Income Expenditure model and the IS-LM model

Part one:				Quotas are also means of restricting imports, this
1. What are the key similarities and differences				involves the action by governments whereby a
between the simple				certain level or quantity of imports is set, example a
Income Expenditure model, as represented by the				country importing freely goods from abroad may
Keynesian Cross				place a quotas that only 50 units of a good will be
Diagram or the Injections-Withdrawals diagram, and				imported and therefore reducing imports, this will
the IS-LM model?				protect the domestic producers of agricultural
How does the analysis of expansionary fiscal policy				products.
differ in the two?				The last form of restriction is through a trade ban, a
Models?				government may completely ban import of good
The income expenditure model by Keynes depicts				from abroad and this means that there will be zero
the composition of income (Y) and expenditure (E),				imports of a certain good in the economy, the other
the model states that expenditure is equal to income,				protective measure is the use of subsidies to
expenditure includes income and investment and for				farmers in the farm, subsidies means that the
this reason the model can be stated as Y = C + I +				government will spend an amount of money in order
G for a closed economy where Y is income, C is				to reduce cost of inputs example fertilizers and
consumption and I is investment and G is				seeds so that the production costs are lower then
government expenditure.				the market price.
The IS LM model depict equilibrium in the good				From the above discussion therefore it is claear that
market and the money market, the LM curve joins				agricultural countries will protect their agricultural
together points of interest rates and national income				sectors through tariffs, quaotas, ban on imports and
at which the money sector is at equilibrium, the IS				finally by subsidizing inputs and final goods produced.
curve on the hand joins together points of interest				4) Why do some of the nations that are members
rate and national income where the good market is				of the World Trade
at equilibrium.				Organization finds it worthwhile to also form regional
Similarities of the two model is that they both depict				trade blocks?
equilibrium in the commodity market, however the				Members of the World trade union will also join
difference is that the IS LM curve depict the				regional trading blocks depending on the various
equilibrium in the money market and also in the				advantages associated, countries will join trading
commodity market while the Keynes model only				blocks in order to gain regional advantages of trading,
depict equilibrium in the commodity market.				this include lower tariffs for member countries, no
Another major difference is that the Keynes theory				restrictions on imports and exports and also no
only considers the relationship of expenditure and				quotas on imports and exports in the block.
income but the IS LM depicts the relationship				By joining regional trading blocks the countries also
between investment, savings, interest rates and				find advantages in that they achieve fair trade from
income, therefore it is clear that the two theories				these blocks, fair trade involves the consideration of
have similarities and differences despite being useful				the social welfare of member country citizens and
in determining the effects of monetary and fiscal				therefore more beneficial than free trade which only
policies.				advocate for zero barriers to trade between trade
An expansionary fiscal policy:				partners.
We first discuss the effect of an expansionary policy				Trading blocks will have special treatments of
using the Keynes model, according to Keynes Y = C				member countries depending on the set policies,
+ I + G, an expansionary monetary policy will				trading blocks will lead to trade creation, trade
increase G and therefore increase Y; the following				creation involves the formation of trading blocks that
diagram explains the expansionary fiscal policy:				lead to a country to switch from a high cost import
From the above diagram an expansionary fiscal policy				source into a low cost import source, the trade
will shift the aggregate demand curve from				creation is welfare improving.
aggregate demand 1 to aggregate demand 2; this will				The world trade union may lead to trade diversion,
increase the income or output level from Y0 to Y1.				trade diversion is the occurrence where a country is
Therefore an expansionary demand curve has a				forced to import from a high cost source and
positive effect of increasing the aggregate demand				therefore it is welfare worsening, for this reason
according to Keynes.				therefore countries will form regional trade blocks to
Using the IS LM model an expansionary fiscal policy				improve this problem that worsens the welfare of a
will affect the IS curve, an increase in government				country.
