Simple Income Expenditure model and  the IS-LM model

Part one:

1. What are the key similarities and differences between the simple Income Expenditure model, as represented by the Keynesian Cross Diagram or the Injections-Withdrawals diagram, and the IS-LM model? How does the analysis of expansionary fiscal policy differ in the two?

Models?

The income expenditure model by Keynes depicts the composition of income (Y) and expenditure (E), the model states that expenditure is equal to income, expenditure includes income and investment and for this reason the model can be stated as Y = C + I + G for a closed economy where Y is income, C is consumption and I is investment and G is government expenditure.

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The IS LM model depict equilibrium in the good market and the money market, the LM curve joins together points of interest rates and national income at which the money sector is at equilibrium, the IS curve on the hand joins together points of interest rate and national income where the good market is at equilibrium.

Similarities of the two model is that they both depict equilibrium in the commodity market, however the difference is that the IS LM curve depict the equilibrium in the money market and also in the commodity market while the Keynes model only depict equilibrium in the commodity market.

Another major difference is that the Keynes theory only considers the relationship of expenditure and income but the IS LM depicts the relationship between investment, savings, interest rates and income, therefore it is clear that the two theories have similarities and differences despite being useful in determining the effects of monetary and fiscal policies.

An expansionary fiscal policy:

We first discuss the effect of an expansionary policy using the Keynes model, according to Keynes Y = C + I + G, an expansionary monetary policy will increase G and therefore increase Y; the following diagram explains the expansionary fiscal policy:

From the above diagram an expansionary fiscal policy will shift the aggregate demand curve from aggregate demand 1 to aggregate demand 2; this will increase the income or output level from Y0 to Y1. Therefore an expansionary demand curve has a positive effect of increasing the aggregate demand according to Keynes.

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Using the IS LM model an expansionary fiscal policy will affect the IS curve, an increase in government spending will increase shift the IS curve upward as follows:

From the chart above the IS curve shifts up [ward as a result of an increase in government expenditure or in other word expansionary fiscal policy.

The main difference in the two analysis of the fiscal policy is that the Keynes model does not show the changes in interest raters as a result of increased government expenditure while the IS LM model shows the change in interest rate that will be undertaken to cater for inflation.

2. Explain what is meant by financial markets equilibrium and examine the Impact of an increase in central bank (high-powered) money on the Equilibrium.

Financial market equilibrium can be stated as the point where money demand by the individuals equals money supply, money demand according to Keynes include precautionary money demand, liquidity preference demand and speculative money demand. Increasing money supply is done by the central banks of a country and the result of increasing money supply is the increasing of inflationary pressure, inflation is the persistent rise in the price of goods in the economy for a long period of time, using the IS LM model we can depict the result of this

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increase in money supply:

The increase in money supply will cause the LM curve to shift downward or to the right, as a result there will be an increase in demand and therefore increased aggregate demand due to excess money, this will lead to aggregate demand exceeding the aggregate supply and therefore an inflationary pressure, therefore there will be an increase in inflation and good prices will rise.

Therefore from the above diagram the equilibrium point in the money market will shift, the shift will be at a higher output level and also at a lower interest level according to the IS LM curve, however it should be pointed out that despite the increase in output there will be an inflationary pressure ion the economy which will lead to increase prices in the economy, to solve this problem the monetary policy makers will decide to increase interest rates or even for the fiscal policy makers may reduce government expenditure to solve the problem of inflation.

3. Answer both parts a and b.

a. According to the IS-LM model, what is the channel through which

contractionary monetary policy affects the real economy?

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A contractionary monetary policy is that which reduces money supply, the tool used here is increasing interest rate in order to reduce money supply in an economy, the contractionary policy will affect the LM curve which is depict the relationship between interest rates and output in the money market. However this will still affect the real or the commodity market as follows.

When the money supply increase then there will be money circulating in the economy, as a result people will have more money to spend and therefore their demand for goods and services will increase, the total demand by individuals in the economy is referred to as the aggregate demand, the total supply in the economy is referred to as aggregate demand and therefore as aggregate demand increases it will exceed the aggregate supply, according to the law of demand and supply if demand exceeds supply then the price rises, for this reason therefore the effect will be an increase in prices of good in the entire economy.

