Question

% per year % per year - - L - - L - - L - - L - - L - L - L L - L L - - L - L - L - L - - L - - L - - L - - L - - L - - L - - L - - L - - L - --L--L--L--L--L--LLLL - - L - - L - - L - - L - - L - - L - - L - - L - - L - - - L - - - -- J-- --r- - LLL LLLLLLLL -r-r- -r--r-er --r - - -r--r --r -- - - L --r -r - --L --L --L --L --L --L --L --L - --L --L --L --L --L --L -- --L --L --L --L --L --L --L - - - - - L - - L - - --L--L-- LL - LL- LL - - L - - L - L - - L -- ENW A u ovo vo FHü -- --r- - L - - L - - - - L --L --L --L --L -- --L X -L--L- --L --L --L --L --L --L -- -- -- -r--r-- --L --L -- L - -L - -L --L - -L - -L --L - - L L- - - - L - - - -L --L --L --L --L--L- -- -- --r --r--r--r--r--r--r- L --L --L --L--L --L --L --L --L - --L--L --L--L--L--L --L--L --L --L --L- -- -- L --L --L - -L --L --L - -L - - L L --L --L --L --L --L --L - L - - L - - - L - - L - - L- -- -- -- - - L - - L --r-- -- --r MPK poor MPKR r 7- - --- -- 0 2 4 6 18 20 22 24 19 21 23 1 3 8 10 12 14 16 7 9 11 13 15 17 Units of capital (Thousands) 5

Assume factor price equalization does not hold. The world has 24,000 units of capital and two countries, Rich and Poor. The diagram above shows the marginal product of capital in each country. The horizontal axis shows the allocation of the 24,000 units of capital to Rich from left to right and to Poor from right to left. So, for example, if Rich has 14,000 units of capital, Poor has 24,000 - 14,000 = 10,000 units of capital.

Suppose initially that Rich and Poor prohibit international investment. Rich has 19,000 units of capital.

a. What will be the interest rate in Poor? In Rich? Briefly explain.

Suppose Rich and Poor remove all restrictions on international investment between them and investors in both countries are interested only in maximizing the return on their investments.

b. How much (net) international investment will there be over time, between Rich and Poor? Does capital flow from Poor to Rich or from Rich to Poor. Briefly explain.

c. Identify the area in the graph that corresponds to (i) the net increase in Poor’s income that results from the international investment you described in part (b). (ii) the net increase in Rich’s income that results from the international investment you described in part (b).

Answer 1

Points to note:

1)The diagram above shows the marginal product of capital in each country. (MPK poor)represents poor country & (MPK Rich) represents Rich country

2.The horizontal axis shows the allocation of the 24,000 units of capital to Rich from left to right and to Poor from right to left. So, for example, if Rich has 14,000 units of capital, Poor has 24,000 - 14,000 = 10,000 units of capital.

Ans a) When International Investent is prohibited and Rich has 19000 units of capital it means Poor countrty is left with 24000 - 19000 = 5000. At 5000 units of capital interest will be calculated corresponding to the point on MPK poor curve. Calulating 5000 i.e coresponding to 24000 - 5000 = 19000  from left to right the point corresponding will be at 10 % rate of return. at the same level inerest for Rich Country corresponding to point on  (MPK Rich) curve will be 3 % . This is because Marginal productivity of capital for Poor country At 5000 level is high and for Rich country at 19000 is lower.

b) when Rich and Poor remove all restrictions on international investment between them and investors in both countries are interested only in maximizing the return on their investments then movement of capital will start from a country which has surplus capital which in this case is Rich. The movement of capital from Rich Country will continue to poor country till Marginal product of capital  and Rate of Interest for each country becomes equal i.e Corresponding to 13000 units. ie there will be movement of 19000 - 13000 = 6000 units of capital from rich to poor making 11000 units of capital invested in poor country.

c)

% per year % per year - - L - - L - - L - - L - - L - L - L L - L L - - L - L - L - L - - L - - L - - L - - L - - L - - L - - L - - L - - L - - --L--L--L--L--L--LLLL - L - - L - - L - - L - - L - - L - - L - - L - - - L L 7 - - - - L - - - - - -- --r- - - LLL L -r--r-er J -- -- --r - - -r--r - - --r --r--r--r--retreat --r -r --L --L --L --L --L --L --L --L - --L --L --L --L --L --L - - - L - - L - - L - - - - L - - L - - --L --L --L --L --L --L --L - L - L ENW A u ovo vo FHü -- -- --L --L -- - - L --L --L --L --L -- - - L - - L - - L -- -- --L --L-- L -L --L --L - -L --L - -L - - L L - A -- -- -- - -- -- L --L --L --L --L --L --L --L --L - --r--r--r--r--r--r- -L--L- - - L - - L - - L- -- L --L --L --L --L --L --L -- L L --L--L--L-UL - L - - L - - L- - -- -- -- - - - L - - L - -- - --r -- -- - -- - - MPK poor MPKid r L- LL- 7- - -- -- 0 2 4 6 18 20 22 24 19 21 23 1 3 8 10 12 14 16 7 9 11 13 15 17 Units of capital (Thousands) 5

1. Blue Area represents gain to poor country

2. Red area represents gain to rich country