spending will increase shift the IS curve upward as				From the above discussion therefore it is clear that
follows:				the world trade organization member countries will
From the chart above the IS curve shifts up [ward				form trading blocks in order to gain from the
as a result of an increase in government expenditure				advantages associated with the regional trading
or in other word expansionary fiscal policy.				blocks such as reduction of tariffs and quotas on
The main difference in the two analysis of the fiscal				export and also imports. The countries will also aim at
policy is that the Keynes model does not show the				realizing trade creation and eliminating trade diversion.
changes in interest raters as a result of increased				5) Are there any valid reasons to believe that
government expenditure while the IS LM model				primary commodities mustexperience a decline in their
shows the change in interest rate that will be				relative prices over the long run?
undertaken to cater for inflation.				Commodities produced in an economy will be
2. Explain what is meant by financial markets				produced by firms in order for them to gain profits,
equilibrium and examine the				firms will enter an industry that receives abnormal
Impact of an increase in central bank (high-powered)				profits meaning that the firms will be gaining higher
money on the				profits in the industry than other industry.
Equilibrium.				The firm therefore will make economic profits in the
Financial market equilibrium can be stated as the point				short run but in the long run this will not be the case,
where money demand by the individuals equals				as the production of primary products becomes
money supply, money demand according to Keynes				more attractive to firms then more firms join in the
include precautionary money demand, liquidity				production opf these products, competition rises in
preference demand and speculative money demand.				the industries and firms are forced to reduce the
Increasing money supply is done by the central banks				prices of these commodities. The reduction of prices
of a country and the result of increasing money				can therefore be attributed to the increased
supply is the increasing of inflationary pressure,				competition.
inflation is the persistent rise in the price of goods in				The prices will fall also becosue of the increase in
the economy for a long period of time, using the IS				supply of these commodities, as more frims joins the
LM model we can depict the result of this increase in				industry of producing primary commodities then there
money supply:				is an increase in the supply of the commodity, as a
The increase in money supply will cause the LM curve				result supply exceeds the demand level and as the
to shift downward or to the right, as a result there				law ofd demand states then the prices are expected
will be an increase in demand and therefore increased				to fall, therefore the price decline in the long run can
aggregate demand due to excess money, this will				be attributed to the increased supply level.
lead to aggregate demand exceeding the aggregate				In the short run also we expect that the primary
supply and therefore an inflationary pressure,				commodities will not have close substitutes, as more
therefore there will be an increase in inflation and				firms enter the industry more substitutes will be
good prices will rise.				introduced to the market offering competition to the
Therefore from the above diagram the equilibrium				product, for this reason therefore due the existence
point in the money market will shift, the shift will be				of substitutes to the product the price of the
at a higher output level and also at a lower interest				commodity will decline in the long run.
level according to the IS LM curve, however it should				From the above discussion therefore it is clear that
be pointed out that despite the increase in output				the price of primary commodities will decline in the
there will be an inflationary pressure ion the economy				long run, this can be explained by the increased
which will lead to increase prices in the economy, to				supply more firms into the industry and substitute
solve this problem the monetary policy makers will				products .
decide to increase interest rates or even for the				6) Has the widespread adoption of floating exchange
fiscal policy makers may reduce government				rates made the
expenditure to solve the problem of inflation.				International Monetary Fund redundant?
3. Answer both parts a and b.a. According to the				The float exchange rate regime is a situation
IS-LM model, what is the channel through				whereby the currency is allowed to fluctuate
whichcontractionary monetary policy affects the real				according to the international market, the adoption of
economy?				this regime has not made the IMF to be redundant
A contractionary monetary policy is that which				and the reason is because the organization has other
reduces money supply, the tool used here is				functions it plays in the international market, it
increasing interest rate in order to reduce money				controls trade and also plays other major roles in the
supply in an economy, the contractionary policy will				international market.
affect the LM curve which is depict the relationship				Through the wide spread of adoption of the float
between interest rates and output in the money				system the IMF has been viewed as redundant or
market. However this will still affect the real or the				repetitive in the functions it plays and the functions
commodity market as follows.				played by the float system, however by observing
When the money supply increase then there will be				the functions of the IMF this is not true because the
money circulating in the economy, as a result people				IMF plays other functions apart from control of
will have more money to spend and therefore their				exchange rates.
