Economics Monetary Policy Paper Essay

Economics Monetary Policy Paper

SECTION A

Answer ALL the following questions

1. Consider a world made of three countries, Home (H), Foreign (F) and an aggregate that will be named the Rest of the World (RoW). Consider the market for beef. Home is characterized by an (inverse) import demand function for this product given by P = 40 � Q

2 . Foreign is

characterized by an (inverse) export supply curve given by P = 10+ Q 2 . The Rest of the World

in assumed to be willing to sell any amount of apples for a price of P RoW = 20 GBP per kg. of beef. Answer the following questions:

(a) Assume that H introduces a tari↵ of 2 GBP per kg. of beef that applies on all possible import sources. Determine the domestic price of beef prevailing in H, the overall imports of beef in H and the quantity imported from each of H’s trading partners.

(b) H is considering whether to establish a customs union (CU) with F , holding its tari↵ policy vis a vis RoW una↵ected. Determine the domestic price of beef prevailing in H, the overall imports of beef in H and the quantity imported from each of H’s trading partners. You have been hired to provide advice on whether country H should establish the CU or not. What is your recommendation? Why? You should provide a quantitative analysis, as the policy makers are quite demanding.

(c) Two old trade economists have proposed an alternative type of CU, e.g. one in which trade with RoW is maintained at the same level as under the regime described in part (a) of this exercise. In order to keep trade flows unchanged, a new tari↵ policy vis a vis RoW might have to be implemented. Under this new type of CU, determine the domestic price of beef prevailing in H, the overall imports of beef in H and the quantity imported from each of H’s trading partners. Once again, you have been hired to provide advice on whether country H should establish the CU or not. What is your recommendation? Can you think of ways for country F to make the creation of this type of CU desirable from the point of view of H (hint: think about potential transfers)?

(d) Consider now an alternative policy to that described in part (c), e.g. one in which the tari↵ applied by H on all possible beef imports is reduced to 1 GBP per kg. Compare the welfare e↵ects of the two policies. Which one is more desirable from the point of view of H? How is this result known in the literature?

2. This question is about a small country deciding what trade policy to choose for the computer sector, which is served by a foreign monopoly. The demand curve of this small country is par- ticular: For high quantities, consumers reduce demand strongly when prices increase; whereas for low quantities, they do not. The intuition is that consumers need computers, but when they are abundant, they care less about extra units.

Specifically, demand is described by the following piecewise function:

Q = 5 � P

2 for Q  2 (1)

Q = 14 � 2P for Q > 2 (2)

2

3

The foreign monopolist has a constant marginal cost equal to 4.

(a) Solve for the optimal prices and quantities the foreign monopolist will choose for the small home economy. To do so, first plot the demand function, the marginal revenue function, and then find the solution. Explain every step you take to solve this question. (hint: use the concept of residual demand to solve for the piecewise MR function).

The home government argues that it can increase surplus by using trade policy, given the characteristics of this sector.

(b) The first strategy it explores is to subsidise imports by paying the foreign firm s = 2 for each unit imported. Show the solution graphically as in (a) and explain.

(c) The government also explores imposing an “inverse quota”, establishing that the foreign firm must sell at least 6 units to be allowed to sell in the home market. Are inverse quotas and import subsidies equivalent in this setting? Explain clearly your reasoning.

(d) Calculate consumer surplus, foreign surplus and government revenue in each case: (i) Free trade (no subsidies, no quota), (ii) import subsidy, (iii) inverse quota. Use graphs to guide your intuition and explain the di↵erences between the three scenarios. What is the total home surplus in each case? What would the government choose? Explain.

(e) The government learns that inverse quotas are forbidden under international law. Would the government choose import subsidies then? Would the home country experience terms- of-trade gains in that case? Explain your answers.

(f) In light of this exercise, discuss the main factor determining the government choice in (e). Your answer should cover whether this exercise can inform trade policy in sectors with other characteristics.

SECTION B

Answer ONE of the following questions

3. “The recent trade war with China is the result of a decline in the U.S. role in the global economy”. Discuss this statement and argue why it might be plausible.

4. Explain how the level of politically motivated trade protection is influenced by factor endow- ments and inequality.

3 End

Economics Monetary Policy Paper Essay

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