Question

Consider the following input-output table, please answer questions a-h. Note that a one word answer is not acceptable. For full credit, you must provide explanation for your answers and show how you arrive at them.

                             Man Hours Required to Produce Unit of Output

                                           Country A            Country B

                    Good X                5                         15

                    Good Y                1                          5

            e. Which country would prefer an international terms of trade of 5? 3? Why?

F. Let      W_A= wage rate in A in terms of A's currency

                          W_B= wage rate in B in terms of B's currency

                             R  = exchange rate defined as number of units of B's currency per unit of A's currency.

Then, in order to have balance of payments equilibrium, (W_A.R)/W_Bmust lie in some range, i.e.,  m < (W_A.R)/W_B< n.

              Determine the value of m and n.

            g. If W_A= 5, W_B= 2 and R = 3, which country will export which good?

h. Given that wages are fixed in each country at W_A= 5 and W_B= 2, what is the limit within which exchange rate can fluctuate in order for comparative advantage to

assert itself.

Answer 1

e. International Terms of Trade = Relative Price of Exports/Imports

Hence when , Country A & B trade in good X

=> Country B has to incur a cost of 15 labour hours = 15 units = Price of exports

=> Country A has to incur a cost of 5 labour hours = 5 units = Price of imports

Price of exports /Price of imports = 3 = 15/5 , hence country prefers Terms of trade =3

when , Country A & B trade in good Y

=> Country B has to incur a cost of 5 labour hours = 5 units = Price of exports

=> Country A has to incur a cost of 1 labour hours = 1 units = Price of imports

Price of exports /Price of imports = 5/1 = 5

Hence again country prefers Terms of Trade = 5 for good Y .

f.

W(a)*R/W(b) lies in a range (m,n)

R is the fixed exchange rate hence

For balance of payments :

W(a)*h1*R = W(b)*h2

h1 = labor hours in country A

h2 = labor hours in country B

Hence , W(a)*R/W(b) = h2/h1

Maximum value of h2/h1 = 15/1 = 15 = n

Minimum Value of h2/h1 = 5/5 = 1 = m

hence (m,n) = (1,15)

g.

W(a)*h1*R = W(b)*h2

5*h1*3= 2*h2

15/2 = h2/h1

hence h2 = labor hours of country B = 15

and h1 = labor hours of country A = 2

Therefore country B will export Good X (One unit = 15 hours)

and country A will export Good Y (two units = 2 hours)

h. Exchange rate can fluctuate between

5*h1*R = 2*h2

R = 2*h2/5*h1 ; h2/h1 lie between 1,15

Therefore 2*h2/5*h1 lie between 1*2/5 to 15*2/5

=> 2/5 to 6

R lies between (2/5,6)