demand for goods and services will increase, the total				The float system is put in place by a country in order
demand by individuals in the economy is referred to				to act as a guide to the exchange rate system, the
as the aggregate demand, the total supply in the				value of a currency against another is determined by
economy is referred to as aggregate demand and				the demand and supply in the international market,
therefore as aggregate demand increases it will				the IMF have functions raging from control of trade
exceed the aggregate supply, according to the law				between countries, offering monetary support to
of demand and supply if demand exceeds supply				countries, controlling the exchange rates and also
then the price rises, for this reason therefore the				acts as a central bank to the world.
effect will be an increase in prices of good in the				For this reason therefore the wide adoption of the
entire economy.				float system by countries does not mean that the
For this reason therefore it is clear that an increase in				existence of IMF is repetitive due to the fact that
money supply will definitely affect the commodity				the IMF plays other major roles in the international
market, this will be as a result of increased demand				market and trade between countries. For this reason
for goods which will in the long run exceed the supply				therefore the adoption of the float system by
level in the economy and as a result increase the				countries doe not make the IMF irrelevant and
prices of goods in the economy.b. Use the IS-LM				therefore both the IMF and the system are relevant
model to illustrate a "policy mix" which controls				in the international markets.
(orreduces) a budget deficit without causing a sharp				7) In a world of floating exchange rates how can
contraction in realoutput.				large imbalances of tradepersist?
A policy mix is referred to as the use of both fiscal				In a floating exchange rate regime the currency of a
and monetary policies to fine tune an economy,				country is allowed to fluctuate according to the
when then government runs a budget deficit it				international market, in this regime countries gain
means that it has increased spending and therefore				advantages in that the country is less prone to
the IS curve will have to shift upwards, there is				external shocks that may lead to inflation in the
therefore a need to reduce the inflationary pressure				country, this regime is also preferred due to the
by use of a monetary policy which in this case will				reduction of effects due to reduction in the effect
reduce money supply in the economy, this reduction				caused by international business cycles.
in money supply will shift the LM curve upwards,				However this regime has a disadvantage in that unlike
however because the policy makers want to achieve				in the fixed exchange rate regime a currency is less
a higher output level then the monetary policy will				certain and greater instability of exchange rate,
only be aimed at reducing the output level by a lower				therefore in this exchange rate regime there is high
margin than return to the original output level.				speculative attacks that may lead to great losses.
The following diagram demonstrates the effect:				When a country adopts a float exchange rate regime
From the above diagram an increase in government				there may also be a problem of trade balances, this
expenditure will shift the IS curve from IS1 to IS 2,				may be as a result of prolonged depreciation of a
this will increase the output level from Y0 to Y1,				currency value in the international market leading to
however in order to reduce the effect of this policy				the problem of greater cost of imports and at the
the monetary policy will be to reduce the money				same time exports become more cheap in the
supply, a reduction in money supply will shift the LM				international market, as a result therefore the
curve from LM 1 to LM 2, the final equilibrium				problem of balance of trade occurs due to more
therefore will be the intersection of LM 2 and IS 2				imports than exports. Therefore a float exchange
and therefore our output level will be at output level				rate regime may also lead to the increased problem
Y2 which is higher than Y0 which was our original				of trade imbalances.
output level.				Therefore the adoption of a float system does not
4. Answer all parts a, b and c.a. What, according to				reduce the problem of trade balances, this is
Blanchard, are the key factors affecting				becosue the value of a currency is determined by
thedetermination of the aggregate nominal wage?				the demand and supply of the currency in the
According to Blanchard the aggregate nominal wage				market and therefore a currency can depreciate
depends on a number of factors, it depends on the				against other currencies leading to an increase in the
expected price changes, the level of unemployment				debt and trade balances problems.
in the economy and finally other factors that affect				8) If the European Union can benefit from the
the wage rate, therefore Blanchard considered				adoption of a single currency would the same be true
changes in price or inflation as one factor that affect				of the whole world?