For this reason therefore it is clear that an increase in money supply will definitely affect the commodity market, this will be as a result of increased demand for goods which will in the long run exceed the supply level in the economy and as a result increase the prices of goods in the economy.

b. Use the IS-LM model to illustrate a “policy mix” which controls (or

reduces) a budget deficit without causing a sharp contraction in real

output.

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A policy mix is referred to as the use of both fiscal and monetary policies to fine tune an economy, when then government runs a budget deficit it means that it has increased spending and therefore the IS curve will have to shift upwards, there is therefore a need to reduce the inflationary pressure by use of a monetary policy which in this case will reduce money supply in the economy, this reduction in money supply will shift the LM curve upwards, however because the policy makers want to achieve a higher output level then the monetary policy will only be aimed at reducing the output level by a lower margin than return to the original output level.

The following diagram demonstrates the effect:

From the above diagram an increase in government expenditure will shift the IS curve from IS1 to IS 2, this will increase the output level from Y0 to Y1, however in order to reduce the effect of this policy the monetary policy will be to reduce the money supply, a reduction in money supply will shift the LM curve from LM 1 to LM 2, the final equilibrium therefore will be the intersection of LM 2 and IS 2 and therefore our output level will be at output level Y2 which is higher than Y0 which was our original output level.

4. Answer all parts a, b and c.

a. What, according to Blanchard, are the key factors affecting the

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determination of the aggregate nominal wage?

According to Blanchard the aggregate nominal wage depends on a number of factors, it depends on the expected price changes, the level of unemployment in the economy and finally other factors that affect the wage rate, therefore Blanchard considered changes in price or inflation as one factor that affect the nominal wage and also the rate of inflation which influences the nominal wage.

Blanchard stated the aggregate nominal wage function as follows:

W = Pe F(U ,Z)

Where W is the nominal wage, Pe is expected price change, U is the unemployment and Z are other factors that affect the nominal wage.

b. What is the price-setting relation put forward by Blanchard? Explain

briefly.

Blanchard Having stated the nominal wage as W = Pe F(U ,Z) he assumed that Pe = P which

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means that the price is equal to the expected price change, therefore the model can be stated as W = P F(U ,Z)

We divide both sides by P

W/P = F(U ,Z) which is the wage setting relation

He stated that the price of good P = (1+U)W

Where U is the mark up which is the difference between the selling and production cost

Therefore if we divide both sides by W our equation will be as follows:

P/W = (1+u)

Therefore when we get the inverse W/P = 1/(1+u) which is the price setting relation

c. How can the analyses in parts (a) and (b) be combined to explain

the “natural rate of unemployment”.

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According to Blanchard the wage setting relation and the price setting relation determine the equilibrium rate of unemployment, the equilibrium rate of inflation is the natural rate of unemployment, having our two equations:

W/P = F(U ,Z) which is the wage setting relation and W/P = 1/(1+u) which is the price setting relation the we can eliminate W/P as follows:

F(U ,Z) = 1/(1+u)

But in this case we write the function as follows:

F(Un ,Z) = 1/(1+u)

Where Un is the natural rate of unemployment.

5. Answer all parts a, b and c.

a. What does the aggregate supply relation describe and how can it be

derived?

The aggregate supply curve depicts the equilibrium points of price and output in the economy in which both goods and services are supplied in an economy,

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b. What does the aggregate demand relation describe and how can it

be derived?

The aggregate supply curve depicts the points of prices and output at which there is equilibrium in the goods and services demand in the economy, Graphically it is derived from the IS curve and the monetary policy curve, this derivation is demonstrated below:

The IS curve in the first diagram and the monetary policy curve helps us to derive the aggregate demand curve, the monetary policy curve shows actions by monetary policy makers and this curve depict the relationship between interest rates and inflation, when inflation increases then the monetary policy makers increase interest rates and this is what the monetary policy curve depict and therefore this helps depict the aggregate demand curve.

c. What is determined in the aggregate supply-aggregate demand

model?

The aggregate demand aggregate supply is important in determining the equilibrium output level, it also helps us to determine the equilibrium output level.

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6. Use the AS-AD model to examine the effect of a fiscal contraction (without an accompanying change in monetary policy) in the short run and the medium run. Explain the mechanisms at work as fully as possible and make clear how the interest rate, output, the price level and private investment is affected by the policy change.

