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International Mobility of Labour and Capital


SUBJECT 1: International Mobility of Labor and Capital

  1. Amount of capital and labor.

The amount of labor and capital used in each industry must add up to the total for the economy, so


We have that  and  so


From these two quotations we can find  and  :


From the above we have:


  1. Amount of capital and labor.

The amount of labor and capital used in each industry must add up to the total for the economy, so


We have that  and  so


From these two quotations we can find  and  :


From the above we have:


  1. Amount of capital and labor.

The amount of labor and capital used in each industry must add up to the total for the economy, so


We have that  and  so


From these two quotations we can find  and  :


From the above we have:


  1. Rybczynski theorem.

Comparing parts a and part b, the increase in the amount labor in the economy has increased the amount and capital devoted to textiles (Lt=125, Kt= 250) and decreased the amount of labor and capital devoted to automobiles. Therefore, the output of textiles increases and the output of automobiles decreased, due to the overall increase in labor. Textiles are labor- intensive because they use 2 units of capital per unit of labor and automobiles are capital- intensive because they use 10 units of capital per unit of labor (Png, 2002).

The change in outputs is in accordance with the Rybczynski Theorem so the increase in labor has increased the output of the labor-intensive good and decreased the output of the other good.

Comparing (b) with (c) there is an increase in the amount of capital in the economy. In accordance with the Rybczynski Theorem there has been a rise in the amount of labor and capital devoted to automobiles production and a fall in the amount of capital devoted to textiles production.

SUBJECT 2: International Mobility of Labor and Capital

  1. Net gain HO

Home Foreign

OH Κη Ko K* Kf OF

The country’s Home output increases by area KoK*GR but also “Home” has more cost for acquiring further capital from “Foreign” and this cost is area KoK*GS, so the net gain in country HO is:

  1. Net gain FO

The country’s Foreign output decreases by area KoK*GC but also “FO” gains for selling more capital to ”HO” and this gain is area KoK*GS, so the net gain for “FO” is:

  1. World net welfare

The world net welfare is the sum of the “HO” net gain and the “FO” net gain so the world net welfare is:


World net welfare is


  1. Debit and Credit transactions.

In the following table we can see the effects in credit and debit of Greek balance of payments of the four transactions that we have:

Transactions Credit Debit
Japanese purchase of Greek Treasury bonds

Japanese payment using Thessaloniki account

x x
Greek citizen consumes a meal in Paris

Paying the meal with Visa card

x x
Gift to parents living in Sofia

Receipts of the check by parents

x x
Export of programming service

British payment out its account in Greece

x x
  1. Purchasing power parity (PPP)

The theory of absolute equivalence of purchasing power parity , based on the law of one price, is a theory of exchange rates whereby a unit of any currency should buy the same quantity of goods in each country (Appleyard et. al., 2006).

In other words, the price of a product in the domestic market at the time t must be equal to the price of the product in a foreign country in the same period , at the current exchange rate. If there are no trade restrictions and other transaction costs, the law of one price must be true, otherwise it will create opportunities for arbitrage. However, the law of one price should apply only to goods traded internationally (Png, 2002).

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The absolute equivalence of purchasing power enforces the law of one price in a basket of goods considered to represent the consumption of an average consumer in a given country and is used to calculate price indices. That is, general price levels determine exchange rates.

Limitations of the purchasing power parity

The purchasing power parity :

  • focuses only on trade and price levels
  • assumes absence of commercial friction
  • are unlikely to apply when the prices of domestic and foreign markets represent different baskets.
  • assumes that prices and exchange rates are flexible.
  • does not apply to goods that are not easily transferred between countries
  • does not apply to goods and services that are not perfect substitutes.

The absolute purchasing power parity assumes the absence of transport costs , tariffs or other barriers to the free movement of trade , so the relevant version of this theory comes to fill the gap. The relative purchasing power parity says that the rate of change in product prices should be similar when measured in a common currency, provided that the cost of transport and the various barriers to trade remain unchanged. As there are no changes in transportation costs, trade barriers, etc. , the change in the exchange rate should be approximately proportional to the change in the ratio of the general price levels of two countries. The relative purchasing power parity is often used to classify a currency as overvalued or undervalued. The term overvalued or undervalued suggests that exchange rates should not be what is in free foreign exchange market (Png, 2002).

According to purchasing power parity, should not be underestimated the domestic currency. If depreciate less than advises purchasing power parity, the domestic currency is overvalued and if the domestic currency depreciated more than stating the purchasing power parity , the domestic currency is undervalued (Varian, 2006).

The relative purchasing power parity does not mean that it is not easy to predict the exchange rate, but the quality depends on the quality of forecasting price levels in both countries. Without such price changes, a company faces no real foreign exchange risk from its operation. Thus the distinction between the nominal rate and the real exchange rate is very important because they have different implications for the foreign exchange risk (Appleyard et. al., 2006).

