Topic 6: The 1-2-3 Model

Question 1

How many goods does the 1-2-3 model have? Why is this an advantage over the Salter model?

Answer 1

X - imported, foriegn produced product

Y - Produced at home for export only

N - Non tradeable home product

This allows us to consider changes in the prices of import and export products relative to each other.

Question 2

How is the real exchange calculated in the 1-2-3 model?

Answer 2

Question 3

What is the normal numeraire in the 1-2-3 model?

Answer 3

X, the exported good!

Question 4

In the 1-2-3 model, what is the equation for the terms of trade?

Answer 4

C_X = KA + p_YY

Question 5

How is the 1-2-3 model diagram drawn? Show the final diagram.

Answer 5

First draw the BOP & C_N=N quadrents.

Then draw the production frontier. Now trace it along and draw the consumption possibility frontier - which is the same shape, but shifted & magnified on the C_X axis.

Now pick an equilibrium on the consumption frontier and trace it back to the production quadrant.

Question 6

What endogenous variables cause the real exchange to change in the 1-2-3 model?

Answer 6

e_R ​α P_Y, P_N

So if there is an increase in P_Y but decrease in P_N, or vise versa, the change is ambigous

Question 7

Show the affects of a resource boom in the 1-2-3 model

Answer 7

We assume leontiff preferences (or we could assume both goods are normal).

As P_N increases, there has been a real appreciation

Question 8

Show the affects of a surge in net inflows on the capital account in the 1-2-3 model.

Answer 8

Production shifts towards N.

P_Y/P_Y increases, so w/r increases.

There is also a real appreciation.

Question 9

What is the affect of an increase in the export price in the 1-2-3 model?

Answer 9

still an increase in production of N relative to X, increase in the price of P_N relative to P_X.

So even though the price increase is for capital intensive goods, a subsiquent even greater price increase of non tradeables means wage rises dominate rent rises. (In the model, at least).

Question 10

How do real exchange rate increases as considered in the Salter & 1-2-3 model manifest?

Answer 10

As e_R = E P_Y/ P_Y*

We consider P_Y* to be exogenous, dependent on foriegn monitary policy.

So then a real appreciation is split between an increase in the exchange rate E, and prices P_Y. The split will depend on monitary policy in the local economy. If prices are maintained, then the whole increase will occur through the exchange rate.