The diagram below shows the effect of policy change on the aggregate demand.

A contractionary fiscal policy shifts the aggregate demand curve to the left, from the above diagram if we assume that the original aggregate demand is aggregate demand 1 and the contractionary fiscal policy shifts the aggregate demand to aggregate demand 2 then various changes are evident in the economy.

From the diagram the output level will decline, this is signified by the decline in output from Y1 to Y2, prices will also decline from P1 to P2. This happens because government spending declines, when the government increases spending then consumers in the economy have more to spend but in our case the government reduces spending meaning that the consumers will reduce spending due to lack of excess funds. For this reason therefore there will be a decline in the demand for goods in the economy and therefore the aggregate demand shifts downward.

Investment is also affected by this change in policy, due to low demand for goods and services in the economy there will be a decline in investment.

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7. What is meant by the expectations-augmented Phillips curve and how is it related to the natural rate of unemployment?

The Phillips curve shows the relationship between inflation and unemployment, when inflation is high then the rate of unemployment is low, the augmented Phillips curve is similar to the Phillips curve but it takes into consideration the role of expectations in an economy, when a monetary policy is aimed at reducing the rate of inflation then we expect the inflation to fall but due to expectations there will a further fall in the rate of inflation and therefore a shift in the Phillips curve, the diagram below demonstrates the augmented Phillips curve.

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from the above diagram if monetary policies are aimed at reducing inflation from Inf 1 to Inf 2 then we expect unemployment to rise inflation will decline from inf1 to inf 2, unemployment will increase from U1 to U2, however due to expectations the Philips curve will shift from Phillips curve 1 to Phillips curve 2 and therefore the outcome will be a higher unemployment level U3

8. What, according to Solow’s model, is the determinants of economic growth in the long run? In your answer, set out Solow’s analysis graphically and/or algebraically.

Robert Solow explained a situation where a country would experience growth even if it depended on exhaustible resources, when an economy uses exhaustible resources there is a high possibility that in the long run the resources will be diminished and economic growth will not be possible, however Solow explained the possibility of growth despite the disadvantages associated with Use of exhaustible resources.

Solow stated the Cobb Douglass production function which he stated as follows:

Y = ectLgDhK1-g-h

Where e is a constant

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C is the rate of technological change

T is time in years

L is labor

D is land

K is capital

Therefore according to this model production depended on the technology, time, labor, land and capital, further manipulation of this model was made by Solow where he divided both sides of the equation by L which is labor, this model can therefore be stated as follows:

Y      = ect D  h K         1-g-h

───             ───    ───

L                         L            L

From the above equation Solow raised four scenarios which are as follows:

One:

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If we assume that there is no technological progress in an economy and therefore the value of C in the equation is 0 and that K/L remains constant and D/L approaches zero due to increased population therefore increasing L then the natural resources are being used up and therefore Y/L approaches zero.

Two:

If D/L is declining due to population growth, then there is a possibility that K/L is going up, the reason for this is because when we use resources then there is capital accumulation where K is rising, for this reason therefore if capital accumulation is allowed to take place as we use up resources then there is a high possibility that Y/L is constant of even rising.

Three:

When the population grows in a Malthusian version then the population growth will lead to a situation where Y/L approaches zero, however this according to Malthus could be resolved by holding the population constant and therefore K/L will increase without an upper bound and when this happens then Y/L will rise.

Four:

If we allow technological progress to take place where C is not zero then there is a high possibility of experiencing an increase in Y/L in the long run, therefore technology could resolve the problem of use of exhaustible resources where there is population growth.

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International economics

1) Briefly explain Ricardo’s principle of comparative cost and consider its significance for a nation’s choice of international trade policy.

Ricardo derived the theory of comparative advantage, according to Adam Smith countries would trade due to absolute advantage, his theory was based on the assumption was labor and that differences in labor productivity caused trade, a country had absolute advantage if it used less units of labor in the production of a certain good.

In the absolute theory the analysis considered two goods, comparative advantage theory came up to explain a situation where a country had absolute advantage in the production of two goods and still gain from trading with the other country, to explain Ricardo’s theory we consider country 1 and country 2, also good a and good 2, this is summarized below:

From the above table country 2 has absolute advantage in the production of both good a and good b, however it would still be profitable to trade with country 1, we can state that country 2 has comparative advantage in production of good a, therefore country 2 should specialize in producing good a and country 1 will specialize in the production of good b. therefore both countries will gain by trading.

