International Trade and Finance

Absolute Advantage

Definition

A country has an absolute advantage in producing a good if it can produce more of that good with the same amount of resources, or use fewer resources to produce the same amount, compared to another country.

Example

Country	Rice (units/labour hour)	Cloth (units/labour hour)
Country A	10	5
Country B	4	8

Country A has an absolute advantage in producing rice (10 > 4). Country B has an absolute advantage in producing cloth (8 > 5).

Limitation

Absolute advantage alone does not explain why trade occurs between countries where one country has an absolute advantage in ALL goods. For that, we need comparative advantage.

---

Comparative Advantage

Definition

A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than another country. This is the basis for mutually beneficial trade.

The Principle of Comparative Advantage (Ricardo)

Even if one country has an absolute advantage in all goods, both countries can still benefit from trade if they specialise according to their comparative advantage. A country should specialise in and export the good in which it has a lower opportunity cost, and import the good in which it has a higher opportunity cost.

Example

Country	Rice (units/labour hour)	Cloth (units/labour hour)
Country A	10	5
Country B	4	8

Opportunity costs:

Country A:

• Opportunity cost of 1 unit of rice = 5/10 = 0.5 units of cloth
• Opportunity cost of 1 unit of cloth = 10/5 = 2 units of rice

Country B:

• Opportunity cost of 1 unit of rice = 8/4 = 2 units of cloth
• Opportunity cost of 1 unit of cloth = 4/8 = 0.5 units of rice

Comparative advantage:

• Country A has a lower opportunity cost in producing rice (0.5 < 2). A has a comparative advantage in rice.
• Country B has a lower opportunity cost in producing cloth (0.5 < 2). B has a comparative advantage in cloth.

Result: Country A should specialise in rice and export it. Country B should specialise in cloth and export it. Both countries benefit from trade.

Gains from Trade

Before trade (autarky), if each country splits labour equally:

Country A (10 hours total, 5 hours each):

• Rice: $5 \times 10 = 50$ units
• Cloth: $5 \times 5 = 25$ units

Country B (10 hours total, 5 hours each):

• Rice: $5 \times 4 = 20$ units
• Cloth: $5 \times 8 = 40$ units

World total: Rice = 70, Cloth = 65

After specialisation (each country devotes all labour to its comparative advantage good):

Country A (10 hours on rice): Rice = $10 \times 10 = 100$ units Country B (10 hours on cloth): Cloth = $10 \times 8 = 80$ units

World total: Rice = 100, Cloth = 80

Specialisation increases total world output by 30 units of rice and 15 units of cloth. Both countries can trade and be better off than before.

Worked Example: Calculating Gains from Trade

Country X can produce either 80 tonnes of wheat or 40 tonnes of silk. Country Y can produce either 40 tonnes of wheat or 80 tonnes of silk.

Opportunity costs:

Country X: 1 wheat = 40/80 = 0.5 silk; 1 silk = 80/40 = 2 wheat.

Country Y: 1 wheat = 80/40 = 2 silk; 1 silk = 40/80 = 0.5 wheat.

X has comparative advantage in wheat (0.5 silk vs 2 silk). Y has comparative advantage in silk.

If each specialises fully: X produces 80 wheat, 0 silk. Y produces 0 wheat, 80 silk. Total: 80 wheat, 80 silk.

If they trade at 1 wheat = 1 silk (between 0.5 and 2), and X exports 30 wheat for 30 silk:

X ends up with: 50 wheat, 30 silk. Before (half resources each): 40 wheat, 20 silk. Gains: +10 wheat, +10 silk.

Y ends up with: 30 wheat, 50 silk. Before: 20 wheat, 40 silk. Gains: +10 wheat, +10 silk.

Both countries gain from trade.

Conditions for Comparative Advantage

Comparative advantage arises from differences between countries in:

1. Factor endowments: Different countries have different quantities and qualities of factors of production (land, labour, capital) 2. Technology: Different production technologies and productivity levels 3. Climate and natural resources: Agricultural and mineral-based comparative advantages 4. Human capital: Education, skills, and training levels 5. Institutions: Legal systems, property rights, infrastructure

---

Terms of Trade

Definition

The terms of trade (TOT) is the ratio of a country's export prices to its import prices. It measures how many units of imports a country can buy with one unit of exports.

$\mathrm{Terms of Trade} = \frac{\mathrm{Index of Export Prices}}{\mathrm{Index of Import Prices}} \times 100$

Interpretation

Terms of Trade	Interpretation
Improving (rising)	A country can buy more imports for the same quantity of exports. Its purchasing power in international trade has increased.
Deteriorating (falling)	A country must export more to buy the same quantity of imports. Its purchasing power has decreased.

Example

If the export price index is 120 and the import price index is 100:

$\mathrm{TOT} = \frac{120}{100} \times 100 = 120$

A TOT of 120 means the country can buy 20% more imports per unit of exports compared to the base year.

Factors Affecting Terms of Trade

- Improving TOT: Rising export prices, falling import prices, currency appreciation, higher demand for exports, technological improvements in export industries - Deteriorating TOT: Falling export prices, rising import prices, currency depreciation, lower demand for exports, rising costs of imported raw materials

Limitations of Terms of Trade

- A deteriorating TOT does not necessarily mean a country is worse off -- it could reflect increased export volumes (the country is exporting more, even at lower prices) - TOT only measures price changes, not volume changes - Does not account for changes in the quality of goods traded

---

Trade Barriers

Tariffs

A tariff is a tax imposed on imported goods. It raises the domestic price of the imported good, making it less competitive compared to domestically produced goods.

Effects of a tariff:

1. The domestic price of the imported good increases (by the amount of the tariff) 2. The quantity of imports decreases (consumers buy less of the more expensive import) 3. Domestic producers benefit (they face less competition and can sell more at a higher price) 4. Domestic consumers lose (they pay higher prices and have less choice) 5. Government gains tariff revenue 6. There is a deadweight loss (net loss to society) due to inefficient resource allocation

Deadweight loss of a tariff:

$\mathrm{DWL} = \mathrm{Loss in consumer surplus} - \mathrm{Gain in producer surplus} - \mathrm{Tariff revenue}$

Worked Example: Tariff Deadweight Loss

A small country imports Good T at a world price of USD 20. At P = 20, domestic demand is 500 units and domestic supply is 200 units. A tariff of USD 5 per unit is imposed. At P = 25, domestic demand falls to 450 and domestic supply rises to 250.

Imports before tariff: 500 - 200 = 300. Imports after tariff: 450 - 250 = 200.

Tariff revenue: 5 \times 200 = 1000.

DWL_{consumption} = 0.5 \times 50 \times 5 = 125 (triangle from reduced consumption). DWL_{production} = 0.5 \times 50 \times 5 = 125 (triangle from inefficient domestic production). Total DWL = 250.

Quotas

A quota is a quantitative restriction on the volume or value of imports. It sets a maximum limit on the quantity of a good that can be imported during a given period.

Effects of a quota:

1. The domestic price of the imported good increases (supply is restricted) 2. The quantity of imports is limited to the quota 3. Domestic producers benefit (less competition, higher prices) 4. Domestic consumers lose (higher prices, less choice) 5. Unlike tariffs, the government does NOT necessarily gain revenue (the quota rent may go to foreign producers or importers who hold the quota licences)

Subsidies

A subsidy is a payment by the government to domestic producers, lowering their costs of production and allowing them to sell at a lower price.

