S6 Economics Practice Paper: International Trade and Exchange Rates

Countries A and B each use 100 labour hours. Country A can produce 25 electronic parts or 50 pieces of textile; Country B can produce 10 electronic parts or 40 pieces of textile. In autarky each country splits its labour equally between the two goods.

(a) Calculate the opportunity cost of one electronic part and of one piece of textile in each country. (3 marks)
(b) State the comparative advantage of each country and explain. (2 marks)
(c) If the terms of trade are 1 electronic part for 3 pieces of textile and Country A uses all 100 hours for electronic parts, trading 10 parts for textile, calculate its gains from trade. (2 marks)

(a) Country A: 1 electronic part costs 50 / 25 = 2.0 textiles; 1 textile costs 25 / 50 = 0.5 electronic part. Country B: 1 electronic part costs 40 / 10 = 4.0 textiles; 1 textile costs 10 / 40 = 0.25 electronic part. (3 marks)
(b) Country A has a comparative advantage in electronic parts because its opportunity cost (2.0 textiles) is lower than Country B (4.0). Country B has a comparative advantage in textiles because its opportunity cost (0.25 parts) is lower than Country A (0.5). (2 marks)
(c) Autarky: 12.5 parts and 25 textiles. Specialising gives 25 parts; trading 10 parts for 30 textiles leaves 15 parts. Gains: +2.5 parts and +5 textiles. (2 marks)

A small open economy has domestic demand Qd = 120 – P and domestic supply Qs = -40 + 2P for electronic parts, with quantity in thousands and price in dollars. The world price is $40 and the government imposes a specific tariff of $10 per unit.

(a) Calculate the domestic price and import quantity before and after the tariff. (2 marks)
(b) Calculate the changes in consumer surplus and producer surplus. (3 marks)
(c) Calculate tariff revenue and the deadweight loss caused by the tariff. (2 marks)

(a) Before: price $40, demand 80 thousand, supply 40 thousand, imports 40 thousand. After: price $50, demand 70 thousand, supply 60 thousand, imports 10 thousand. (2 marks)
(b) Consumer surplus falls from $3,200 to $2,450, a loss of $750. Producer surplus rises from $400 to $900, a gain of $500. (3 marks)
(c) Tariff revenue = 10 x 10 = $100. Deadweight loss = 750 – 500 – 100 = $150 (production distortion $100 plus consumption distortion $50). (2 marks)

An economy has a base-year export price index of 100 and import price index of 100. Next year export prices rise 8%, import prices rise 14%, and export volume rises 6%.

(a) Calculate the terms of trade index next year. (3 marks)
(b) State whether the terms of trade improved or deteriorated and by how much. (2 marks)
(c) Calculate the income terms of trade index and state its direction of change. (2 marks)

(a) Terms of trade index = 108 / 114 x 100 = 94.74. (3 marks)
(b) It deteriorated by 5.26%: import prices rose faster than export prices, so each unit of exports buys less imports. (2 marks)
(c) Income terms of trade = 108 x 1.06 / 114 x 100 = 100.42, up 0.42%, as higher export volume offsets the price deterioration. (2 marks)

A Hong Kong exporter sells electronic goods to a European client for EUR 20,000, with a production cost of HKD 140,000. The exchange rates are EUR 1 = USD 1.10 and USD 1 = HKD 7.80.

(a) Calculate the EUR/HKD cross rate. (2 marks)
(b) Calculate the export profit in HKD and the profit margin. (3 marks)
(c) If the HKD appreciates to USD 1 = HKD 7.50 while EUR/USD is unchanged, recalculate the margin. (2 marks)

(a) EUR/HKD = 1.10 x 7.80 = 8.58. (2 marks)
(b) Revenue = 20,000 x 8.58 = HKD 171,600; profit = 171,600 – 140,000 = HKD 31,600; margin = 31,600 / 171,600 = 18.41%. (3 marks)
(c) New rate 1.10 x 7.50 = 8.25; revenue HKD 165,000, profit HKD 25,000, margin 15.15%. The appreciation cuts revenue by HKD 6,600 and the margin by 3.26 percentage points. (2 marks)

The same basket of goods costs HKD 46 in Hong Kong and USD 5.2 in the United States. The market exchange rate is USD 1 = HKD 7.80.