the nominal wage and also the rate of inflation which				The adoption of the Euro in the European union has
influences the nominal wage.				led to many advantages, the euro ensures the
Blanchard stated the aggregate nominal wage				creation of an optimal currency area which helps in
function as follows:				the achievement of economic efficiency, if the whole
W = Pe F(U ,Z)				world adopted the Euro then the same advantages
Where W is the nominal wage, Pe is expected price				will still be realized.
change, U is the unemployment and Z are other				The euro also reduces the transaction cost and also
factors that affect the nominal wage.b. What is the				the risk associated with exchanging currencies, the
price-setting relation put forward by Blanchard?				cost of exchanging currency in trade is reduced and
Explainbriefly.				also the risk involved in holding other currencies that
Blanchard Having stated the nominal wage as W = Pe				may be affected by exchange rate fluctuations.
F(U ,Z) he assumed that Pe = P which means that				The disadvantages of Difference in prices among
the price is equal to the expected price change,				nations is also reduced by the Euro, the price
therefore the model can be stated as W = P F(U ,Z)				differences may have speculative attacks which may
We divide both sides by P				lead to huge losses, the adoption of the euro by
W/P = F(U ,Z) which is the wage setting relation				other countries will lead to the reduction of these
He stated that the price of good P = (1+U)W				disadvantages associated with price differences. The
Where U is the mark up which is the difference				single currency also ensures ease to trade between
between the selling and production cost				countries because it used as a currency for
Therefore if we divide both sides by W our equation				accounting in the Euro zone. Finally another advantage
will be as follows:				associated with the Euro is that there is an
P/W = (1+u)				advantage of economic stability through low inflation
Therefore when we get the inverse W/P = 1/(1+u)				and stable economy, this can be extended to the
which is the price setting relationc. How can the				other countries all over the world that adopt the
analyses in parts (a) and (b) be combined to				currency.
explainthe "natural rate of unemployment".				Therefore the Europena union requirement that new
According to Blanchard the wage setting relation and				economies should adopt the Euro is becosue the
the price setting relation determine the equilibrium				adoption of a single currency unit in accounting
rate of unemployment, the equilibrium rate of inflation				ensures efficiency in accounting and lowers the
is the natural rate of unemployment, having our two				burden of having to convert other currencies into the
equations:				Euro, there are also advantages in that the prices
W/P = F(U ,Z) which is the wage setting relation				differences of goods in the member countries is
and W/P = 1/(1+u) which is the price setting relation				reduced and that there is a reduction of speculative
the we can eliminate W/P as follows:				attacks.
F(U ,Z) = 1/(1+u)				1. Using production possibility curves demonstrate
But in this case we write the function as follows:				Ricardo's principle of comparative cost. Explain the
F(Un ,Z) = 1/(1+u)				significance of the shape of the ‘PPC's that you
Where Un is the natural rate of unemployment.				have employed.
5. Answer all parts a, b and c.a. What does the				According to Ricardo trade occurs as a result of
aggregate supply relation describe and how can it				differences in labor productivity, if we assume that
bederived?				labor is the only factor of production and that only
The aggregate supply curve depicts the equilibrium				two goods are produced i.e. good A and good B then
points of price and output in the economy in which				we can formulate the production possibility curve
both goods and services are supplied in an				using the following data from the two countries:
economy,b. What does the aggregate demand				The above table states that country 1 will produce
relation describe and how can itbe derived?				20 units of good a and 19 units of good b, country 2
The aggregate supply curve depicts the points of				will produce 15 units of good a and 18 units of good
prices and output at which there is equilibrium in the				b, for this reason therefore it is clear that country 1
goods and services demand in the economy,				has absolute advantage in production of both goods
Graphically it is derived from the IS curve and the				but it has comparative advantage in producing good
monetary policy curve, this derivation is				a, the country 2 has a less comparative disadvantage
demonstrated below:				in production of good b, therefore it would be better
The IS curve in the first diagram and the monetary				for country 1 to produce good a and then country 2
policy curve helps us to derive the aggregate				produced good b. by doing this it is evident that both
demand curve, the monetary policy curve shows				countries will gain from trading when they specialize.