Effects of a subsidy:

1. Domestic production increases (lower costs encourage more output) 2. The domestic price may decrease 3. Imports decrease (domestic goods become more competitive) 4. Domestic consumers benefit (lower prices) 5. Government incurs a cost (taxpayers bear the burden of the subsidy) 6. May be considered unfair by trading partners (can lead to trade disputes)

Comparison of Trade Barriers

Feature	Tariff	Quota	Subsidy
Form	Tax on imports	Limit on import quantity	Payment to domestic producers
Effect on price	Raises domestic price	Raises domestic price	Lowers domestic price
Government revenue	Yes (tax revenue)	No (unless quota licences sold)	No (government pays)
Effect on imports	Reduces imports	Fixes maximum imports	Reduces imports
Effect on domestic output	Increases	Increases	Increases
Consumer effect	Higher prices, less choice	Higher prices, less choice	Lower prices
Producer effect	Protected from foreign competition	Protected from foreign competition	Supported financially

---

Arguments For and Against Free Trade

Arguments For Free Trade

1. Comparative advantage: Trade allows countries to specialise according to comparative advantage, increasing total world output and welfare 2. Lower prices for consumers: Increased competition from imports leads to lower prices and greater variety 3. Economies of scale: Access to larger international markets allows firms to produce on a larger scale, reducing average costs 4. Increased competition: Domestic firms must become more efficient to compete with foreign firms 5. Transfer of technology: Trade facilitates the spread of technology and knowledge between countries 6. Economic growth: Export-oriented growth has been a key driver of economic development (e.g., East Asian economies) 7. Consumer choice: Consumers have access to a wider range of goods and services 8. Peace and cooperation: Economic interdependence reduces the likelihood of conflict between nations

Arguments Against Free Trade (Protectionism)

1. Infant industry argument: New industries in developing countries need temporary protection from established foreign competitors until they become efficient enough to compete internationally 2. Strategic industries: Some industries (defence, energy) are strategically important and should be protected for national security reasons 3. Anti-dumping: Protection is needed to prevent foreign firms from "dumping" goods below cost to drive domestic producers out of business 4. Employment protection: Free trade can lead to job losses in industries that cannot compete with cheaper imports 5. Balance of payments: Restricting imports can help correct a persistent current account deficit 6. Protecting domestic culture and identity: Some argue that trade can erode cultural identity (e.g., local food, media) 7. Revenue: Tariffs can be a source of government revenue (important for developing countries with limited tax systems)

Criticisms of Protectionism

- Retaliation: Protectionist measures often trigger retaliatory tariffs from trading partners, leading to trade wars (e.g., US-China trade tensions) - Higher prices: Consumers pay more for protected goods - Inefficiency: Protection shields domestic firms from competition, reducing their incentive to improve efficiency - Misallocation of resources: Resources are diverted to protected (inefficient) industries away from efficient industries - Higher cost of inputs: Tariffs on imported raw materials raise production costs for domestic industries that use those inputs

---

Balance of Payments

Definition

The balance of payments (BOP) is a systematic record of all economic transactions between the residents of one country and the rest of the world during a given period (usually one year).

Structure of the Balance of Payments

The BOP consists of three main accounts:

1. Current Account

The current account records trade in goods and services, income flows, and current transfers.

Component	Description
Trade in goods (visible trade)	Exports minus imports of physical goods
Trade in services (invisible trade)	Exports minus imports of services (e.g., banking, tourism, transport)
Primary income	Income from investments abroad minus income paid to foreign investors (e.g., dividends, interest)
Secondary income (current transfers)	One-way transfers with nothing received in return (e.g., remittances, foreign aid)

$\mathrm{Current Account Balance} = \mathrm{(X - M)}_{\mathrm{goods}} + \mathrm{(X - M)}_{\mathrm{services}} + \mathrm{Primary Income} + \mathrm{Secondary Income}$

Current account surplus: When credits (inflows) exceed debits (outflows). The country is earning more from abroad than it is spending.

Current account deficit: When debits exceed credits. The country is spending more abroad than it is earning.

2. Capital Account

The capital account records capital transfers and the acquisition/disposal of non-produced, non-financial assets (e.g., patents, copyrights, land). This account is typically small.

3. Financial Account

The financial account records cross-border investments in financial assets.

Component	Description
Direct investment	Long-term investment in enterprises (e.g., FDI -- setting up factories abroad)
Portfolio investment	Investment in shares, bonds, and other securities
Other investment	Trade credits, loans, currency and deposits
Reserve assets	Changes in the country's official foreign exchange reserves held by the central bank

BOP Identity

The balance of payments must always balance (sum to zero):

$\mathrm{Current Account} + \mathrm{Capital Account} + \mathrm{Financial Account} = 0$

If the current account is in deficit, the capital and financial accounts must be in surplus by an equal amount (and vice versa).

Hong Kong's Balance of Payments

Hong Kong typically runs a current account surplus because:

- Strong export of services (financial services, trade logistics, tourism, professional services) - Large net investment income from abroad (Hong Kong is a major international investor) - The current account surplus is offset by financial account outflows (Hong Kong residents investing abroad)

---

Exchange Rates

Definition

The exchange rate is the price of one currency in terms of another. It determines how much of one currency is needed to buy one unit of another currency.

Types of Exchange Rate Systems

Fixed Exchange Rate

The exchange rate is set and maintained at a predetermined level by the central bank or government.

- The central bank intervenes in the foreign exchange market to maintain the rate - Requires large foreign exchange reserves - Hong Kong operates a linked exchange rate system (fixed to the USD at ~7.8)

Floating Exchange Rate

The exchange rate is determined by market forces of supply and demand for the currency, with no (or minimal) government intervention.

- The exchange rate fluctuates freely based on changes in demand and supply - No need for large foreign exchange reserves - Most major currencies (USD, EUR, JPY) float freely (or managed float)

Managed Float (Dirty Float)

The exchange rate is primarily determined by market forces, but the central bank occasionally intervenes to smooth out excessive fluctuations or achieve policy objectives.

Depreciation and Appreciation

Depreciation: A decrease in the value of a currency relative to another currency (under a floating exchange rate system). More domestic currency is needed to buy one unit of foreign currency.

Appreciation: An increase in the value of a currency relative to another currency (under a floating exchange rate system). Less domestic currency is needed to buy one unit of foreign currency.

Under a fixed exchange rate system, the equivalent terms are devaluation (downward adjustment of the fixed rate) and revaluation (upward adjustment of the fixed rate).

Causes of Exchange Rate Changes (Floating System)

Factors causing DEPRECIATION of a currency:

Factor	Mechanism
Higher inflation	Domestic goods become relatively more expensive; demand for exports falls; demand for imports rises; demand for domestic currency falls
Lower interest rates	Capital flows out to countries with higher returns; demand for domestic currency falls
Current account deficit	More imports than exports; net selling of domestic currency to buy foreign currency
Increased money supply	More currency in circulation reduces its value
Lower economic growth	Less attractive for foreign investment; lower demand for currency
Speculation	If traders expect depreciation, they sell the currency, causing it to depreciate (self-fulfilling)

Factors causing APPRECIATION of a currency:

The reverse of the above factors.