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2) Comment on the view that international trade is an imperfect substitute for international factor mobility.

It is clear from the factor equalization theory that international trade can be a perfect substitute of international factor mobility, this theory states that if factors of production cannot move freely across countries while goods can then the free movement of good will eventually lead to factor price equalization, this means that trade can lead to the equalization of prices of factors of production.

The factor equalization theory states that having two countries whereby one country is capital endowed and the other is endowed in labor then if the two countries specialize where the capital endowed country produces capital intensive goods and the labor endowed country produces labor intensive good then if they specialize and there is free trade between the countries then this will lead to a rise in factor prices, the reason for this is because the labor endowed country will produce labor intensive goods because labor is abundant and therefore cheap, however specialization will lead to increased demand for labor and therefore there will be a rise in price per unit labor.

For this reason therefore international trade can be viewed as a perfect substitute of factor mobility between countries, the factor equalization theory is based on the assumptions that there exist no factor reversals meaning that if a there are those goods that are capital intensive

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and those that are labor intensive and no capital intensive good is produced by substituting capital for labour, there is a competitive market in the good and factor market, there is full employment in both countries, there arew no demand reversals which means that capital intensive goods producing country will import labor intensive goods and that the labor intensive goods producing country will import capital intensive goods, the other assumption states that factors of production cannot move freely but good can and that production curves exhibits constant returns to scale.

3) Explain the main economic instruments that countries use to protect their agricultural sectors from international competition and assess their relative economic efficiency.

Most countries will protect their agricultural sector from international competition through the use of trade barriers and also through subsidizing their production, for this reason therefore trade restrictions help reduce import as from the international market and therefore protect the agricultural sector.

Tariffs are forms of taxes imposed on good by the government, the government earns revenue from tariffs and therefore it is beneficial, when a tariff is imposed on imports their price rises and this price may rise higher than the domestic price of the locally produced goods, this way consumers will consume domestic products other than the imported products and therefore protect domestic production.

Quotas are also means of restricting imports, this involves the action by governments whereby a certain level or quantity of imports is set, example a country importing freely goods from abroad

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may place a quotas that only 50 units of a good will be imported and therefore reducing imports, this will protect the domestic producers of agricultural products.

The last form of restriction is through a trade ban, a government may completely ban import of good from abroad and this means that there will be zero imports of a certain good in the economy, the other protective measure is the use of subsidies to farmers in the farm, subsidies means that the government will spend an amount of money in order to reduce cost of inputs example fertilizers and seeds so that the production costs are lower then the market price.

From the above discussion therefore it is claear that agricultural countries will protect their agricultural sectors through tariffs, quaotas, ban on imports and finally by subsidizing inputs and final goods produced.

4) Why do some of the nations that are members of the World Trade Organization finds it worthwhile to also form regional trade blocks?

Members of the World trade union will also join regional trading blocks depending on the various advantages associated, countries will join trading blocks in order to gain regional advantages of trading, this include lower tariffs for member countries, no restrictions on imports and exports and also no quotas on imports and exports in the block.

By joining regional trading blocks the countries also find advantages in that they achieve fair trade from these blocks, fair trade involves the consideration of the social welfare of member country citizens and therefore more beneficial than free trade which only advocate for zero barriers to trade between trade partners.

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Trading blocks will have special treatments of member countries depending on the set policies, trading blocks will lead to trade creation, trade creation involves the formation of trading blocks that lead to a country to switch from a high cost import source into a low cost import source, the trade creation is welfare improving.

The world trade union may lead to trade diversion, trade diversion is the occurrence where a country is forced to import from a high cost source and therefore it is welfare worsening, for this reason therefore countries will form regional trade blocks to improve this problem that worsens the welfare of a country.

From the above discussion therefore it is clear that the world trade organization member countries will form trading blocks in order to gain from the advantages associated with the regional trading blocks such as reduction of tariffs and quotas on export and also imports. The countries will also aim at realizing trade creation and eliminating trade diversion.

5) Are there any valid reasons to believe that primary commodities must experience a decline in their relative prices over the long run?

