inflows and which one would face capital outflows? Explain by referring to the relevant concepts.

Answer

Answer 1
Ricardian Model is focused on the comparative advantage. As per this model, comparative advantage is referred as the capability of a nation to manufacture a good at a less opportunity cost as compared to the other country (Kurokawa, Pang, & Tang, 2016). The opportunity cost measures the extent of every nation to give up manufacturing of one good concerning others. As per the theory of comparative advantages, two-nation would obtain mutual advantages from the business is the expertise in the manufacturing of goods for which they possess comparativeadvantage (Ethier, 2017). The theory given by the Ricardian model is based on the assumptionthat the entire world consists of two countries, each applying a single input to the manufacture of 2 goods. Further, the level of technology is fixed and labour is the only element, which is fixed and homogeneous. Further, this model states that there is no connection betweenthe level of production and cost, whichmeans cost does not change with the level of output (Gumpert, & Wink, 2020). Along with this, there is the existence of perfect competition in the market and the cost of transportation is zero. On the other hand, Heckscher-Ohlin (H-O) theory, focused on the causes or reasons of comparative advantages, which is not explained in the Ricardian model. This theory is based on the assumption that comparative advantages of the nation are founded on its endowments of factors of production (Cavusoglu, 2019). This model assumes 2*2*2 theory, that is there is two-nation, two goods, and two factors of production such as capital: rent, Labor: wages. As per this model, the level of technology does not createdifferences in countries, however, by the factors of production for which they are capable, countries may vary. Further, the H-O model argues that goods vary by the factors of production they require, which is known as Factor Intensity (Ito, Rotunno, & Vézina, 2017). Based onthe above aspect, it has been seen that H-O model differs from comparative advantage theory that emphasis on efficiency of the process of production. The reason behind the same is that nations produce the goodsbased on possession of resources that they in bulk, it would be inexpensive to manufacture these types of goods. Broadly, nations that possess more capital would produce more capital-intensive goods and on the other hand, nations that have more labour would expertise in labour-intensive goods. This nation would engage in business with each other.

Answer 2
In the present case scenario, it has been given that there are two countries namely, the United States and Rest of the World. Further, there is two costs of production such as capital and land. The United States in capital abundant country and steel is the capital intensive product. It has been seen that differences in the prices of the commodity of two nations provides the benefits of comparative advantage, and create the basis for mutually profitable trade (Zhang, 2018). Since, in this case, there are two factors of production, therefore H-O theory would be applied. As per this theory, every country has a comparative advantage in the commodity that it can manufacture as per availability of its factor intensity (Zhang, 2017). Further, the United State has the comparative advantage of steel, because it is a capital intensive product and the United States has more capital. Therefore, capital is an inexpensive factor concerning the land in the United States. On the other hand, Rest of the world possesses the comparative advantageconcerning wheat because wheat requires more land and the rest of the world possess more land as compared to the capital. In this case, by the application of H-O theory, it can be said that the United States would expertise in the production of steel and export of steel, however import of wheat. On the other hand, the rest of the world would expertise in the production of wheat and export of wheat but the import of steel.

By consideringthe above graph, it can be concluded that the United State would better off by opening up of free trade. The reason behind the same is that United States would export the steel as its production requires more capital, which is possessed by the US in abundant and inexpensive factor and on the other hand, it would import wheat as it requires more land which is a scarce and expensive factor.

Answer 3
The deficit in current account measures the trade of country where the value of the products and services of import is more than the value of the goods its export. Normally, the developing country run surpluses, while the developed country likely to run a deficit (Zhang, 2016). It cannot be said that the current account deficit is always detrimental to the interest of the economy. With this aspect, the United Kingdom, a developed countryrunning a deficit in its current account should finance its deficit by borrowing from the foreigners. International debt is referred to as the capability of the government to borrow money from outside of their nation for maintenancefor financial liquidity or economic growth. There are several benefits which can be availed by the UK by borrowing from foreigners. By this UK can access to a financial capital to fund investment, enhances its financial globalization, and encourage better macro-economic policies and regulations in the borrowing nation (Hebous, & Ruf, 2017). By borrowing from the outside nation, the UK can manage its economy only by payment of interest. Moreover, money can be borrowed from foreigners in the form of bonds, treasury securities, and some other manner. Further, international finance is not only providing benefit to the government only but also offers an advantage to companies as well as individuals. Companies can raise funds in different currencies, and this currency differential is not only lead towards for diversification of risk but also helps in lower the rate of interest in restricted international finance. It has been observed thatthe UK can achieve the advantage of increased financial globalization by borrowing money from foreigners. However, the country needs to understand the reasonable economic management in the borrowing nation. The reason behind the same is that issuing of foreign currency debt assist the government to apply better polices to confirm that its extent of sovereign risk does not prevent the issuance of debt. Apart from these, borrowing money from foreigners is considered a strong commitment mechanism. By this UK has more incentive for repayment of its loan and can create a credible or supreme relationship with its foreign investors. Along with the above aspect, cost-efficient is another benefit which can be availed by the UK by borrowings from foreigners.