Effects of Exchange Rate Changes

Effects of DEPRECIATION:

Effect	Explanation
Exports become cheaper	Foreign buyers need less of their currency to buy domestic goods; export demand increases
Imports become more expensive	Domestic consumers need more domestic currency to buy foreign goods; import demand decreases
Current account may improve	Higher export revenue and lower import spending (if the Marshall-Lerner condition holds)
Imported inflation	More expensive imports raise the cost of imported raw materials and consumer goods
Foreign debt becomes more expensive	If debt is denominated in foreign currency, more domestic currency is needed to repay

Effects of APPRECIATION:

The reverse of the above effects.

The J-Curve Effect

When a currency depreciates, the current account may initially WORSEN before improving. This is because:

1. In the short run, import and export quantities are relatively fixed (inelastic demand) 2. The price effect dominates: imports cost more (worsening the trade balance) while export volumes have not yet increased enough to offset this 3. Over time, quantities adjust (demand becomes more elastic): export volumes rise and import volumes fall, improving the trade balance

The path of the current account balance looks like the letter "J" -- hence the name.

Marshall-Lerner Condition

The Marshall-Lerner condition states that a currency depreciation will improve the current account balance only if the sum of the price elasticities of demand for exports and imports is greater than 1:

$|\varepsilon_X| + |\varepsilon_M| \gt 1$

Where:

- $\varepsilon_X$ = price elasticity of demand for exports - $\varepsilon_M$ = price elasticity of demand for imports

If this condition is satisfied, the quantity effect of a depreciation (more exports sold, fewer imports bought) outweighs the price effect (lower export prices, higher import prices), and the trade balance improves.

---

Effects of Exchange Rate Changes on the Hong Kong Economy

Since Hong Kong operates a linked exchange rate system (pegged to the USD at ~7.8), the HKD appreciates or depreciates together with the USD.

When the USD/HKD Appreciates

Effect	Impact on Hong Kong Economy
Exports become more expensive	Hong Kong's exports (goods and services) become more expensive for foreign buyers; export demand falls; tourism from abroad decreases
Imports become cheaper	Imports become cheaper; cost of imported raw materials and consumer goods decreases
Inflation	Lower imported inflation; overall inflation rate tends to decrease
Tourism	Fewer tourists (Hong Kong becomes more expensive for visitors); tourism revenue falls
Investment	Foreign investment may decrease (higher costs); outward investment may increase (cheaper to invest abroad)
Current account	May deteriorate (lower export revenue, though import costs also fall)

When the USD/HKD Depreciates

The reverse effects: exports become cheaper (boosting export demand and tourism), imports become more expensive (increasing costs and imported inflation), and the current account may improve.

---

Trade Dependency

Definition

Trade dependency measures the degree to which a country's economy relies on international trade. It is typically measured as:

$\mathrm{Trade Dependency Ratio} = \frac{\mathrm{Total Trade (Exports + Imports)}}{\mathrm{GDP}} \times 100\%$

Hong Kong's Trade Dependency

Hong Kong is one of the most trade-dependent economies in the world, with a trade-to-GDP ratio exceeding 300%. This reflects:

- Re-export trade: Hong Kong imports goods, adds value (logistics, packaging, marketing), and re-exports them, mainly to and from mainland China - Small domestic market: Limited domestic demand means firms must look to international markets - Strategic location: Natural deep-water harbour and proximity to mainland China - Free port: No tariffs on imports or exports - Simple tax system and minimal trade barriers

Advantages of High Trade Dependency

- Access to large international markets allows economies of scale - Exposure to international competition drives efficiency and innovation - Technology transfer through trade and foreign investment - Diversified sources of goods and services - Economic growth driven by export demand

Disadvantages of High Trade Dependency

- Vulnerability to external shocks (e.g., global recession, trade wars, pandemics) - Dependence on the economic health of trading partners (especially China for Hong Kong) - Exposure to exchange rate fluctuations (mitigated by the linked exchange rate in HK's case) - Potential for structural unemployment if export industries decline

---

Common Pitfalls

1. Confusing absolute and comparative advantage: Absolute advantage is about who can produce MORE (absolute productivity). Comparative advantage is about who has a LOWER OPPORTUNITY COST. Trade is based on comparative advantage, not absolute advantage.

2. Forgetting that comparative advantage requires different opportunity costs: If two countries have the same opportunity costs for both goods, neither has a comparative advantage, and there are no gains from specialisation and trade.

3. Confusing the balance of payments with the current account: The balance of payments includes the current account, capital account, AND financial account. The BOP always balances (sums to zero). A current account deficit is offset by a capital/financial account surplus.

4. Saying a BOP deficit is always bad: A current account deficit is not inherently bad. It may reflect strong domestic investment (importing capital goods for future growth) or strong consumer demand. The composition of the deficit matters.

5. Confusing depreciation and devaluation: Depreciation occurs under a FLOATING exchange rate (market-driven). Devaluation occurs under a FIXED exchange rate (government/central bank decision).

6. Stating that depreciation always improves the current account: This is only true if the Marshall-Lerner condition is satisfied (sum of elasticities > 1). In the short run, depreciation may worsen the current account (J-curve effect).

7. Confusing terms of trade with balance of trade: Terms of trade measures the RATIO of export prices to import prices (a price index). Balance of trade measures the DIFFERENCE between export revenue and import spending (a monetary value).

8. Assuming Hong Kong has a flexible exchange rate: Hong Kong has a FIXED linked exchange rate to the USD. The HKD does not float freely. The HKMA intervenes to maintain the peg.

9. Ignoring the J-curve effect: When analysing the effect of a depreciation on the current account, remember the short-run vs long-run distinction. The current account may worsen before it improves.

10. Confusing quotas and tariffs: A tariff raises revenue for the government. A quota does NOT necessarily raise government revenue (the quota rent may go to foreign producers). Both restrict imports, but they work differently.

---

Practice Problems

Question 1: Comparative Advantage

Country X can produce either 60 units of wheat or 30 units of cloth with all its resources. Country Y can produce either 40 units of wheat or 40 units of cloth.

(a) Which country has an absolute advantage in wheat? In cloth? (b) Calculate the opportunity cost of producing each good in each country. (c) Which country has a comparative advantage in wheat? In cloth? (d) If they specialise and trade at an exchange rate of 1 wheat = 1.2 cloth, show that both countries gain from trade.

(a) Wheat: Country X produces 60 units vs Country Y's 40 units. X has an absolute advantage in wheat.

Cloth: Country X produces 30 units vs Country Y's 40 units. Y has an absolute advantage in cloth.

(b) Opportunity costs:

Country X:

- 1 wheat = 30/60 = 0.5 cloth - 1 cloth = 60/30 = 2 wheat

Country Y:

- 1 wheat = 40/40 = 1 cloth - 1 cloth = 40/40 = 1 wheat

(c) Comparative advantage:

- Wheat: Country X has lower opportunity cost (0.5 cloth < 1 cloth). X has a comparative advantage in wheat. - Cloth: Country Y has lower opportunity cost (1 wheat < 2 wheat). Y has a comparative advantage in cloth.