Commodities produced in an economy will be produced by firms in order for them to gain profits, firms will enter an industry that receives abnormal profits meaning that the firms will be gaining higher profits in the industry than other industry.

The firm therefore will make economic profits in the short run but in the long run this will not be the case, as the production of primary products becomes more attractive to firms then more firms join in the production opf these products, competition rises in the industries and firms are

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forced to reduce the prices of these commodities. The reduction of prices can therefore be attributed to the increased competition.

The prices will fall also becosue of the increase in supply of these commodities, as more frims joins the industry of producing primary commodities then there is an increase in the supply of the commodity, as a result supply exceeds the demand level and as the law ofd demand states then the prices are expected to fall, therefore the price decline in the long run can be attributed to the increased supply level.

In the short run also we expect that the primary commodities will not have close substitutes, as more firms enter the industry more substitutes will be introduced to the market offering competition to the product, for this reason therefore due the existence of substitutes to the product the price of the commodity will decline in the long run.

From the above discussion therefore it is clear that the price of primary commodities will decline in the long run, this can be explained by the increased supply more firms into the industry and substitute products .

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The float exchange rate regime is a situation whereby the currency is allowed to fluctuate according to the international market, the adoption of this regime has not made the IMF to be redundant and the reason is because the organization has other functions it plays in the international market, it controls trade and also plays other major roles in the international market.

Through the wide spread of adoption of the float system the IMF has been viewed as redundant or repetitive in the functions it plays and the functions played by the float system, however by observing the functions of the IMF this is not true because the IMF plays other functions apart from control of exchange rates.

The float system is put in place by a country in order to act as a guide to the exchange rate system, the value of a currency against another is determined by the demand and supply in the international market, the IMF have functions raging from control of trade between countries, offering monetary support to countries, controlling the exchange rates and also acts as a central bank to the world.

For this reason therefore the wide adoption of the float system by countries does not mean that the existence of IMF is repetitive due to the fact that the IMF plays other major roles in the international market and trade between countries. For this reason therefore the adoption of the float system by countries doe not make the IMF irrelevant and therefore both the IMF and the system are relevant in the international markets.

7) In a world of floating exchange rates how can large imbalances of trade

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persist?

In a floating exchange rate regime the currency of a country is allowed to fluctuate according to the international market, in this regime countries gain advantages in that the country is less prone to external shocks that may lead to inflation in the country, this regime is also preferred due to the reduction of effects due to reduction in the effect caused by international business cycles.

However this regime has a disadvantage in that unlike in the fixed exchange rate regime a currency is less certain and greater instability of exchange rate, therefore in this exchange rate regime there is high speculative attacks that may lead to great losses.

When a country adopts a float exchange rate regime there may also be a problem of trade balances, this may be as a result of prolonged depreciation of a currency value in the international market leading to the problem of greater cost of imports and at the same time exports become more cheap in the international market, as a result therefore the problem of balance of trade occurs due to more imports than exports. Therefore a float exchange rate regime may also lead to the increased problem of trade imbalances.

Therefore the adoption of a float system does not reduce the problem of trade balances, this is becosue the value of a currency is determined by the demand and supply of the currency in the market and therefore a currency can depreciate against other currencies leading to an increase in the debt and trade balances problems.

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8) If the European Union can benefit from the adoption of a single currency would the same be true of the whole world?

The adoption of the Euro in the European union has led to many advantages, the euro ensures the creation of an optimal currency area which helps in the achievement of economic efficiency, if the whole world adopted the Euro then the same advantages will still be realized.

The euro also reduces the transaction cost and also the risk associated with exchanging currencies, the cost of exchanging currency in trade is reduced and also the risk involved in holding other currencies that may be affected by exchange rate fluctuations.

The disadvantages of Difference in prices among nations is also reduced by the Euro, the price differences may have speculative attacks which may lead to huge losses, the adoption of the euro by other countries will lead to the reduction of these disadvantages associated with price differences. The single currency also ensures ease to trade between countries because it used as a currency for accounting in the Euro zone. Finally another advantage associated with the Euro is that there is an advantage of economic stability through low inflation and stable economy, this can be extended to the other countries all over the world that adopt the currency.