Answer 4
Interest rate parity is referred to as a theory which states that difference between the rates of interest in two nations is equivalent to the difference in the forward's exchange rate and spot exchange rate. This parity takes two distinct aspects, such as uncovered interest rate parity and covered interest rate parity (Cerutti, Obstfeld, & Zhou, 2019). With this aspect, covered interest rate parity referrers as a theoretical situation in which the connection among the rate of interests and the values of currency at the spot rate and forwarding rates of two countries at an equilibrium. The covered interest rate parity condition means there is no opportunity is variable to the investor for arbitrage by forwarding contracts, which generally presents between nations with distinct interest rate.

Apart from this, inflow and outflow of capital in any country is based on the value of the currency, interest rates and some other elements. Normally, devaluation in the currency of any country is a trigger for capital flight (Levich, 2017). The reason behind the same is that foreign investors flee from that nation before the value of assets held by them would decrease. In the Asian crisis for the year 1997, this behaviour had been observed; however, investors come back to those countries before the steadiness in currency and growth of economy started. The formula for computation of covered interest rate parity -.

(1+id)=SF?(1+if)
Here,
S denotes current spotexchange rate between two currencies.
F denotes forward spot exchange rate between two currencies.
iddenotesthe rate of interest of domestic currency or the base currency
ifdenotesthe rate of interest of foreign currency or quoted currency.

In the present case, the following information is given -
Three months interest rate of US (New York) = 5%
Three months interest rate of UK (London) = 4%
Spot rate (£0.50/$) = 1$ = 0.50£ or 1 £ = 2$
Three months forward rate = £.47/$ = 1$= .47 £ or 1 £ = 2.13£
Covered interest rate parity =

.50(1+0.05*3/12) / (1+0.04*3/12)
= 0.50
Here, quoted three months forward rate = 1$ = 0.47£ or 1 £ = 2.13$
Arbitrage three months forward rate = 1$ = 0.50£ or 1 £ = 2$

Therefore, it can be said that pound is underpriced in the forward market.The reason behind the same is that it should take 0.50$ to purchase pound, but the quoted interest rate if 0.47 $ per pound. In other words, the value of Pound would depreciate, therefore for the UK, there would be capital outflow, and US would face capital inflow.

REFERENCES
Cavusoglu, N. (2019). The chain version of Heckscher-Ohlin theory correctly predicts US trade flows!. International Economics, 157, 170-178.
Cerutti, E. M., Obstfeld, M., & Zhou, H. (2019). Covered interest parity deviations: Macrofinancial determinants (No. w26129). National Bureau of Economic Research.
Ethier, W. J. (2017). The Relevance of Ricardian Trade Theory for the Political Economy of Trade Policy. In 200 Years of Ricardian Trade Theory (pp. 185-187). Springer, Cham.
Gumpert, M., & Wink, R. (2020). Ricardian model theory under different transfer forms and input factors. Economic Research-Ekonomska Istraživanja, 33(1), 579-603.
Hebous, S., & Ruf, M. (2017). Evaluating the effects of ACE systems on multinational debt financing and investment. Journal of public economics, 156, 131-149.
Ito, T., Rotunno, L., & Vézina, P. L. (2017). Heckscher–ohlin: Evidence from virtual trade in value added. Review of International Economics, 25(3), 427-446.
Kurokawa, Y., Pang, J., & Tang, Y. (2016). Exchange rate regimes and wage comovements in a Ricardian model with money. Journal of International Economics, 102, 96-109.
Levich, R. (2017). CIP: Then and Now, A Brief Survey of Measuring and Exploiting Deviations from Covered Interest Parity. In conference “CIP-RIP (pp. 22-23).

Zhang, S. (2016). Institutional arrangements and debt financing. Research in International Business and Finance, 36, 362-372.
Zhang, W. B. (2017). Multi-Regional Growth, Agglomeration and Land Values in a Generalized Heckscher-Ohlin Trade Model. Eastern European Business and Economics Journal, 3(3), 270-305.
Zhang, W. B. (2018). A Growth Theory Based on Walrasian General Equilibrium, Solow-Uzawa Growth, and Heckscher-Ohlin Trade Theories. Interdisciplinary Description of Complex Systems: INDECS, 16(3-B), 452-464.