(d) Gains from trade:

Before trade, if each country spends half its resources on each good:

Country X: 30 wheat + 15 cloth Country Y: 20 wheat + 20 cloth

After specialisation:

- Country X produces only wheat: 60 wheat, 0 cloth - Country Y produces only cloth: 0 wheat, 40 cloth

If X exports 20 wheat to Y at the rate 1 wheat = 1.2 cloth:

- X receives: $20 \times 1.2 = 24$ cloth from Y - X ends up with: $60 - 20 = 40$ wheat and $0 + 24 = 24$ cloth - Y ends up with: $0 + 20 = 20$ wheat and $40 - 24 = 16$ cloth

Comparison:

Country	Before Trade (Wheat, Cloth)	After Trade (Wheat, Cloth)	Gains
X	30, 15	40, 24	+10 wheat, +9 cloth
Y	20, 20	20, 16	0 wheat, -4 cloth

Wait -- Country Y is worse off. Let me recalculate with a different exchange rate.

Let me try 1 wheat = 0.8 cloth.

X exports 20 wheat to Y at rate 1 wheat = 0.8 cloth:

- X receives $20 \times 0.8 = 16$ cloth - X: 40 wheat, 16 cloth (was 30, 15; gains: +10 wheat, +1 cloth) - Y: 20 wheat, 24 cloth (was 20, 20; gains: 0 wheat, +4 cloth)

Now both countries gain. The exchange rate must be between the two opportunity costs: between 0.5 (X's cost of wheat in terms of cloth) and 1 (Y's cost of wheat in terms of cloth). Any exchange rate where $0.5 \lt \mathrm{exchange rate} \lt 1$ will benefit both countries.

Question 2: Tariff Analysis

A small country imports Good Z. The world price is USD 10 per unit. At this price, domestic demand is 1,000 units and domestic supply is 400 units. The government imposes a tariff of USD 2 per unit. At the new price of USD 12, domestic demand falls to 900 units and domestic supply rises to 500 units.

(a) Calculate the change in the quantity of imports. (b) Calculate the tariff revenue collected by the government. (c) Calculate the deadweight loss from the tariff.

(a) Before tariff: Imports = Domestic demand - Domestic supply = 1,000 - 400 = 600 units

After tariff: Imports = 900 - 500 = 400 units

Change in imports = 400 - 600 = -200 units (imports decrease by 200 units)

(b) Tariff revenue = Tariff per unit x Quantity of imports after tariff = $2 \times 400 =$800

(c) Deadweight loss consists of two components:

DWL from consumption distortion (consumption side): This is the loss in consumer surplus due to reduced consumption. Triangle with base = 100 units (consumption falls from 1,000 to 900) and height = USD 2 (the tariff). $\mathrm{DWL}_{\mathrm{consumption}} = \frac{1}{2} \times 100 \times 2 = 100$

DWL from production distortion (production side): This is the loss due to inefficient domestic production (resources diverted from more efficient uses). Triangle with base = 100 units (domestic production rises from 400 to 500) and height = USD 2. $\mathrm{DWL}_{\mathrm{production}} = \frac{1}{2} \times 100 \times 2 = 100$

Total DWL = $100 + 100 = 200$

The deadweight loss of the tariff is USD 200.

Question 3: Balance of Payments

Country Z has the following transactions in a year (all values in USD million):

- Exports of goods: 500 - Imports of goods: 700 - Exports of services: 300 - Imports of services: 200 - Income received from abroad: 150 - Income paid abroad: 100 - Current transfers received: 50 - Current transfers paid: 80

(a) Calculate the current account balance. (b) Is there a surplus or deficit? What does this imply about the capital and financial accounts?

(a) Current Account = Trade in goods + Trade in services + Primary income + Secondary income

Trade in goods = 500 - 700 = -200 (deficit) Trade in services = 300 - 200 = +100 (surplus) Primary income = 150 - 100 = +50 (surplus) Secondary income = 50 - 80 = -30 (deficit)

Current Account Balance = $-200 + 100 + 50 - 30 = -80$

(b) The current account has a deficit of USD 80 million. This means the country is spending more on imports, income payments, and transfers than it is earning from exports, income receipts, and transfers.

By the BOP identity: Current Account + Capital Account + Financial Account = 0

If the capital account is small (say, approximately zero), then:

Financial Account = +80 million (surplus)

This means the country must be receiving net financial inflows of USD 80 million -- either through borrowing from abroad, selling assets to foreigners, or using its foreign exchange reserves. A current account deficit is financed by a corresponding surplus in the financial account.

Question 4: Exchange Rate Effects

The exchange rate between the Euro (EUR) and USD changes from 1 EUR = 1.20 USD to 1 EUR = 1.35 USD.

(a) Has the EUR appreciated or depreciated against the USD? By what percentage? (b) What is the effect on Eurozone exports to the US? Explain. (c) What is the effect on the Eurozone current account? Explain.

(a) The EUR has APPRECIATED against the USD. Previously, 1 EUR bought 1.20 USD; now it buys 1.35 USD. The EUR can buy more USD, so it has appreciated.

Percentage change = $(1.35 - 1.20) / 1.20 \times 100\% = 0.15 / 1.20 \times 100\% = 12.5\%$

The EUR has appreciated by 12.5% against the USD.

(b) Eurozone exports to the US become MORE EXPENSIVE. A European good that cost EUR 100 previously cost a US buyer $100 \times 1.20 =$120. After the appreciation, it costs $100 \times 1.35 =$135. US consumers will buy fewer European goods (quantity demanded falls along the demand curve), so Eurozone export volumes and revenue to the US are likely to decrease.

(c) The Eurozone current account is likely to DETERIORATE (at least initially):

- Exports become more expensive for foreign buyers, reducing export revenue - Imports from the US become cheaper for Eurozone consumers, increasing import spending - Both effects reduce the trade surplus (or increase the trade deficit)

However, the full effect depends on the Marshall-Lerner condition. In the short run, demand for exports and imports may be relatively inelastic, so the current account may worsen significantly. In the long run, quantities adjust and the effect may be less severe. There may also be a J-curve effect.

Question 5: Terms of Trade

A country's export price index rises from 100 to 120, while its import price index rises from 100 to 110.

(a) Calculate the initial and new terms of trade. (b) Has the terms of trade improved or deteriorated? (c) Explain whether the country is necessarily better off.

(a) Initial TOT = $100 / 100 \times 100 = 100$

New TOT = $120 / 110 \times 100 = 109.09$

(b) The terms of trade have IMPROVED from 100 to 109.09. The country can now buy approximately 9% more imports for the same quantity of exports compared to the base period.

(c) The country is NOT necessarily better off. While the terms of trade have improved (higher export prices relative to import prices), this improvement could be caused by:

1. Reduced export volumes: If export prices rose because the country is supplying less (due to supply constraints), the total export revenue could fall despite higher prices. The country earns more per unit but sells fewer units.

2. Higher import costs: Although import prices rose less than export prices, the country still faces higher import costs. If the country imports essential goods (e.g., oil), the higher costs could harm domestic industries and consumers.

3. Elasticities of demand: If foreign demand for the country's exports is elastic, higher export prices lead to a proportionally larger drop in export volumes, reducing total export revenue.

The terms of trade only measures the price ratio. To determine if the country is truly better off, we need to look at the VOLUME of trade as well (trade volumes and the trade balance).

Question 6: Hong Kong's Trade and Exchange Rate

Explain how a significant depreciation of the Chinese yuan (CNY) against the USD (and therefore against the HKD) would affect the Hong Kong economy.

Since the HKD is pegged to the USD, a depreciation of the CNY against the USD means the CNY also depreciates against the HKD.

Effects on Hong Kong:

1. Exports to mainland China become more expensive: Chinese consumers need more CNY to buy HKD goods and services. Hong Kong's export volumes to China are likely to decrease, reducing export revenue from Hong Kong's largest trading partner.