Therefore the Europena union requirement that new economies should adopt the Euro is becosue the adoption of a single currency unit in accounting ensures efficiency in accounting and lowers the burden of having to convert other currencies into the Euro, there are also advantages in that the prices differences of goods in the member countries is reduced and that there is a reduction of speculative attacks.

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1. Using production possibility curves demonstrate Ricardo’s principle of comparative cost. Explain the significance of the shape of the ‘PPC’s that you have employed.

According to Ricardo trade occurs as a result of differences in labor productivity, if we assume that labor is the only factor of production and that only two goods are produced i.e. good A and good B then we can formulate the production possibility curve using the following data from the two countries:

The above table states that country 1 will produce 20 units of good a and 19 units of good b, country 2 will produce 15 units of good a and 18 units of good b, for this reason therefore it is clear that country 1 has absolute advantage in production of both goods but it has comparative advantage in producing good a, the country 2 has a less comparative disadvantage in production of good b, therefore it would be better for country 1 to produce good a and then country 2 produced good b. by doing this it is evident that both countries will gain from trading when they specialize.

For both countries the production possibility curve will be as follows:

From the above diagram country 1 has absolute advantage in the production of both good whereby it produces more of good A and good B than country 2, however country 2 can produce more of good a than of good b, for this reason therefore it would better produce good a and then the country 2 will specialize in production of good b, both countries will gain by trading.

2. How are a country’s ‘commodity terms of trade’ calculated? What factors determine the terms of trade?

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Terms of trade is the ratio that is determined by getting the relative price of export to the imports, it is a measure of social welfare of an economy that trades with other countries, terms of trade can be seen where a country gives up lesser exports for imports. An example is where a country exports 100 pounds worth of goods for 200 pound worth of imports, the terms of trade for this country will be 100/200 = 0.5, for the other country the terms of trade will be 200/100 =2.

Terms of trade is determined by the value of exports and the value of imports, however problems arises when there are trade barriers between countries and therefore the barriers to trade also affect the terms of trade.

From the above discussion it is clear that the value of exports and also the value of the imports are the major determinants of the terms of trade, when the value of exports are higher than the value of imports then the terms of trade are greater than 1 and therefore favorable, however when the imports have a higher value than the exports then the term of trade is less than 1 and therefore unfavorable and can lead to balance of trade.

3. Contrast the effects on income distribution, production and consumption of a good subjected to the imposition of a protective tariff as opposed to a quota.

The following diagram demonstrates the effect of a tariff on imports:

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If we assume that the international price of a good is at p and a tariff value t is imposed on the good then the price will rise to P+t, quantity demanded will decline from q4 to q3, the area colored in the chart demonstrates the value of government revenue, loss in consumer surplus and producer surplus, from the chart government revenue is realized, a loss in consumer expenditure and an increase in producer surplus and a dead weight loss.

Quota:

A quota is a quantities protection measure whereby a government only gives a limit to how much to be imported, the quota dies not yield revenue, it leads to a loss in consumer surplus, and quota holders are the only beneficially to the protection measure.

The diagram below shows the effect of a quota on the demand and supply:

From the above diagram if we assume that the price of the products is the international price and that the demand for the good is q4. The domestic production level is q1 and the total demanded is q4 and for this reason therefore q4 minus q1 is imported, if the government states that the import level should be at q3 then the price of the product will rise.

From the above discussion therefore it is clear that a tariff will yield revenue to the government

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while the quota will not yield any revenue to the government but the quota holders gain the process and for this reason the quota will lead to an unsuitable income distribution, in both cases the price will rise but in the quota the price rise will be determined by the quantity set for import while in the tariff case the price is determined by the level of tax imposed. The tariff also does not restrict the quantity imported, more can be imported at high prices but in the case of the quota import quantity is restricted.,

4. Explain the importance of the ‘Most Favored Nation’ concept for the operations of the World Trade Organization.

The most favored nation in trade refers to a situation whereby a country awards a trade partner all trade advantages, it involves low tariffs on imports from the awarded nation therefore that nation will have an advantage than the other countries trading in the same country.

The importance in that the country which is awarded the MFN will export more, the importing country will also have a chance of getting supplies from the most efficient supplier. The award also ensures that imports are affordable in the importing country. The awarded country will also experience economic growth due to the increased exports.

