Professor Dr.

Michael Pflüger Lehrstuhl für VWL – Internationale Ökonomik Universität Würzburg

Tutorin: Valérie von Gleichen

Problem Set 3
Ricardian Theory (III)
Exercise 1 (Dornbusch-Fischer-Samuelson model)

Use the Dornbusch-Fischer-Samuelson model and assume that a constant, exogenous fraction α of
expenditures is spent on a continuum of traded goods z ∈ [0,1] and the share (1-α) is spent on another
continuum of nontraded goods x ∈ [0,1]. Assume that the labor coefficients to produce traded goods
in the domestic and the foreign economy are as in the standard DFS-model. Moreover, assume that
nontraded goods are produced with local labor under constant returns with labor coefficients of unity.
(i) Derive and explain the domestic goods market equilibrium condition! Derive the equilibrium
in the traded goods sector! Depict this equilibrium graphically and compare this equilibrium
with the equilibrium in the standard DFS-model.
(ii) Assume that the domestic economy grants an income transfer T to the foreign economy. Derive
and explain the goods market clearing condition! Depict the situation with an income transfer
graphically! Show that the domestic economy suffers from a secondary burden and explain this
result intuitively!

Exercise 2 (Dornbusch-Fischer-Samuelson model)

Use the Dornbusch-Fischer-Samuelson model to study the introduction of an ad valorem import tariff
by the home country and by the foreign country (the size of the tariff can possibly differ across
countries). Ignore the tariff revenue in your analysis.

Exercise 3 (Dornbusch-Fischer-Samuelson model)

Use the Dornbusch-Fischer-Samuelson model to study the transfer problem, i.e. a unilateral transfer
of income from home to foreign. Consider two cases:
(i) Trade is costless.
(ii) Trade is costly.

Exercise 4 (Parameterized version of the Dornbusch-Fischer-Samuelson model)

i) Use the following parameterization of the A(z)-curve in the Dornbusch-Fischer-Samuelson
1 1
az *  Τ θ  1 − z θ
model: A (=
z) =    
az  Τ *   z 
Explain this parameterization and characterize the meaning of each parameter! Provide a
qualitatively correct graph which depicts this curve (i-a) when 𝑇𝑇 = 𝑇𝑇 ∗ for two values of 𝜃𝜃, a
low one and a higher one, (i-b) for a given value of 𝜃𝜃 assuming that 𝑇𝑇 > 𝑇𝑇 ∗ .

(ii) Assume that the domestic economy runs a trade deficit D and derive the two equilibrium
conditions of the parameterized model! Explain qualitatively and intuitively what this trade
deficit implies for the international wage differential and the specialization threshold in the
traded goods sector!

Tutorial International Trade and the Multinational Firm – Winter Term 2021/22
Professor Dr. Michael Pflüger Lehrstuhl für VWL – Internationale Ökonomik Universität Würzburg
Tutorin: Valérie von Gleichen

Exercise 5 (Quantitative analysis with the Dornbusch-Fischer-Samuelson model)

Use the parameterized version of the DFS-model of the previous exercise. Consumers in both
economies have identical preferences and spend a constant, exogenous fraction α of expenditures on a
continuum of traded goods z ∈ [0,1] and the share (1-α) is spent on another continuum of nontraded
goods x ∈ [0,1]. The preference for traded goods is a Cobb-Douglas-subutility function which implies
constant and equal budget shares to traded goods. Use 𝑧𝑧 to denote the aggregate budget share devoted
to goods produced by the domestic economy (home).
(i) State and explain the two equilibrium conditions under the assumption that the domestic
economy runs a trade deficit D with the foreign economy!

(ii) Assume that the trade deficit is counterfactually changed to D’. State the new equilibrium
conditions!

(iii) Assume that you are at a G-7 summit as a US economic policy advisor where a stern debate
about trade imbalances erupts. During a break in the meeting you are asked to brief your
delegation members on the issue by providing a rough estimate of key effects of the US trade
deficit on its economy. Base your advice on the parameterized DFS-model where the United
States is the domestic economy and where all foreign trading partners are collapsed into a rest
of the world ROW.

(iii-i) Draw on “wits.worldbank.org” to obtain the most current GDP of the US and of the
remainder of the world as well as the exports and imports of the United States. Assume that
𝜃𝜃 = 3.6.

(iii-ii) Explain what the data imply for the initial specialization threshold and the share of
expenditures devoted to traded goods!

(iii-iii) Explain the steps that are necessary to derive the implications for the relative wage.
Perform this derivation analytically. (Hint: You may hereby use the lecture notes.)

(iii-iv) The preferences for traded goods are expressed by the mentioned Cobb-Douglas
1 
subutility and formalized by the function U T = exp  ∫ ln c ( z ) dz  . The corresponding price-index
0 
1 
derived from solving the expenditure minimization problem is P = exp  ∫ ln p ( z ) dz  . Use this
0 
information to show that the price-index for traded goods in this version of the DFS-model is
1
 1 −
given by=
P exp −  ⋅ Τw−θ + Τ * w *−θ  θ . (Hint: You may hereby use the lecture notes.)
 θ

(iii-v) Calculate the change in the price index of traded goods that occurs with the elimination
of the trade deficit both analytically and numerically! (Hint: You may hereby use the lecture
notes.)

(iii-vi) Define the real wage under the assumed Cobb-Douglas preferences. Calculate the
change in the real wage associated with an elimination of the deficit! (Hint: You may hereby
use the lecture notes.)

(iii-vii) Calculate what the elimination of the deficit implies for the tradables sector share of
GDP! (Hint: You may hereby use the lecture notes.)

Tutorial International Trade and the Multinational Firm – Winter Term 2021/22