Economic Assignment Exploring The Theory Of Comparative Advantage
Critically distinguish between the Ricardian concept of comparative advantage and the Heckscher-Ohlin model. (25 marks)
Assume a two-country, two-good, two-input model. Let the countries in the model be the United States and the Rest of the World and the goods be steel and wheat. The two factors of production are capital and land. Further, the United States is capital-abundant and steel production is capital-intensive. Suppose, in the absence of trade, the United States operates at a point on its productionpossibility curve where it produces and consumes 20 units of wheat and 20 units of steel. Once it engages in free trade, the international price of one unit of steel is two units of wheat. In response to the opening of trade, the United States moves along its production-possibility curve to a new point where it produces 30 units of steel and 10 units of wheat. Is the United States better off following the opening of trade? Illustrate with a diagram and provide a clear explanation for your answer.
Using the UK as an example, explain how a country that is running a deficit in its current account must ‘finance’ this deficit by borrowing from foreigners. (25 marks)
Suppose that the three-months interest rate in New York is 5 percent and the three-months interest rate in London is 4 percent, and that the spot rate is £0.50/$ (e=d/f ) and the threemonths forward rate is £0.47/$ (eF =d/f). If UK is the domestic country, calculate the covered interest differential. On the basis of this result, which country would you expect to face capital inflows and which one would face capital outflows? Explain by referring to the relevant concepts.
Differences between the Richardian model of comparative advantage and the Heckscher-Ohlin Model
Comparative advantage is an economic term explored in the segments of economic assignment, which means ability of economy to engage in business with each other, exporting the products that they have comparative advantage in productivity (Gumpert, & Wink, 2020). With this aspect of economic assignment, theory of comparative advantage is explained by Richardian model as well as H-O model is different aspect, which is explained as below -
- The Richardian model of comparative advantage suggests that nation expertise in manufacturing products and services that they can do best. Further, it assumes that there is only one factor of production, which is labor (Soo, 2017). On the other hand, H-O model states that there is two factor of production, namely capital and labor.
- According to Richardian model examined in the economic assignment, due to differences in productivity of labor, business takes places among two countries. Further, differences in labor arise because of variation in technology (Jones, 2017). Moreover, comparative advantages according to the Richardian model takes place because two nations avail mutual benefits from trade as they expertise in production of product for which they have comparative benefits. On the other hand, as per H-O model, one nation has comparative advantages over other nation due to variation in connected amounts in every factor. It can be said that, H-O model emphasizes on efficiency in the manufacturing process. Since, country engages in production of those goods, which they have significant amount of resource required for production. By this, they can manufacture goods in cheapest manner. Along with above aspect, Richardian theory is applicable in short-run. The reason behind the same is that, variation in productivity of labor takes place because of changes in technology, and technology can change worldwide as passes of time (Mathur, Arora, Singh, & Roy, 2017). On the other hand, it is also stated herein economic assignment that H-O model assumed that in the long run national have same technology.
Factors of production
A nation can grab the comparative advantages when it can produce the goods at lower prices as compared to another nation (Zhang, 2016). With this aspect, a country can gain comparative advantage on the basis of availability of resources. This is well suggested in the H-O model. As per this theory there are two factors of production is required (Ruiz Napoles, 2020). In the present case scenario of economic assignment, it has been seen that land and capital are two factors of production, and United States and Rest of the world is considered as two countries. Since, steel is capital intensive product and US is capital abundant country. By the application of H-O theory, it is suggested that US should produce more steel because it is abundant capital as steel required more capital as compared to the wheat (Smith, Jamiyansuren, Kitsuki, Yang, & Lee, 2018). Before, open trade, US produces 20 units of wheat and 20 units of steel, however after opening up free trade it produces 30 units of steel and 10 units of wheat. Since, international price is one unit of steel is equivalent to two units of wheat.
(K/L)U.S> (K/L) ROW
(K/L) Steel> (K/L) Wheat
Here, (K/L) in the United States, is the capital land ratio, and (K/L) ROW, shows capital land ratio of Rest of World. Further, (K/L) Steel shows that capital land ratio in the production of steel and (K/L) wheat shows that capital land ratio in the production of Wheat.