2. Imports from mainland China become cheaper: Hong Kong consumers and firms can buy Chinese goods and services at lower HKD prices. This reduces the cost of imported goods (including food, consumer products, and raw materials), benefiting consumers and firms that use Chinese inputs.

3. Tourism: Hong Kong becomes more expensive for mainland Chinese tourists. Fewer mainland tourists visit Hong Kong, reducing tourism revenue (a significant component of Hong Kong's service exports). Conversely, Hong Kong residents may travel more to mainland China (it is cheaper for them).

4. Inflation: Cheaper imports from China put downward pressure on prices in Hong Kong, contributing to lower inflation. This benefits consumers but may reduce profit margins for Hong Kong retailers.

5. Re-exports: Since much of Hong Kong's trade involves re-exports to and from China, a weaker CNY could reduce re-export volumes (as Chinese demand for goods via Hong Kong decreases).

6. Current account: The net effect on the current account is ambiguous. The current account could deteriorate due to lower export and tourism revenue, but the import side also changes. The overall effect depends on the elasticities of demand for Hong Kong's exports and imports.

7. Employment: Sectors reliant on exports to China and mainland tourism (retail, hospitality) may face job losses. Sectors that import from China or serve mainland tourists visiting less (manufacturing) may benefit from lower costs.

Question 7: Trade Policy Evaluation

The government of a developing country is considering imposing a tariff on imported steel to protect its domestic steel industry. Discuss the economic arguments for and against this policy.

Arguments for the tariff:

1. Infant industry protection: The domestic steel industry may be in its early stages and unable to compete with established foreign producers who benefit from economies of scale. Temporary protection could allow the domestic industry to grow and achieve competitiveness.

2. Employment: The steel industry may be a major employer. Without protection, cheap imports could force domestic steel firms out of business, causing significant job losses and associated social problems.

3. National security: Steel is a critical input for defence, infrastructure, and construction. A country that relies entirely on imported steel may be vulnerable during international conflicts or supply disruptions.

4. Balance of payments: Reducing steel imports would reduce the country's import bill, helping to correct a current account deficit.

5. Anti-dumping: If foreign steel producers are selling below cost (dumping), a tariff can prevent them from driving domestic producers out of business.

Arguments against the tariff:

1. Higher prices for consumers and downstream industries: The tariff raises the domestic price of steel. Industries that use steel as an input (construction, automotive, manufacturing) face higher production costs, making their products less competitive. Consumers ultimately pay higher prices.

2. Deadweight loss: The tariff creates a deadweight loss -- the loss in consumer surplus exceeds the gain in producer surplus and government revenue. Resources are misallocated towards less efficient domestic steel production.

3. Retaliation: Trading partners may retaliate with tariffs on the country's exports, potentially triggering a trade war that harms other export-oriented industries.

4. Reduced efficiency: Protection shields domestic steel producers from international competition, reducing their incentive to improve efficiency, innovate, or reduce costs. In the long run, the industry may remain uncompetitive.

5. Higher cost of infrastructure: If the government is building infrastructure (roads, bridges, buildings), higher steel prices increase the cost of public projects, burdening taxpayers.

6. Income distribution effects: The tariff benefits a relatively small number of steel producers and workers, while the costs are spread across the entire population (higher consumer prices). This may worsen income inequality.

Question 8: Marshall-Lerner Condition

The price elasticity of demand for a country's exports is 0.6, and the price elasticity of demand for its imports is 0.3.

(a) Does the Marshall-Lerner condition hold? Will a depreciation of the currency improve or worsen the current account?

(b) If the price elasticity of demand for imports were 0.8 instead, what would the answer be?

(a) Marshall-Lerner condition: $|\varepsilon_X| + |\varepsilon_M| \gt 1$

$|0.6| + |0.3| = 0.9$

Since $0.9 \lt 1$, the Marshall-Lerner condition is NOT satisfied. A depreciation of the currency would WORSEN the current account. The quantity effect (increased export volumes and decreased import volumes) is smaller than the price effect (lower export prices and higher import prices), so the trade balance deteriorates.

(b) With $\varepsilon_M = 0.8$:

$|0.6| + |0.8| = 1.4$

Since $1.4 \gt 1$, the Marshall-Lerner condition IS satisfied. A depreciation would IMPROVE the current account. The quantity effect now outweighs the price effect, and the trade balance improves.

Question 9: Current Account and Financial Account

A country has the following BOP data (in USD billion):

- Exports of goods: 400 - Imports of goods: 500 - Exports of services: 200 - Imports of services: 150 - Net primary income: +30 (net inflow) - Net secondary income: -20 (net outflow) - Net financial account (excluding reserves): +60 (net inflow)

(a) Calculate the current account balance. (b) Calculate the change in official foreign exchange reserves. (c) Is the central bank buying or selling foreign currency?

(a) Current Account = (400 - 500) + (200 - 150) + 30 + (-20) = -100 + 50 + 30 - 20 = -40

The current account has a deficit of USD 40 billion.

(b) From the BOP identity: Current Account + Capital Account + Financial Account = 0

Assuming the capital account is approximately 0:

Current Account + Financial Account = 0

$-40 + (\mathrm{Net financial account} + \mathrm{Change in reserves}) = 0$

The financial account (excluding reserves) is +60. Let $R$ be the change in reserve assets (positive means an increase in reserves, which is recorded as a negative in the financial account):

$-40 + 60 + (-R) = 0$

$20 - R = 0$

$R = 20$

The central bank's foreign exchange reserves INCREASE by USD 20 billion.

(c) An increase in foreign exchange reserves means the central bank is BUYING foreign currency (using domestic currency). This is consistent with a current account deficit -- the central bank is supplying domestic currency to the foreign exchange market to maintain the exchange rate (if it is a fixed or managed rate system) or to smooth volatility.

Question 10: Trade Creation vs Trade Diversion

Country A and Country B form a free trade area (removing tariffs between them). Previously, Country A imported Good X from Country C (the most efficient world producer) at USD 10 per unit, plus a tariff of USD 3. After the free trade area, Country A imports Good X from Country B at USD 11 per unit, with no tariff.

(a) Is this trade creation or trade diversion? Explain. (b) What is the effect on world efficiency?

(a) This is an example of trade diversion. Before the free trade area, Country A imported from Country C (the most efficient producer) at a total cost of USD 13 per unit (USD 10 price + USD 3 tariff). After the free trade area, Country A imports from Country B at USD 11 per unit (no tariff).

Although the price to consumers in Country A falls from USD 13 to USD 11 (a gain for consumers), trade has been diverted from the more efficient producer (Country C, cost = USD 10) to the less efficient producer (Country B, cost = USD 11). The world is producing Good X less efficiently than before.

Trade creation would occur if the free trade area caused Country A to start importing a good that it previously produced domestically (because the removal of tariffs made imports cheaper than domestic production). This improves efficiency.

Trade diversion occurs when the removal of tariffs between member countries causes imports to shift from a more efficient non-member country to a less efficient member country. This reduces efficiency.

(b) World efficiency DECREASES. Production has shifted from Country C (which can produce at USD 10) to Country B (which produces at USD 11). More of the world's resources are being used to produce Good X than necessary. The gain to Country A consumers is partially offset by the loss in global productive efficiency.

This is a key criticism of preferential trade agreements (free trade areas, customs unions): they can create trade diversion that partially offsets the benefits of trade creation.