actions by monetary policy makers and this curve				For both countries the production possibility curve
depict the relationship between interest rates and				will be as follows:
inflation, when inflation increases then the monetary				From the above diagram country 1 has absolute
policy makers increase interest rates and this is what				advantage in the production of both good whereby it
the monetary policy curve depict and therefore this				produces more of good A and good B than country
helps depict the aggregate demand curve.c. What is				2, however country 2 can produce more of good a
determined in the aggregate supply-aggregate				than of good b, for this reason therefore it would
demandmodel?				better produce good a and then the country 2 will
The aggregate demand aggregate supply is important				specialize in production of good b, both countries will
in determining the equilibrium output level, it also helps				gain by trading.
us to determine the equilibrium output level.				2. How are a country's ‘commodity terms of
6. Use the AS-AD model to examine the effect of a				trade' calculated?
fiscal contraction				What factors determine the terms of trade?
(without an accompanying change in monetary policy)				Terms of trade is the ratio that is determined by
in the short runand the medium run. Explain the				getting the relative price of export to the imports, it
mechanisms at work as fully aspossible and make				is a measure of social welfare of an economy that
clear how the interest rate, output, the price leveland				trades with other countries, terms of trade can be
private investment is affected by the policy change.				seen where a country gives up lesser exports for
The diagram below shows the effect of policy				imports. An example is where a country exports 100
change on the aggregate demand.				pounds worth of goods for 200 pound worth of
A contractionary fiscal policy shifts the aggregate				imports, the terms of trade for this country will be
demand curve to the left, from the above diagram if				100/200 = 0.5, for the other country the terms of
we assume that the original aggregate demand is				trade will be 200/100 =2.
aggregate demand 1 and the contractionary fiscal				Terms of trade is determined by the value of
policy shifts the aggregate demand to aggregate				exports and the value of imports, however problems
demand 2 then various changes are evident in the				arises when there are trade barriers between
economy.				countries and therefore the barriers to trade also
From the diagram the output level will decline, this is				affect the terms of trade.
signified by the decline in output from Y1 to Y2,				From the above discussion it is clear that the value
prices will also decline from P1 to P2. This happens				of exports and also the value of the imports are the
because government spending declines, when the				major determinants of the terms of trade, when the
government increases spending then consumers in				value of exports are higher than the value of imports
the economy have more to spend but in our case				then the terms of trade are greater than 1 and
the government reduces spending meaning that the				therefore favorable, however when the imports
consumers will reduce spending due to lack of excess				have a higher value than the exports then the term
funds. For this reason therefore there will be a decline				of trade is less than 1 and therefore unfavorable and
in the demand for goods in the economy and				can lead to balance of trade.
therefore the aggregate demand shifts downward.				3. Contrast the effects on income distribution,
Investment is also affected by this change in policy,				production and consumption of a good subjected to
due to low demand for goods and services in the				the imposition of a protective tariff as opposed to a
economy there will be a decline in investment.				quota.
7. What is meant by the expectations-augmented				The following diagram demonstrates the effect of a
Phillips curve and how isit related to the natural rate				tariff on imports:
of unemployment?				If we assume that the international price of a good is
The Phillips curve shows the relationship between				at p and a tariff value t is imposed on the good then
inflation and unemployment, when inflation is high				the price will rise to P+t, quantity demanded will
then the rate of unemployment is low, the				decline from q4 to q3, the area colored in the chart
augmented Phillips curve is similar to the Phillips curve				demonstrates the value of government revenue, loss
but it takes into consideration the role of				in consumer surplus and producer surplus, from the
expectations in an economy, when a monetary policy				chart government revenue is realized, a loss in
is aimed at reducing the rate of inflation then we				consumer expenditure and an increase in producer
expect the inflation to fall but due to expectations				surplus and a dead weight loss.
