1. Production possibilities curves (PPCs) show that while China has an absolute advantage in both shoes and cloth, India has a comparative advantage in shoes since they can produce shoes at a lower opportunity cost than China. 2. Free trade leads to countries specializing in what they have a comparative advantage in. With free trade in corn, the domestic country produces Q1 quantity at the world price while importing Q1Q2 quantity. 3. A subsidy on domestic wheat production shifts the domestic supply curve downward, reducing imports from Q1Q2 to Q1Q3 while increasing domestic production from Q1 to Q3.

1. Production possibilities curves (PPCs ) to show comparative advantage 3 Shoes (pairs) China 2 India 0 5 12 Cloth (meters)

2. Comparative Advantage China has an absolute advantage in the production of both shoes and cloth. It can produce more of both than India with the same factor inputs. However, India has a comparative advantage in producing shoes, since they only give up 2.5 meters of cloth for each pair, whereas China gives up 4 meters of cloth. China should specialize in cloth and India should specialize in shoes.

3. Free Trade in Corn D Sdomestic Price of corn ($ per tonne) Sworld Q1 Qe Q3 Quantity of Corn (tonnes)

4. Free Trade Before trade, Qe corn is produced domestically at a price of Pe. When free trade takes place, Q1Q2 of corn is imported at the world price of Pw, and Q1 of corn is produced domestically.

5. A subsidy on domestic wheat production Sdomestic D Sdomestic + subsidy Price of corn ($ per tonne) Sworld Q1 Q3 Q2 Quantity of Corn (tonnes)

6. Subsidy When the government gives a subsidy to domestic producers, the domestic supply curve shifts downwards from Sdomestic to Sdomestic + subsidy. The price to consumers remains the same, but imports fall from Q1Q2 and domestic production increases from Q1 to Q3.

7. A tariff on corn imports Sdomestic D Price of corn ($ per tonne) Sworld+ tariff Sworld Q1 Q3 Q4 Q2 Quantity of Corn (tonnes)

8. Tariff The imposition of a tariff upon imported corn means that the price will rise from Pw to Pw + tariff. Imports will fall from Q1Q2 to Q3Q4 and domestic production will increase from Q1 to Q3.

9. J-Curve Z Current account surplus 0 Time X Current account deficit Y

10. J-Curve The country has a current account deficit and is at X on the diagram. The exchange rate of the currency is lowered to rectify this. In the short term, because of existing contracts and imperfect knowledge, the deficit worsens to Y. However, in the long term, if the Marshall-Lerner condition is fulfilled, export revenue will begin to increase and import expenditure will start to fall. The current account deficit will get smaller, moving in the direction of Z on the diagram.

11. A floating currency S (of PoundfromUK) 1 Pound = 1.26 Price of Pound in Euro D (for Pound from EU) Q 0 Quantity of Pound

12. Floating Currency The exchange rate of the pound against the Euro is being determined solely by the demand for the pound and the supply of it. In this case, the exchange rate will be 1 pound = 1.26 euros.

13. An increase in the demand for the Pound S 1.37 Price of Pound in Euro 1.26 D2 D1 Q 0 Quantity of Pound

14. An increase in the demand for the Pound The demand for the pound has increased from D1 to D2. this may have been caused by an increase in UK interest rates, increased demand for UK products, speculation that the pound will increase in value, or a more favorable investment climate in the UK. In all cases, EU citizens will want more pounds, thus increasing the demand for the pound on the foreign exchange market. The exchange rate of the pound will rise to 1 pound = 1.37 euros.

15. An increase in the supply of the Pound S1 S2 Price of Pound in Euro 1.26 1.15 D 0 Quantity of Pound

16. Increase in supply The supply of the pound has increased from S1 to S2. this may have been caused by an increase in foreign interest rates, increased demand for foreign products, speculation that the pounds will decrease in value, or amore favorable investment climate in foreign countries. In all cases, UK citizens will want more foreign currency, thus increasing the supply of pounds on the foreign exchange market. The exchange rate of the pound will fall to 1 pound = 1.15 euros.