There are serious indications against the validity of PPP in the short term . Short term exchange rates are adjusted very quickly to imbalance, but long-term contracts and price agreements make many prices in the economy sticky prices, both in the short and medium term.

So as prices, trade and arbitrage goods meet with dullness, the purchasing power parity is not foolproof. Long term, however, there is evidence supporting the purchasing power parity , since countries with persistent positive differences in inflation rates tend to see a devaluation of local currencies.

Similarly, in the long term, countries with persistent negative differences in inflation rates tend to see an appreciation of local currencies. Over time, the relative price levels of importance. It should be noted that the assumption of equivalence of purchasing power is not a complete theory, it simply describes a relationship . Also the relation holds and vice versa, ie a change in the exchange rate will affect the price levels and vice versa (Varian, 2006).

A practical application of PPP

Many analysts use the exchange rate dictates the equivalence of purchasing power to compare key sizes between different countries. Moreover, the rates dictated by purchasing power parity is more stable than the market rates and thus large changes in market rates do not affect too much the valuations of financial fundamentals (Appleyard et. al., 2006).


  1. Forward exchange rate.

A forward contract in foreign exchange (currency forward or forward exchange contract) is an agreement between a bank and a client (or another bank ) to deliver a given amount of foreign currency at a given time in the future , but at a rate to be agreed to once the contract is made.

This rate is a forward rate. In every contract there are two positions: the buyer (long position) and the seller (short position). Futures contracts are used for three reasons (Appleyard et. al., 2006):

  • for compensation and coverage of risk and uncertainty (hedging)
  • peculation (speculation), ie buying and selling for profit and
  • for arbitrage, ie attempt to profit without risk

In fixed exchange rate the government sets the exchange rate, perhaps after international consultations and the supply and demand determine the baseline exchange rate. When the official exchange rate is higher from the base, then we say that the exchange rate is overrated. The country can devalue its currency, reducing the exchange rate at the basic level. The country may put restrictions on international transactions to reduce the supply of currency foreign exchange market, thereby increasing the basic exchange-rate (Png, 2002).

The forward exchange market allows ability to cover its foreign currency risk caused by changes in the exchange rate.

The determination of the forward price is formed by three main factors (Png, 2002):

1. The difference between domestic interest rates from foreign

2. The duration of the forward transaction f

3. and parity spot.

This means that the determination of the forward rate is determined by the behaviour of investors in the forex market. If the futures market force F-S / S> 0, then an investor borrows € with which to buy $ sided market and since then lend, sells the value of its investment futures market. Dollars buy more euros in forward market than in the spot market. The opposite if F-S / S <0.

Covered interest arbitrage is usually carried out by commercial banks pursuing profits (large) exchange transactions due discrepancies between different interest rates and exchange rates, minimizing their foreign exchange risk.

The covered (forward) interest rate parity is:


iD is the interest rate in domestic country

iF is the interest rate in foreign country

St is the current spot exchange rate at time t

Ft is the forward exchange rate at time t

The domestic interest rate is

  1. Exchange rate and interest rate comparisons

By free rate is meant a system of a fixed rate based on the forces of supply and demand. The exchange rate is that the equilibrium of supply and demand for a currency. Market participants continuously adjust their expectations and needs for foreign currency assessing and responding to any available information or new news. As a result, when changing expectations for inflation rates, interest rates, economic growth, the relevant government policies, etc., ie quantities that affect supply and demand for a currency, we adjusted the rate and equilibrium.

In such a system the exchange rate fluctuations will be random, as long as may be determined by the random flow of information to the market.

If the government adopts a flexible exchange rate and market participants expect the exchange rate to depreciate from its current value e0, then they will not invest in the currency that it will be depreciated. The exchange rate will be uncovered and equal to

and the domestic interest will be

The exchange rate compare to e0 is lower. The depreciation in exchange rates leads to lower interest rates in the domestic country and the domestic interest rate compare with i* is lower.

  1. Domestic interest rate after devaluation.

If the financial participants believe that the government is credible and there will be no further devaluation then they will buy the devaluated currency in low interest, they will change it to the appreciated currency that has higher interest and they will lend in the higher interest. Then they will take the profits and exchange them in the domestic currency in the expected exchange rate and they will have gain from the arbitrage. The domestic interest rate after devaluation will be increased (Varian, 2006).


  1. Png, I.(2002), Managerial Economics, 2nd edition, Blackwell Publishers Ltd, 2002.
  2. Appleyard A., Field, C. & Cobb T. (2006). International Economics (5th ed.). McGraw–Hill Irwin
  3. Varian, H.R.(2006), Intermediate microeconomics: a modern approach (7 ed.), WW.Norton &Company, New York.
  4. Agiomirgiannakis G.M,Vlassis M., International EconomicEnviroment, HOU PROJECT TEAM publications, Patras 2005.
  5. Krugman P.,Obstfeld M.,Melitz M.,International Economics theory and policy,9th edition, PEARSON, Boston 2012
  6. http://en.wikipedia.org/wiki/Purchasing_power_parity


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