there will a further fall in the rate of inflation and				Quota:
therefore a shift in the Phillips curve, the diagram				A quota is a quantities protection measure whereby
below demonstrates the augmented Phillips				a government only gives a limit to how much to be
curve.from the above diagram if monetary policies				imported, the quota dies not yield revenue, it leads
are aimed at reducing inflation from Inf 1 to Inf 2				to a loss in consumer surplus, and quota holders are
then we expect unemployment to rise inflation will				the only beneficially to the protection measure.
decline from inf1 to inf 2, unemployment will increase				The diagram below shows the effect of a quota on
from U1 to U2, however due to expectations the				the demand and supply:
Philips curve will shift from Phillips curve 1 to Phillips				From the above diagram if we assume that the price
curve 2 and therefore the outcome will be a higher				of the products is the international price and that the
unemployment level U3				demand for the good is q4. The domestic production
8. What, according to Solow's model, is the				level is q1 and the total demanded is q4 and for this
determinants of economicgrowth in the long run? In				reason therefore q4 minus q1 is imported, if the
your answer, set out Solow's analysisgraphically and				government states that the import level should be at
or algebraically.				q3 then the price of the product will rise.
Robert Solow explained a situation where a country				From the above discussion therefore it is clear that a
would experience growth even if it depended on				tariff will yield revenue to the government while the
exhaustible resources, when an economy uses				quota will not yield any revenue to the government
exhaustible resources there is a high possibility that in				but the quota holders gain the process and for this
the long run the resources will be diminished and				reason the quota will lead to an unsuitable income
economic growth will not be possible, however Solow				distribution, in both cases the price will rise but in the
explained the possibility of growth despite the				quota the price rise will be determined by the
disadvantages associated with Use of exhaustible				quantity set for import while in the tariff case the
resources.				price is determined by the level of tax imposed. The
Solow stated the Cobb Douglass production function				tariff also does not restrict the quantity imported,
which he stated as follows:				more can be imported at high prices but in the case
Y = ectLgDhK1-g-h				of the quota import quantity is restricted.,
Where e is a constant				4. Explain the importance of the ‘Most Favored
C is the rate of technological change				Nation' concept for the operations of the World
T is time in years				Trade Organization.
L is labor				The most favored nation in trade refers to a
D is land				situation whereby a country awards a trade partner
K is capital				all trade advantages, it involves low tariffs on imports
Therefore according to this model production				from the awarded nation therefore that nation will
depended on the technology, time, labor, land and				have an advantage than the other countries trading
capital, further manipulation of this model was made				in the same country.
by Solow where he divided both sides of the				The importance in that the country which is awarded
equation by L which is labor, this model can therefore				the MFN will export more, the importing country will
be stated as follows:				also have a chance of getting supplies from the most
Y = ect D h K 1-g-h				efficient supplier. The award also ensures that
─── ───				imports are affordable in the importing country. The
───				awarded country will also experience economic
L L L				growth due to the increased exports.
From the above equation Solow raised four scenarios				The other importance of the most favorable nation is
which are as follows:				that a country given this award has an opportunity
One:				to grow economically, this is because the country is
If we assume that there is no technological progress				offered an opportunity to export products to a
in an economy and therefore the value of C in the				country at lower tariffs and for this reason the level
equation is 0 and that K/L remains constant and D/L				of exports increases and therefore production in the
approaches zero due to increased population				country increases and at the same time the level also
therefore increasing L then the natural resources are				improved terms of trade.
being used up and therefore Y/L approaches zero.				The term is also important in promoting trade
Two:				creation, this is to say that the country is allowed to
If D/L is declining due to population growth, then				import from low cost sources and therefore impose
there is a possibility that K/L is going up, the reason				less tariffs on imports from the country it chooses,
for this is because when we use resources then				this helps improve the welfare of its citizens.
