Answer to Question 1
(See Section 7). The statement is true. The pressures come from three main sources: excess demand for output and labor; inflationary expectations; and, raw material prices.
Answer to Question 2
In this case, Home residents will buy a 50 percent share of the land in Foreign, and they will pay for it by giving Foreign residents a 50 percent share in Home land. Explain why. To understand why, think about the returns to the Home and Foreign portfolios when both are equally divided between titles to Home and Foreign land. When times are good at Home (and therefore bad in Foreign), each country earns the same return harvest, which is 75 every year with certainty.
Half of the Home harvest (100 ton of kiwi fruit) plus half of the Foreign harvest (50 tons of kiwi fruit) or 75 tons of fruit.
0.5 100 + 0.5 500 = 75.
In the opposite case-bad times in Home, good time in Foreign-each country still earns 75 tons of fruit.
Thus, we have shown that if the countries hold portfolios equally divided between the two assets, each country earns a certain return of 75 tons of kiwi fruit. This certain return is exactly the same as the average harvest each faced before international asset trade was allowed. This trade completely eliminates the risk faced by both countries without changing average returns. Assuming risk-averse individuals in both countries, the two countries are better off as a result of asset trade.
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