(a) Using absolute purchasing power parity, calculate the theoretical USD/HKD rate. (3 marks)
(b) State whether the HKD is overvalued or undervalued against the USD and by how much, using the PPP rate as the base. (3 marks)
(c) Give two reasons why PPP deviates from the market rate in the short run. (2 marks)

(a) PPP rate = 46 / 5.2 = 8.85 HKD per USD. (3 marks)
(b) The market rate (7.80) is below the PPP rate, so the HKD is undervalued by (8.85 – 7.80) / 8.85 x 100 = 11.8%. (3 marks)
(c) Non-traded goods cannot be arbitraged; transport costs and tariffs; brand and quality differences; capital flows and interest rates affect the market rate. (any two, 2 marks)

The one-year HKD deposit rate is 4.5% and the one-year USD deposit rate is 2.0%. The spot rate is USD 1 = HKD 7.80 and the bank can borrow and lend freely in both currencies.

(a) Using interest rate parity, calculate the theoretical one-year forward rate. (3 marks)
(b) Calculate the forward premium of the USD against the HKD in percentage terms. (3 marks)
(c) If the market one-year forward rate is 8.05, calculate the arbitrage profit per USD (borrow HKD, buy USD, invest, sell USD forward) and state the direction of adjustment. (2 marks)

(a) Forward rate = 7.80 x 1.045 / 1.020 = 7.9912, about 7.99. (3 marks)
(b) Forward premium = (7.9912 – 7.80) / 7.80 x 100 = 2.45%, matching the 2.5% interest differential. (3 marks)
(c) Borrow HKD 7.80, buy USD 1, invest at 2% to get USD 1.02, sell forward at 8.05 for HKD 8.211; repay 7.80 x 1.045 = HKD 8.151; profit HKD 0.06 per USD. Forward selling pushes the forward rate down toward 7.99. (2 marks)

The balance of payments of an economy (in billions): goods exports 4,200, goods imports 4,600, net services 350, net income -120, net transfers 30; non-reserve financial account: net FDI inflow 200, net portfolio inflow 80, net other investment outflow 100.

(a) Calculate the current account balance. (3 marks)
(b) Calculate the net non-reserve financial account. (2 marks)
(c) Calculate the change in reserve assets and state whether reserves rose or fell. (3 marks)

(a) Current account = 4,200 – 4,600 + 350 – 120 + 30 = -140 billion (deficit). (3 marks)
(b) Net non-reserve financial account = 200 + 80 – 100 = +180 billion. (2 marks)
(c) Change in reserves = -(CA + FA) = -(-140 + 180) = -40 billion, so reserve assets rose by 40 billion and the accounts balance. (3 marks)

An economy has exports of 100 billion and imports of 120 billion. The absolute price elasticity of export demand is 0.6 and that of import demand is 0.5.

(a) Calculate the initial trade balance. (2 marks)
(b) Test whether the Marshall-Lerner condition holds and explain its implication. (3 marks)
(c) After a 10% depreciation, export volume rises 6% and import volume falls 5% while prices are unchanged; calculate the new trade balance and the improvement. (3 marks)

(a) Trade balance = 1,000 – 1,200 = -200 billion. (2 marks)
(b) 0.6 + 0.5 = 1.1, which exceeds 1, so the Marshall-Lerner condition holds: depreciation improves the trade balance over time, though it may worsen first (J-curve). (3 marks)
(c) New exports = 1,000 x 1.06 = 1,060; new imports = 1,200 x 0.95 = 1,140; new balance = -80 billion, an improvement of 120 billion. (3 marks)

Hong Kong operates a linked exchange rate system with a strong-side guarantee of 7.75 and a weak-side guarantee of 7.85. On a certain day the market rate is USD 1 = HKD 7.88. Aggregate balance is HKD 50 billion and the money multiplier is 2.5. A bank holds USD 100 million.