there is capital accumulation where K is rising, for this				From the above discussion it is clear that the most
reason therefore if capital accumulation is allowed to				favorable nation award is important in the world
take place as we use up resources then there is a				trade organization, when countries join the
high possibility that Y/L is constant of even rising.				organization they are supposed to impose common
Three:				tariffs and also lower tariffs on imports from
When the population grows in a Malthusian version				member countries, however in the case where the
then the population growth will lead to a situation				country awards another country the most favored
where Y/L approaches zero, however this according				nation then the country imposes less tariffs and
to Malthus could be resolved by holding the				quotas on the goods imported from the country.
population constant and therefore K/L will increase				5. Should the formation of regional trade blocs be
without an upper bound and when this happens then				considered as favorable to thedevelopment of a
Y/L will rise.				global free trade system?
Four:				Trading blocks are important in the promotion of free
If we allow technological progress to take place				worldwide trade, this is because trading blocks evolve
where C is not zero then there is a high possibility of				from simple trade agreements to more complex and
experiencing an increase in Y/L in the long run,				free trade areas, example a few countries may
therefore technology could resolve the problem of				decide to remove tariffs on the goods imported
use of exhaustible resources where there is				from the trade partners.
population growth.				Due to the problem of protectionism through tariffs,
International economics				bans and quotas the regional blocks which are
1) Briefly explain Ricardo's principle of comparative				formed to help eliminate these barriers to trade, this
cost and consider itssignificance for a nation's choice				helps in the increase of free and fair trade in the
of international trade policy.				regions, and that the blocks are formed by trade
Ricardo derived the theory of comparative				partners this helps in the establishment of a global
advantage, according to Adam Smith countries would				free trade system.
trade due to absolute advantage, his theory was				As countries join trading blocks they move from less
based on the assumption was labor and that				complex to more complex integrations, the most
differences in labor productivity caused trade, a				common trade integration block is the preferential
country had absolute advantage if it used less units				trading agreement where the country imposes lower
of labor in the production of a certain good.				tariffs on goods from member countries, the other
In the absolute theory the analysis considered two				trade integration type is the free trade area where
goods, comparative advantage theory came up to				countries agree to impose zero tariffs on goods from
explain a situation where a country had absolute				member countries, the other is the common external
advantage in the production of two goods and still				tariffs, then the common market which involves the
gain from trading with the other country, to explain				free movement of capital and labor. And finally the
Ricardo's theory we consider country 1 and country				complete economic integration which involves the
2, also good a and good 2, this is summarized below:				countries becoming one economic and political unit,
From the above table country 2 has absolute				for this reason therefore the formation of the
advantage in the production of both good a and				trading blocks will lead to the achievements of a
good b, however it would still be profitable to trade				world wide free trade practice.
with country 1, we can state that country 2 has				6. Consider whether the US current account deficit is
comparative advantage in production of good a,				a threat to international financial stability and trade.
therefore country 2 should specialize in producing				The current account is the summation of the balance
good a and country 1 will specialize in the production				of trade, abroad factor income and transfers from
of good b. therefore both countries will gain by				abroad, therefore balance of trade is a major factor
trading.				that determine deficit in the current account.
According to the above analysis it is clear that a				US being a major economy in the world will affect
country should advocate for free trade because the				the other countries when current account deficits
both trading countries will gain by trading, despite a				occur. In the past the US economy has had an
country having absolute advantage in producing its				unsustainable current account deficit, as a result there
products over other countries it would still be				has been an increase in indebtedness of the
profitable to trade and this is explained by the				economy that affect other economies, other
comparative advantage theory by Ricardo. For this				economies are not fully paid for their exports as a
reason country should eliminate all tariffs and quotas				result of more deficits incurred by the US.
so as to gain from trading as Ricardo stated in his				To resolve the problem the US government has
comparative advantage theory.				resulted into the formulation of trade policies that
2) Comment on the view that international trade is				have helped reduce the deficit, as a result exporting
an imperfect substitute for international factor				countries to the US have experienced a reduction in
mobility.				the demand for their goods, as a result this has also
It is clear from the factor equalization theory that				resulted into problems to the US trade partners.
