Question 1

1 2
~Our production model is the Cobb-Douglas production function: 𝑌 = 𝐴𝐾 ⁄3 𝐿 ⁄3. Output Y
depends on the productivity parameter A, the capital stock K, and labor L and tells us how
much Y can be produced if ‘L’ workers are combined with ‘K’ machines.
~The production function exhibits constant returns to scale in capital and labor together i.e.
if we double the amount of each input, we will double the amount of output.

A) The production function tells us how much Y can be produced if L workers are combined with L
machines. If Country 2 loses 10% of its capital which is K, I would want to invest in Country 2 because of
the marginal product of capital (MPK).

MPK is the extra amount of output that is produced when one unit of capital is added holding all other
inputs constant. As mentioned earlier, our production model exhibits constant returns to scale in capital
and labor together. Therefore, an increase in K alone, would exhibit decreasing returns i.e. doubling
both K and L doubles the output. Therefore, doubling just K would less than double the output. Each
additional unit of capital deployed increases the output less and less when all other things are held
constant.

In this case, since Country 2 has 90% of the capital of Country 1, the increase in capital (our investment),
would have a larger increase in production output in Country 2. The marginal product of capital depends
on ratio L/K. Therefore, MPK declines as K rises. (Charles Jones p.72-75)

B) I would prefer moving to the country where I will earn a higher wage. The wage is calculated by the
formula

1⁄
2 𝐾̅ 3
𝑤 = . 𝐴̅. ( )
∗
3 𝐿̅

The formula shows that the wage is inversely proportional to Labor forces L to the third root. Since only
the labor force is changing (Country 1 loses 10% of its labor force), we can see that the wage in Country
1 will be about 3.6% higher than the wages in Country 2. Therefore, I would prefer moving to Country 1.
(Charles Jones p. 81)

Question 2

The increase in unemployment rate can be thought of as good news when it is during a natural rate of
unemployment. In one of the two components of natural rate of unemployment, there’s frictional
unemployment. This is when the workers are in between jobs in the dynamic economy. During this time,
people are hopeful in finding a job rather than being in the category of “not looking for work”. When people
are not looking for work, they are not in the labor force. Therefore, they are not a part of the unemployed
category. There can be an increase in unemployment when the economy has more people entering or re-
entering the labor force. This could be due to job creation or people that are encouraged to look for a job
again. (Charles Jones p. 185)

Question 3
The PCE is the price index of all the goods we consume, which is the preferred price index of the Fed. There
is also the CPI which is based on different and the public is more aware if CPI. CPE is updated monthly, and I
believe the PCE deflator releasing on November 27th will not influence the monetary policy action of the
FED by very much, if there isn’t much change in PCE. If inflation increases, I think the Fed will tighten
monetary policy. The impact is fairly modest as it follows the CPI and CPI is released first. The core PCE price
index is closely watched by the Federal Reserve as it conducts monetary policy.
(https://www.economy.com/dismal/indicators/definition/usa_income_pce)

Question 4

Yes, I believe that the long run trend looks the way the theory predicts. The quantity theory of money pins
down the price in the US and price in the rest of the world, so the law of one price is left to pin down the level
of the nominal exchange rate. The nominal exchange rate is simply equal to the ratio of the price levels of
two economies in the long run. The quantity theory of money tells us that one of the key determinants of
the price level in a country is the money supply in that country. If the nominal exchange rate was falling over
the last 19 years, it must be the case that the price level in Japan was rising more slowly than the price level
in the US. This means that the inflation rate in the US was much higher than it was in Japan. The
depreciation of the dollar relative to the yen is the different rates of inflation in the two economies. (Charles
Jones p. 550 and p.551 figure 20.2)
Question 5

EAST WEST
Labor Force 200 100
Number of Notepads a worker can produce 5 50
Number of Pens a worker can produce 100 200
Percentage of income spent on Notepads 80% 80%
Percentage of income spent on Pens 20% 20%

AUTARKY
Wage [Pens – Numeraire good] 100 pens 200 pens
Price of Notepads [No. of Pens/No. of Notepads] 20 4
Consumption of Notepads per person 4 40
Consumption of Pens per person 20 40
Fraction of Labor making Notepads 50% 50%
Fraction of Labor making Pens 50% 50%
Total Production of Notepads 500 2500
Total Production of Pens 10000 10000

FREE TRADE
Fraction of Labor making Notepads 0% 100%
Fraction of Labor making Pens 100% 0%
Total Production of Notepads 0 5000
Total Production of Pens 20000 0
World Price of Notepads 16 pens
Wage 100 pens 800 pens
Consumption of Notepads per person 5 40
Consumption of Pens per person 20 160
Total Consumption of Notepads 1000 4000
Total Consumption of Pens 4000 16000

FREE MIGRATION
Wage 200 pens
Price of Notepads [No. of Pens/No. of Notepads] 4
Consumption of Notepads per person 40
Consumption of Pens per person 40
Fraction of Labor making Notepads 50%
Fraction of Labor making Pens 50%
Total Production of Notepads 7500
Total Production of Pens 30000

A. A country has an absolute advantage over another country in producing a

particular good if it does so more cheaply. Since the workers in the West are more
productive at making both Notepads and Pens, they have an absolute advantage.
This is shown by how the wages are higher and the price of a notepad is cheaper in
 the West when we assume that both regions are closed to trade.

B. A comparative advantage is when the relative price of a good is lower than in

another country. The West has a comparative advantage on notepads, and the
East has a comparative advantage on pens.

C. In autarky, the relative price of a notepad (in terms of pens) is 20 pens in the East
and 4 pens in the West. This is calculated by dividing the wages by the number of
notepads a worker can produce in each region.

D. We can calculate the consumption of pens and notepads in case of an autarky,

using the following equations:
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝐼𝑛𝑐𝑜𝑚𝑒 𝑠𝑝𝑒𝑛𝑡 𝑜𝑛 𝑃𝑒𝑛𝑠 × 𝑊𝑎𝑔𝑒
𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑓 𝑃𝑒𝑛𝑠 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑒𝑛𝑠

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝐼𝑛𝑐𝑜𝑚𝑒 𝑠𝑝𝑒𝑛𝑡 𝑜𝑛 𝑁𝑜𝑡𝑒𝑝𝑎𝑑𝑠 × 𝑊𝑎𝑔𝑒

𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑓 𝑁𝑜𝑡𝑒𝑝𝑎𝑑𝑠 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑁𝑜𝑡𝑒𝑝𝑎𝑑𝑠

Using this, we find that there is a consumption of 20 pens and 4 notepads in the East
and a consumption of 40 pens and 40 notepads in the West.

E. Using the same as in section D, but substituting the wages and prices of goods in a
free trade economy, we find that there is a consumption of 20 pens and 5 notepads
in the East and a consumption of 160 pens and 40 notepads in the West.

F. If there was free migration, people from the East would move to the West as the
wages there are higher. Thus, the world economy with free migration of labor will
look like the western economy under autarky.
From the table above, we can see that in the East as we compare free trade to free
migration, the consumption per person increases from 5 notepads and 20 pens
under free trade to 40 notepads and 40 pens under free migration. In the West, the
consumption per person decreases from 40 notepads and 160 pens under free trade
to 40 notepads and 40 pens under free migration. This shows that the Eastern region
with the lower wages under free trade regime, receives all the welfare gains under
free migration regime, whereas the welfare gains are shared between the East and
the West under a free trade regime.

Question 6

I really enjoyed the Italy presentation because their presentation not only looked really well
put together, but they were very knowledgeable and passionate about Italy.