---

Problem Set

Problem 1: Comparative Advantage with Numbers

Country M can produce either 200 tonnes of coffee or 100 tonnes of tea. Country N can produce either 100 tonnes of coffee or 200 tonnes of tea.

(a) Which country has an absolute advantage in coffee? In tea? (b) Calculate the opportunity cost of each good in each country. (c) Which country has a comparative advantage in coffee? In tea? (d) If they specialise and trade at an exchange rate of 1 coffee = 1.5 tea, show that both gain.

Solution

(a) Coffee: M (200 vs 100). Tea: N (200 vs 100).

(b) M: 1 coffee = 0.5 tea; 1 tea = 2 coffee. N: 1 coffee = 2 tea; 1 tea = 0.5 coffee.

(c) M has comparative advantage in coffee (0.5 tea vs 2 tea). N has comparative advantage in tea.

(d) Before trade (half resources each): M: 100 coffee, 50 tea. N: 50 coffee, 100 tea.

After specialisation: M: 200 coffee, 0 tea. N: 0 coffee, 200 tea.

M exports 60 coffee for 60 \times 1.5 = 90 tea.

M: 140 coffee, 90 tea (gains: +40 coffee, +40 tea). N: 60 coffee, 110 tea (gains: +10 coffee, +10 tea).

Both gain.

If you get this wrong, revise: Comparative Advantage

Problem 2: Balance of Payments Calculation

Country P has the following transactions (USD billion):

- Exports of goods: 600, Imports of goods: 800 - Exports of services: 250, Imports of services: 150 - Investment income received: 120, Investment income paid: 80 - Transfers received: 30, Transfers paid: 50 - Net financial account (excl. reserves): +40

(a) Calculate the current account balance. (b) Calculate the change in reserves. (c) Is the central bank buying or selling foreign currency?

Solution

(a) Goods: 600 - 800 = -200. Services: 250 - 150 = +100. Primary income: 120 - 80 = +40. Secondary income: 30 - 50 = -20.

Current account = -200 + 100 + 40 - 20 = -80 (deficit of USD 80 billion).

(b) CA + FA = 0 (approximately). -80 + 40 + (-R) = 0, so R = -40.

Reserves decrease by USD 40 billion (negative means reserves fall).

(c) The central bank is selling foreign currency to support the domestic currency (or to finance the current account deficit).

If you get this wrong, revise: Balance of Payments

Problem 3: Exchange Rate Effects

The exchange rate changes from 1 GBP = 10 HKD to 1 GBP = 11 HKD.

(a) Has the GBP appreciated or depreciated against the HKD? By what percentage? (b) What is the effect on UK exports to Hong Kong? (c) What is the effect on the UK current account, assuming the Marshall-Lerner condition holds?

Solution

(a) APPRECIATED. Previously 1 GBP bought 10 HKD, now 11 HKD. % change = (11-10)/10 \times 100\% = 10\%.

(b) UK exports to HK become more expensive. A good costing GBP 100 previously cost HKD 1000, now costs HKD 1100. HK consumers buy less, so UK export volumes fall.

(c) The UK current account is likely to deteriorate. More expensive exports reduce export revenue; cheaper imports (from HK perspective) increase import spending. Both effects reduce the trade surplus (or increase the deficit), assuming the Marshall-Lerner condition is satisfied.

If you get this wrong, revise: Depreciation and Appreciation

Problem 4: Marshall-Lerner Condition

A country's price elasticity of demand for exports is 0.4 and for imports is 0.9.

(a) Does the Marshall-Lerner condition hold? (b) If the country's currency depreciates, will the trade balance improve or worsen in the short run? (c) What is the minimum value of import elasticity needed for depreciation to improve the trade balance?

Solution

(a) Sum = |0.4| + |0.9| = 1.3. Since 1.3 \gt 1, the Marshall-Lerner condition holds.

(b) Even though the ML condition holds, the trade balance may worsen in the short run due to the J-curve effect (quantities adjust slowly, price effect dominates initially). In the long run, quantities adjust and the trade balance improves.

(c) We need |0.4| + |e_M| \gt 1, so |e_M| \gt 0.6. The import elasticity must exceed 0.6.

If you get this wrong, revise: Marshall-Lerner Condition

Problem 5: Trade Policy Evaluation

Country Z is considering joining a free trade area with Country W and Country V. Currently, Country Z imports Good G from Country W (the world's most efficient producer) at USD 15 per unit, paying a tariff of USD 5 (domestic price = USD 20). After the FTA, Country Z can import from Country V at USD 17 per unit, tariff-free (domestic price = USD 17).

(a) Is this trade creation or trade diversion? (b) What is the effect on world efficiency?

Solution

(a) This is trade diversion. Before the FTA, Z imported from W at a total cost of USD 20 (USD 15 price + USD 5 tariff). After the FTA, Z imports from V at USD 17 (no tariff). The lower domestic price benefits Z consumers, but production has shifted from W (efficient, cost = 15) to V (less efficient, cost = 17).

(b) World efficiency decreases. Resources that could produce Good G at USD 15 (in W) are now being used to produce it at USD 17 (in V). The world wastes USD 2 per unit of misallocated production.

If you get this wrong, revise: Trade Barriers

Problem 6: Hong Kong Exchange Rate

The US Federal Reserve raises interest rates significantly. Explain the effects on Hong Kong's economy given the Linked Exchange Rate System.

Solution

Since the HKD is pegged to the USD, higher US interest rates force higher HKD interest rates to maintain the peg (to prevent capital outflows from HKD to USD assets).

Effects on Hong Kong:

1. Borrowing costs rise: Mortgage rates, business loan rates, and HIBOR increase, reducing consumption and investment. 2. Property market pressure: Higher mortgage costs reduce housing affordability, putting downward pressure on property prices. 3. Economic slowdown: Higher borrowing costs dampen aggregate demand, potentially slowing GDP growth and increasing unemployment. 4. Capital inflows: Higher HKD rates attract foreign capital, strengthening demand for HKD (but capped at 7.75 by the convertibility undertaking). 5. Exports: The stronger USD/HKD makes HK exports more expensive for foreign buyers, reducing export demand. Tourism from mainland China becomes more expensive. 6. Inflation: Lower import prices (stronger currency) reduce imported inflation. 7. No monetary autonomy: The HKMA cannot lower rates to stimulate the economy even if HK enters a recession -- it must follow the Fed.

If you get this wrong, revise: Effects of Exchange Rate Changes on the Hong Kong Economy

Problem 7: Terms of Trade and Welfare

A country's export price index rises from 100 to 130, while its import price index rises from 100 to 140 over the same period.

(a) Has the TOT improved or deteriorated? (b) Is the country necessarily worse off? (c) Under what circumstances could the country be better off despite a deteriorating TOT?

Solution

(a) Initial TOT = 100/100 \times 100 = 100. New TOT = 130/140 \times 100 = 92.86.

TOT has deteriorated from 100 to 92.86.

(b) Not necessarily. The TOT only measures price ratios, not volumes. If export volumes have increased substantially, total export revenue could still rise despite lower per-unit terms.

(c) The country could be better off if: - Export volumes increased enough to offset the lower price ratio - Import prices fell in real terms (e.g., due to technological progress among trading partners) - The composition of trade shifted towards higher-value exports

For example, if export volumes doubled while prices rose 30%, total export revenue rose significantly. Even though each unit of exports buys fewer imports than before, the country has many more units to trade.

