Question

Consider the world with two countries: Country A and Country B. There are two states of the world: State 1 and State 2. In State 1, output of Country A is $100 billion, and output of Country B is $80 billion. In State 2, output of Country A is $70 billion, and output of Country B is $120 billion. Assume that the share of labor income in output is 70% for Country A and 60% for Country B, respectively.

a.)Derive the income distribution in each country in each state when there is no foreign direct investment.

b.)Consider foreign direct investment such that residents in each country hold 50% of domestic portfolio and 50% of foreign portfolio. Derive the income distribution in each country in each state in this case.

c.)Based on your answers in Parts (a) and (b), does foreign direct investment help residents in the two countries diversify income risk? Explain your reasoning.

Answer 1

a) Labour income in Country A in state 1 = 70/100 *$100= $70 billion

Labour income in Country B in state 1 = 60/100*$80= $48 billion

Labour income in Country A in state 2 = 70/100*$70= $49 billion

Labour income in Country B in state 2 = 60/100 *$120= $72 billion

b) labour income in Country A in state 1 when there is foreign direct investment (FDI) = 50/100 *($100+$80) =50/100 *$180 = $90 billion

Labour income in Country B in state 1 = 50/100 *($100+$80) = $90 billion

Labour income in Country A in state 2 when there is FDI = 50/100 *($70+$120) = $95 billion

Labour income in Country B in state 2 when there is FDI = 50/100 *($70+$120) = $95 billion

c) It is clear from case a) and case b) that foreign direct investment helps the residents of both country A and country B to diversify income risk. Their income is supposed to increase when there is FDI allowing residents of a country to invest 50% in domestic portfolio and remaining 50% in foreign portfolio.