international trade can be a perfect substitute of				Also due to the fact that many countries have
international factor mobility, this theory states that if				pegged their currencies against the dollar, when there
factors of production cannot move freely across				is a depreciation in the dollar then the other
countries while goods can then the free movement				currencies that are pegged to the dollar will also
of good will eventually lead to factor price				depreciate against other currencies, this will lead to
equalization, this means that trade can lead to the				increased trade balances and undesirable terms of
equalization of prices of factors of production.				trade resulting to more debt problem of the
The factor equalization theory states that having				countries.
two countries whereby one country is capital				7. In what senses, if any, is the International
endowed and the other is endowed in labor then if				Monetary Fund the world's central bank?
the two countries specialize where the capital				The international monetary fund is viewed as a
endowed country produces capital intensive goods				world's central bank, this is evident from the
and the labor endowed country produces labor				functions it plays in the entire world. The central bank
intensive good then if they specialize and there is				of a country plays the function of being a lender of
free trade between the countries then this will lead				last resort, settles interbank debts, issues notes and
to a rise in factor prices, the reason for this is				coins, and holds reserves and a bank to all the other
because the labor endowed country will produce				commercial banks and also a bank to the
labor intensive goods because labor is abundant and				government.
therefore cheap, however specialization will lead to				The international monetary fund function include
increased demand for labor and therefore there will				offering funds as loan to countries , this is similar to
be a rise in price per unit labor.				the central banks of countries which lend money to
For this reason therefore international trade can be				banks. Another function that the IMF plays is the
viewed as a perfect substitute of factor mobility				monitoring of exchange rates, the central bank of a
between countries, the factor equalization theory is				country also plays a role in determining the exchange
based on the assumptions that there exist no factor				rate.
reversals meaning that if a there are those goods				The other function that is similar to that of a central
that are capital intensive and those that are labor				bank is the monitoring of trade between countries, a
intensive and no capital intensive good is produced by				central bank will settle balances between commercial
substituting capital for labour, there is a competitive				bank while for the IMF balances are settled for the
market in the good and factor market, there is full				trading countries. From the above functions therefore
employment in both countries, there arew no				it is clear that the IMF can be referred to as a
demand reversals which means that capital intensive				world's central bank, this is because it plays similar
goods producing country will import labor intensive				functions as those of a central bank of a country.
goods and that the labor intensive goods producing				8. Explain and assess the economic case for insisting
country will import capital intensive goods, the other				that all new members of the
assumption states that factors of production				European Union adopts the Euro as their currency.
cannot move freely but good can and that				The adoption of a single currency which is the Euro
production curves exhibits constant returns to scale.				lead to various advantages, the economics behind the
3) Explain the main economic instruments that				requirement that new countries joining the European
countries use to protect their agricultural sectors				union to adopt the Euro is because the Euro is used
from international competition and assess their				as a unit of accounting and therefore the ease of
relative economic efficiency.				determining trade balances between the trading
Most countries will protect their agricultural sector				partners.
from international competition through the use of				The Euro also ensures that there is a reduced risk to
trade barriers and also through subsidizing their				trade, this reduces speculative attacks in the market
production, for this reason therefore trade				and also a reduced transaction cost ensuring that low
restrictions help reduce import as from the				price of goods is traded within the European union
international market and therefore protect the				member countries. The Euro also ensures that
agricultural sector.				efficiently is achieved by the member countries and
Tariffs are forms of taxes imposed on good by the				therefore there will be an added advantage in joining
government, the government earns revenue from				the union and adopting the Euro currency.
tariffs and therefore it is beneficial, when a tariff is				The cost differences associated with trade whereby
imposed on imports their price rises and this price				in countries some goods are more expensive than in
may rise higher than the domestic price of the locally				other countries, by the adoption of the Euro in these
produced goods, this way consumers will consume				countries the price differences are reduced and
domestic products other than the imported products				therefore efficient sources are obtained improving
and therefore protect domestic production.				the welfare for all the country members.

Global Trade

Income Expenditure model and the IS-LM model