If you get this wrong, revise: Terms of Trade

Problem 8: Tariff vs Quota

A country imports 1000 units of Good K at a world price of USD 50. The government wants to reduce imports to 600 units.

(a) If a tariff is used, what is the minimum tariff per unit? What happens to government revenue? (b) If a quota of 600 units is used, who receives the quota rent? (c) Which policy is more efficient? Why?

Solution

(a) The tariff must raise the domestic price enough to reduce imports from 1000 to 600. The exact tariff depends on the elasticities of demand and supply. Government collects tariff revenue on the 600 units imported.

(b) Under a quota, the quota rent = (domestic price with quota - world price) \times 600. This rent may go to: foreign producers (if they hold the licences), domestic importers (if they hold the licences), or the government (if licences are auctioned).

(c) A tariff is generally more efficient because: (1) it generates government revenue that can be used to reduce other distortionary taxes; (2) the quota rent may go to foreign producers, worsening the country's terms of trade; (3) tariffs allow the market to determine who imports, allocating import rights to the most efficient importers.

If you get this wrong, revise: Trade Barriers

---

Extended Problem Set: Advanced International Trade and Finance

Problem 9: Comparative Advantage with Three Countries

Three countries can produce computers and textiles with the following labour requirements (hours per unit):

	Computers	Textiles
Hong Kong	10	5
Mainland China	30	3
Vietnam	50	2

(a) Which country has an absolute advantage in each good? (b) Calculate the opportunity cost of 1 computer in each country. (c) If each country has 1000 labour hours, calculate the production possibility for each country under autarky (assuming equal split). (d) Which country should specialise in which good? Calculate the gains from trade if they specialise completely and trade at an exchange rate of 1 computer $= 4$ textiles.

Solution

(a) Absolute advantage in computers: Hong Kong (10 hours vs 30 and 50). Absolute advantage in textiles: Vietnam (2 hours vs 3 and 5). Mainland China has no absolute advantage in either good.

(b) Opportunity cost of 1 computer: - Hong Kong: $5/10 = 0.5$ textiles. - Mainland China: $3/30 = 0.1$ textiles. - Vietnam: $2/50 = 0.04$ textiles.

(c) Autarky (500 hours on each): - Hong Kong: 50 computers, 100 textiles. - Mainland China: 16.67 computers, 166.67 textiles. - Vietnam: 10 computers, 250 textiles. - World total: 76.67 computers, 516.67 textiles.

(d) Vietnam has the lowest opportunity cost for computers (0.04 textiles per computer) -- comparative advantage in computers. Hong Kong has the lowest opportunity cost for textiles (2 computers per textile) -- comparative advantage in textiles. Mainland China has an intermediate position and should specialise in textiles (opportunity cost of 1 textile = 0.1 computers, lower than Hong Kong's 2).

With specialisation: Vietnam: 20 computers. Hong Kong: 200 textiles. China: 333.33 textiles. World: 20 computers, 533.33 textiles.

If Vietnam exports 10 computers at 1:4, it receives 40 textiles. Vietnam consumes 10 computers and 40 textiles. Hong Kong receives 20 computers for 80 textiles. Hong Kong consumes 20 computers and 120 textiles. China consumes 0 computers and 253.33 textiles.

Compared to autarky, Vietnam gains ($10 - 10 = 0$ computers, $40 - 250 =$ actually needs to import textiles). This shows that three-country trade requires careful allocation to ensure all gain.

If you get this wrong, revise: Comparative Advantage

Problem 10: Exchange Rate Pass-Through and Inflation

A country imports 40% of its consumption basket. The domestic currency depreciates by 15%. The import price elasticity of demand is 0.6, and domestic producers' mark-up over costs is 20%.

(a) Calculate the immediate impact on import prices in domestic currency terms. (b) If importers pass through 80% of the exchange rate change to consumers, calculate the effect on the CPI. (c) Explain why exchange rate pass-through is typically incomplete. (d) Apply this analysis to Hong Kong, where imports are approximately 180% of GDP.

Solution

(a) A 15% depreciation increases the domestic currency price of imports by 15% (assuming foreign exporters do not change their prices in foreign currency). The immediate impact on import prices is $+15\%$.

(b) If 80% pass-through: import prices rise by $0.80 \times 15\% = 12\%$.

CPI weight of imports is 40%. Direct effect on CPI $= 0.40 \times 12\% = 4.8\%$.

If domestic producers raise prices by 3% (matching part of the import price increase), the domestic component (60% weight) contributes $0.60 \times 3\% = 1.8\%$.

Total CPI impact $= 4.8\% + 1.8\% = 6.6\%$.

(c) Exchange rate pass-through is typically incomplete because: 1. Foreign exporter pricing-to-market: Foreign firms may absorb some of the exchange rate change by reducing profit margins to maintain market share. 2. Domestic distribution costs: A significant portion of the final price consists of domestic costs (transport, retail margin, local taxes) that do not change with the exchange rate. 3. Long-term contracts: Many import prices are set by contracts denominated in domestic currency, delaying the pass-through. 4. Substitution: Consumers may switch to domestically produced substitutes when import prices rise.

(d) Hong Kong context: Hong Kong's import-to-GDP ratio exceeds 180% due to the re-export trade. For the CPI basket, the direct import content is approximately 40--50%. The Linked Exchange Rate means the HKD moves with the USD. When the USD appreciates, the HKD appreciates against other currencies, making non-USD imports cheaper and HKD exports more expensive.

If you get this wrong, revise: Exchange Rates and Inflation

Problem 11: Balance of Payments and the Mundell-Fleming Model

A small open economy with a floating exchange rate has: IS: $Y = 1000 - 50r + 2e$ LM: $Y = 200 + 50r$ BP: $Y = 500 + 100r - 10e$ (where $e$ is the exchange rate, domestic currency per foreign currency).

(a) Calculate the equilibrium output, interest rate, and exchange rate. (b) The government increases spending by 100. Calculate the new equilibrium and explain the crowding-out mechanism. (c) Under a fixed exchange rate, would fiscal policy be more or less effective? (d) How does this relate to Hong Kong's Currency Board?

Solution

(a) From LM: $r = (Y - 200)/50$.

IS: $Y = 1000 - (Y - 200) + 2e = 1200 - Y + 2e$. So $2Y = 1200 + 2e$, $Y = 600 + e$.

BP: $Y = 500 + 2(Y - 200) - 10e = 500 + 2Y - 400 - 10e = 100 + 2Y - 10e$.

$-Y = 100 - 10e$. $Y = 10e - 100$.

Setting equal: $600 + e = 10e - 100$. $700 = 9e$. $e = 77.78$.

$Y = 600 + 77.78 = 677.78$. $r = (677.78 - 200)/50 = 9.56\%$.

(b) New IS: $Y = 1100 - 50r + 2e$. $Y = 1100 - (Y - 200) + 2e = 1300 - Y + 2e$. $Y = 650 + e$.

Setting equal to BP: $650 + e = 10e - 100$. $750 = 9e$. $e = 83.33$.

$Y = 733.33$. $r = 10.67\%$.

The fiscal expansion increases output by 8.2% but raises interest rates, causing currency appreciation. The appreciation reduces net exports, partially offsetting the fiscal stimulus.