The other importance of the most favorable nation is that a country given this award has an opportunity to grow economically, this is because the country is offered an opportunity to export products to a country at lower tariffs and for this reason the level of exports increases and therefore production in the country increases and at the same time the level also improved terms of trade.

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The term is also important in promoting trade creation, this is to say that the country is allowed to import from low cost sources and therefore impose less tariffs on imports from the country it chooses, this helps improve the welfare of its citizens.

From the above discussion it is clear that the most favorable nation award is important in the world trade organization, when countries join the organization they are supposed to impose common tariffs and also lower tariffs on imports from member countries, however in the case where the country awards another country the most favored nation then the country imposes less tariffs and quotas on the goods imported from the country.

5. Should the formation of regional trade blocs be considered as favorable to the development of a global free trade system?

Trading blocks are important in the promotion of free worldwide trade, this is because trading blocks evolve from simple trade agreements to more complex and free trade areas, example a few countries may decide to remove tariffs on the goods imported from the trade partners.

Due to the problem of protectionism through tariffs, bans and quotas the regional blocks which are formed to help eliminate these barriers to trade, this helps in the increase of free and fair trade in the regions, and that the blocks are formed by trade partners this helps in the establishment of a global free trade system.

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As countries join trading blocks they move from less complex to more complex integrations, the most common trade integration block is the preferential trading agreement where the country imposes lower tariffs on goods from member countries, the other trade integration type is the free trade area where countries agree to impose zero tariffs on goods from member countries, the other is the common external tariffs, then the common market which involves the free movement of capital and labor. And finally the complete economic integration which involves the countries becoming one economic and political unit, for this reason therefore the formation of the trading blocks will lead to the achievements of a world wide free trade practice.

6. Consider whether the US current account deficit is a threat to international financial stability and trade.

The current account is the summation of the balance of trade, abroad factor income and transfers from abroad, therefore balance of trade is a major factor that determine deficit in the current account.

US being a major economy in the world will affect the other countries when current account deficits occur. In the past the US economy has had an unsustainable current account deficit, as a result there has been an increase in indebtedness of the economy that affect other economies, other economies are not fully paid for their exports as a result of more deficits incurred by the US.

To resolve the problem the US government has resulted into the formulation of trade policies that have helped reduce the deficit, as a result exporting countries to the US have experienced

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a reduction in the demand for their goods, as a result this has also resulted into problems to the US trade partners.

Also due to the fact that many countries have pegged their currencies against the dollar, when there is a depreciation in the dollar then the other currencies that are pegged to the dollar will also depreciate against other currencies, this will lead to increased trade balances and undesirable terms of trade resulting to more debt problem of the countries.

7. In what senses, if any, is the International Monetary Fund the world’s central bank?

The international monetary fund is viewed as a world’s central bank, this is evident from the functions it plays in the entire world. The central bank of a country plays the function of being a lender of last resort, settles interbank debts, issues notes and coins, and holds reserves and a bank to all the other commercial banks and also a bank to the government.

The international monetary fund function include offering funds as loan to countries , this is similar to the central banks of countries which lend money to banks. Another function that the IMF plays is the monitoring of exchange rates, the central bank of a country also plays a role in determining the exchange rate.

The other function that is similar to that of a central bank is the monitoring of trade between countries, a central bank will settle balances between commercial bank while for the IMF balances are settled for the trading countries. From the above functions therefore it is clear that the IMF can be referred to as a world’s central bank, this is because it plays similar functions as those of a central bank of a country.

8. Explain and assess the economic case for insisting that all new members of the

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European Union adopts the Euro as their currency.

The adoption of a single currency which is the Euro lead to various advantages, the economics behind the requirement that new countries joining the European union to adopt the Euro is because the Euro is used as a unit of accounting and therefore the ease of determining trade balances between the trading partners.

The Euro also ensures that there is a reduced risk to trade, this reduces speculative attacks in the market and also a reduced transaction cost ensuring that low price of goods is traded within the European union member countries. The Euro also ensures that efficiently is achieved by the member countries and therefore there will be an added advantage in joining the union and adopting the Euro currency.

The cost differences associated with trade whereby in countries some goods are more expensive than in other countries, by the adoption of the Euro in these countries the price differences are reduced and therefore efficient sources are obtained improving the welfare for all the country members.

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