Before opening of free trade, total units in United States is 20 units of steel, and 20 units of where, which is equivalent to 30 units of steel, and after opening up of free trade, 30 units of steel and 10 units of wheat, which is equivalent of 35 units of steel. On the basis of above graph provided within the economic assignment, it can be said that, US would definitely well off by opening of trade. The reason behind the same is that, the US produce and export steel, which is capital intensive and inexpensive as compared to other factor.
Borrowing from foreigners by UK
The government of UK faces the current account deficit when the value of import of goods and services is more than the value of export of its goods and services. The deficit in current account may be set off by obtaining borrowings from the foreigners (Panda, Sethi, & Chaudhuri, 2016). There are a number of reasons mentioned in the economic assignment, which assists the UK government to take loan from foreigners, which are explained as below –
- Loan from foreigners would provide government of UK to access to financial capital for fund investment. The issuance of foreign currency debt is a mechanism of financing of local investment which is not possible in other manner if there is low extent of domestic demands for bonds, as well as if there is less domestic saving (Qi, Roth, & Wald, 2017). There are a number of benefits from this investment. It would assists in creation of employment and also generates revenue, which provides the benefits to government in terms of enhanced tax revenue, and customers who archives significant level of profits. Along with this, investment leads towards improvisation in the national profit of the nation and consequently gross domestic product per capital would increase. Overall, it reflects about improvised welfare of employees along with productivity level of the labor. Therefore, based on the analysis done within the economic assignment it can be said that if UK finance its current account deficit from taking loan to foreigners, then it would increase overall development.
- Another reason for obtaining loan from foreigners is that it would enhance the financial globalization. It is usual, that issuing of foreign currency debt assist the government with respect to improvisation of polices, rules and regulations, which assist its extent of dominant risk does not restrict the debt issuance or flow of equity in the nation. Therefore, it is very significant for the government to take into account economic as well as financial management system of the borrowing nation. It can be said in the context of this economic assignment that, increased financial globalization assists towards more improvised public and corporate governance, along with application of policies on macroeconomic policies. Further, enhanced governance and proper monetary management leads towards economic growth and stability in nation.
- Afterwards, taking loan from foreigners is also considered as powerful commitment mechanism. The government of UK can made incredible relationship with foreigners, which provides several benefits.
Government of UK can set off its current account deficit by taking loan from foreigners. It has been seen that borrowing from foreigner provides several benefits to the country, companies, as well as individual level.
Covered interest differential
Interest rate parity explored in this section of economic assignment is a mechanism that assists about the powerful connection among rate of interest and movement in the values of currency of nations. Uncovered interest rate parity takes place when there is no contracts connected to the forward interest rate, rather than parity is founded only on spot exchange rate (Du, Tepper, & Verdelhan, 2018). There are some assumptions in the covered interest rate parity such as –
- Covered interest rate parity keep into an impact of a no-arbitrage condition that mitigate all probable impact of opportunities to generate risk-free profits from all over the globalized market (Avdjiev, Du, Koch, & Shin, 2019).
- It has been assumed by covered interest rate parity that two assets are same in all aspect excluding their currency in which they are dominated.
- This theory works as per the assumption that difference in the rate of interest of two assets in the forward market must be equals to zero in continuous manner.
Along with above aspects of economic assignment, rate of interest of countries, value of currency, associated cost, also creates impact on mind set of investors. With this aspect, if any country has low rate of interest as compared to other country, then in such case investor would borrow the money from nation that offers low interest rate, and invest this amount in such assets that provides higher rate of return. Along with this, if there is undervaluation or depreciation of currency, then in such case capital flight would take place. If contrary situation take place, then in such case capital inflow would happen.
In the present case of economic assignment, three months rate of interest of New York and London is 5% and 4% respectively. The UK is the domestic currency. Further the spot rate is 1 £ = 2$.
Computation of covered interest differential
In the above formula, domestic current interest rate reflected by Id, foreign current interest arte shown by If. F and S show the current spot rate, and forward rate.
Covered interest rate parity –
(1+0.04*3/12) = F/2(1+0.05*3/12)
F = 2
That is, 1 £ = 2$.
Table 1 Forward rate
Quoted three months forward rate
1 £ = 2.13$
Three months forward rate by covered interest rate parity
1 £ = 2$
On the basis of above rates provided within the economic assignment, it can be said that currency value of Pound is depreciated, and on the other hand, the currency value of $ is appreciated. Further, if there is devaluation in currency, then generally investors run away from those countries. Thus, it has been concluded that UK would face capital outflow and US would face capital inflow.
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