(c) Under a fixed exchange rate, fiscal policy is more effective. The government spending increase raises interest rates, attracting capital inflows. The central bank must intervene to prevent appreciation (buying foreign currency, selling domestic currency), which increases the money supply and reinforces the fiscal expansion.

(d) Hong Kong's Currency Board: With a fixed exchange rate and free capital mobility, monetary policy is not independent (follows the Fed). Fiscal policy is the primary tool for domestic stabilisation. Any fiscal expansion that raises HK interest rates attracts capital inflows, forcing the HKMA to expand the money supply, amplifying the stimulus.

If you get this wrong, revise: Mundell-Fleming Model

Problem 12: Foreign Direct Investment and Development

An MNC invests USD 500 million in a manufacturing plant. Expected annual profit: USD 80 million for 20 years. Required return: 10%. The host country offers a tax holiday (0% tax for 5 years, then 20%).

(a) Calculate the NPV without the tax holiday (20% tax throughout). (b) Calculate the NPV with the tax holiday. (c) Calculate the value of the tax holiday. (d) Explain benefits and costs of FDI for the host country.

Solution

(a) After-tax profit $= 80 \times 0.80 = 64$ million.

NPV $= -500 + 64 \times \frac{1 - 1.10^{-20}}{0.10} = -500 + 64 \times 8.514 = -500 + 544.9 = 44.9$ million.

(b) Years 1--5: profit $= 80$. Years 6--20: profit $= 64$.

NPV $= -500 + 80 \times 3.791 + 64 \times 7.606 \times 0.621 = -500 + 303.3 + 302.1 = 105.4$ million.

(c) Value of tax holiday $= 105.4 - 44.9 = 60.5$ million.

(d) Benefits: capital inflows, technology transfer, employment creation, export development, productivity spillovers. Costs: profit repatriation, crowding out of domestic firms, environmental degradation, labour exploitation, dependence on foreign capital. China's experience demonstrates both: FDI was crucial for industrialisation and export growth, but profit repatriation now creates a growing primary income deficit in the BOP.

If you get this wrong, revise: Foreign Direct Investment

---

Additional Problems: DSE Exam-Style Integration

Problem 13: Currency Crises and Speculative Attacks

Country X has a fixed exchange rate of 1 USD = 5 LC. Foreign reserves = USD 20 billion. Monetary base = LC 150 billion. Net domestic credit = LC 50 billion.

(a) Verify the monetary base identity: NFA + NDA = Monetary Base. (b) If the government finances a fiscal deficit of LC 10 billion by borrowing from the central bank, calculate the effect on reserves (assuming the peg is maintained). (c) If speculative attacks cause the central bank to lose USD 5 billion, what happens to the monetary base? (d) Using the Krugman (1979) first-generation model, explain why persistent fiscal deficits lead to inevitable currency crises.

Solution

(a) NFA = $5 \times 20 =$ LC 100 billion. NDA = 50 billion. NFA + NDA = 150 billion = Monetary base. Verified.

(b) Domestic credit increases to 60 billion. Monetary base rises to 160 billion. To maintain the peg, the central bank sells USD reserves and buys LC, reducing NFA. New NFA = $150 - 60 = 90$ billion = USD 18 billion. Reserves fall by USD 2 billion.

(c) NFA falls to $100 - 25 = 75$ billion = USD 15 billion. New monetary base = 75 + 60 = 135 billion. The monetary base contracts by LC 15 billion (10%), which is contractionary.

(d) The Krugman model shows that fiscal deficits financed by central bank credit creation cause continuous reserve loss. The process is self-reinforcing: fiscal deficit $\to$ money creation $\to$ excess supply of money $\to$ capital outflow $\to$ reserve loss $\to$ speculation $\to$ more reserve loss $\to$ crisis. Reserves are finite; when exhausted, devaluation is forced.

If you get this wrong, revise: Currency Crises

Problem 14: Global Value Chains and Trade in Value Added

A smartphone is designed in the US (USD 200 value added), uses chips from Taiwan (USD 100), a display from South Korea (USD 80), assembled in China (USD 30 value added), and sold in Europe for USD 500.

(a) Calculate gross exports for each economy. (b) Calculate China's domestic value added share. (c) If the US imposes a 25% tariff on Chinese exports, calculate the effective tariff rate on China's value added. (d) Explain why gross trade statistics overstate the US-China trade imbalance.

Solution

(a) Gross exports: US = USD 200 (design services to China), Taiwan = USD 100 (chips to China), South Korea = USD 80 (display to China), China = USD 500 (finished phone to Europe).

(b) China's domestic value added = USD 30. Share = $30/500 = 6\%$. China's gross export is 94% foreign value added.

(c) Tariff on gross value = $0.25 \times 500 =$ USD 125. Effective tariff on Chinese value added = $125/30 = 417\%$. The 25% nominal tariff translates to a 417% effective rate on China's actual contribution.

(d) Traditional statistics record the full USD 500 as Chinese exports to the EU, but USD 470 of this represents value added by the US, Taiwan, and South Korea. The bilateral US-China trade imbalance is much smaller in value-added terms than in gross terms. The OECD-WTO TiVA database addresses this by decomposing trade into domestic and foreign value added.

Hong Kong is a re-export hub: its gross trade figures massively overstate domestic value added. Most Hong Kong "exports" are goods produced elsewhere, with Hong Kong adding value through logistics and finance.

If you get this wrong, revise: Global Value Chains

Problem 15: Development Strategies -- ISI vs Export Promotion

Country D considers two strategies: - ISI: 50% tariff on imports. - EP: 5% tariff with production subsidy of 20 per unit.

Domestic demand: $Q_d = 1000 - 5P$. Supply: $Q_s = -200 + 10P$. World price $P_w = 50$.

(a) Calculate welfare under free trade, ISI, and EP. (b) Which strategy has smaller DWL? Why? (c) Using South Korea and Latin America as examples, evaluate which strategy is more effective for development.

Solution

(a) Free trade: $P = 50$. $Q_d = 750$, $Q_s = 300$. Imports = 450. CS = 56,250. PS = 4,500. Total welfare = 60,750.

ISI (50% tariff): $P = 75$. $Q_d = 625$, $Q_s = 550$. Imports = 75. CS = 39,062.5. PS = 15,125. Tariff revenue = 1,875. Welfare = 56,062.5. DWL = 4,687.5.

EP (5% tariff + subsidy 20): Consumer price = 52.5. Producer receives 72.5. $Q_d = 737.5$, $Q_s = 525$. Imports = 212.5. CS = 54,391. PS = 13,781. Subsidy cost = 10,500. Tariff revenue = 531. Net welfare = 58,203. DWL = 2,547.

(b) EP has smaller DWL (2,547 vs 4,687.5). The subsidy distorts production (overproduction) but keeps prices low for consumers. The tariff distorts both production and consumption, creating larger DWL.

(c) South Korea (EP): Pursued export-oriented industrialisation from the 1960s. Faced international competition, forcing efficiency. GDP per capita rose from USD 158 (1960) to over USD 30,000 (2020). Latin America (ISI): Protected industries became inefficient. Fiscal deficits ballooned. The 1980s "lost decade" of debt crises and stagnation followed.

EP outperforms ISI because: (1) international competition forces efficiency; (2) access to world markets enables scale economies; (3) export earnings provide foreign exchange; (4) EP is self-correcting (uncompetitive firms fail), while ISI rewards inefficiency.

If you get this wrong, revise: Development Strategies