(a) Explain how the bank arbitrages against the HKMA at the market rate of 7.88 and calculate its HKD profit. (3 marks)
(b) Calculate the effect of the HKMA operation on the aggregate balance and on money supply. (4 marks)
(c) Explain how arbitrage pushes the market rate back inside the convertibility band. (3 marks)

(a) At a market rate of 7.88 the bank sells USD in the market at 7.88 and buys USD from the HKMA at the 7.85 weak-side guarantee, earning HKD 0.03 per USD; on USD 100 million the profit is HKD 3 million. (3 marks)
(b) The HKMA sells USD 100 million and takes in HKD 785 million, so the aggregate balance falls from 50 billion to 49.215 billion; money supply falls from 50 x 2.5 = 125 billion to 49.215 x 2.5 = 123.04 billion, a fall of 1.96 billion. (4 marks)
(c) Continued arbitrage sells USD into the market and buys from the HKMA, adding USD supply and HKD demand; the shrinking aggregate balance also raises HKD interest rates and attracts inflows, pushing the rate back inside 7.75-7.85. (3 marks)

A Hong Kong exporter receives USD 500,000 with a production cost of HKD 3,600,000. A Hong Kong importer buys goods for USD 200,000 and sells locally at a fixed HKD 1,800,000. The exchange rate moves from USD 1 = HKD 7.80 to USD 1 = HKD 8.10.

(a) Calculate the exporter profit and margin before and after the depreciation. (4 marks)
(b) Calculate the importer profit and margin before and after the depreciation. (4 marks)
(c) State two methods the importer can use to hedge foreign exchange risk. (2 marks)

(a) Before: revenue HKD 3,900,000, profit HKD 300,000, margin 7.69%. After: revenue HKD 4,050,000, profit HKD 450,000, margin 11.11%, a rise of HKD 150,000. (4 marks)
(b) Before: cost HKD 1,560,000, profit HKD 240,000, margin 13.33%. After: cost HKD 1,620,000, profit HKD 180,000, margin 10.00%, a fall of HKD 60,000 (25%). (4 marks)
(c) Buy a forward contract to lock the rate; buy a USD call option; pay early or switch to local suppliers. (any two, 2 marks)

A country imposes a 20% ad valorem tariff on all imported electronic parts. The partner country produces at $90 per unit while the rest of the world produces at $80 per unit. Before the customs union the country imports 1,000 units; after forming a customs union with the partner, the import price falls and imports rise to 1,100 units.

(a) Calculate the import price before and after the customs union and the saving per unit. (3 marks)
(b) Decide whether this is trade creation or trade diversion and explain. (3 marks)
(c) Calculate the consumer gain, the loss of tariff revenue and the net welfare change. (4 marks)

(a) Before: domestic price = 80 x 1.2 = $96 (imported from the rest of the world); the partner price with tariff is 90 x 1.2 = $108, so it is not chosen. After: partner goods enter duty free at $90, saving $6 per unit. (3 marks)
(b) This is trade diversion: imports switch from the low-cost rest of the world ($80) to the higher-cost partner ($90) only because of the tariff difference. (3 marks)
(c) Consumer gain = 0.5 x (1,000 + 1,100) x 6 = $6,300; lost tariff revenue = 80 x 20% x 1,000 = $16,000; net welfare = 6,300 – 16,000 = -$9,700, a net loss. (4 marks)

A Hong Kong importer must pay USD 1,000,000 in three months. The spot rate is 7.82 and the three-month forward rate is 7.88. A USD call option with a strike of 7.85 costs HKD 0.02 per USD. The importer may remain unhedged, use the forward contract, or buy the option.

(a) Calculate the HKD cost using the forward contract. (2 marks)
(b) If the spot rate in three months is 8.00 or 7.70, calculate the unhedged cost and compare it with the forward cost. (4 marks)
(c) Calculate the maximum HKD cost of the 7.85 call option and state its advantage over the forward contract. (4 marks)

(a) Forward cost = 1,000,000 x 7.88 = HKD 7,880,000. (2 marks)
(b) At 8.00 the cost is HKD 8,000,000, i.e. HKD 120,000 more than the forward; at 7.70 the cost is HKD 7,700,000, i.e. HKD 180,000 less. The forward locks the cost and gives up the benefit of a fall. (4 marks)
(c) Premium = 1,000,000 x 0.02 = HKD 20,000; maximum cost = 1,000,000 x 7.85 + 20,000 = HKD 7,870,000. The option caps the cost while keeping the benefit of a cheaper spot rate, at the price of the premium. (4 marks)